Sep 2011 – Be Careful with Certain Schedule C Business Expenses

 When we run a small business, we face challenges from many sources and have many opportunities. This article is designed to help reduce the risk of being audited by the IRS for certain business expenses, to improve your chances of being successful with defending these expenses in the event of an audit, and to enhance your understanding of related tax treatments.

AUTO EXPENSES

There are generally two methods allowed: actual expenses and standard mileage.

Under both methods, the taxpayer must make a distinction between business use and personal use. The IRS mentions, “If you use your car for both business and personal purposes, you must divide your expenses between business and personal use. You can divide your expense based on the miles driven for each purpose.”

Examples of actual expenses are depreciation, licenses, lease payments, registration fees, gasoline, insurance, repairs, oil, garage rent, tires, tolls, and parking fees. Depreciation issues for vehicles often apply when using the actual expense method, and they can become complicated at times.

The standard mileage rate method generally involves taking business miles driven and multiplying by the cents-per-mile rate set for the time period when the driving took place. Business mileage generally does not include commuting mileage; however, exceptions include cases of commuting to temporary, non-typical, or multiple work locations.

Publication 463 lists multiple restrictions, including the following cases in which you cannot use the standard mileage:

- Use the car for hire

- Use five or more cars at the same time

- Claimed a depreciation deduction for the car using any method other than straight line, such as MACRS

- Claimed a section 179 deduction on the car

- Claimed the special depreciation allowance on the car

- Claimed actual car expenses after 1997 for a car you leased

Because the usual tax treatment of auto depreciation involves MACRS, the choice to use actual auto expenses in a year will typically make that vehicle ineligible for future-year standard-mileage-rate-method tax treatment.

In recent times, when the IRS audits a taxpayer, it has insisted on seeing detailed logs on vehicle business use, and the absence of such records can often lead to the IRS disallowing part or even all of a claim for auto expense deductions.

TRAVEL EXPENSES

Business travel expenses should have a legitimate business purpose, be distinguished from personal travel expenses, and should be accompanied by thorough written records of what transpired. If the travel expenses reported on a tax return seem disproportionately big compared to business activity (such as revenue), the IRS can see this as a red flag.

In an audit, the IRS may request substantial records in order provide evidence of the legitimacy. Additionally, the taxpayer may need to answer questions about who, what, when, where, why, and how much in relation to business travel.

“Per diem” rules can affect some travel calculations. Here are related excerpts from Publication 463:

- “You can use the actual cost of your meals to figure the amount of your expense before reimbursement and application of the 50% deduction limit. If you use this method, you must keep records of your actual cost.”

- “Generally, you can use the ‘standard meal allowance’ method as an alternative to the actual cost method. It allows you to use a set amount for your daily meals and incidental expenses (M&IE), instead of keeping records of your actual costs. The set amount varies depending on where and when you travel.”

- “If you use the standard meal allowance, you still must keep records to prove the time, place, and business purpose of your travel.”

BUSINESS USE OF HOME

In order to deduct for business use of home, some area of your home must be reserved to be exclusively for business. Even a seemingly incidental personal use of that area during the tax year could be grounds for the IRS to later disallow the related expenses. Also, if your business uses both a business office away from home and a part of your home dedicated to it, and the IRS later inquires about details, it could prove difficult to persuade the IRS to accept the business use of home deductions.

BUSINESS GIFTS

For taxable business expense purposes, there is an annual limit of $25 per person that receives business gifts from you. Although amounts over $25 per recipient would not be deductible, some things that a person might otherwise think of as a business gift may need to count as entertainment, and some expenses could count either as a gift or as entertainment. Publication 463 states, “If you give a customer tickets to a theater performance or sporting event and you do not go with the customer to the performance or event, you have a choice. You can treat the cost of the tickets as either a gift expense or an entertainment expense, whichever is to your advantage… If you go with the customer to the event, you must treat the cost of the tickets as an entertainment expense.”  Also, Treasury Regulation Section 1.274-3 explains that advertising and promotional items that meet certain conditions are not considered gifts for income tax purposes.

CONTRACT LABOR

If you have independent contractors the IRS requires proper W-9 records and proper 1099 reporting. Additionally, there has been extra concern in recent times on the part of the government about proper selection of whether someone paid is a contractor or an employee. Please see Tax Topic 762 (http://www.irs.gov/taxtopics/tc762.html ) for more details.

References

IRS Publication 463. http://www.irs.gov/pub/irs-pdf/p463.pdf

IRC Sec. 162

Treas. Reg. Sec. 1.162-1

Treas. Reg. Sec. 1.162-2

IRC Sec. 167

IRC Sec. 179

IRC Sec. 280A

IRC Sec. 274(b)

Treas. Reg. Sec. 1.274-3

“IRS Announces 2011 Standard Mileage Rates.” http://www.irs.gov/newsroom/article/0,,id=232017,00.html

“IRS Increases Mileage Rate to 55.5 Cents per Mile.” http://www.irs.gov/newsroom/article/0,,id=240903,00.html

Instructions for Form 1099-MISC. http://www.irs.gov/instructions/i1099msc/ar02.html

Form W-9. http://www.irs.gov/pub/irs-pdf/fw9.pdf

IRS Tax Topic 762. http://www.irs.gov/taxtopics/tc762.html

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