Recordkeeping Hotline

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.

Paying Your Child A Tax-Deductible Allowance

A favorite tax-planning tactic is to have a minor child work for the family-owned business. Income earned by the child is taxed at the child’s tax rate, which is likely to be much lower than the parents’ rate. In addition, the company gets a deduction for the child’s salary. A dramatic taxpayer victory* shows just how effective this tactic can be.

The facts: The taxpayers owned a mobile-home park and hired their three children, aged 7,11, and 12 to work there. The children cleaned the grounds, did landscaping work, maintained the swimming pool, answered phones, and did minor repair work. The taxpayers deducted over $17,000 that they paid to the children during a three-year period. But the IRS objected, and the case went to trial. Court’s decision: Over $15,000 of deductions were approved. Most of the deductions that were disallowed were attributable to the seven-year-old. But even $1,200 of his earnings were approved by the court.

Key: The children actually performed the work for which they were paid. And the work was necessary for the business. The taxpayers demonstrated that if their children had not done the work, they would have had to hire someone else to do it.

Loopholes in setting up a business

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.


  • 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…


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.

Insurance: A Great Investment Vehicle

The Darlings of Tax Reform

Since Tax Reform policies went into effect, the insurance industry’s deferred annuities have become on of the most attractive investment products around.

Deferred annuities can serve as an alternative for individuals whose incentive to continue to make IRA contributions was greatly weakened by Tax Reform. Although contributions to a deferred annuity are not tax deductible, earnings do accumulate tax deferred. Advantage over an IRA: There is no limit to the amount of money you can invest in an annuity.

The new variable annuity can serve as the ideal replacement for investments that used to receive the benefit of favorable long-term capital gains treatment. Long-term gains from investments in stocks can be sheltered in a variable annuity. That income is not taxed until you withdraw your money.

How Annuities Work

An individual buys and annuity from an insurance company, paying a lump sum or a series of payments over time. In return, the insurance company guarantees that the funds will grow at a certain tax-free rate. Then, beginning on a specified date, the individual receives regular income payments for life.

Payments depend on the amount of money contributed to the account, the length of time the funds are left in it, and the rate of return earned on the funds. Also a factor in determining the size of the payments is whether you include your spouse and other heirs as beneficiaries. Different options enable you to have payments continue to your spouses, or to your children, or for a minimum of, say, 20 years, regardless of who is there to receive them after you die.

Deferred annuities, therefore, can be considered part insurance and part investment. If you are willing to part with at least $5,000 (the minimum amount can differ from company to company) for five years or longer, you can be guaranteed a competitive, tax-free return on your funds. Because the earned income is not taxed until you begin withdrawing the money (presumably at a lower tax rate), your funds accumulate much faster than they would if they were taxed. The insurance component, of course, is guaranteed regular monthly income payments for the rest of your life-taking the worry and risk out of budgeting for your retirement income. Also, should you die before you begin receiving payments, your heirs are guaranteed to receive the full amount of your original principal.

Fixed Rate Versus Variable

There are two basic types of deferred annuity-fixed and variable.

Fixed annuity: The insurance company guarantees that your funds will grow at a specified rate for a specified period of time. Most companies guarantee a specific rate of return for at least the first year. Thereafter, the rate usually fluctuates at least once a year, according to the then-prevailing interest rates. Although the rates of return for fixed annuities may vary, your principal always remains intact.

Variable annuity: The rate of return is determined by the performance of investments you select from a broad range of mutual funds offered by the insurance company. Investing in a variable annuity is almost identical to investing in a family of mutual funds. You have the same exchange privileges and the choice of putting all your money into one fund or a blend of different funds, or even of dividing your money between a fixed annuity and a variable annuity. You can earn a much larger return than you might with a fixed annuity. However, if your investments perform poorly, your original principal may diminish.

The minimum investment for a deferred annuity is generally $5,000, although some single-premium annuities can require a one-time lump-sum investment of as little as $2,500. A flexible premium annuity, paid over time, may have an initial minimum as low as $1,000 and require small monthly payments.

Most companies levy an annual management charge of 0.5%-1.5% of total assets. If you invest in a variable annuity, you will also pay a percentage of your total assets to cover management costs for the mutual fund.

