November 17, 2009

Rent Expense

Rent is any amount you pay for the use of property you do not own. In general, you can deduct rent as an expense only if the rent is for property you use in your trade or business. If you have or will receive equity in or title to the property, the rent is not deductible.

Unreasonable rent. You cannot take a rental deduction for unreasonable rent. Ordinarily, the issue of reasonableness arises only if you and the lessor are related. Rent paid to a related person (defined below) is reasonable if it is the same amount you would pay to a stranger for use of the same property. Rent is not unreasonable just because it is figured as a percentage of gross sales.
Related persons. For this purpose, the following are considered related persons.

 

  1. An individual and his or her brothers and sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
  2. An individual and a corporation if the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.
  3. Two corporations that are members of the same controlled group as defined in section 267(f) of the Internal Revenue Code.
  4. A grantor and a fiduciary of any trust.
  5. Fiduciaries of two separate trusts if the same person is a grantor of both trusts.
  6. A fiduciary and a beneficiary of the same trust.
  7. A fiduciary and a beneficiary of two separate trusts if the same person is a grantor of both trusts.
  8. A fiduciary of a trust and a corporation if the trust or a grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.
  9. A person and a tax-exempt educational or charitable organization that is controlled directly or indirectly by that person or by members of the family of that person.
  10. A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership.
  11. Two S corporations or an S corporation and a regular corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.
  12. An executor of an estate and a beneficiary of the estate unless the sale or exchange is in satisfaction of a pecuniary bequest.

To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, see Related Persons in Publication 542, Corporations. For rules that apply to transactions between partners and partnerships, see Publication 541, Partnerships.

Rent on your home. If you rent your home and use part of it as your place of business, you may be able to deduct the rent you pay for that part. You must meet the requirements for business use of your home. For more information, see Business use of your home in chapter 1.
Rent paid in advance. Generally, rent paid in your trade or business is deductible in the year paid or accrued. If you pay rent in advance, you can deduct only the amount that applies to your use of the rented property during the tax year. You can deduct the rest of your payment only over the period to which it applies.

 

Example 1.

 

You are a calendar year taxpayer and you leased a building for 5 years beginning July 1. Your rent is $12,000 per year. You paid the first year’s rent ($12,000) on June 30. You can deduct only $6,000 ( × $12,000) for the rent that applies to the first year.

Example 2.

 

You are a calendar year taxpayer. Last January you leased property for 3 years for $6,000 a year. You paid the full $18,000 (3 × $6,000) during the first year of the lease. Each year you can deduct only $6,000, the part of the lease that applies to that year.

Canceling a lease. You generally can deduct as rent an amount you pay to cancel a business lease.
Lease or purchase. There may be instances in which you must determine whether your payments are for rent or for the purchase of the property. You must first determine whether your agreement is a lease or a conditional sales contract. Payments made under a conditional sales contract are not deductible as rent expense.
Conditional sales contract. Whether an agreement is a conditional sales contract depends on the intent of the parties. Determine intent based on the provisions of the agreement and the facts and circumstances that exist when you make the agreement. No single test, or special combination of tests, always applies. However, in general, an agreement may be considered a conditional sales contract rather than a lease if any of the following is true.
  • The agreement applies part of each payment toward an equity interest you will receive.
  • You get title to the property after you make a stated amount of required payments.
  • The amount you must pay to use the property for a short time is a large part of the amount you would pay to get title to the property.
  • You pay much more than the current fair rental value of the property.
  • You have an option to buy the property at a nominal price compared to the value of the property when you may exercise the option. Determine this value when you make the agreement.
  • You have an option to buy the property at a nominal price compared to the total amount you have to pay under the agreement.
  • The agreement designates part of the payments as interest, or that part is easy to recognize as interest.
Leveraged leases. Leveraged lease transactions may not be considered leases. Leveraged leases generally involve three parties: a lessor, a lessee, and a lender to the lessor. Usually the lease term covers a large part of the useful life of the leased property, and the lessee’s payments to the lessor are enough to cover the lessor’s payments to the lender.   If you plan to take part in what appears to be a leveraged lease, you may want to get an advance ruling. Revenue Procedure 2001-28 on page 1156 of Internal Revenue Bulletin 2001-19 contains the guidelines the IRS will use to determine if a leveraged lease is a lease for federal income tax purposes. Revenue Procedure 2001-29 on page 1160 of the same Internal Revenue Bulletin provides the information required to be furnished in a request for an advance ruling on a leveraged lease transaction. In general, Revenue Procedure 2001-28 provides that, for advance ruling purposes only, the IRS will consider the lessor in a leveraged lease transaction to be the owner of the property and the transaction to be a valid lease if all the factors in the revenue procedure are met, including the following.

 

  • The lessor must maintain a minimum unconditional “at risk” equity investment in the property (at least 20% of the cost of the property) during the entire lease term.
  • The lessee may not have a contractual right to buy the property from the lessor at less than fair market value when the right is exercised.
  • The lessee may not invest in the property, except as provided by Revenue Procedure 2001-28.
  • The lessee may not lend any money to the lessor to buy the property or guarantee the loan used by the lessor to buy the property.
  • The lessor must show that it expects to receive a profit apart from the tax deductions, allowances, credits, and other tax attributes.
The IRS may charge you a user fee for issuing a tax ruling.
Leveraged leases of limited-use property. The IRS will not issue advance rulings on leveraged leases of so-called limited-use property. Limited-use property is property not expected to be either useful to or usable by a lessor at the end of the lease term except for continued leasing or transfer to a lessee. See Revenue Procedure 2001-28 for examples of limited-use property and property that is not limited-use property.
Leases over $250,000. Special rules are provided for certain leases of tangible property. The rules apply if the lease calls for total payments of more than $250,000 and any of the following apply.

 

  • Rents increase during the lease.
  • Rents decrease during the lease.
  • Rents are deferred (rent is payable after the end of the calendar year following the calendar year in which the use occurs and the rent is allocated).
  • Rents are prepaid (rent is payable before the end of the calendar year preceding the calendar year in which the use occurs and the rent is allocated).

These rules do not apply if your lease specifies equal amounts of rent for each month in the lease term and all rent payments are due in the calendar year to which the rent relates (or in the preceding or following calendar year).   Generally, if the special rules apply, you must use an accrual method of accounting (and time value of money principles) for your rental expenses, regardless of your overall method of accounting. In addition, in certain cases in which the IRS has determined that a lease was designed to achieve tax avoidance, you must take rent and stated or imputed interest into account under a constant rental accrual method in which the rent is treated as accruing ratably over the entire lease term. For details, see section 467 of the Internal Revenue Code.

Taxes on Leased Property

If you lease business property, you can deduct as additional rent any taxes you have to pay to or for the lessor. When you can deduct these taxes as additional rent depends on your accounting method.

Cash method. If you use the cash method of accounting, you can deduct the taxes as additional rent only for the tax year in which you pay them.
Accrual method. If you use an accrual method of accounting, you can deduct taxes as additional rent for the tax year in which you can determine all the following.
  • That you have a liability for taxes on the leased property.
  • How much the liability is.
  • That economic performance occurred.

