Recordkeeping Alert

As a result of Tax Reform, recordkeeping is now necessary in some areas that never required records before. Crucial: Keep flawless records.

IRA contributions. For most people, the new rules have cut out deductible Individual Retirement Account contributions. If you or your spouse has a company pension plan and your Adjusted Gross Income is greater than $50,000 ($35,000 for single taxpayers), your IRA contributions aren’t deductible. However, nondeductible contributions to IRAs are still slowed (generally up to $2,000).

Recordkeeping alert: Taxpayers who have both deductible and nondeductible IRAs must now begin keeping special, detailed records of all their contributions for tax purposes. Reason: When you withdraw money from your IRA, the IRS aggregates all your IRA accounts together and treats the withdrawal as if it were both from your deductible and your nondeductible contributions, even if they were in separate IRAs. Result: Part of every withdrawal is going to be taxed, and part of every withdrawal is going to be tax-free.

Since the deferred earning on IRAs are taxed at withdrawal, every withdrawal must be broken down into three parts to figure out the tax:

Earnings on the IRA. (100% is taxed at withdrawal whether the earnings are from deductible or nondeductible contributions.

Return of a deductible contribution (i.e., contributions made before 1987, while you were still allowed to deduct the contribution on you tax return). It’s taxed at withdrawal because it wasn’t taxed in the year you made the contribution.

Return of a nondeductible contribution (i.e., contributions made in 1987 or after that will not be deductible on your tax return). It’s not taxed at withdrawal because it was taxed in the year you made the contribution.

   Income shifting. Gifts to children under age of 14 that generate investment (unearned) income over $1,300/year will be taxed at the parents’ tax rates.

Recordkeeping alert: Avoid mixing this type of unearned income with the child’s earned income (which is always taxed at the child’s own rates no matter how much he/she earns). Put the unearned income into an account that is separate from the earned income so there will be no question as to how to treat the income for tax purposes.

Meal and entertainment expenses that you incur in the course of your business are only 50% deductible. This limit applies whether you are eating out alone or entertaining clients in order to get new business. Included in this limit: Food, beverages, cover charges, gratuities, taxes, theater tickets, etc.

Exception: An employment who is reimbursed for these expenses by his employer doesn’t have to worry about this rule once he has properly accounted for them to his employer. The employer, rather than the employee, takes the 50% deduction.

Recordkeeping alert: Don’t lose or misplace a single receipt for meal and entertainment expenses. Keep a diary to record the details, especially if you entertained others. Carry this diary around with you at all times.

Interest Recordkeeping Requirements

The IRS requires that you document fully the flow of funds for all loans you take in order to determine the deductibility of the interest.

Personal mortgage interest on two residences is fully deductible up to certain limits. The deductibility of other interest depends on how the funds are used.

For example, funds you borrow for the purpose of making investments are deductible to the extent of your investment income. Personal interest isn’t deductible. Interest that you pay on funds used to purchase a passive activity or real estate is lumped with the gains or losses from that activity. To the extent that there’s a net loss, the interest may not be deductible because of the limitations inherent in those transactions.

The recordkeeping requirements are very stringent. In the past, if you borrowed money on a margin account, the IRS presumed that the interest was for investment purposes. Now the burden is on you, the taxpayer, to show proof of the flow of funds.

Advice: If you borrow money and want to get a tax deduction for the interest, keep careful records to indicate the uses and applications of the monies borrowed. Also, keep records proving you repaid the principal. Obviously, if you have a choice of which loan to repay first, you should repay the loan that gives you the least deductibility of interest.

Retaining Records

Most records have to be held for only three years after the due date of you tax return. That’s when the statute of limitations expires for tax audits by the IRS and refund claims by the taxpayer. But some records should be kept indefinitely, especially those relating to the acquisition of property, whether by purchase, gift, or inheritance. Reason: If you ever sell the property, you can’t determine profit or loss without proof of its original cost or other tax basis.

Lost Records

John and Louise Kranc deposited all their records with their accountant in order to prepare their tax return. The accountant lost the records. The Krancs then argues that the substantiation requirements for their deductions should be waived because it wasn’t their fault that the records had been lost. Tax Court: The Krancs were out of luck. They should have kept copies of the records they gave to the accountant.

