What You Need to Know About the IRS and
Other Tax Savings Hints for 1997 and Beyond
© by Greta P. Hicks, CPA
The IRS code is filled with general rules and exceptions, fine print and pitfalls, and tax breaks if you can find them. The following are some of the most commonly overlooked tax savings hints expressed in general terms. For how these suggested savings affect your tax return, I recommend that you consult with you tax advisor. Between your having the facts and her having the knowledge, you can pick and choose those exceptions and savings that are best for you. The old saying, "Two heads are better than one," is still true.
When a business first begins, you choose an accounting method for reporting income and expenses. The two most common methods of accounting are cash and accrual. The cash method of accounting is used by most service type businesses and the accrual method is used by manufacturing, retail, and other businesses having an inventory. Once the accounting method is chosen, it cannot be changed without the approval of the IRS. Even if you choose the wrong method of accounting to change to the correct method, you have to notice and receive approval from the IRS.
A business on the cash basis of accounting reports its income at the time the cash is received. The business may have accounts receivables from sales made to customers but those receivables are not income until actually received. The cash basis of reporting income and expenses is by far the most simple and most common form of reporting income to the IRS or to lenders. Mom and Pop cash based businesses are perceived by the IRS to have little or no internal control over cash receipts. Currently the IRS is targeting businesses who have a volume of cash transactions, such a restaurants, bars, service stations, beauty and barber shops, auto repair shops, mobile food vendors, and laundromats.
Accrual basis of accounting businesses report their income at the time the sale is made and the money is due to be received and their expenses at the time the expense is payable. Should a customer fail to pay, you write off the uncollectible accounts receivable as a bad debt deduction on your tax return. This method of accounting is not optional but required by any business where inventory is a material factor. Types of businesses that have inventories are retail stores, manufacturing facilities, wholesalers, mobile food vendors, restaurants, bars, and printers.
The accrual method of accounting requires more detail books and records and I recommend that you maintain a complete double entry set of books. If you use a computer system select the software based upon its doubt entry standards. Typical single entry software is Quicken where Quickbooks Pro, Daceasy, and Peachtree are double entry systems. Quicken is adequate for small cash basis businesses where accrual businesses, corporations, and partnerships need to use a system that will provide them with not only a Profit and Loss Statement but also a Balance Sheet. Selecting the wrong system can increase professional tax and financial preparation fees substantially. Opt for a more expensive program and reduce professional accounting fees.
What is income? Generally reported by:
Alimony, support and separate maintenance payments N Y
Annuities in excess of cost N Y
Awards Y Y
Bargain purchases from employer to extent that
profit percentage exceeds cost N Y
Bad debts, previously written off and recovered Y Y
Barter income Y Y
Annuities in excess of cost N Y
Awards Y Y
Bargain purchases from employer to extent that
profit percentage exceeds cost N Y
Bad debts, previously written off and recovered Y Y
Barter income Y Y
Bond sales in excess of cost Y Y
Bonuses Y Y
Buried treasure Y Y
Business interruption insurance proceeds
based on income experience Y N
Business profits Y N
Checks, uncashed by payee, for previously deducted
items Y Y
Christmas bonuses from employed, based on
percentage of salary N Y
Commissions Y Y
Compensation, property received, value of Y Y
Damages, back compensation Y Y
Damages, loss of income Y Y
Debts, cancellation of, generally Y Y
Defamation damage away Y Y
Discharge of indebtedness Y Y
Dividends, stock distributed in lieu of money Y Y
Embezzlement proceeds Y Y
Farm income Y Y
Future services, prepayment of Y Y
Gambling winnings Y Y
Hobby income N Y
Insiderís profits Y Y
Interest Y Y
Layoff pay benefits N Y
Lease cancellation, payments received for Y Y
Losses, previously deducted Y Y
Prizes Y Y
Punitive damage award Y Y
Rents Y Y
Rewards Y Y
Royalties Y Y
Security deposits, when retained by lessor Y Y
Tips Y Y
Treasure trove Y Y
Unemployment benefits N Y
Wages N Y
What is not income?