The liability and amount of taxes are determined by state or local law and the lease agreement. Economic performance occurs as you use the property.

Example 1.

 

Oak Corporation is a calendar year taxpayer that uses an accrual method of accounting. Oak leases land for use in its business. Under state law, owners of real property become liable (incur a lien on the property) for real estate taxes for the year on January 1 of that year. However, they do not have to pay these taxes until July 1 of the next year (18 months later) when tax bills are issued. Under the terms of the lease, Oak becomes liable for the real estate taxes in the later year when the tax bills are issued. If the lease ends before the tax bill for a year is issued, Oak is not liable for the taxes for that year.

Oak cannot deduct the real estate taxes as rent until the tax bill is issued. This is when Oak’s liability under the lease becomes fixed.

Example 2.

 

The facts are the same as in Example 1 except that, according to the terms of the lease, Oak becomes liable for the real estate taxes when the owner of the property becomes liable for them. As a result, Oak will deduct the real estate taxes as rent on its tax return for the earlier year. This is the year in which Oak’s liability under the lease becomes fixed.

Cost of Getting a Lease

You may either enter into a new lease with the lessor of the property or get an existing lease from another lessee. Very often when you get an existing lease from another lessee, you must pay the previous lessee money to get the lease, besides having to pay the rent on the lease.

If you get an existing lease on property or equipment for your business, you generally must amortize any amount you pay to get that lease over the remaining term of the lease. For example, if you pay $10,000 to get a lease and there are 10 years remaining on the lease with no option to renew, you can deduct $1,000 each year.

The cost of getting an existing lease of tangible property is not subject to the amortization rules for section 197 intangibles discussed in chapter 8.

Option to renew. The term of the lease for amortization includes all renewal options plus any other period for which you and the lessor reasonably expect the lease to be renewed. However, this applies only if less than 75% of the cost of getting the lease is for the term remaining on the purchase date (not including any period for which you may choose to renew, extend, or continue the lease). Allocate the lease cost to the original term and any option term based on the facts and circumstances. In some cases, it may be appropriate to make the allocation using a present value computation. For more information, see Regulations section 1.178-1(b)(5).

 

Example 1.

 

You paid $10,000 to get a lease with 20 years remaining on it and two options to renew for 5 years each. Of this cost, you paid $7,000 for the original lease and $3,000 for the renewal options. Because $7,000 is less than 75% of the total $10,000 cost of the lease (or $7,500), you must amortize the $10,000 over 30 years. That is the remaining life of your present lease plus the periods for renewal.

Example 2.

 

The facts are the same as in Example 1, except that you paid $8,000 for the original lease and $2,000 for the renewal options. You can amortize the entire $10,000 over the 20-year remaining life of the original lease. The $8,000 cost of getting the original lease was not less than 75% of the total cost of the lease (or $7,500).

Cost of a modification agreement. You may have to pay an additional “rent” amount over part of the lease period to change certain provisions in your lease. You must capitalize these payments and amortize them over the remaining period of the lease. You cannot deduct the payments as additional rent, even if they are described as rent in the agreement.

 

Example.

 

You are a calendar year taxpayer and sign a 20-year lease to rent part of a building starting on January 1. However, before you occupy it, you decide that you really need less space. The lessor agrees to reduce your rent from $7,000 to $6,000 per year and to release the excess space from the original lease. In exchange, you agree to pay an additional rent amount of $3,000, payable in 60 monthly installments of $50 each.

You must capitalize the $3,000 and amortize it over the 20-year term of the lease. Your amortization deduction each year will be $150 ($3,000 ÷ 20). You cannot deduct the $600 (12 × $50) that you will pay during each of the first 5 years as rent.

Commissions, bonuses, and fees. Commissions, bonuses, fees, and other amounts you pay to get a lease on property you use in your business are capital costs. You must amortize these costs over the term of the lease.
Loss on merchandise and fixtures. If you sell at a loss merchandise and fixtures that you bought solely to get a lease, the loss is a cost of getting the lease. You must capitalize the loss and amortize it over the remaining term of the lease.

Improvements by Lessee

If you add buildings or make other permanent improvements to leased property, depreciate the cost of the improvements using the modified accelerated cost recovery system (MACRS). Depreciate the property over its appropriate recovery period. You cannot amortize the cost over the remaining term of the lease.

If you do not keep the improvements when you end the lease, figure your gain or loss based on your adjusted basis in the improvements at that time.

For more information, see the discussion of MACRS in Publication 946, How To Depreciate Property.

Assignment of a lease. If a long-term lessee who makes permanent improvements to land later assigns all lease rights to you for money and you pay the rent required by the lease, the amount you pay for the assignment is a capital investment. If the rental value of the leased land increased since the lease began, part of your capital investment is for that increase in the rental value. The rest is for your investment in the permanent improvements.   The part that is for the increased rental value of the land is a cost of getting a lease, and you amortize it over the remaining term of the lease. You can depreciate the part that is for your investment in the improvements over the recovery period of the property as discussed earlier, without regard to the lease term.

Capitalizing Rent Expenses

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction. You recover the costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.

Indirect costs include amounts incurred for renting or leasing equipment, facilities, or land.

Uniform capitalization rules. You may be subject to the uniform capitalization rules if you do any of the following, unless the property is produced for your use other than in a business or an activity carried on for profit.

 

  1. Produce real property or tangible personal property. For this purpose, tangible personal property includes a film, sound recording, video tape, book, or similar property.
  2. Acquire property for resale.

However, these rules do not apply to the following property.

  1. Personal property you acquire for resale if your average annual gross receipts are $10 million or less for the 3 prior tax years.
  2. Property you produce if you meet either of the following conditions.
    1. Your indirect costs of producing the property are $200,000 or less.
    2. You use the cash method of accounting and do not account for inventories.
Example 1.

 

You rent construction equipment to build a storage facility. If you are subject to the uniform capitalization rules, you must capitalize as part of the cost of the building the rent you paid for the equipment. You recover your cost by claiming a deduction for depreciation on the building.

Example 2.

 

You rent space in a facility to conduct your business of manufacturing tools. If you are subject to the uniform capitalization rules, you must include the rent you paid to occupy the facility in the cost of the tools you produce.

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November 16, 2009

How to File an Offer in Compromise

The Form 656-B, Offer in Compromise Booklet (PDF) contains information about filing an offer in compromise, worksheets, and all forms necessary to file an offer in compromise.

When submitting an offer in compromise (OIC), taxpayers must use the most current version of Form 656, Offer in Compromise (PDF), or Form 656-L, Offer in Compromise (Doubt as to Liability) (PDF), depending on the basis of the offer in compromise. Taxpayers should file Form 656 when there is doubt that the liability could be collected in full through a lump sum or an installment agreement and file Form 656-L when it is believed that the tax liability is incorrect.  Taxpayers may not file offers concurrently claiming both that the tax liability is incorrect along with an inability to pay the liability.

