Step 1-8

Recordkeeping by Employees

IRS regulations also provide rules for the reporting of information on tax returns and the recordkeeping substantiation requirements of those who incur ordinary and necessary business expenses as an employee. The term "ordinary and necessary business expenses" means only those expenses which are a normal and regular part of the conduct of your business and are directly attributable to such business. The term does not include nondeductible personal, living, or family expenses.

Employees who pay for ordinary and necessary business expenses themselves are usually reimbursed by their employers. The general rule is that an employee who makes an adequate accounting to his employer is not required to substantiate that expense account information to the IRS, except if there is an excess of reimbursement over expenses, or if certain other situations exist, as discussed below.

Employees who are not required to make an adequate accounting to their employers must substantiate their expenses to the IRS. IRS regulation 1.274-5(e)(4) states:

An adequate accounting means the submission tot he employer of an account book, diary, log, statement of expenses, trip sheet, or similar record maintained by the employee in which the information as to each element of an expenditure... is recorded at or near the time of the expenditure or use, together with supporting documentary evidence... An adequate accounting requires that the employee account for all amounts received from his employer during the taxable year as advances, reimbursements, or allowances... for travel, entertainment, gifts, and the use of listed property.

Although the IRS can require any taxpayer to substantiate pertinent information concerning expense accounts, you will not be called upon to substantiate your expense account information unless you fall within one of the following categories:

• You are not required to account to your employer, or you do not make such an accounting.
• Your expenses exceed the total amounts reimbursed or advanced to you,and you claim a deduction on your tax return for the excess.
• You are related to your employer within the meaning of Code Section 267(b) (such as family members, individuals who own more than 50 percent of the stock in their corporation). Or,
• The IRS has determined that the accounting procedures used by your employer for the reporting and substantiation of expenses by employees are not adequate.

IRS regulations include a note that says:

It is to the advantage of taxpayers who may be called upon to substantiate expense account information to maintain as adequate and detailed records of travel, transportation, entertainment, and similar business expenses as practical since the burden of proof is upon the taxpayer to show that such expenses were not only paid or incurred but also that they constitute ordinary and necessary business expenses.

The regulations even contain suggestions that an employee prepare a daily diary or record of expenditures, "maintained in sufficient detail to enable him to readily identify the amount and nature of any expenditure, and the preservation of supporting documents, especially in connection with large or exceptional expenditures." The IRS recognizes that it is often difficult to do this and they are willing to give a little: "Detailed records of small expenditures incurred in traveling or for transportation, as, for example, tips, will not be required." (Aren't they understanding?)

To put this in perspective read the following rules keeping this basic fact in mind: Whenever you take a deduction on your tax return for an ordinary and necessary business expense as an employee, you must maintain such records and supporting evidence as will substantiate each element of an expenditure as required by Code Section 274(d). These rules apply to employees who are not outside salespeople.

Rule #1:

You need not report on your tax return any expenses for travel, local transportation, and entertainment, paid or incurred by you solely for the benefit of your employer if you account to your employer, and such expenses are either charges to your employer, or you are reimbursed or advanced in full an amount equal to the expenses. In this situation the reimbursement is not reported on your return either. However, if your reimbursements equal your expenses, and you do not account to your employer, you must attach a completed IRS Form 2106, "Employee Business Expense," to your tax return.

Rule #2:

You must report as income on your tax return any amount of reimbursement or advance paid you by your employer in excess of the ordinary and necessary business paid you by your employer in excess of the ordinary and necessary business expenses paid or incurred by you.

• You do not have to file Form 2106 (or a similar statement) if you accounted to your employer, and your employer does not include the total reimbursements on your Form W-2. Instead you will report the excess as income on line 7 of your Form 1040.
• You must file Form 2106 (or a similar statement) if your employer includes the total reimbursement on your Form W-2, regardless of whether you account to your employer. * You must file Form 2106 (or a similar statement) if your employer does not include reimbursements on your Form W-2 and you do not account to your employer.

Rule #3:

If your ordinary and necessary business expenses exceed the amount reimbursed or advanced to you by your employer, you are allowed to deduct the excess payment on your tax return. To secure a deduction for such excess payment, you must submit IRS Form 2106, "Employee Business Expenses," with your tax return. If you decide not to take a deduction for the excess, you do not need to file Form 2106.

Rule #4:

If you are not required to account to your employer for your ordinary and necessary business expenses, and therefore are not reimbursed for such expense, you can take a deduction on your tax return by filing IRS Form 2106 with your tax return.

Rule #5:

If you do not claim from your employer a reimbursement to which you are entitled, you may not claim a deduction for the expenses to which that reimbursement applies.

If you are not an outside salesperson you can only use Form 2106 for:

• Reimbursed or unreimbursed transportation expenses, car expenses, travel away from home, and
• Other expenses that are reimbursed. Other expenses that are not reimbursed are reported on Schedule A.

If you are an outside salesperson you use Form 2106 for all your reimbursed or unreimbursed business expenses.

See Next Section: Exhibit 1-1: IRS Publication 552, Recordkeeping for Individuals (PDF Format)

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