Accident and health plans proceeds unless received tax benefit in prior year
Athletic facilities on employerís premises
Bad debts collected by cash basis business
Bequests and devises
Bonds, interest on state, city, etc.
Business interruption insurance proceeds based
on per diem idleness
Capital contributions to corporations
Child support payments
Damages, personal injuries or sickness
Disability pensions, Veterans Administration
Employee discount, qualified
Fellowships and scholarships, degree program
Fringe benefits, as previously discussed
Life insurance proceeds, paid on death of the insured
Life insurance dividends
Living expenses, damaged home being repaired
Social Security old age, disability and survivorís benefits, partial exclusion
Stock distributions in general
Stock options incentive
A business on the cash basis of accounting deducts expenses when the item is paid and an accrual basis business deducts expenses at the time that the purchase is made and you are legally obligated to pay the invoice. On most business expenses, the IRS requires a copy of the canceled check plus a copy of the invoice from the vendor or supplier. One without the other is usually not sufficient. The IRS requires more detailed records for entertainment, meals, lodgings, business use of cars, business use of homes, and business gifts. For IRS purposes, a log, diary, appointment book, or calendar should supplement your financial records.
A business meal is a meal where business was discussed before, after or during the meal. The records required to substantiate the business purpose of the meal are the name of the person entertain, the business relationship, the amount of the meal, location, and the type of business discussed. Recent laws say that you do not need a receipt for an expenditure of less than $75 however, you do have to have a diary, log book, or other contemporaneous record that gives all the information than would be on the receipt if you had one. As a practical matter, I have found it is much easier to get a receipt at the restaurant and write on the receipt the name of the person and a note regarding the business discussed. In representing taxpayers before the IRS, the auditor will ALWAYS ask for a receipt. No receipt, no diary, no log, no deduction.
Once the meal has been established as a business meal, the law provides than only 50% of total business meals are deductible. There are, however, many types of food items than are 100% deductible. I recommend that you set up an account on your books for 50% deductible meals and another account for 100% deductible meals. Type of business meals that are 100% deductible are:
- Dinner for an employee working overtime
- Lunch ordered in for a staff meeting
- Lunch and dinner provided at or near cost to employees at an employer-operated cafeteria.
- Per diem reimbursement up to the federal limit.
- Meals incurred by employees or owners and invoiced to customers.
- Occasional cocktail parties, group meals, or picnics for employees and their guests (no customers allowed).
- Coffee, donuts, and soft drinks
- Holiday turkey or hams.
- Fruit provided on account of illness, outstanding performance, or family crisis.
The IRS assumes travel is personal unless records are maintained to established the business reason for the travel. Your calendar, diary or log should reflect the travel destination and business purpose of the trip. The record keeping for foreign travel is further restricted and for details, you can read ASBA Today, "Deductible Foreign Travel," July/Aug. 1996 or consult IRS Publication 463. Travel expenses include trains, planes, rental cars, motels, taxis, tips, motels/hotels, and any other away from home over night expenses. Travel do not include meals eaten while away from home. All meals including meal incurred while traveling are only 50% deductible and should be grouped with entertainment meals not with travel expenses.
The IRS looks at a car or pickup a mixed use asset, an asset that is used both for business and personal. The IRS assumes that the asset is 100% personal and it is up to the business to prove it has been used for business purposes. Upon audit, the IRS will want to see a log or diary explaining the business use. A detailed log is not necessary but a calendar with the business miles written in and accompanied by you appointment book is sufficient to establish business use. DO keep a log and DO make it simple. Cars and pickups are deductions frequently audited by the IRS and often trigger audits by the IRS.
Besides the issue of business use, the depreciation on vehicles is limited and the amounts change each year. For example: The maximum depreciation allowed for a vehicle purchased in 1996 is $3,060 for the first year, $4,900 for the second year, and $2,980 for each year there after. Check with your advisory or IRS publications for the most current limitation amount.