Insurance companies typically charge a declining surrender fee of 5%-6% (which usually falls to zero after five or six years) if you liquidate the principal of your annuity. And if you withdraw your money before age 59 1/2, the IRS will charge you a penalty.

Get the most out of modifiers

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.

Child’s Compensation Taxed

A seven-year-old child received a $30,000 court award for personal injuries. The award will be invested on the child’s behalf. How will it be taxed?

A court’s award of damages as compensation for personal injuries is tax-free when received. However, when the award if invested, the income it produces is taxed under normal rules.

In the case of a child under age 14, investment income exceeding $1,300 may be taxed at the top-bracket rate of the child’s parents. To avoid tax, the award may, of course, be placed in an investment that is tax-exempt (such as municipal bonds) or in one that will defer taxes (such as growth stocks or Series EE saving bonds).

Business-Travel Loopholes

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.

Business meals, travel, and entertainment deductions

Business-Meal Loopholes

The Tax Reform Act of 1986 put tough limits on deductions for business meals and entertainment. Only 50% of these expenses is deductible. The limit applies to food, beverages, taxes, tips, tickets, cover charges, and whatever else you spend for business purposes on eating out and entertainment. All are just 50% deductible.

Even though the value of deducting an extra $1 of business-meal expenses was reduced because of the drop in tax rates, the incentive to get the biggest deduction legally possible still exists.

The Angles

Reimbursement angle. Employees are not subject to the 50% rule if their company reimburses them for business-meal and entertainment expenses. It’s the company that’s subject to the rule-the company must limit the amount of the deduction it claims on its tax return to 50% of the amount given to reimburse the employee. Bottom line: The tax law has no adverse effect on the expense account of an employee who is reimbursed in full for business-meal and entertainment costs. It may be more desirable to have your employer reimburse you than for you to receive an expense allowance and deduct meal and entertainment expenses on your own return, as they will be limited to 50%.

Lodging loophole. The 50% rule applies to business meals (including those you eat while traveling away from home on business) and to entertainment of travel expenses and, thus, are not subject to the rule. Question: What if your hotel rate is stated only on the European or American plan and includes either two or three meals a day? Is your hotel bill (including meals) fully deductible? The new law does not say. This may be a loophole.

Company-party loophole. The 50% rule does not apply to certain traditional employer-paid social or recreational activities that are primarily for the benefit of the employees. Holiday parties and annual summer outings will continue to be fully deductible.

Strategy: Include in your travel plans conventions that provide three meals a day and a speaker at each meal as part of the cost.

Source: Randy Bruce Blaustein, former IRS agent, now a partner of Blaustein, Greenberg & Co., 155 E. 31 St., New York 10016

How To Prove Business Purpose Of Spouse On Company Trip

It’s possible to deduct the cost of taking your spouse on a business trip. The key is to prove your spouse’s involvement in the business aspects of the trip.


Explain your job responsibilities to your spouse.

Involve your spouse in interacting with people relevant to the trip and with other spouses who are present. They should discuss general aspects of the job being worked on. There’s no need for detailed descriptions of the business project

Make sure there are official functions, such as seminars, dinners, and parties, to which spouses are invited. (If you’re not self-employed, ask your employer to specify that it’s mandatory to take spouses to these events.)

Eat all your meals with business associates. Make sure that business is discussed at each of these meals and that your spouse participated in the discussions.

Document all of your spouse’s ideas on the business by having your spouse write memos to you containing these ideas.

If it’s the policy of the company not to pay for spouses on business trips but to require the spouse’s attendance, request a written memo from your employer stating this policy.

Source: New Tax Traps/ New Opportunities by Edward Mendlowitz, CPA, Boardroom Special Report, Springfield, NJ 07081.

Business-Gift Loophole

An advertising company employed an independent salesman. As favors to prospective customers, he gave out $40,000 worth of tickets to shows and sporting events. The company paid for the tickets and deducted their full cost. IRS position: The company’s expense deduction was subject to the limit of $25 per recipient under the tax law. Court’s decision: The ticket expenses were deductible by the company. The $25 business-gift limitation applied to the independent salesman, not to the company that employed him.

Source: World Wide Agency, Inc., TC Memo 1981-419

Expense Formula Fails

A company had many representatives traveling on the road. It reimbursed their travel costs for transportation, meals, and lodging on a cents-per-mile basis. IRS ruling: The number of miles and employee travels doesn’t give an adequate indication of the amount he/she spends on meals or lodging. Thus, the company’s reimbursement formula in not sufficient to make the reimbursements tax-free.

