Dependent Care Exclusion for Sole Proprietors on Schedule C

MWW15lecture

Lecture at MidWest Writers Workshop

Question:  Can a sole proprietor deduct child and dependent care expenses directly on Schedule C as part of a dependent care benefit plan, rather than claim the dependent care credit on line 49 of Form 1040?

Answer:

Under a qualified dependent care benefit plan, an employer can exclude or deduct the following dependent care benefits:

  1. Amounts the employer paid directly to either the employee or the care provider for the care of the taxpayer’s qualifying person while the employee is at work.
  2. The fair market value of care in a daycare facility provided or sponsored by the taxpayer’s employer, and
  3. Pre-tax contributions the taxpayer made under a dependent care flexible spending arrangement.

The amount that can be deducted or excluded is limited to the smallest of:

  1. The total amount of dependent care benefits the taxpayer received during the year,
  2. The total amount of qualified expenses the taxpayer incurred during the year,
  3. The taxpayer’s earned income,
  4. The spouse’s earned income, or
  5. $5,000 ($2,500 if married filing separately).

An employee’s salary may have been reduced to pay for these benefits.  However, IRS Pub. 503 makes the statement that if the taxpayer is self-employed and receives benefits from a qualified dependent care benefit plan, then the self-employed individual (sole proprietor or general partner in a partnership) is both the employer and the employee.  In this case, the self-employed individual would not get an exclusion from wages.  Instead, the taxpayer would get a deduction on Form 1040, Schedule C, line 14.  To claim the deduction, the self-employed individual uses Form 2441 to support the Schedule C deduction.

Why is this significant?   Deductions taken on Schedule C directly not only lower your taxable income (and federal income tax) and your self-employment tax.

Caution:  If your Schedule C shows a loss before your dependent care exclusion, and Schedule C is your only source of earned income (in other words, you do not have wages from another employer-employee activity), the  dependent care exclusion will not be allowed when you complete Form 2441   If you are married, your spouse’s earned income, if lower than your dependent care exclusion, would also lower the deduction available.  Also, if you have other employees (not subcontractors) that work for you in your sole proprietorship (other than your spouse or dependent), you may not exclude them from your plan.  Get advice on this from your tax preparer, preferably a CPA or enrolled agent.

Since IRS Pub. 503 and the instructions to Form 2441 implicitly give a self-employed individual permission to deduct his or her expenses directly on Schedule C rather than take the credit on line 49 on the Form 1040, with no mention of the anti-discrimination and the 25% rules, there are those who claim a sole proprietor with no employees can take the deduction.

Cross references:

  • IRS Pub. 503, Child and Dependent Care Expenses
  • Form 2441, Child and Dependent Care Expenses
  • IRC Sec. 129

 

 

 

Sole Proprietors: Hire Your Spouse and Deduct Your Healthcare Expenses on Schedule C

Reduce Income Tax and Self-Employment Tax with a Health Reimbursement Arrangement (HRA)

A health reimbursement arrangement (HRA) is solely funded by an employer for the benefit of its employees.  Employees are reimbursed by the employer tax free  for qualified medical expenses up to a maximum dollar amount for a coverage period.

Qualified medical expenses are those specified in the plan that would generally qualify for the medical and dental expense deduction on Form 1040, Schedule A.  Qualified medical expenses include amounts paid for health insurance premiums, amounts paid for long-term care coverage, and deductible/copays that are not otherwise covered by a health insurance plan.

Sole Proprietor with Employee Spouse Strategy

Example:  John is a sole proprietor with this wife, Marsha, as his only employee.  John provides his one employee an HRA that will reimburse up to $9,000 of medical expenses per year.  Marsha uses the $9,000 to pay for health insurance premiums for a policy that she purchases, plus deductibles and copays not covered by her insurance policy.  Marsha purchases a family policy that also covers John as her spouse.  Thus, the $9,000 is 100% deductible by John as a business expense on Schedule C and 100% excludable by Marsha as an employee benefit.