Cars and trucks are considered listed property and require that detailed information be furnished on the back side of the Form 4562, Depreciation Schedule. Not all vehicles require detailed records and the depreciation is not limited on all vehicles. Cars over 2,000 unloaded gross vehicle weight and pickups over 2,000 gross vehicle weight are not listed property and have no depreciation limitations.
The old general rule of trading in a car for a new car is now an obsolete general rule. Because tax depreciation is limited on luxury vehicles, the economic decline of the vehicle is greater. The new general rule is to sell your old business car and you will most likely have a deductible business loss on your tax return.
Vehicles furnished to employees can be a near tax free benefit providing the business has written policies. Develop a written plan whereby employees are prohibited from using the company auto for ANY personal use except commuting to and from the office. A value of $1.50 per one way commute should be added to their W-2 form as wages. If employees are allowed to use autos for commuting and personal use, include the federal mileage rate ($.31 for 1996) in their W-2 form as wages.
Employees who fail to keep logs and substantiate the business use to the company are subject to ALL miles being considered personal and the total value of the vehicle included in their W-2 form. There are several alternate ways of calculating the value of the personal use, but these methods are the most simple.
Business gifts remain limited to $25 per person per year. I recommend that you maintain a record including the name of the person receiving the gifts and the business relationship of that person. Gifts do not include small advertising specialty items such as pens, caps, cups, and other items of de minimus value.
The bad news is that beginning January 1, 1994, club dues were no longer deductible. Types of clubs specifically named in the law are business, social, athletic, luncheon, and sporting clubs. The good news is that not all organizations were included in the list. If business is conducted before, during, or after meetings held by service and fraternal organizations, chambers of commerce, and professional associations, the dues will be deductible as a business expense.
According to IRS publications, the home office deduction is dead. Not true. A home office is an area that is used exclusively and regularly for a trade or business and is deductible if:
- It is a place used o meet or deal with patients, clients, or customers, OR
- It is a place used to store inventory or samples, OR
- It is a separate structure, OR
- It is the principal place of business for your trade or business.
The first three types of offices are easily identifiable and easy to qualify as a deductible home office. The "principal place of business" type of home office has been defined loosely as deductible if you spend more than 50% of your time in the office or the office is the place where you earn the majority of your money. For example: It is difficult for an outside sales person to spend 50% of his time in his home office so unless he qualified under one of the other three types of offices, he will have no deductible home office. Be very carefully about reading the IRS publications on home office because they are extremely conservative.
If you want to give your employees some benefits that are deductible by you and non-taxable to them, here are some hints:
- The first $5,000 of dependent care expenses paid by the employer.
- The value of the first $50,000 of group term life insurance.
- Automobile mileage paid up to the amount allowed per mile by the IRS. Currently $.31 but changes each year.
- Per diem paid which is not in excess of the federal rate.
- Allowable moving expenses.
- No additional-cost-services: Services offered for sale to customers and available to employees are non-taxable to the employee if the employees use of the services does not cost the employer any additional moneys. (Frequently used by air line employees.)
- Qualified employee discounts Ė Employees may receive a 20% discount for service and a percentage equal to the employerís profit percentage in the case of goods that they purchase from the employer.
- Working condition fringe benefits Ė Business expenses such as publications, if paid by the employee and are deductible as miscellaneous itemized deductions by the employee, are actually paid for the employer, they are not income to the employee.
- De minimis fringe benefits Ė expenses that are small and administratively impractical to account for: Use of copy machine, typewriter, or computer to write personal letters; occasional cocktail parties, group meals, or picnics, traditional birthday or holiday gifts of property; occasional theater or sporting event tickets; coffee, donuts, and soft drink; local telephone calls; and fruit, books, or flowers provided on account of illness, etc.
- Up to $60 per month for qualified parking.
- On premises athletic facilities.
- Health and accident insurance and reimbursements.
- Cafeteria plans.