Leasing Assets To Your Own Corporation

The fact that the corporate form is selected as the basic means of conducting a business enterprise does not mean that all of the physical components of the enterprise need to be owned by the corporation. Indeed, there may be legal, tax, and personal financial planning reasons for not having the corporation own all the assets to be used in the business.

Whether the corporation is to be the continuation of a sole proprietorship or partnership or a wholly new enterprise, decisions can be made about which assets owned by the predecessor or acquired for use in the corporation are to be owned by the corporation and which assets are to be made available to the corporation through a leasing or other contractual arrangement.

For the assets that go to the corporation, decisions must be made about how they are to be held and on what terms they are to be made available to the corporation.

There are several possible choices. The assets may by owned by:

• An individual shareholder or some member of his family;
• A partnership, limited or general, in which family members participate; or
• A trust for the benefit of family members.

A separate corporation is still another possibility, but the risk of being considered a personal holding company and incurring penalties due to passive income (including rent and royalties) may make this impractical.

Normally a leasing arrangement is used in order for the assets to be made available for corporate use. Assuming that the rental is fair, it would be deductible by the corporation and taxable to the lessor. Against the rental income, the lessor would have possible deductions for interest paid on loans financing the acquisition of the asset, depreciation, maintenance and repairs, insurance and administrative costs.

These deductions might produce a tax-free cash flow for the lessor. When depreciation and interest deductions begin to run out, a high-tax-bracket lessor might find that he/she is being taxed at too high a rate on the rental income. At this point, he may transfer the leased property to a lower-tax-bracket family member.

He might also consider a sale of the property to his corporation. This sale would serve to extract earnings and profits from the corporation at favorable tax rates. At the same time, it would give the corporation a high tax basis for the asset than it had in the hands of the lessor, thus increasing the corporation’s depreciation deductions. This, of course, would reduce the corporation’s tax liabilities and benefit the shareholders-the lessor included, if he/she is a shareholder.

How To Deduct Start-Up Costs Sooner

Avoid being forced to capitalize and amortize start-up costs over a five-year period. The trick is to get “in business” quickly. You can claim business deductions or losses only when you’re “in business.” (You’re considered to be “in business” when you’re trying to get sales.) Any subsequent expenses you incur will be to “expand” an existing business, and you can take full deductions for those items.

For example, let’s say you want to open a sales organization. The start-up costs include getting products to sell and interviewing salespeople. If you can get one line, no matter how small, and make a few sales, you’re considered to be in business. Then you can spend time looking to expand into other products and to hire a sales force.

Incorporating A Business Tax-Free

You may have a sole proprietorship or partnership and reach a point in the growth of your business where you want to incorporate. There’s a special provision in the Internal Revenue Code (Section 351) that enables a business before the incorporation own at least 80% of the business after incorporation.

If you incorporate in this way, the IRS can’t recapture depreciation deductions or investment credits (if still applicable). If the assets are subsequently disposed of, the recaptures will take place at the corporate and not at the individual level, even though you may have initially received the benefit from the investment credit or depreciation.

How To Set Up A Hobby As A Business

You can set up a hobby as a business and deduct your losses. However, you must be able to prove that the hobby is a for-profit business. If you realize some profit in at least three out of the most recent five consecutive years, it is presumed that the business is for profit. But even if you don’t show and profit, you may be able to prove that the business is intended to make a profit.

To prove that you have a profit motive in conducting your business, keep detailed records. Present evidence of your advertising campaigns, attempts to generate new business, and sales analyses. It’s not necessary to show that you run a big business, reaping huge profits, but only that you have genuine intentions of running the business in a businesslike way.

Best Way To Set Up A Family Business

A business can be organized as a corporation, a proprietorship, a partnership, or even a trust. Use combined forms of ownership to cut taxes.

Examples:

• Use a corporation to operate the business.
• Have an individual, as sole proprietor, or a partnership own the machinery and equipment and rent it to the corporation.
• Have an individual or partnership hold title to the real estate and rent it to the corporation.
• Use a trust (for the benefit of the children of the owners) as a partner in the partnership (in either the equipment partnership or the real estate partnership or both).