Market Reform Rules

All employee group health plans are subject to the Market Reform rules under the Health Care Reform Act of 2010.  HRAs are generally considered to be group health plans and thus subject to the Market Reform rules.  However, the Market Reform rules do not apply to a plan that has only one participant who is a current employee on the first day of the plan year.  Also, the Market Reform rules do not apply to plans in relation to a provision of reimbursing only excepted benefits, such as accident-only coverage, disability income, certain limited-scope dental and vision benefits, certain long-term care benefits, and certain health FSAs [IRS Notice 2013-54].

Caution

Since Marsha is John’s only employee, the Market Reform rules do not apply to John’s HRA plan.  If John were to hire more employees, John would need to purchase health insurance for each employee and integrate his HRA with other coverage in order for his HRA to meet the Market Reform rules.

Excise Tax

Under the Health Plan Reform Act of 2010, there is established a new Patient-Centered Outcomes Research Trust Fund (PCORTF) designed to carry out provisions relating to comparative effectiveness research.  This trust fund is funded by a fee imposed on specified health insurance providers.  The fee for plan years ending on or after October 1, 2014 and before October 1, 2015, is $2.08 multiplied by the average number of lives covered under the health plan.  The fee is paid as an excise tax by filing Form 720, Quarterly Federal Excise Tax Return, for the quarter covering April, May, and June with a due date of July 31.

In my example above, with John and Marsha, John must pay the excise tax of $2.08 for his one employee (Marsha) covered under his HRA by filing the second quarter Form 720 by July 31 each year.

Recommendation

Retain a competent adviser in benefits administration to assist you in properly setting up your plan and to monitor its compliance.  Also, discuss this strategy with your professional tax consultant before you implement it.

 

 

No Deduction Allowed for Substantial Use of RV

Jackson, Tax Court Memo. 2014-160

The taxpayer was an insurance agent who specialized in selling insurance policies specific to recreational vehicles (RVs).  To gain access to RV owners, the taxpayer was a member of several RV clubs.  The clubs held RV rallies which were primarily social events.  Only RV owners could attend these rallies.  Ownership was also required by certain RV parks, which often prohibited RV’s older than a certain age.

The taxpayer gathered sales leads at every rally.  He attached to his RV advertisement promoting his insurance business.  He invited potential customers to come to his RV and discuss the prospective client’s insurance needs.  It would often take months, if not years, for a relationship with a potential customer to develop into an actual sale.

The court stated there was no question the taxpayer used his RV for some personal purposes.  The taxpayer claimed, however, that he was entitled to deductions related to the business use of his RV.

The court acknowledged that the taxpayer actively sold insurance polocies during his time at the rallies, and that business activities conducted in using his RV generated a significant amount of revenue.  After reviewing the evidence in the record and considering the taxpayer’s testimony, the court concluded that the taxpayer spent two-thirds of his time during these rallies on business and one-third of his time for personal pleasure.  Thus, the primary use of the RV was for business, not pleasure.  However, none of the deductions for the business use was allowed because of IRC section 280A.

The Tax Court has previously ruled that an RV qualifies as a dwelling unit for purposes of the office-in-home rules under IRC section 280A.  Under the general rule, any personal use, including watching TV in the RV, makes the entire day a personal day.  IRC section 280A(c) has an exception to this general rule which allows a taxpayer to allocate costs to business use if a portion of the dwelling unit is “exclusively used” on a regular basis “as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business.”  The court said exclusivity is the key to this case.  The taxpayer did not use any portion of his RV exclusively for business.  Therefore, no deduction for the expenses allocated to the business use is allowed.

 

No Office-in-Home for Motor Home

Dunford, Tax Court Memo, 2013-189

A married couple lived in Illinois.  For 2005 and 2006, the tax years at issue, they filed a joint tax return with a Schedule C consulting business.  Most of the work was performed away from the taxpayer’s home in Illinois, sometimes working at or near client’s business locations.