- Meals furnished on the business premises of the employer and furnished for the convenience of the employer.
- Lodging - same as meals plus the employee must accept the lodging as a condition of employment.
Health Insurance Deduction
The deduction for health insurance expenses was a hot discussion item at the 1995 White House Conference on Small Business. Non-corporate taxpayers wanted to be able to deduct 100% of their health insurance as does a regular C Corporation. Self-employed individuals as well as general partners in a partnership and shareholders owing more than two percent of the outstanding stock of an S corporation are now able to deduct a greater percentage of health insurance premiums on themselves, their spouses and dependents. Consult you advisor because this is a political hot potato subject to revocation and change.
1998 through 2002 45
Equipment, furnishings, cars, and buildings are assets and generally cannot be written off in the year of purchase. They are capitalized and become assets subject to a depreciation method prescribed by the IRS. Typically assets are written off or expensed over a five, seven, fifteen, or thirty nine year period. A half year of depreciation is allowed in the year the assets is purchased. If more than 40% of the assets are purchased during the last quarter of the year, all assets are depreciable beginning in the middle of the month of the purchase. Avoid this potentially limiting effect by purchasing the bulk of your depreciable business assets prior to September 30 of each year.
Qualified assets purchased and placed in service before December 31, are eligible for the Section 179 expensing election. A qualified assets is personal property purchased, placed in service, and used in a trade or business. The expensing election is available for all businesses who purchase less than $200,000 of personal property assets in a given year. There is a taxable income limitation but any qualified asset purchased in excess of the taxable income limitation can be carried over to future years. It is not necessary to "full pay" for the qualified asset. Purchase with a promissory note or credit card allows you to get a full Section 179 deduction without having to spend an equal amount of cash immediately.
The maximum amount that can be expensed in the year of purchase varies each year. Below are the amounts approved by Congress most recently. However, you will need to consult with your tax advisor to update yourself on the law changes effective after 12/31/96.
2003 and after 25,000
Charitable donations by businesses are usually limited to cost or basis, however the law allows a more generous deduction for inventory which is donated to organizations who use the food the feed the needy. For example: A bakery can donate its unsold four day old bread to a soup kitchen or homeless shelter and deduct its full fair market value price of the donated bread.
Recent law changes have made buying a business which includes considerable goodwill more attractive from a tax prospective. Beginning after April 13, 1993, any amount allocated to goodwill is amortizable over 15 years. Goodwill is defined as going concern value, intangibles, information base, know-how, customer and supplier lists, license, permits, and covenant not to compete. When negotiating the purchase price of the assets, keep in mind that there needs to be an agreement between the buyer and seller on the value of individual assets. It is to the buyers benefit to have maximum fair market value allocated to furniture, fixtures, and equipment because they qualify for the Section 179 expensing election and for the 5 or 7 year depreciation. Since goodwill is amortizable over 15 years, it will be wise to allocate more to goodwill than to real property structures since they are depreciable over 39 years and land is never depreciable. It is to the benefit of the seller to allocate as much to goodwill as possible since it is taxable at capital gain rates where the sale of furniture, fixture, and equipment is usually recaptured at ordinary income rates.
DANGER! When you buy a corporations stock rather than acquiring the assets only, you are buying not only the assets of the corporation but also the liabilities, listed and unlisted. For example: Sap buys a business by acquiring the corporate stock. A year later the IRS closes the business down for non-payment of payroll taxes incurred prior to Sap buying the business, because the taxes are a liability of the corporation he purchased. Sorry, Sap. Next time, buy the assets and not the corporationís stock.
Starting a New Business
The costs of starting or getting ready to start a new business are "start up costs" which are amortizable over 5 years. These start up cost cannot be written off when paid or incurred. They are accumulated until the business is in operation and written off over a 5 year period. Your tax return for the first year of ANY new business should include an "election to amortize start up costs." If the IRS audits the business later and determines some items expensed should be start up costs, at least the start up costs will be amortizable. Without the election statement on the return, the costs are capitalized and deductible only when the business is sold or terminated. Take this protective measure on 1st year business return.
Changing Form of Business
When you start a business, the IRS assigns the business a federal identification number or employer identification number (EIN). That number should be used only as long as you are doing business in the same form. For example: If you change from a sole proprietorship to a corporation, get a new number for the corporation. If you change from a sole proprietorship to a partnership, get a new number. Your failure to get a new EIN could result in your new business entity being held responsible for taxes of the old entity.
Empowerment Zones and Enterprise Communities
If you take the risk to start a new business in a designated empowerment zone or enterprise community, you will be allowed special tax incentives, such as:
- Up to $37,500 of Section 179 first year expensing of assets.
- Employment tax credit of 20% of the fist $15,000 in wages paid to each qualified employee
- Work opportunity credits for wages paid to qualified employees
- Accelerated depreciation.
Most Common Tax Preparation Mistakes
- Failure to report all Forms 1099-INT, Interest Income
- Failure to report all Forms 1099-B, Sales
- Incorrect reporting of Form 1099-DIV, Gross Dividends, Capital Gains, and Non-Taxable Distributions
- Failure to report Forms 1099-NEC on Schedule C, Business Income and Expenses
- Failure to complete Schedule SE on profits from business
- Incorrectly reporting administrative expenses in Cost of Good Sold
- Failure to complete Form 8829, Home Office
- Failure to complete Form 4562, Depreciation
- Wages on income tax return fail to match wages on employment tax Forms W-3, W-2, 941, and 940
- Failure to take 50% off of meals & entertainment
- In correctly calculating the tax
- Failure to sign the return
What Triggers Audits?
- Any Form 1099 or W-2 that was sent to IRS but not on your income tax return.
- Gross profit margin out of line.
- Small businesses with many cash transactions.
- Businesses with losses.
- Travel, meals, entertainment out of proportion to income.
- Bad debt write offs
Handling IRS Audits
The IRS has three types of audits. A correspondence audit is performed by mail and the requests for documents is usually limited to certain issues or items on or not on the return. An office audit is initiated by a letter asking you to bring certain records into the IRS office. Most businesses are audited by Revenue Agents who either come to your place of business or that of your representative. If you or your company happens to be selected for an audit, here are some tips.
Plan ahead: Up front analysis and planning are the key to bringing the audit to a quick, low cost, and less time consuming event. Here are some basic steps to take:
- Carefully read the IRS notice and determine what it is they are really after, what questions they are likely to ask, and what documents they would likely ask for.
- Determine what records you have, where they are, and those you need to get from third parties.
- Discuss the audit process with your tax professional, the records available, and the timing of the audit.
- If an office audit, organize the records making sure the canceled checks and receipts total the amount on the tax return.
- If a field audit, make sure your books and records tie (agree with) the income tax return. Initially, have available general ledgers, accounts receivable, accounts payable, and any other journals & ledgers your company maintains along with bank records. They usually make several trips and ask for receipts, contracts, and other source documents during the examination.
Doís and Doníts: When handling your own audit, practice these doís and doníts:
- Stay calm.
- Be organized
- Never give the IRS person more information than requested
- Value silence. Donít chatter or exchange casual conversation because nothing is casual about an IRS audit or auditor.
- Answer questions honestly, but be brief
- Never give the IRS the only copy of a document
- Do not leave original records with the auditor
- Donít be argumentative or belligerent
- Insist on getting copies of information in their files
- Keep in touch with the auditor.
At the conclusion of the audit or at your failure to supply sufficient information, the auditor will issue an audit report. Your options at this time are:
- Supply additional information or facts to the auditor that will hopefully change their mind.
- Ask to discuss the audit report with the Group Manager.
- Agree with the decision and sign the report.
- Disagree with the decision and read IRS Publication No. 5, Your Appeals Rights. Follow itís instructions by filing a timely protest and requesting a conference with an appeals officer.