This arrangement reaps some important tax benefits:

• Tax losses are passed through to the high-tax-bracket owners. When partnerships begin producing income, transfer title to the low-bracket children for income-splitting purposes.
• Income from the rental goes to the owners without dilution for corporate taxes.
• Income to the children aged 14 or older benefits from income-splitting.

The possibilities for combining the above are endless. Consider such additional entities as S corporations, multiple corporations, and multiple trusts.

Caution: The “passive-loss” rules, imposed by the Tax Reform Act of 1986, severely restrict the deductibility of many partnership losses, S corporation losses, and losses from rental property. Always check with a tax professional before deciding on the structure of your business.

When To Set Up A Venture Partnership

You may be asked to help friends or relatives start up a small business by providing the capital to finance the deal. Set up the business as a partial shelter for the amounts you invest. Uncle Sam helps you reduce the amount that you’re investing by allowing you to deduct a large share of the losses. I call such a deal a venture partnership. Here’s how it works:

You become the limited partner. As such, you’re entitled to deduct a very large share of the losses, up to 99%, since you’re putting in all the money. At the point that the business turns around, the percentages drop. You might receive 50% of the profits after getting your money back, and the person you helped also received 50% of the profits. Now both of you can share in the profits as partners, but at the outset you get the benefit of a larger share of the losses. Caution: These write-offs are subject to the passive-activity-loss rules.

Best Tax Shelter In America

Tax Reform has taken dead aim at tax shelters. It’s not longer possible to offset your salary or investment income with paper losses generated by passive investments in oil wells, real estate developments, etc. Neither is it possible to cut the family’s tax bill greatly by shifting investment income to children who are under age 14.

But even under Tax Reform, the best tax shelter still remains. With it you can generate large paper losses, claim deductions for personal or hobby-like expenses, and legally shift income to your low-tax-bracket minor children.

The best tax shelter is a sideline business.

Here’s how a sideline business can be used to get the big tax-sheltering-type deductions, along with winning examples of taxpayers who have already done it…

Income-Shifting

Under Tax Reform, investment income exceeding $1,300 for a child under age 14 is taxed at the rate paid by the child’s parents. But this rule does not apply to the earned income of a child.

Result:  When a child works for a parent’s sideline business, earning are taxed at the child’s own low tax rate. Since the parent deducts the salary paid to the child as a business expense, the family’s total tax bill is lowered by the difference between the parent’s high tax rate and the low or zero rate on the child’s salary.

Of course, this income-shifting technique is also available for children over age 14 and other family members. And even greater tax benefits can be obtained when family members use the salary you pay to make deductible IRA retirement contributions, or when the business pays for deductible benefits.

The only rule that governs paying salaries to family members is that they must actually earn their salaries. Salary deductions have been allowed when:

• • A doctor paid his four children, ages 13 to 16, to answer telephone calls, take messages, and prepare insurance forms.

Source: James Moriarity, TC Memo 1984-249.

• • The owner of a rental property hired his teenage sons to maintain and clean the building.

Source: Charles Tschupp, TC Memo 1963-98

• • A business owner hired his wife to act as the company’s official hostess.

Source: Clement J. Duffey,  11 AFTR2d 1317.

What Qualifies

A part-time activity can easily qualify as a business. The only requirement is that you operate your activity with the objective of making a profit. You don’t actually have to make a profit, nor do you have to expect to make a profit in the near future. Examples:

 

Home Deductions

A major benefit of running a sideline business out of your home is the possibility of claiming a home-office deduction. This entitles you to deduct expenses that were formally personal in nature, such as rent, utility, insurance, and maintenance costs attributable to the office. Even better: You can depreciate the part of your home that’s used as an office, getting large paper deductions that cost your nothing out of pocket.

To qualify for the deduction, you must have a part of your home that’s used exclusively for business and is that primary place where you conduct the sideline business. Winning examples:

• • A doctor who owned and managed rental properties to get extra income could deduct one bedroom in his two-bedroom apartment as an office.