In most cases, taxpayers must submit Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, and/or Form 433-B, Collection Information Statement for Businesses. Neither the Form 433-A nor Form 433-B is required when a taxpayer submits an OIC based solely as to doubt as to liability.

How Many Forms 656 and Application Fees are Required?

The general rule when determining how many offers and application fees are necessary is “one fee and form per entity”. The Form 656-B contains an Offer in Compromise Application Fee and Payments matrix to assist you in determining the number of Forms 656 and application fees required.

Examples:

A married couple owing the same joint income tax liability may file only one Form 656 listing the joint liability. One fee of $150 should be attached to the Form 656. A married couple opting to file separate offers to compromise the same joint liability may do so, but two $150 application fees will be required.

When a married couple owes a joint liability and one spouse also owes an individual (non-joint) liability, two OICs and two application fees are needed.

A divorced, separated or married couple living apart may still file one From 656 listing their joint liability and pay only one $150 fee as long as all the taxes owed are joint liabilities. Taxpayers in these situations that opt to file separate offers must pay a $150 application fee for each offer that is submitted for consideration.

Note: These examples assume that the taxpayers do not meet one of the exceptions for paying the application fee: the OIC is filed under doubt as to liability or the taxpayer has completed and attached Form 656-A and the OIC Application Fee and Payment Worksheet to Form 656.

Keys to Success in the Offer in Compromise Program:

  1. Explore all collection options before submitting an offer in compromise
  2. Complete the “Is Your Offer in Compromise Processable?” checklist located in the Form 656-B, Offer in Compromise Booklet.
  3. Submit all required documentation
  4. Complete all items on Form 656, Offer in Compromise
  5. Include all required fees and payments
  6. Be current with all filing and paying requirements (estimated taxes and federal tax deposits) and remain current
  7. Respond promptly to all requests for additional information
  8. Complete all items on Form 433-A or Form 433-B

Where to File Form 656

Residents of: Alaska, Arizona, California, Colorado, Hawaii, Idaho, Kentucky, Louisiana, Mississippi, Montana, Nevada, New Mexico, Oregon, Tennessee, Texas, Utah, Washington, Wisconsin or Wyoming:

If you are a wage earner, retiree, or a self-employed individual without employees; then mail Form 656 and all attachments to:

Memphis Internal Revenue Service
Center COIC Unit
PO Box 30803 AMC
Memphis, TN 38130-0804

If you are other than a wage earner, retiree, or self-employed individual without employees; then mail Form 656 and all attachments to:

Memphis Internal Revenue Service
Center COIC Unit
PO Box 30804, AMC
Memphis, TN 38130-0804

Residents of: Arkansas, Connecticut, Delaware, District of Columbia, Florida, Georgia, Illinois, Indiana, Iowa, Kansas, Maine, Maryland, Massachusetts, Michigan, Minnesota, Missouri, Nebraska, New Hampshire, New Jersey, New York, North Carolina, North Dakota, Ohio, Oklahoma, Pennsylvania, Puerto Rico, Rhode Island, South Carolina, South Dakota, Vermont, Virginia, West Virginia, or have a foreign address:

If you are a wage earner, retiree, or a self-employed individual without employees; then mail Form 656 and all attachments to:

Brookhaven Internal Revenue Service
Center COIC Unit
PO Box 9007
Holtsville, NY 11742-9007

If you are other than a wage earner, retiree, or a self-employed individual without employees; then mail form 656 and all attachments to:

Brookhaven Internal Revenue Service
Center COIC Unit
PO Box 9008
Holtsville, NY 11742-9008

Where to File Form 656-L (Doubt as to Liability)

Brookhaven Internal Revenue Service
COIC Unit
PO Box 9008
Holtsville, NY 11742-9008

In addition to accessing the Form 656 and Form 656-L online, you may obtain it by calling the IRS toll free number  1-800-829-3676 or by visiting your local IRS office.

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November 15, 2009

Do You Qualify for an Offer in Compromise?

The objective of the Offer in Compromise (OIC) program is to accept an OIC when it is in the best interest of both the taxpayer and the government and promotes voluntary compliance with all future payment and filing requirements.

If you are unable to pay your tax liability in a lump sum or through an installment agreement and you have exhausted your search for other payment arrangements, you may be a candidate for an offer in compromise.

In order for your offer in compromise to be considered, you must meet the following requirements:

  • You are not a debtor in an open bankruptcy proceeding
  • Submit one of the following payments with the offer:
    • Lump Sum Offer- 20 percent payment or a signed From 656-A, Income Certification for Offer in Compromise Application Fee and Payment
    • Periodic Payment Offer- The first installment or a signed Form 656-A, Income Certification for Offer in Compromise Application Fee and Payment.

Low Income Exemption and Guidelines

The application fee is waived if an individual (not a corporation, partnership or other entity) taxpayer’s income falls at or below IRS Low Income Guidelines. The Form 656-B, Offer in Compromise Booklet (PDF), contains a worksheet titled “IRS Monthly Low Income Guidelines Worksheet” designed to assist taxpayers in determining whether they are eligible for the low income exemption. Qualifying taxpayers are also exempt from making any OIC payments while the offer is being investigated.

Once you have determined that you are eligible for the low income exemption, you must submit Form 656-A, Offer Certification for Offer in Compromise Application Fee and Payment. The worksheet along with Form 656-A must be attached to the Form 656 application and mailed to the IRS for consideration.

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November 14, 2009

What You Must Know Before You File an Offer in Compromise

All Taxpayers Do Not Qualify for an Offer in Compromise

Absent special circumstances, if you have the ability to fully pay your tax liability in a lump sum or via an installment agreement, an offer in compromise will not be accepted.

Offer in Compromise Payments are Non-refundable

The IRS considers the 20 percent payment for a lump sum offer and any periodic payments as “payments on tax” and are not refundable, regardless of whether the offer is declared not-processable or is later returned, withdrawn, rejected or terminated by the IRS.

Federal Tax Liens are Not Released

If there is a Notice of Federal Tax Lien on record prior to acceptance of the offer, the lien is not released until the OIC terms are satisfied or until the liability is paid, whichever comes first.  A Notice of Federal Tax Lien may be filed during the course of the OIC investigation.

Payments May be Designated

You may designate in writing how the IRS should apply payments made with the filing of the offer and while an offer is under investigation. Without a written designation, payments will be applied to the tax liability and in the government’s best interest. The $150 application fee cannot be designated, but is applied to the tax liability and in the government’s best interest.

Refunds

The IRS will keep any refund, including interest due, because of an overpayment of any tax or other liability, for tax periods extending through the calendar year the IRS accepts the OIC.

Exception: Offers submitted under the basis of doubt as to liability.

Levies

The IRS will keep all payments and credits made, received or applied to the total original tax liability before the OIC was submitted.  The IRS may also keep any proceeds from a levy that was served prior to the submission of an OIC, but which were not received at the time the OIC was submitted.

Statutory Period for Collection Suspended

The statutory period for collection is suspended during the period that the OIC is under consideration (pending) and is further suspended if the OIC is rejected by the IRS and you appeal the rejection.