Owing IRS Money
If you owe money to the IRS for back taxes, the IRS Collection Division will be in contact with you first by telephone and later in person. To avoid federal tax liens, levies of bank accounts or pay checks, or seizure and sale of the business, you need to take affirmative action to resolve this problem.
First and foremost feel conformable that you owe the money. Find out why and how much you owe. Request abatement of any penalties due to reasonable cause. File corrected or amended returns. Once the amount you owe is established, then begin to think of your options for payment.
The IRS is not a friendly creditor so if you can borrow the money from a bank, friend, or family member you would have a less threatening creditor. You settlement options are:
Full pay the tax.
- If you are temporarily broke, ask that they put your account in a "temporarily un-collectible status." This is NOT a permanent solution. It only buys you time to get your finances together. Interest and penalties continue to compound daily.
- Ask to make payments on an installment basis. The will ask the business to complete a financial statement, Form 433B, and you as an individual to complete a Form 433A, Personal Financial Statement. Based upon the results of these two forms, the IRS will calculate you payment amount. These forms and the negotiations are complex. I recommend that you will want to consult with a tax advisor familiar with the IRS Collection Divisionís policies and procedures.
- Submit an Offer-In-Compromise, Form 656 complete with Forms 433A and 433B. This is a process that takes six to 18 months to complete. The IRS performs a complete financial investigation and determines whether they can accept the amount that you have offered. If accepted, all debt but the offer amount will be forgiven. It is common for taxpayers to see professional advice regarding the completion and submission of the forms and/or the negotiations with the IRS Offer Group personnel.
- File bankruptcy. Depending upon the type of bankruptcy and the age of the tax debt, bankruptcy can discharge tax debt. If not dischargeable, a payout plan can be arranged between the Court and the IRS. If the IRS is your major creditor, you will need to seek the advice of an attorney who is not only familiar with bankruptcy but also expert at dischargeability of taxes in bankruptcy and dealing with the IRS.
Doís and Doníts:
The IRS Collection Division personnel have tremendous power to collect money. Since you are in the wrong for not paying your taxes, you greatest strength is your ability to negotiate successfully (peacefully) with the Revenue Officer.
Hereís some suggestions:
- Do respond as soon as possible to written notices from the IRS Service Centers. Sometimes dealing with the computer is easier than a live person.
- Do respond to IRS bill collecting telephone calls timely. Again, dealing on the phone is sometimes quicker and less threatening than dealing with a live person.
- If you put it off long enough that a live person calls on you, you are in serious trouble. Be assertive, courteous, truthful, and give an appearance of cooperation. If you donít want to do it yourself, there are persons who specialize in this area.
- Return phone calls and meet deadlines timely.
- Do not let any IRS person, live or on the phone, complete the Forms 433 for you. Complete them, have them reviewed, and submit the completed for to the IRS.
- If all else fails, hire a hired gun!
Writing To The IRS Computer
The IRS computer and computer programs are antiques but they are what we have at the moment so we have to deal with them as they exist.
Their computer keeps track of the tax forms filed, the amounts due, paid, and owed. If you determine payments have been improperly posted, it is best to send the IRS copies of your canceled checks front and back. Make sure the back side is legible because it has codes on it that tells the IRS employee where the check was posted. After three tries you can address your correspondence to PROBLEMS RESOLUTION, Your Service Center location and address. OR, avoid the problem by making sure that all checks include the taxpayerís name, address, Federal Identification Number, Employer Identification Number, Social Security Number, tax form number, and tax periods, years or quarters.
List of Articles by Greta P. Hicks, CPA
GRETA P. HICKS, CPA and former IRS manager, concentrates in solutions to IRS problems and advises business and tax professional on IRS policies
and procedures. Ms Hicks is owner of TAX SOLUTIONS, Inc., a company providing
educational materials and programs on solutions to IRS problems and is
a nationally known speaker and writer on solutions to IRS problems. To
arrange for consultation contact:
Greta's web site: http://www.gretahicks.com
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