Source: Edwin R. Cruphey, 73 TC 766.

• • A woman who did economic consulting work out of a home office could deduct it, even though her husband, a famous newspaper editor, use the same office for nondeductible activities. The Tax Court did not reduce her deduction because her husband shared the office.

Source: Max Frankel, 82 TC 318.

Big Dollar Deductions

Tax Reform prohibits taxpayers from offsetting their salary and investment income with losses from businesses in whish they participate as passive investors (as shareholders or limited partners without management duties).

But if you actively manage your own sideline business, it’s still possible to claim big loss deductions. Important: Tax losses do not necessarily mean cash losses. Items such as depreciation on cars, equipment, and real estate can result in deductible tax losses while the business is earning a cash-flow profit.

A sideline business is presumed to have a profit objective if it has reported a profit in three out of five years (two out of seven year for horse breeders). But such a business may be deemed to have a profit objective, even after reporting many years of continuous losses. Winning examples:

• • A real estate operator tried to develop and market an automatic garage door opener. He was entitled to deduct $355,000 over 11 years because he had made a sincere effort to sell the door openers.

Source: Frederick A. Purdy, TC Memo 1967-82.

• • A horse farm incurred 20 straight years of losses totaling over $700,000. During the next seven years, it lost another $119,000, but in two of those years it had profits totaling $17,000. Since the two-out-of-seven-years test had been met, the farm was ruled to be a profit-motivated business, and all of its losses were deductible.

Source: Hunter Faulconer, 48 F2d 890

• • A corporate vice president and management expert ran a breeding farm as a sideline and lost $450,000 over 12 years. The loss was deductible because evidence indicated that it often takes 8 to 12 years to establish an acceptable bloodline for the animals involved.

Source: Lawrence Appley, TC Memo 1979-433

Start-Up Tactic

When starting a new sideline business, you can protect your deductions by electing to have the IRS postpone its examination of your business status until after you’ve been operating for four years (six years in the case of a horse farm). You’ll be able to treat your sideline as a business during that period, even if it earns continuous losses. But if you can’t demonstrate a profit objective at the end of that period, you’ll owe back taxes. Make the election by filing the IRS Form 5213, Election to Postpone Determination That Activity Is for Profit.

Winning examples:

• • Eugene Feistman, a probation office, collected and traded stamps for many years. The Tax Court initially refused to let him deduct his costs, saying his collecting was merely a hobby. So he filed a business registration certificate with the local government, opened an account that allowed him to make sales by charge card, set up an inventory, and started keeping good business records concerning purchases and sales.

New ruling: Now Feistman could deduct his costs because he was operating in a businesslike manner. The Tax Court allowed him to deduct $9,000 over two years.

Source: Eugene Feistman, TC Memo 1982-306

• • Gloria Churchman, a housewife, admitted that she painted for pleasure, but she was also able to show that she made a serious effort to sell her works at shows and galleries. The Tax Court allowed her to deduct her expenses and losses, including the cost of a studio in her home.

Source: Gloria Churchman, 68 TC 696

• • Melvin Nickerson, an executive who lived in the city, bought a farm and began renovating it on weekends. He intended to retire to it in the future. Although Nickerson didn’t expect to make a profit from the farm for another 10 years, the Court of Appeals allowed him to deduct his renovation costs right away. It said that his expectation of future profits, combined with the real work he put in, sufficed to justify a deduction now.

Source: Melvin Nickerson, 700 F2d 402

• • Bernard Wagner, an accountant, fancied himself a songwriter and music promoter. He hired a band, rehearsed it, booked It, and copyrighted the songs he wrote. Although his chances of success were slight, he intended to succeed, so the Tax Court allowed him to deduct his costs and losses.

Source: Bernard Wagner, TC Memo 1983-606

• • J.V. Keenon bought a house, moved into it, then rented an apartment in the house to his own daughter. The Tax Court agreed that he was now in the real estate rental business, so he could deduct depreciation on the rented apartment, along with utilities, insurance, and related expenses. And this was in spite of the fact that he charged his daughter a below-market rent. The Court felt that the rent was fair because it’s safer to rent to a family member than to a stranger.