Five Year Compliance

If your offer is accepted, you must timely file all tax returns and timely pay all tax for five years or until the offered amount is paid in full, whichever period is longer.  Failure to adhere to these terms will result in default of the offer and the IRS may then collect the amounts originally owed plus penalties and interest.

OIC Payment and Application Fee Exceptions

If you qualify for a low-income exception waiver or you submit a doubt as to liability offer you are exempt from the $150 application fee and any OIC payments due upon submission of the OIC or during the course of the investigation. The low income waiver does not apply to businesses.

Appeal

If your OIC is rejected, you will have the opportunity to file an appeal which will be heard by the IRS Office of Appeals.  There are no appeal rights associated with offers that are returned, withdrawn or terminated.

Approved Installment Agreement

If you have an approved installment agreement and submit a periodic payment offer, you are not required to continue to make the installment agreement payments while the offer is being investigated.  You will, however, be required to make the OIC periodic payments as they become due.

Mandatory Acceptance

Per IRC 7122(f), the IRS will deem an offer “accepted” if it is not withdrawn, returned or rejected within 24 months of the IRS receipt date. If a liability included in the offer amount is disputed in any judicial proceeding, that time period is omitted from calculating the 24-month time frame.

Public Inspection Files

The law requires the IRS to make certain information from accepted Offers in Compromise available for public inspection and review. These public inspection file locations are located in designated IRS Area Offices.

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November 13, 2009

Deduct Business Expense – Employee Pay

Introduction

You can generally deduct the pay you give your employees for the services they perform. The pay may be in cash, property, or services. It may include wages, or salaries, or other compensation, such as vacation allowances, bonuses, commissions, and fringe benefits. For information about deducting employment taxes, see chapter 5.

You can claim the following employment credits if you pay wages to individuals who meet certain requirements.

  • Work opportunity credit (claimed on Form 5884).
  • Credit for affected Midwestern disaster area employers (claimed on Form 5884-A).
  • Empowerment zone and renewal community employment credit (claimed on Form 8844).
  • Indian employment credit (claimed on Form 8845).
  • Welfare-to-work credit (claimed on Form 8861).
  • Credit for employer differential wage payments (claimed on Form 8932; only for payments made in 2009).

Reduce your deduction for e

Tests for Deducting Pay

To be deductible, your employees’ pay must be an ordinary and necessary expense and you must pay or incur it. These and other requirements that apply to all business expenses are explained in chapter 1.

In addition, the pay must meet both of the following tests.

  • Test 1. It must be reasonable.
  • Test 2. It must be for services performed.

The form or method of figuring the pay does not affect its deductibility. For example, bonuses and commissions based on sales or earnings, and paid under an agreement made before the services were performed, are both deductible.

Test 1—Reasonableness

Determine the reasonableness of pay by the facts and circumstances. Generally, reasonable pay is the amount that like enterprises pay for the same, or similar, services.

You must be able to prove that the pay is reasonable. Base this determination on the circumstances that exist when you contract for the services, not those that exist when the reasonableness is questioned. If the pay is excessive, the excess is disallowed.

Factors to consider. To determine if pay is reasonable, consider the following items and any other pertinent facts.

  • The duties performed by the employee.
  • The volume of business handled.
  • The character and amount of responsibility.
  • The complexities of your business.
  • The amount of time required.
  • The cost of living in the locality.
  • The ability and achievements of the individual employee performing the service.
  • The pay compared with the gross and net income of the business, as well as with distributions to shareholders if the business is a corporation.
  • Your policy regarding pay for all your employees.
  • The history of pay for each employee.

Test 2—For Services Performed

You must be able to prove the payment was made for services actually performed.

Employee-shareholder salaries. If a corporation pays an employee who is also a shareholder a salary that is unreasonably high considering the services actually performed, the excessive part of the salary may be treated as a constructive distribution to the employee-shareholder. For more information on corporate distributions to shareholders, see Publication 542, Corporations.

Kinds of Pay

Some of the ways you may provide pay to your employees in addition to regular wages or salaries are discussed next. For specialized and detailed information on employees’ pay and the employment tax treatment of employees’ pay, see Publication 15, Publication 15-A, Publication 15-B, and Publication 15-T.

Awards

You can generally deduct amounts you pay to your employees as awards, whether paid in cash or property. If you give property to an employee as an employee achievement award, your deduction may be limited.

Achievement awards. An achievement award is an item of tangible personal property that meets all the following requirements.

  • It is given to an employee for length of service or safety achievement.
  • It is awarded as part of a meaningful presentation.
  • It is awarded under conditions and circumstances that do not create a significant likelihood of disguised pay.

Length-of-service award. An award will qualify as a length-of-service award only if either of the following applies.

  • The employee receives the award after his or her first 5 years of employment.
  • The employee did not receive another length-of-service award (other than one of very small value) during the same year or in any of the prior 4 years.

Safety achievement award. An award for safety achievement will qualify as an achievement award unless one of the following applies.

  1. It is given to a manager, administrator, clerical employee, or other professional employee.
  2. During the tax year, more than 10% of your employees, excluding those listed in (1), have already received a safety achievement award (other than one of very small value).

Deduction limit. Your deduction for the cost of employee achievement awards given to any one employee during the tax year is limited to the following.

  • $400 for awards that are not qualified plan awards.
  • $1,600 for all awards, whether or not qualified plan awards.

A qualified plan award is an achievement award given as part of an established written plan or program that does not favor highly compensated employees as to eligibility or benefits.

A highly compensated employee for 2008 is an employee who meets either of the following tests.

  1. The employee was a 5% owner at any time during the year or the preceding year.
  2. The employee received more than $105,000 in pay for the preceding year.

You can choose to ignore test (2) if the employee was not also in the top 20% of employees ranked by pay for the preceding year.

An award is not a qualified plan award if the average cost of all the employee achievement awards given during the tax year (that would be qualified plan awards except for this limit) is more than $400. To figure this average cost, ignore awards of nominal value.

Deduct achievement awards as a nonwage business expense on your return or business schedule.

You may not owe employment taxes on the value of some achievement awards you provide to an employee. See Publication 15-B.

Bonuses

You can generally deduct a bonus paid to an employee if you intended the bonus as additional pay for services, not as a gift, and the services were performed. However, the total bonuses, salaries, and other pay must be reasonable for the services performed. If the bonus is paid in property, see Property, later.

Gifts of nominal value. If, to promote employee goodwill, you distribute food, or merchandise of nominal value to your employees at holidays, you can deduct the cost of these items as a nonwage business expense. Your deduction for de minimus gifts of food or drink are not subject to the 50% deduction limit that generally applies to meals. For more information on this deduction limit, see Meals and lodging, later.

Education Expenses

If you pay or reimburse education expenses for an employee, you can deduct the payments if they are part of a qualified educational assistance program. Deduct them on the “Employee benefit programs” or other appropriate line of your tax return. For information on educational assistance programs, see Educational Assistance in section 2 of Publication 15-B.