Source: IRS Letter Ruling 8634029.

Travel and Entertainment Rules

The Tax Reform Act of 1986, as amended, limits deductions for most meals and entertainment to 50% of cost. Moreover, the expenditures qualify as business meals or business entertainment only if business is actually being discussed. Business transportation (air fare, cabs, etc.) remains fully deductible, but travel to investment seminars or investment conventions is not.

Here’s a checklist showing the deductibility of some common travel and entertainment expenses:

Type of expense                                                                                             Deductible

Lunch with customer; business discussed before, during,

Or after the meal…………………………………………………………50%

Cab fare to restaurant…………………………………………………….100%

No business discussed……………………………………………………None

Air far to Chicago to call on customer……………………………….100%

Lodging in Chicago………………………………………………………100%

Meals in Chicago (alone)…………………………………………………50%

Meals with customer, no business discussed:

Your meal…………………………………………………………50%

Customer’s meal………………………………………………….None

Air fare to L.A. for doctor to attend medical convention…………….100%

Meals in L.A………………………………………………………………50%

Air fare to Houston for investment seminar…………………………..None

Lodging in Houston……………………………………………………….None

Tickets to ballgame for taxpayer and customer; business discussed….50%

Cab fare to game…………………………………………………………..100%

Food and drink at game……………………………………………………50%

Complimentary theater tickets for customer; taxpayer not present……None

Lunch at service organization as member……………………………..50%

Tickets to charity golf tournament run by volunteers…………………100%

Greens fees, carts, food and beverages consumed while

Hosting customers; business discussed……………………………………50%

Trooper Costs

Minnesota State Troopers were required to take their on-duty meals in public restaurants to maintain public visibility. When off duty, they were required to make sure their patrol cars were parked off the street. Steven Pillsbury and Karl Christey were troopers who claimed business deductions both for their meal costs and the cost of renting garage space for their vehicles. Court: The meals were properly deducted because they were clearly a required part of the job. The garage costs were not deductible because it was not necessary for the troopers to rent garage space in order to keep the cars off the street.

Source: Steven Pillsbury, D Minn., No. 3-85-1361

On-The-Job Meals

Robert Walsh worked in a grocery store and was required to be on the premises at all times during his shift, in order to meet emergencies. For meals, he bought food from the store, ate on the premises, and deducted the cost as a business expense. Tax Court: To get a deduction a worker must be required to buy meals that are provided by the employer. Walsh was not entitled to a deduction because he could have brought his lunch from home.

Source: Robert M. Walsh, TC Memo 1987-18

Benefits Of Helping Parents

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).

All About Company Cars

When a company provides an automobile for an executive, it must keep very detailed records concerning business use of the vehicle in order to prevent the car’s value from being included in the executive’s income. Methods used by some companies in the past to address these recordkeeping requirements haven’t worked as well since Tax Reform. Examples:

  • Giving an executive an auto allowance that is included in his/her income. The executive then deducts the business use of the car on his personal return.
  • Providing the executive with a company-owned car, but including its full value in his/her income. The executive deducts business use of the car on his personal return.

Snag: Tax Reform upset both these alternatives. Under Tax Reform, business expenses cannot be deducted on a personal return, except to the extent that they exceed 2% of the Adjusted Gross Income (AGI).

Thus, an executive who receives a car allowance will have to pay tax on some of it, even if it is used entirely to pay business costs…And an executive who reports a company car in income will have to pay tax on some of its value, even if it’s used only for business.

What to Do

With smart planning, it is possible for executives to avoid the tax cost of the 2%-of-AGI limit, whether the company is subsidizing an executive’s use of his own car or providing a car to him outright. How to do it:

Convert a car allowance into a reimbursement program. The difference between an allowance and a reimbursement is that a riembursement is made for specified expenses. The executive must give the company an itemized report of his/her business driving-including mileage, tolls, parking fees, and the cost of oil and gas-and receive payment either for actual costs or at a rate not exceeding IRS allowance per mile.

Benefit: The payment to the executive is neither included in his income nor deducted on his return, so the 2%-of-AGI limit is avoided. Danger: Many companies that say they have reimbursement programs are in fact providing allowances to their executives, because the payments made to them are not based on sufficiently itemized expense reports. Such programs are now subject to IRS scrutiny.