Source: J.V. Keenon, TC Memo 1982-144.

You’ve probably heard a lot about how the accurate use of modifiers can increase your income. Fortunately, it takes only a few minutes for you and your staff to learn how to use these valuable coding tools.

To prompt yourself to use modifiers, when appropriate, alter your encounter form by adding a column next to the one for the CPT code. While you’re at it, add a column for ICD-9-CM diagnosis codes, as well. So your new encounter form would contain these columns: CPT code/Modifier/Description/ICD-9-CM/Fee.

Here are some examples of how to use the most common modifiers:

-25 Significant, separately identifiable E&M service on the same day as a procedure or other service. This is primary care’s most frequently used modifier. It allows you to bill for a procedure plus an office visit on the same day.

When insurance companies evaluate claims that use this modifier, they review the “separately identifiable” requirement. In other words, they ask whether the E&M service is above and beyond the basic protocol for performing the procedure itself.

They also want proof that the E&M service was “significant”. Many carriers require enough documentation to support the equivalent of a 99213. (Of course, this is in addition to documentation related to performance of the procedure.)

Example: You examine a patient and discover prostate nodules, though you can’t make a certain diagnosis. So you order a biopsy. How do you bill this visit? Bill for the biopsy, then select the appropriate E&M code for the office visit, and append modifier     -25. This modifier allows you to get paid your full fee for both codes.

-26 Professional component. Certain procedures are a combination of physician and technical components. When the physician component is claimed separately, you may report the service by adding modifier -26.

Example: You’re called to the emergency room at 3 am to diagnose and treat a patient who is presenting with respiratory problems. You suspect pneumonia. After examining the patient, you order and X-ray. Because a radiologist is not available, you bill for the X-ray operation using -26. You’ll need to prepare a separate, signed report of your interpretation.

-53 Discounted procedure. Example: You attempt a sigmoidoscopy, but even using your smallest instrument, you’re unable to enter the colon. So you stop the procedure.

Submit your bill at your full fee with the addition of modifier -53. Along with your documentation, include a cover letter explaining why you discontinued the procedure.

Another example: You’re unable to complete excision of subcutaneous birth control implants. Let’s say you’re unable to remove only three of the six implants before the patient experiences edema and pain. The rest will require anesthesia and surgical removal.

In this situation, you can bill the procedure at your full fee with the addition of modifier -53. Your reimbursement should be between 75 and 100 percent of your normal fee.

If you late complete the procedure, bill for it a second time. You should receive your full fee. If you perform the second attempt under anesthesia on the same day, add modifier -59 to claim. (More on -59 below.)

-55 Postoperative management only. This modifier allows you to share in a surgical fee if you provide the postoperative follow-up.

Example: You refer a patient to a surgeon in another town. It will be difficult for the patient to see the surgeon for a follow-up, so the surgeon agrees for you to do it.

To get paid, simply bill the CPT code for the surgery and append modifier -55. The postoperative fee for most surgical procedures is 10 percent of the procedure reimbursement.

The only other requirement is for the surgeon to append modifier -54 to the surgical procedure code. This indicates that he’s billing for surgery only, thus allowing you to bill for the postoperative services.

-59 Procedures and services not normally reported together. This may represent a different session or patient encounter, different procedure or surgery, different site or rate lesion, or a separate injury not ordinarily encountered on the same day by the same physician.

Example: You treat a patient for an upper respiratory infection. Since the patient is overdue for a breast/pelvic exam, you perform one during the same office visit. Append modifier -59 to the code for the breast/pelvic exam. Expect to be reimbursed at 50 percent of the allowable fee.

-76 Repeat procedure by same physician. Use this modifier if you need to repeat an X-ray, ECG, or other service.

Example: You order an ECG but decide that the results look wrong, so you have the procedure repeated. Add modifier -76 to the second test in order to receive payment for both. You can also use the modifier if you re-order a test to monitor responses to medications or changes in symptoms.

-91 Repeat clinical diagnostic laboratory test. This relatively new modifier is used to report a lab test that’s repeated on the same day in order to obtain subsequent results.