For 2005, the taxpayers were away from home for half the year (the colder months), and for 2006, they were away the entire year.  During these periods, they traveled and stayed in their motor home.  The motor home had a sleeping area, a bathroom, and a kitchenette with a countertop.  Across the vehicle from the kitchen counter was a second countertop that was used as a desk, and on which the taxpayer had a computer and office supplies.

Throughout 2005 and 2006, the taxpayers traveled all across the U.S., but most of their travel time they were in Florida, California, and Nevada. The taxpayer’s three children also lived in Florida, Nevada and Quincy, Illinois, locations where the taxpayers spent significant time.  They kept no contemporaneous log that showed the business character of their travel. A reconstructed log of their travel that was entered into evidence in court often contradicted the documentary evidence of their whereabouts.  They had blended purposes, personal and business, for their travel, but their dominant motive for their travel plans was personal (the pleasure of being in the locations they chose and of being near their children).  Their clients reimbursed most of their travel expenses for airline, auto rental, standard mileage rate, per diem, meals, and office-related expenses.

The reimbursements included nearly all of the mileage they recorded in their activity log.  All of these reimbursements were deducted as travel expenses or meal expenses on Schedule C.  During the audit, the IRS did not dispute the deductibility of reimbursed expenses that the taxpayer’s had billed to their clients.  The disallowed deductions were for non-billed expenses.

Included in the expenses disallowed by the IRS were vehicle expenses including repairs and maintenance, depreciation, insurance, tax and licenses, and utilities.  These travel-related expenses were disallowed for at least one of the following reasons:

  •  The taxpayers used the motor home as a residence during 2005 and 2006, so IRC section 280A disallows the deductions.
  • The taxpayers had already claimed and been allowed deductions for their business use of their motor home and other vehicles based on the standard mileage rate, so that deductions for actual costs would be duplicative, and
  • The taxpayers failed to adequately substantiate their entitlement to many of their vehicle-related deductions.

IRC section 280A states that no deduction is allowed with respect to the use of a dwelling unit which is used by the taxpayer during the tax year as a residence, unless the business use of home exception is met.  IRC section 280A(c)(1) allows a deduction “to the extent such item is allocable to a portion of the dwelling unit which is exclusively used on a regular basis” for business.  The taxpayers did not prove that there was an identifiable portion of their motor home that was used exclusively for business purposes. The area they seemed to put forward as the home office was the countertop that was used as a desk.  But they did not make any showing of the percentage of the vehicle that constituted this area (it would be a very small percentage), and it is implausbile to suggest that, in the cramped quarters of a motor home, an unclosed area like the countertop would somehow be exclusively reserved to business activity.  Accordingly, the court ruled all deductions (other than deductions for interest expenses on Schedule A) claimed with respect to the use of their motor home were disallowed.

Actual expenses for the use of their motor home were also disallowed on the grounds that many would be duplicative to the standard mileage rate deduction that the IRS had already allowed based on the taxpayers billing their clients for reimbursement of travel expenses.  Actual expenses for the use of their motor home were also disallowed on the grounds that they failed to provide adequate substantiation for these travel costs.  A motor home is considered listed property, and deductions for business use of listed property require a higher level of substantiation than the taxpayrs provided.

 

 

IRS Announces 2016 Standard Mileage Rates

By Gary A. Hensley, MBA, EA

IRS, in Notice 2016-1, announced the optional 2016 standard mileage rates for taxpayers to use in computing the deductible costs of operating an automobile for business, charitable, medical, or moving expense purposes.

Highlights:

Business mileage:  The standard mileage rate for transportation or travel expenses for 2016 is 54 cents per mile (compared to 57.5 cents in 2015) for all miles of business use (business standard mileage rate).

Charitable mileage:  The standard rate for 2016 is 14 cents per mile (same as 2015) for use of an automobile in rendering gratuitous services to a charitable organization.