Any company that provides regular  payments on a periodic basis without checking current expense reports falls into this category. So does any firm that provides a per-day or per-mile travel allowance that lumps together driving costs with estimated amounts for such other expenses as meals and lodging. Important: Establish itemized expense reporting and reimbursement procedures now.

Include only part of the value of a company-owned car in the executive’s income. The key is for to company to make an allocation of auto use for business and personal purposes. Only personal use of the car is included in the executive’s income. Since business use of the car is not reported, the executive does not need to take an offsetting deduction, and again the 2%-of-AGI limit is avoided.

Extra benefits: When an executive is provided with a company-owned car, the firm doesn’t have to bother making periodic expense reimbursements-so bookkeeping is simplified. And the company can also claim depreciation deductions for the vehicle. But accurate records documenting the amount of auto use allocated for business and personal purposes are a must.

Two Ways to Keep Records

  • The company can set up it’s own recordkeeping system for each car-for example, the requiring that an auto diary be kept for each vehicle.
  • The company can require those using company cars to file written statements saying that they are keeping records sufficient to document the cars’ business use. The company then avoids these recordkeeping duties. However, an executive who signs such a statement but doesn’t keep adequate records may be liable to the IRS for negligence penalties.

Source: Pamela Pecarich, partner, and Steven Woolf, Lynn Hogan, and Jeffrey Hillier, managers, Coopers & Lybrand, 1800 M St. NW, Washington, DC 20036

Sheriff’s Car

A deputy sheriff is require to be on call to respond to emergencies 24 hours a day. He is provided with a clearly marked sheriff’s vehicle and required to keep it at home so that he can respond to official calls in it. He is prohibited from making personal use of the car, except that he is required to commute normally would be a taxable fringe benefit. But here the car is tax-free, since the sheriff’s personal use of the car has a law-enforcement purpose.

Drive The Company Car Tax-Free- Almost

Business owners can drive the company car until its cost has been fully depreciated and then switch to keep it for personal use without tax liability. The car will not become taxable until it is sold. At that time, there will be a taxable gain to the extent that the sale price exceeds the depreciated basis in the car-that is, the original cost of the car reduced by the depreciation deductions that were claimed.

Business Use Of Your Car

If you use your car less than 50% of the time for business, you can’t deduct accelerated (ACRS) depreciation. You can use only the straight-line method of depreciation, writing off the same amount each year.

If you use the car more then 50% for business, you can use accelerated depreciation. However, you are limited in the amount you can deduct for depreciation, as follows, for cars placed in service in 1995: First year: $3,060; second year, $4,900; third year, $2,950; each succeeding year, $1,775. Any depreciation not deducted in one year can be carried forward indefinitely until the entire cost is recovered. Obviously, the deduction pertains only to the business percent of use. For example, if you use your car 80% for business in the first year after buying it, you can deduct $2,448 (80% x $2,060).

You must keep accurate records of the business use of your car. If you don’t, expect the IRS to disallow any claims you make. You records should indicate the mileage of each business trip and all other automobile expenses incurred, including repair bills, tolls, and parking fees. Ensure the accuracy of your records by keeping a diary of all your cash expenses.

Company-Car Loophole

Everybody seems to have found a way to get around the rules taxing employees for personal use of company-owned automobiles. One way to create a loophole for yourself-a loophole that will be difficult to plug-is to have a second car available for personal use. IRS agents have reported cases of taxpayers buying dinky used cars to substantiate the fact that they have another car available for weekend and after hours use.

Bad News For Executives

More than one out of 10 companies have eliminated company-provided executive cars. Half of the companies that still do provide the cars report it as extra income on employees’ W-2 tax forms. Reasons: Tax Reform, high insurance costs, and cost-control programs.

Cost Cutting

Don’t buy company cars for sales and service people. Instead, pay these employees a monthly fee, plus $0.10 a mile, to use their own cars on the job. Company benefits: No outlay for extra maintenance and administrative personnel. No losses when used cars are sold. Better employee morale-almost all prefer to use their own cars, and there’s no chance that a new employee will get stuck with an overused company auto. To make this system work, ensure that reimbursement for use of a private vehicle covers all the costs of operating it.