Example: Say you need to repeat a test for serum creatinine to diagnose renal insufficiency. Similarly, you may want to order multiple tests on a given day for blood sugar values after administration of medication to lower elevated glucose. Append modifier -91 to claims for the later tests.

Vacation Costs As A Business Expense

Tax Reform has cracked down on many travel-related deductions. But there are still deductions you can take for travel, and you should not miss those that still apply.

Traveling for Business

Travel expenses. You can fully deduct the cost of getting to and from your destination on a trip made primarily for business reasons. This expense remains fully deductible, even if you extend the trip for pleasure or take a side trip for pleasure. In addition, during the business part or your stay, you can deduct the cost of hotel, lodging, local transportation, and 50% of meals and business-related entertainment.

Example: You travel to New York City strictly for business reasons and decide to take a side trip for the weekend, vacationing at a sumptuous Long Island beach resort. The trip between New York City and home remains fully deductible, as long as you can prove you traveled there for business. But the cost of traveling between New York City and the resort is not deductible because that part of the trip is entirely for personal pleasure. Also, the related expenses of meals, lodging, and local transportation while at the beach resort are not a deductible business expense.

Mixing business with pleasure. The cost of traveling to and from your destination on a trip made primarily for vacation or pleasure isn’t deductible, even if you conduct some business while on the trip. However, some of the other business-related expenses may be deductible.

Example: You go on a vacation to Florida, but while there you take a customer who lives in Florida out to lunch. Under Tax Reform, 50% of the meal expense is deductible if business was actually discussed during the meal. Be sure to include tax, tips, and parking-lot fees at the restaurant when calculating the 50%. The cost of traveling to the restaurant, if you take a taxi, for example, is 100% deductible.

Ship travel can be an asset on a combined business-vacation trip. Reason: Days spent in transit count as business days in the allocations formula. Example: A two-day business meeting in Paris is followed by a two-week European vacation. If you fly (one day each way), only 22% is deductible (two business days plus two days of travel out of a total of 18 days away). But if you sail (five days each way), 46% is deductible (two business days plus 10 days of travel out of a total of 26 days away).

Acceptable Per Diem

Is there an official rate of per diem meal expenses that the IRS accepts as reasonable while working away from home?

The IRS recognizes a standard per diem meal allowance equal to the greater of $26 to $38 depending on the location, or the rate allowed by the federal government to its employees in the locality where travel occurs.

When reimbursements exceed the per diem, an employee must report them in income and claim an offsetting travel-expense deduction, while maintained all the records necessary to do so. But an employee who received no more than the per diem allowance from his employer need not report it in income.

The per diem allowance can be used only by employees receiving reimbursements. Self-employed persons cannot use the allowance to get an automatic deduction for expenses.

Parents Supported By More Than One Child: Who Takes Deduction?

When brothers and sisters support a parent, plan things so that one of them can deduct the parent’s medical expenses. Here’s how:

File a multiple-support declaration (Form 2120). Where several people contribute, this form designates the one who can take the exemption. If they pay at least 10% each, but nobody gives as much as half, and one of them can take the exemption if the others agree. Each year a different member of the group can claim the exemption by changing the agreement.

Deduct Your Parents’ Medical Costs

You may be supporting your parents by giving them money regularly to pay their bills, including medical expenses.

Suppose you’re paying medical expenses for them and also providing half their support, but you can’t claim them as dependents because their gross income exceeds IRS limits. You may be able to deduct your parents’ medical expenses. The key is for you to pay these expenses directly. Of course, the amount you can deduct is subject to the limitations on your own medical-expense deductions.

Family-Medical-Bill Loophole

John Ruch was able to deduct his mother’s medical bills, even though he paid them with money that she had given him. Court: Ruch had received the money through a legal and binding gift from his mother. Since the money was legally his when he paid, he was entitled to the deduction.

Shifting Capital Gains

Give appreciated securities to your parents instead of cash if you are supporting them. They can cash in the securities and pay tax on the appreciation in their low tax bracket. You’ll avoid paying tax in your high tax bracket.

Caution: A large gain could push your parents into a higher bracket. Of course, if you and your parents are in the same tax bracket, this ploy won’t help you (nor will it hurt).