Medical care and moving:  The standard mileage for 2016 is 19 cents per mile (compared to 23 cents in 2015) for use of an automobile for medical care or as part of a move (for which the expenses are deductible under IRC 217).

Basis Reduction Amount

For automobiles a taxpayer use for business purposes, the portion of the business standard mileage rate treated as depreciation (when sold or traded in) is 23 cents per mile for 2012, 23 cents per mile for 2013, 22 cents per mile for 2014, 24 cents per mile for 2015, and 24 cents per mile for 2016.

Remember:  A taxpayer is not required to use the standard business mileage but instead may substantiate using actual allowable expense amounts if the taxpayer maintains adequate records or other sufficient evidence.

 

Substantiating Your Business Expenses Is Critical to Keeping Them

By Gary A. Hensley, MBA, EA

By and large, the rules are straightforward:  the burden of substantiating the “income” of a taxpayer falls on the Internal Revenue Service (IRS) and the burden of substantiating expenses (or deductions) falls totally on the taxpayer.

The position of the IRS and their field revenue agents has been and will be inadequate or no expense documentation/substantiation equals no deduction.  The next recourse for the taxpayer is to go to IRS Appeals and argue that the revenue generated couldn’t have taken place without incurring “some” associated expenses (the Cohan Rule).  The results at the Appeals level varies widely in each case and, generally, the best case scenario is an allowance of “some” of the deductions claimed.  The expense of going to Appeals can more than offset whatever expenses are allowed by the appeals officer (especially if you retain professional representation).

Recent Court Decisions

Under Internal Revenue Code (IRC) section 274(d), for certain expenses, taxpayers are required to be able to provide specific detailed information to substantiate the expenses.

As demonstrated In the recent case of Garza, T.C. Memo. 2014-121, the result boiled down to an all-or-nothing proposition.  Without proper substantiation, no deduction is allowed for a Sec. 274(d) expense, even if the court believes that a legitimate expenditure was made.

Sec. 274(d) identifies four classes of expenses for which specific substantiation is required:

  • Sec. 274(d)(1) for travel expenses (including meals and lodging while away from home);
  • Sec. 274(d)(2) for any item with respect to an activity that is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity;
  • Sec. 274(d)(3) for business gifts (which are limited to $25); and
  • Sec. 274(d)(4) for expenses with respect to any listed property (as defined in Sec. 280F(d)(4)).

In Garza, the court said that “while we believe that petitioner had business travel expenses in relation to his employment, the Court must heed the strict substantiation requirements of section 274(d).”  To support its ruling, the court cited DeLima, T.C. Memo. 2012-291, in which the Tax Court indicated that it had no doubt that the taxpayer used a vehicle for business purposes, but it was bound to deny the vehicle expense deduction because she failed to follow the requirements of Sec. 274(d) and the regulations.

Substantiation Required

Sec. 274(d)(4) requires the taxpayer to substantiate “by adequate records or by sufficient evidence corroborating the taxpayer’s own statement”:

  • The amount of the expense or other item;
  • The time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift;
  • The business purpose of the expense or other item; and
  • The business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.

In light of the above requirements, the message from the above paragraph is that “a taxpayer’s own statement” by itself is not sufficient in the IRS’s consideration of whether to allow a deduction.  As Garza and other cases show, the IRS and the courts look for contemporaneous records with the details listed above and, without it, they may disallow the deduction.

Taxpayers and their tax advisers need to understand what type of substantiation is required to take a deduction (with a solid foundation) on a tax return.

 

 

 

2015 Optional Standard Mileage Rates

The Internal Revenue Service issued the 2015 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes.

Beginning on Jan. 1, 2015, the standard mileage rates for the use of a car (also vans, pickups or panel trucks) will be:

  • 57.5 cents per mile for business miles driven  (up from 56 cents in 2014)
  • 23 cents per mile driven for medical or moving purposes (down a half cent from 2014)
  • 14 cents per mile driven in service of charitable organizations (no change from 2014)