Fringe Benefits

A fringe benefit is a form of pay for the performance of services. You can generally deduct the cost of fringe benefits.

You may be able to exclude all or part of the value of some fringe benefits from your employees’ pay. You also may not owe employment taxes on the value of the fringe benefits. See Table 2-1 in Publication 15-B for details.

Your deduction for the cost of fringe benefits for activities generally considered entertainment, amusement, or recreation, or for a facility used in connection with such an activity (for example, a company aircraft) for certain officers, directors, and more-than-10% shareholders is limited.

See Pub. 15-B for an extensive discussion of fringe benefits.

Meals and lodging. You can usually deduct the cost of furnishing meals and lodging to your employees. Deduct the cost in whatever category the expense falls. For example, if you operate a restaurant, deduct the cost of the meals you furnish to employees as part of the cost of goods sold. If you operate a nursing home, motel, or rental property, deduct the cost of furnishing lodging to an employee as expenses for utilities, linen service, salaries, depreciation, etc.

Deduction limit on meals. You can generally deduct only 50% of the cost of furnishing meals to your employees. However, you can deduct the full cost of the following meals.

  • Meals whose value you include in an employee’s wages.
  • Meals that qualify as a de minimus fringe benefit as discussed in section 2 of Publication 15-B. This generally includes meals you furnish to employees at your place of business if more than half of these employees are provided the meals for your convenience.
  • Meals you furnish to your employees at the work site when you operate a restaurant or catering service.
  • Meals you furnish to your employees as part of the expense of providing recreational or social activities, such as a company picnic.
  • Meals you are required by federal law to furnish to crew members of certain commercial vessels (or would be required to furnish if the vessels were operated at sea). This does not include meals you furnish on vessels primarily providing luxury water transportation.
  • Meals you furnish on an oil or gas platform or drilling rig located offshore or in Alaska. This includes meals you furnish at a support camp that is near and integral to an oil or gas drilling rig located in Alaska.

Employee benefit programs. Employee benefit programs include the following.

  • Accident and health plans.
  • Adoption assistance.
  • Cafeteria plans.
  • Dependent care assistance.
  • Educational assistance.
  • Life insurance coverage.
  • Welfare benefit funds.

You can generally deduct amounts you spend on employee benefit programs on the applicable line of your tax return. For example, if you provide dependent care by operating a dependent care facility for your employees, deduct your costs in whatever categories they fall (utilities, salaries, etc.).

Life insurance coverage. You cannot deduct the cost of life insurance coverage for you, an employee, or any person with a financial interest in your business, if you are directly or indirectly the beneficiary of the policy. See Regulations section 1.264-1 for more information.

Welfare benefit funds. A welfare benefit fund is a funded plan (or a funded arrangement having the effect of a plan) that provides welfare benefits to your employees, independent contractors, or their beneficiaries. Welfare benefits are any benefits other than deferred compensation or transfers of restricted property.

Your deduction for contributions to a welfare benefit fund is limited to the fund’s qualified cost for the tax year. If your contributions to the fund are more than its qualified cost, carry the excess over to the next tax year.

Generally, the fund’s “qualified cost” is the total of the following amounts, reduced by the after-tax income of the fund.

  • The cost you would have been able to deduct using the cash method of accounting if you had paid for the benefits directly.
  • The contributions added to a reserve account that are needed to fund claims incurred but not paid as of the end of the year. These claims can be for supplemental unemployment benefits, severance pay, or disability, medical, or life insurance benefits.

For more information, see sections 419(c) and 419A of the Internal Revenue Code and the related regulations.

Loans or Advances

You generally can deduct as wages an advance you make to an employee for services performed if you do not expect the employee to repay the advance. However, if the employee performs no services, treat the amount you advanced as a loan. If the employee does not repay the loan, treat it as income to the employee.

Below-market interest rate loans. On certain loans you make to an employee or shareholder, you are treated as having received interest income and as having paid compensation or dividends equal to that interest. See Below-Market Loans in chapter 4.

Property

If you transfer property (including your company’s stock) to an employee as payment for services, you can generally deduct it as wages. The amount you can deduct is the property’s fair market value on the date of the transfer less any amount the employee paid for the property.

You can claim the deduction only for the tax year in which your employee includes the property’s value in income. Your employee is deemed to have included the value in income if you report it on Form W-2 in a timely manner.

You treat the deductible amount as received in exchange for the property, and you must recognize any gain or loss realized on the transfer, unless it is the company’s stock transferred as payment for services. Your gain or loss is the difference between the fair market value of the property and its adjusted basis on the date of transfer.

These rules also apply to property transferred to an independent contractor for services, generally reported on Form 1099-MISC.

Restricted property. If the property you transfer for services is subject to restrictions that affect its value, you generally cannot deduct it and do not report gain or loss until it is substantially vested in the recipient. However, if the recipient pays for the property, you must report any gain at the time of the transfer up to the amount paid.

“Substantially vested” means the property is not subject to a substantial risk of forfeiture. This means that the recipient is not likely to have to give up his or her rights in the property in the future.

Reimbursements for Business Expenses

You can generally deduct the amount you pay or reimburse employees for business expenses incurred for your business. However, your deduction may be limited.

If you make the payment under an accountable plan, deduct it in the category of the expense paid. For example, if you pay an employee for travel expenses incurred on your behalf, deduct this payment as a travel expense. If you make the payment under a nonaccountable plan, deduct it as wages and include it in the employee’s W-2.

See Reimbursement of Travel, Meals, and Entertainment in chapter 11 for more information about deducting reimbursements and an explanation of accountable and nonaccountable plans.

Sick and Vacation Pay

Sick pay. You can deduct amounts you pay to your employees for sickness and injury, including lump-sum amounts, as wages. However, your deduction is limited to amounts not compensated by insurance or other means.

Vacation pay. Vacation pay is an employee benefit. It includes amounts paid for unused vacation leave. You can deduct vacation pay only in the tax year in which the employee actually receives it. This rule applies regardless of whether you use the cash or accrual method of accounting.

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November 12, 2009

Deduct Business Expense ” Cost of Goods Sold”

What Can I Deduct?

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

It is important to distinguish business expenses from:

  • The expenses used to figure cost of goods sold,
  • Capital expenses, and
  • Personal expenses.

Cost of Goods Sold

If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your business expenses may be included in figuring cost of goods sold. Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.

The following are types of expenses that go into figuring cost of goods sold.

  • The cost of products or raw materials, including freight.
  • Storage.
  • Direct labor (including contributions to pension or annuity plans) for workers who produce the products.
  • Factory overhead.

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.

This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million.

For more information, see the following sources.

  • Cost of goods sold—chapter 6 of Publication 334.
  • Inventories—Publication 538.
  • Uniform capitalization rules—Publication 538 and section 263A of the Internal Revenue Code and the related regulations.

Capital Expenses

You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called “capital expenses.” Capital expenses are considered assets in your business. There are, in general, three types of costs you capitalize.

  • Business start-up costs (See Tip below).
  • Business assets.
  • Improvements.

