Six tax issues to consider if you’re getting divorced

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Divorce entails difficult personal issues, and taxes are probably the farthest thing from your mind. However, several tax concerns may need to be addressed to ensure that taxes are kept to a minimum and that important tax-related decisions are properly made. Here are six issues to be aware of if you’re in the process of getting a divorce.

  1. Personal residence sale 

In general, if a couple sells their home in connection with a divorce or legal separation, they should be able to avoid tax on up to $500,000 of gain (as long as they’ve owned and used the home as their principal residence for two of the previous five years). If one former spouse continues to live in the home and the other moves out (but they both remain owners of the home), they may still be able to avoid gain on the future sale of the home (up to $250,000 each), but special language may have to be included in the divorce decree or separation agreement to protect this tax exclusion for the spouse who moves out.

If the couple doesn’t meet the two-year ownership and use tests, any gain from the sale may qualify for a reduced exclusion due to unforeseen circumstances.

  1. Pension benefits

A spouse’s pension benefits are often part of a divorce property settlement. In these cases, the commonly preferred method to handle the benefits is to get a “qualified domestic relations order” (QDRO). This gives one former spouse the right to share in the pension benefits of the other and taxes the former spouse who receives the benefits. Without a QDRO, the former spouse who earned the benefits will still be taxed on them even though they’re paid out to the other former spouse.

  1. Filing status

If you’re still married at the end of the year, but in the process of getting divorced, you’re still treated as married for tax purposes. We’ll help you determine how to file your 2024 tax return — as married filing jointly or married filing separately. Some separated individuals may qualify for “head of household” status if they meet the requirements.

  1. Alimony or support payments

For alimony under divorce or separation agreements that are executed after 2018, there’s no deduction for alimony and separation support payments for the former spouse making them. And the alimony payments aren’t included in the gross income of the former spouse receiving them. (The rules are different for divorce or separation agreements executed before 2019.) This was a change made in the Tax Cuts and Jobs Act. However, unlike some provisions of the law that are temporary, the repeal of alimony and support payment deduction is permanent.

  1. Child support and child-related tax return filing

No matter when the divorce or separation instrument is executed, child support payments aren’t deductible by the paying former spouse (or taxable to the recipient). You and your ex-spouse will also need to determine who will claim your child or children on your tax returns in order to claim related tax breaks.

  1. Business interests 

If certain types of business interests are transferred in connection with divorce, care should be taken to make sure “tax attributes” aren’t forfeited. For example, interests in S corporations may result in “suspended” losses (losses that are carried into future years instead of being deducted in the year they’re incurred). When these interests change hands in a divorce, the suspended losses may be forfeited. If a partnership interest is transferred, a variety of more complex issues may arise involving partners’ shares of partnership debt, capital accounts, built-in gains on contributed property and other complex issues.

A range of tax challenges

These are just some of the issues you may have to cope with if you’re getting a divorce. In addition, you may need to adjust your income tax withholding, and you should notify the IRS of any new address or name change. There are also estate planning considerations. We can help you tackle the financial issues involved in divorce.

Be aware of the tax consequences of selling business property

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Looking for some guidance when it comes to dealing with real estate transactions! Our team at Encore Partners, LLP has over 40 combined years of expertise and experience in complex real estate transactions consistently providing guidance to our clients on the best strategies possible to optimize their portfolios. With our robust tax knowledge and understanding, we implement expert business and personal tax strategies for acquisitions, transfers, and transaction tax appeals and abatements. We are able to advise in areas of budget, accruals, and pre-purchase due diligence while implementing strategies to lessen the burden of your real estate transaction taxes.

If you are selling property used in your trade or business, trust the Encore team to assist you with understanding the tax implications. There are many complex rules that can potentially apply. To simplify this discussion, let’s assume that the property you want to sell is land or depreciable property used in your business, and has been held by you for more than a year.

Note: There are different rules for property held primarily for sale to customers in the ordinary course of business, intellectual property, low-income housing, property that involves farming or livestock, and other types of property.

Basic rules

Under tax law, your gains and losses from sales of business property are netted against each other. The tax treatment is as follows:

  1. If the netting of gains and losses results in a net gain, then long-term capital gain treatment results, subject to “recapture” rules discussed below. Long-term capital gain treatment is generally more favorable than ordinary income treatment.
  2. If the netting of gains and losses results in a net loss, that loss is fully deductible against ordinary income. (In other words, none of the rules that limit the deductibility of capital losses apply.)

The availability of long-term capital gain treatment for business property net gain is limited by “recapture” rules. Under these rules, amounts are treated as ordinary income, rather than capital gain, because of previous ordinary loss or deduction treatment.

There’s a special recapture rule that applies only to business property. Under this rule, to the extent you’ve had a business property net loss within the previous five years, any business property net gain is treated as ordinary income instead of long-term capital gain.

Different types of property

Under the Internal Revenue Code, different provisions address different types of property. For example:

  • Section 1245 property. This consists of all depreciable personal property, whether tangible or intangible, and certain depreciable real property (usually real property that performs specific functions). If you sell Section 1245 property, you must recapture your gain as ordinary income to the extent of your earlier depreciation deductions on the asset.
  • Section 1250 property. In general, this consists of buildings and their structural components. If you sell Section 1250 property that’s placed in service after 1986, none of the long-term capital gain attributable to depreciation deductions will be subject to depreciation recapture. However, for most noncorporate taxpayers, the gain attributable to depreciation deductions, to the extent it doesn’t exceed business property net gain, will (as reduced by the business property recapture rule above) be taxed at a rate of no more than 28.8% (25% plus the 3.8% net investment income tax) rather than the maximum 23.8% rate (20% plus the 3.8% net investment income tax) that generally applies to long-term capital gains of noncorporate taxpayers.

Other rules apply to, respectively, Section 1250 property that you placed in service before 1987 but after 1980 and Section 1250 property that you placed in service before 1981.

As you can see, even with the simple assumptions in this article, the tax treatment of the sale of business assets can be complex. Contact us if you’d like to determine the tax implications of transactions, or if you have any additional questions.

What might be ahead as many tax provisions are scheduled to expire?

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Buckle up, America: Major tax changes are on the horizon. The reason has to do with tax law and the upcoming elections.

Our current situation

The Tax Cuts and Jobs Act (TCJA), which generally took effect in 2018, made sweeping changes. Many of its provisions are set to expire on December 31, 2025.

With this date getting closer each day, you may wonder how your federal tax bill will be affected in 2026. The answer isn’t clear because the outcome of this November’s presidential and congressional elections is expected to affect the fate of many expiring provisions. A new political landscape in Washington could also mean other tax law changes.

Corporate vs. individual taxes

The TCJA cut the maximum corporate tax rate from 35% to 21%. It also lowered rates for individual taxpayers, with the highest tax rate reduced from 39.6% to 37%. But while the individual rate cuts expire in 2025, the law made the corporate tax cut “permanent.” (In other words, there’s no scheduled expiration date. Tax legislation could still change the corporate tax rate.)

In addition to lowering rates, the TCJA revised tax law in many other ways. On the individual side, standard deductions were increased, significantly reducing the number of taxpayers who benefit from itemizing deductions for certain expenses, such as charitable donations and medical costs. (You benefit from itemizing on your federal income tax return only if your total allowable itemized write-offs for the year exceed your standard deduction.)

In addition, through 2025, certain itemized deductions are eliminated. Others are more limited, including those for home mortgage interest and state and local tax (SALT).

For small business owners, one of the most significant changes is the potential expiration of the Section 199A qualified business income (QBI) deduction. This is the write-off for up to 20% of QBI from noncorporate pass-through entities, including S corporations and partnerships, as well as from sole proprietorships.

The expiring provisions will affect many taxpayers’ tax bills in 2026, unless legislation extending them is signed into law.

Possible scenarios

The outcome of the presidential election in less than five months, as well as the balance of power in Congress, will determine the TCJA’s future. Here are four possible scenarios:

  1. All of the TCJA provisions scheduled to expire will actually expire at the end of 2025.
  2. All of the TCJA provisions scheduled to expire will be extended past 2025 (or made permanent).
  3. Some TCJA provisions will be allowed to expire, while others will be extended (or made permanent).
  4. Some or all of the temporary TCJA provisions will expire — and new laws will be enacted that provide different tax breaks and/or different tax rates.

How your tax bill will be affected in 2026 will partially depend on which one of these scenarios becomes reality and whether your tax bill went down or up when the TCJA became effective back in 2018. That was based on a number of factors including your income, your filing status, where you live (the SALT limitation negatively affects more taxpayers in certain states), and whether you have children or other dependents.

Your tax situation will also be affected by who wins the presidential election and who controls Congress. Democrats and Republicans have competing visions about how to proceed when it comes to taxes.

Proposals can become law only if tax legislation passes both houses of Congress and is signed by the President (or there are enough votes in Congress to override a presidential veto).

The tax horizon

As the TCJA provisions get closer to expiring, it’s important to know what might change and what tax-wise moves you can make if the law does change. We’ll keep you informed about what’s ahead. We’re here to answer any questions you may have.

Hiring your child to work at your business this summer

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With school out, you might be hiring your child to work at your company. In addition to giving your son or daughter some business knowledge, you and your child could reap some tax advantages.

Benefits for your child

There are special tax breaks for hiring your offspring if you operate your business as one of the following:

  • A sole proprietorship,
  • A partnership owned by both spouses,
  • A single-member LLC that’s treated as a sole proprietorship for tax purposes, or
  • An LLC that’s treated as a partnership owned by both spouses.

These entities can hire an owner’s under-age-18 children as full- or part-time employees. The children’s wages then will be exempt from the following federal payroll taxes:

  • Social Security tax,
  • Medicare tax, and
  • Federal unemployment (FUTA) tax (until an employee-child reaches age 21).

In addition, your dependent employee-child’s standard deduction can shelter from federal income tax up to $14,600 of 2024 wages from your business.

Benefits for your business

When hiring your child, you get a business tax deduction for employee wage expense. The deduction reduces your federal income tax bill, your self-employment tax bill and your state income tax bill, if applicable.

Note: There are different rules for corporations. If you operate as a C or S corporation, your child’s wages are subject to Social Security, Medicare and FUTA taxes, like any other employee’s. However, you can deduct your child’s wages as a business expense on your corporation’s tax return, and your child can shelter the wages from federal income tax with the $14,600 standard deduction for single filers.

Traditional and Roth IRAs

No matter what type of business you operate, your child can contribute to an IRA or Roth IRA. With a Roth IRA, contributions are made with after-tax dollars. So, taxes are paid on the front end. After age 59½, the contributions and earnings that have accumulated in the account can be withdrawn free from federal income tax if the account has been open for more than five years.

In contrast, contributions to a traditional IRA are deductible, subject to income limits. So, unlike Roth contributions, deductible contributions to a traditional IRA lower the employee-child’s taxable income.

However, contributing to a Roth IRA is usually a much better idea for a young person than contributing to a traditional IRA for several reasons. Notably, your child probably won’t get any meaningful write-offs from contributing to a traditional IRA because the child’s standard deduction will shelter up to $14,600 of 2024 earned income. Any additional income will likely be taxed at very low rates.

In addition, your child can withdraw all or part of the annual Roth contributions — without any federal income tax or penalty — to pay for college or for any other reason. