Everyone wants a lower tax bill and we have all heard the numerous strategies and tactics that could save you money. Although there are many viable tax saving methods, one must consider the risk involved, and documentation requirements necessary to enable the taxpayer to take advantage of the strategy.
Mixing business and personal travel
When travel away from home is primarily for business purposes, ordinary and necessary expenses relating to the business travel are deductible. Deductible traveling expenses include travel fares, meals and lodging, and expenses incident to travel such as tolls, telephone, and parking meters. Business travelers should keep in mind they may be able to get a discount on a vacation by incorporating personal travel into the business trip. The following sections cover the rules for deducting the most common expenses incurred.
Be aware that, to deduct any travel, meals, or entertainment expenses, you must be able to substantiate with adequate records or by sufficient evidence (a) the amount of the expense, (b) the time and place of the travel, entertainment, meal, etc., (c) the business purpose of the expense, and (d) the business relationship to the persons entertained. To meet this substantiation requirement, we recommend having a receipt for every expense related to entertainment-type expenses.
Expenses related to travel to and from the destination
Traveling expenses to and from a destination, such as airfare, are only deductible if the trip is related primarily to the taxpayer's trade or business. Though the determination of whether a trip is primarily related to business or personal in nature depends on the facts and circumstances of each case, the allocation of time between personal activity and activities directly relating to the taxpayer's trade or business is an important factor in this consideration. For example, if a taxpayer is out of town for one week, and spends five days in business meetings and the other two days sightseeing, the trip will be considered business in nature barring additional evidence to the contrary. When a trip is considered primarily undertaken for business purposes, 100 percent of the travel costs to and from the destination are deductible, even if the trip contains an element of a personal vacation.
Deducting lodging, meals, and other related expenses
Expenses related to lodging plus 50 percent of meals while on business status are deductible regardless of the primary purposes of the trip (business or personal). For instance, even though the airfare is not deductible due to a trip being greater than 50 percent personal in nature, expenses while at the destination which are properly allocable to the taxpayer's trade or business are deductible. An example would be a lunch meeting with a supplier during the course of a personal vacation. In addition, even though a trip is primarily for business and the airfare to and from the destination is fully deductible, travel and lodging related to non-business personal activities are not deductible.
Travel expenses for bringing your spouse along
The IRS's rules limit the ability to deduct the cost of having your spouse or other companion accompany you on a business trip. The expenses of a spouse are not deductible unless the spouse is an employee of the taxpayer and travels for a bona fide business purpose or the expenses would otherwise be deductible by the spouse. Even if the spouse's travel expenses are not deductible, the deduction allowed to the taxpayer is based on what it would have cost the taxpayer to travel alone, and not 50 percent of the trip expenses. This allows for a tax benefit in such situations as a hotel room costing $150 for single occupancy but $200 for double occupancy. In this situation, the $150 is deductible by the taxpayer, versus only being able to deduct $100 (50 percent of $200). In situations where a rental car is used, the entire cost would be deductible as there is no additional charge for having the spouse along on the trip. It is important to keep records of what the trip would have cost if the taxpayer traveled alone versus the actual expenses incurred to support any deductions claimed.
Business vs. personal status
In determining business vs. personal status, the IRS uses a "common sense test' when applying these rules. For example, if a traveler has business meetings on Thursday, Friday, and Monday, and the cost to fly home over the weekend and return on Monday is more than the cost to stay put, the weekend days are considered business days and the resulting lodging and 50 percent meals expenses are deductible as business expenses for the entire Thursday through Monday period. In addition, these same rules cover incidental expenses such as telephones, tolls, and parking meters.
Another example would be where an employee's business meetings conclude on Friday, but he extends the business trip to take advantage of lower priced fares requiring a Saturday night stay over, and the savings in airfare are higher than the costs of the weekend meals and lodging. In this case, the tax courts concluded that under the common sense test, payments to the employee for the Saturday stay over were deductible by the employer if a "hardheaded business person would have incurred such expenses under like circumstances." Please note however, the IRS has the authority to disallow meal or lodging expenses that are "lavish or extravagant," or costs they determine to be unreasonable.
Business use of vehicles
Owning a vehicle inside your business is an often cited tool for owners to lower their tax liability. However, simply buying a vehicle through the business's name and deducting all the expenses related to the vehicle through the business puts the business and the owner at an increased risk of penalties and interest if ever examined by the IRS. This is because the IRS realizes that this is an often abused tax saving strategy and they have put strict substantiation and record keeping requirements on vehicle expenses. Virtually every Federal and state exam will ask for written documentation maintained for vehicles used for business purposes. Additionally, if written documentation is not maintained, it may open the risk for deeper examination into other areas of the business's and owner's tax returns.
Generally, vehicles are either owned by the individual and the business provides reimbursement for the substantiated business use or they are owned by the business which deducts all expenses and includes the value of the personal use as compensation to the individual. Either way, to be able to get reimbursement or deduct the expenses, detailed written records should be kept to ensure compliance with IRS rules. The records should contain all of the following:
- Date of each use
- Mileage per trip
- Business purpose of the trip
- Description of destination, business purpose, benefit derived, etc.
- Total mileage for the year
Records must be documented. If there are no written records, the IRS may disallow the deduction or require the entire amount of employee use to be included in the employee's compensation (essentially disallowing any deduction).
It is important to make sure your business vehicles and their use are reasonable. For example, it would be unusual to justify more than one vehicle used for business purposes per individual. Also, always maintain a second vehicle for personal use. These simple rules of thumb will help avoid drawing the attention of the IRS.
Business use of home
Deducting expenses related to a home office is another highly scrutinized area by the IRS. It is important to take a look at the requirements below. Qualifying for this deduction is an effective way to lower your tax bill while making minimal investment. If you're self-employed and satisfy the strict rules that govern this area, you may be entitled to above-the-line business expense deductions for the following:
- Direct expenses of the home office such as costs of painting or repairing the home office, depreciation deductions for furniture and fixtures used in the home office, etc.; and
- Indirect expenses of maintaining the home office such as the allocable share of utility costs, depreciation, insurance, etc., as well as an allocable share of mortgage interest, real estate taxes, and casualty losses. (Note that even without the home office deduction, a taxpayer who itemizes would receive the benefit of the home mortgage interest deduction and potentially the real estate tax deduction depending upon AMT implications.)
To be allowed to deduct home office expenses you must meet one of the following three tests:
- If you use your home office exclusively and on a regular basis as your principal place of business. To satisfy this requirement you must either use your home office for administrative or management activities of your business or your home office must be the most important place where you conduct your business.
- Your home office is used on an exclusive and regular basis for meeting patients, clients, or customers. If the office is used by your office manager make sure that it is the only office maintained for that purpose. Many times this may by a spouse or family member taking care of the office management duties.
- Your home office is used exclusively and on a regular basis for business and it is located in a separate unattached structure on the same property as your home. For example, an unattached garage, artist's studio, workshop, or office building.
Renting property to your business
Renting property to a business you own can be an effective way to draw passive income out of the practice. By having a properly setup lease agreement an owner can draw out cash in a form other than wages (or guaranteed payments for a partnership) and potentially reduce payroll taxes (3-15 percent savings depending on wages paid).
When we talk property, many people think of just the land and building that the practice is on. But you could also own equipment outside of the practice and rent it to the practice. In addition, home office space and storage areas could also be rented to your practice. Though you can have your business pay you FMV (Fair Market Value) rent for renting a portion of your residence, if you are an employee of your practice (such as an owner of an S Corporation), you are not allowed any deductions related to the rental such as utilities, repairs, etc. Even with this disallowance of deductions, this is still an effective strategy to avoid payroll taxes on monies pulled from your practice.
It is also disallowed to maintain an entertainment facility as a deductible expense for business activities. Such activities may again open the risk for deeper examination in other areas of your practice and create substantial cost to defend other expense deductions that may have already been allowed.
Due to the potential for abuse, this is another highly scrutinized practice. For example, if rental amounts are too high, you risk possible reclassification as compensation by the IRS. To help alleviate the risk, we recommend that any lease arrangements between related parties be supported by written lease agreements. In addition, the rent charged should be reasonable and the taxpayer should obtain evidence supporting its reasonableness such as comparable market data. In today's digital age the internet can provide an easy place to find supporting market comparables.
There are many strategies for saving money; however, it is important to understand the risks involved with taking deductions, especially if you don't have proper documentation for the deduction. With proper written documentation, most expenses that may likely be challenged will generally be allowed. In addition, you should always hold on to documentation relating to these deductions for four years. We also recommend documenting business approvals for major deductions taken in board minutes for authorization of major transactions. This practice not only allows for substantiation of deductions, but also helps manage risk against general creditors piercing the corporate veil. It is always best to complete the due diligence on the front end rather than scrambling to pull together the documentation when an IRS notice arrives.