You can elect to deduct or amortize certain business start-up costs. See chapters 7 and 8.

Cost recovery. Although you generally cannot take a current deduction for a capital expense, you may be able to recover the amount you spend through depreciation, amortization, or depletion. These recovery methods allow you to deduct part of your cost each year. In this way, you are able to recover your capital expense. You may also be allowed a section 179 deduction. For information on the section 179 deduction and depreciation, see Publication 946.

Going Into Business

The costs of getting started in business, before you actually begin business operations, are capital expenses. These costs may include expenses for advertising, travel, or wages for training employees.

If you go into business. When you go into business, treat all costs you had to get your business started as capital expenses.

Usually you recover costs for a particular asset through depreciation. Generally, you cannot recover other costs until you sell the business or otherwise go out of business. However, you can choose to amortize certain costs for setting up your business. See Starting a Business in chapter 8 for more information on business start-up costs.

If you do not go into business. If you are an individual and your attempt to go into business is not successful, the expenses you had in trying to establish yourself in business fall into two categories.

  1. The costs you had before making a decision to acquire or begin a specific business. These costs are personal and nondeductible. They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility.
  2. The costs you had in your attempt to acquire or begin a specific business. These costs are capital expenses and you can deduct them as a capital loss.

If you are a corporation and your attempt to go into a new trade or business is not successful, you may be able to deduct all investigatory costs as a loss.

The costs of any assets acquired during your unsuccessful attempt to go into business are a part of your basis in the assets. You cannot take a deduction for these costs. You will recover the costs of these assets when you dispose of them.

Business Assets

There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. You must fully capitalize the cost of these assets, including freight and installation charges.

Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules. See Regulations section 1.263A-2 for information on these rules.

Improvements

The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. Improvements are generally major expenditures. Some examples are: new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements.

However, you can currently deduct repairs that keep your property in a normal efficient operating condition as a business expense. Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition.

Restoration plan. Capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration plan to make it suitable for your business. This applies even if some of the work would by itself be classified as repairs.

Capital versus Deductible Expenses

To help you distinguish between capital and deductible expenses, different examples are given below.

Motor vehicles. You usually capitalize the cost of a motor vehicle you use in your business. You can recover its cost through annual deductions for depreciation.

There are dollar limits on the depreciation you can claim each year on passenger automobiles used in your business. See Publication 463.

Generally, repairs you make to your business vehicle are currently deductible. However, amounts you pay to recondition and overhaul a business vehicle are capital expenses and are recovered through depreciation.

Roads and driveways. The cost of building a private road on your business property and the cost of replacing a gravel driveway with a concrete one are capital expenses you may be able to depreciate. The cost of maintaining a private road on your business property is a deductible expense.

Tools. Unless the uniform capitalization rules apply, amounts spent for tools used in your business are deductible expenses if the tools have a life expectancy of less than 1 year or their cost is minor.

Machinery parts. Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition, but not add to its life, is a deductible expense.

Heating equipment. The cost of changing from one heating system to another is a capital expense.

Personal versus Business Expenses

Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part.

For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you generally can deduct 70% of the interest as a business expense. The remaining 30% is personal interest and generally is not deductible. See chapter 4 for information on deducting interest and the allocation rules.

Business use of your home. If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation.

To qualify to claim expenses for the business use of your home, you must meet both of the following tests.

  1. The business part of your home must be used exclusively and regularly for your trade or business.
  2. The business part of your home must be:
    1. Your principal place of business, or
    2. A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business, or
    3. A separate structure (not attached to your home) used in connection with your trade or business.

You generally do not have to meet the exclusive use test for the part of your home that you regularly use either for the storage of inventory or product samples, or as a daycare facility.

Your home office qualifies as your principal place of business if you meet the following requirements.

  • You use the office exclusively and regularly for administrative or management activities of your trade or business.
  • You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.

If you have more than one business location, determine your principal place of business based on the following factors.

  • The relative importance of the activities performed at each location.
  • If the relative importance factor does not determine your principal place of business, consider the time spent at each location.

For more information, see Publication 587.

Business use of your car. If you use your car exclusively in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage.

You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups, insurance, and registration fees. Or, instead of figuring the business part of these actual expenses, you may be able to use the standard mileage rate to figure your deduction. For 2008, the standard mileage rate is 50.5 cents a mile for all business miles driven before July 1, 2008. The rate is 58.5 cents a mile for business miles driven after June 30, 2008, and before January 1, 2009.

If you are self-employed, you can also deduct the business part of interest on your car loan, state and local personal property tax on the car, parking fees, and tolls, whether or not you claim the standard mileage rate.

For more information on car expenses and the rules for using the standard mileage rate, see Publication 463.

How Much Can I Deduct?

You can deduct the cost of a business expense if it meets the criteria of ordinary and necessary and it is not a capital expense.

Recovery of amount deducted (tax benefit rule). If you recover part of an expense in the same tax year in which you would have claimed a deduction, reduce your current year expense by the amount of the recovery. If you have a recovery in a later year, include the recovered amount in income in that year. However, if part of the deduction for the expense did not reduce your tax, you do not have to include that part of the recovered amount in income.

For more information on recoveries and the tax benefit rule, see Publication 525.

Payments in kind. If you provide services to pay a business expense, the amount you can deduct is limited to your out-of-pocket costs. You cannot deduct the cost of your own labor.

Similarly, if you pay a business expense in goods or other property, you can deduct only what the property costs you. If these costs are included in the cost of goods sold, do not deduct them as a business expense.

Limits on losses. If your deductions for an investment or business activity are more than the income it brings in, you have a loss. There may be limits on how much of the loss you can deduct.

Not-for-profit limits. If you carry on your business activity without the intention of making a profit, you cannot use a loss from it to offset other income. See Not-for-Profit Activities, later.

At-risk limits. Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment you have “at risk” in the activity. You are at risk in any activity for the following.

  1. The money and adjusted basis of property you contribute to the activity.
  2. Amounts you borrow for use in the activity if:
    1. You are personally liable for repayment, or
    2. You pledge property (other than property used in the activity) as security for the loan.

For more information, see Publication 925.

Passive activities. Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate, or a rental activity. In general, deductions for losses from passive activities only offset income from passive activities. You cannot use any excess deductions to offset other income. In addition, passive activity credits can only offset the tax on net passive income. Any excess loss or credits are carried over to later years. Suspended passive losses are fully deductible in the year you completely dispose of the activity. For more information, see Publication 925.

Net operating loss. If your deductions are more than your income for the year, you may have a “net operating loss.” You can use a net operating loss to lower your taxes in other years. See Publication 536 for more information.

See Publication 542 for information about net operating losses of corporations.

When Can I Deduct an Expense?

When you can deduct an expense depends on your accounting method. An accounting method is a set of rules used to determine when and how income and expenses are reported. The two basic methods are the cash method and the accrual method. Whichever method you choose must clearly reflect income.

For more information on accounting methods, see Publication 538.

Cash method. Under the cash method of accounting, you generally deduct business expenses in the tax year you pay them.

Accrual method. Under an accrual method of accounting, you generally deduct business expenses when both of the following apply.

  1. The all-events test has been met. The test is met when:
    1. All events have occurred that fix the fact of liability, and
    2. The liability can be determined with reasonable accuracy.
  2. Economic performance has occurred.

Economic performance. You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.

Example.

Your tax year is the calendar year. In December 2008, the Field Plumbing Company did some repair work at your place of business and sent you a bill for $600. You paid it by check in January 2009. If you use the accrual method of accounting, deduct the $600 on your tax return for 2008 because all events have occurred to “fix” the fact of liability (in this case the work was completed), the liability can be determined, and economic performance occurred in that year.

If you use the cash method of accounting, deduct the expense on your 2009 return.

Prepayment. You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash and accrual methods. It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.

Example.

In 2008, you sign a 10-year lease and immediately pay your rent for the first 3 years. Even though you paid the rent for 2008, 2009, and 2010, you can only deduct the rent for 2008 on your 2008 tax return. You can deduct the rent for 2009 and 2010 on your tax returns for those years.

Contested liability. Under the cash method, you can deduct a contested liability only in the year you pay the liability. Under the accrual method, you can deduct contested liabilities such as taxes (except foreign or U.S. possession income, war profits, and excess profits taxes) either in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. However, to take the deduction in the year of payment or transfer, you must meet certain conditions. See Contested Liability in Publication 538 for more information.

Related person. Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not yet paid them. However, if you and the person you owe are related and that person uses the cash method of accounting, you must pay the expense before you can deduct it. Your deduction is allowed when the amount is includible in income by the related cash method payee. See Related Persons in Publication 538.

Not-for-Profit Activities

If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit.

The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

In determining whether you are carrying on an activity for profit, several factors are taken into account. No one factor alone is decisive. Among the factors to consider are whether:

  • You carry on the activity in a businesslike manner,
  • The time and effort you put into the activity indicate you intend to make it profitable,
  • You depend on the income for your livelihood,
  • Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
  • You change your methods of operation in an attempt to improve profitability,
  • You (or your advisors) have the knowledge needed to carry on the activity as a successful business,
  • You were successful in making a profit in similar activities in the past,
  • The activity makes a profit in some years, and
  • You can expect to make a future profit from the appreciation of the assets used in the activity.

Presumption of profit. An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity exceeds the deductions.

If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer’s death.

If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. This means the limits discussed here will not apply. You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption unless the IRS later shows it to be invalid.

Using the presumption later. If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test.

You can elect to do this by filing Form 5213. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity.

The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in the required number of years. If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period.

Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected.

You must file Form 5213 within 3 years after the due date of your return (determined without extensions) for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity.

Limit on Deductions

If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. If you are an individual, these deductions may be taken only if you itemize. These deductions may be taken on Schedule A (Form 1040).

Category 1. Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Deduct them on the appropriate lines of Schedule A (Form 1040). You can deduct a casualty loss on property you own for personal use only to the extent it is more than $100 and exceeds 10% of your adjusted gross income. See Publication 547 for more information on casualty losses. For the limits that apply to mortgage interest, see Publication 936.

Category 2. Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than your deductions under the first category. Most business deductions, such as those for advertising, insurance premiums, interest, utilities, and wages, belong in this category.

Category 3. Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories. Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Where more than one asset is involved, allocate depreciation and these other deductions proportionally.

Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). They are subject to the 2%-of-adjusted-gross-income limit. See Publication 529 for information on this limit.

Example.

Ida is engaged in a not-for-profit activity. The income and expenses of the activity are as follows.

Gross income $3,200
Subtract:
Real estate taxes $700
Home mortgage interest 900
Insurance 400
Utilities 700
Maintenance 200
Depreciation on an automobile 600
Depreciation on a machine 200 3,700
Loss $(500)

Ida must limit her deductions to $3,200, the gross income she earned from the activity. The limit is reached in category (3), as follows.

Limit on deduction $3,200
Category 1: Taxes and interest $1,600
Category 2: Insurance, utilities, and maintenance 1,300 2,900
Available for Category 3 $ 300

The $800 of depreciation is allocated between the automobile and machine as follows.

$600 $800 x $300 = $225 depreciation for the automobile
$200 $800 x $300 = $75 depreciation for the machine

The basis of each asset is reduced accordingly.

Ida includes the $3,200 of gross income on line 21 of Form 1040.The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). Ida deducts the remaining $1,600 ($1,300 for category (2) and $300 for category (3)) as other miscellaneous deductions on Schedule A (Form 1040) subject to the 2%-of-adjusted- gross-income limit.

Partnerships and S corporations. If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. They are reflected in the individual shareholder’s or partner’s distributive shares.

More than one activity. If you have several undertakings, each may be a separate activity or several undertakings may be combined. The following are the most significant facts and circumstances in making this determination.

  • The degree of organizational and economic interrelationship of various undertakings.
  • The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting.
  • The similarity of the undertakings.

The IRS will generally accept your characterization if it is supported by facts and circumstances.

If you are carrying on two or more different activities, keep the deductions and income from each one separate. Figure separately whether each is a not-for-profit activity. Then figure the limit on deductions and losses separately for each activity that is not for profit.

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November 11, 2009

Health Savings Accounts

health savings accountHealth Savings Accounts (HSAs) were created by Public Law 108-173, the “Medicare Prescription Drug, Improvement and Modernization Act of 2003,” signed into law by President Bush on December 8, 2003. Health Savings Accounts will change the way millions meet their health care needs because they are designed to help individuals save for qualified medical and retiree health expenses on a tax-advantaged basis.

Any adult who is covered by a high-deductible health plan (and has no other first-dollar coverage) may establish an HSA. Tax-advantaged contributions can be made in three ways:

  1. the individual or family can make tax deductible contributions to the HSA even if they do not itemize deductions;
  2. the individual’s employer can make contributions that are not taxed to either the employer or the employee; and,
  3. employers sponsoring cafeteria plans can allow employees to contribute untaxed salary through salary reduction.

To encourage saving for health expenses after retirement, individuals age 55 and older are allowed to make additional catch-up contributions to their HSAs. Once an individual enrolls in Medicare they are no longer eligible to contribute to their HSA.

Amounts contributed to an HSA belong to the account holder and are completely portable. Funds in the account can grow tax-free through investment earnings, just like an IRA.

Funds distributed from the HSA are not taxed if they are used to pay qualified medical expenses. Unlike amounts in Flexible Spending Arrangements that are forfeited if not used by the end of the year, unused funds remain available for use in later years.

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November 10, 2009

Overtime

OVERVIEW

An employer who requires or permits an employee to work overtime is generally required to pay the employee overtime premium pay for such work. Employees covered by the Fair Labor Standards Act (FLSA) must receive overtime pay for hours worked in excess of 40 in a workweek of at least one and one-half times their regular rate of pay. The FLSA contains some exceptions (or exemptions) from the overtime pay requirement. Some exemptions apply to specific types of businesses and others apply to specific types of work.

The FLSA does not require overtime pay for work on Saturdays, Sundays, holidays, or regular days of rest unless those hours exceed 40 for the workweek. Extra pay for working weekends or nights is a matter of agreement between the employer and the employee (or the employee’s representative). The FLSA does not require extra pay for weekend or night work or double time pay.

The FLSA provides an exemption from both minimum wage and overtime pay for employees employed as bona fide executive, administrative, professional, and outside sales employees. It also exempts certain computer employees. To qualify for exemption, employees generally must meet certain tests regarding their job duties and be paid on a salary basis at not less than $455 per week. Job titles do not determine exempt status. In order for an exemption to apply, an employee’s specific job duties and salary must meet all the requirements of the Department’s regulations. The FLSA contains other exemptions which are applicable to specific types of work or to specific types of businesses.

COMPLIANCE ASSISTANCE MATERIALS

BASIC INFORMATION

FACT SHEETS

E-TOOLS

POSTERS

RECORDKEEPING

Every covered employer must keep certain records for each non-exempt worker. The Fair Labor Standards Act (FLSA) requires no particular form for the records, but does require that the records include certain identifying information about the employee and data about the hours worked and the wages earned. For a listing of the basic records that an employer must maintain, see the FLSA recordkeeping fact sheet.

APPLICABLE LAWS AND REGULATIONS

  • The Fair Labor Standards Act (FLSA) – Establishes minimum wages, overtime pay, record keeping, and child labor standards for private sector and government workers.
  • 29 CFR Part 541 – Regulation governing exemption from minimum wage and overtime pay requirements for certain employees in executive, administrative, professional, outside sales, and computer-related occupations.
  • 29 CFR Part 778 – Regulation on overtime compensation.

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November 10, 2009

Minimum wage

minimum wageAlthough there are some exceptions, almost all employees in California must be paid the minimum wage as required by state law. Effective January 1, 2008, the minimum wage in California is $8.00 per hour. There are some employees who are exempt from the minimum wage law, such as outside salespersons, individuals who are the parent, spouse, or child of the employer, and apprentices regularly indentured under the State Division of Apprenticeship Standards. Minimum Wage Order (MW-2007)

There is an exception for learners, regardless of age, who may be paid not less than 85% of the minimum wage rounded to the nearest nickel during their first 160 hours of employment in occupations in which they have no previous similar or related experience.

There are also exceptions for employees who are mentally or physically disabled, or both, and for nonprofit organizations such as sheltered workshops or rehabilitation facilities that employ disabled workers. Such individuals and organizations may be issued a special license by the Division of Labor Standards Enforcement authorizing employment at a wage less than the legal minimum wage. Labor Code Sections 1191 and 1191.5

1.

Q.

What is the minimum wage?

A.

Effective January 1, 2008, the minimum wage in California is $8.00 per hour.

For sheepherders, however, effective July 1, 2002, the minimum wage was set at $1,200.00 per month. Effective January 1, 2007 this wage was increased to a minimum monthly salary of $1,333.20. Effective January 1, 2008, the minimum monthly salary for sheepherders will be $1,422.52. Wages paid to sheepherders may not be offset by meals or lodging provided by the employer. Instead, there are provisions in IWC Order 14-2007, Sections 10(F), (G) and (H) that apply to sheepherders with respect to monthly meal and lodging benefits required to be provided by the employer.

2.

Q.

What is the difference between the state and federal minimum wage?

A.

Most employers in California are subject to both the federal and state minimum wage laws. The effect of this dual coverage is that when there are conflicting requirements in the laws, the employer must follow the stricter standard; that is, the one that is the most beneficial to the employee. Thus, since California’s current law requires a higher minimum wage rate than does the federal law, all employers in California who are subject to both laws must pay the state minimum wage rate unless their employees are exempt under California law.

3.

Q.

May an employee agree to work for less than the minimum wage?

A.

No. The minimum wage is an obligation of the employer and cannot be waived by any agreement, including collective bargaining agreements. Any remedial legislation written for the protection of employees may not be violated by agreement between the employer and employee. Civil Code Sections 1668 and 3513

4.

Q.

Is the minimum wage the same for both adult and minor employees?

A.

Yes. There is no distinction made between adults and minors when it comes to payment of the minimum wage.

5.

Q.

I work in a restaurant as a waitperson. Can my employer use my tips as a credit toward its obligation to pay me the minimum wage?

A.

No. An employer may not use an employee’s tips as a credit toward its obligation to pay the minimum wage.

6.

Q.

What can I do if my employer doesn’t pay me at least the minimum wage?

A.

You can either file a wage claim with the Division of Labor Standards Enforcement (the Labor Commissioner’s Office), or file a lawsuit in court against your employer to recover the lost wages. Additionally, if you no longer work for this employer, you can make a claim for the waiting time penalty pursuant to Labor Code Section 203.

7.

Q.

What is the procedure that is followed after I file a wage claim?

A.

After your claim is completed and filed with a local office of the Division of Labor Standards Enforcement (DLSE), it will be assigned to a Deputy Labor Commissioner who will determine, based upon the circumstances of the claim and information presented, how best to proceed. Initial action taken regarding the claim can be referral to a conference or hearing, or dismissal of the claim.

If the decision is to hold a conference, the parties will be notified by mail of the date, time and place of the conference. The purpose of the conference is to determine the validity of the claim, and to see if the claim can be resolved without a hearing. If the claim is not resolved at the conference, the next step usually is to refer the matter to a hearing or dismiss it for lack of evidence.

At the hearing the parties and witnesses testify under oath, and the proceeding is recorded. After the hearing, an Order, Decision, or Award (ODA) of the Labor Commissioner will be served on the parties.

Either party may appeal the ODA to a civil court of competent jurisdiction. The court will set the matter for trial, with each party having the opportunity to present evidence and witnesses. The evidence and testimony presented at the Labor Commissioner’s hearing will not be the basis for the court’s decision. In the case of an appeal by the employer, DLSE may represent an employee who is financially unable to afford counsel in the court proceeding.

See the Policies and Procedures of Wage Claim Processing pamphlet for more detail on the wage claim procedure.

8.

Q.

What can I do if I prevail at the hearing and the employer doesn’t pay or appeal the Order, Decision, or Award?

A.

When the Order, Decision, or Award (ODA) is in the employee’s favor and there is no appeal, and the employer does not pay the ODA, the Division of Labor Standards Enforcement (DLSE) will have the court enter the ODA as a judgment against the employer. This judgment has the same force and effect as any other money judgment entered by the court. Consequently, you may either try to collect the judgment yourself or you can assign it to DLSE.

9.

Q.

What can I do if my employer retaliates against me because I questioned him about not being paid the minimum wage?

A.

If your employer discriminates or retaliates against you in any manner whatsoever, for example, he discharges you because you asked him why you weren’t being paid the minimum wage, or because you file a claim or threaten to file a claim with the Labor Commissioner, you can file a discrimination/retaliation complaint with the Labor Commissioner’s Office. In the alternative, you can file a lawsuit in court against your employer.

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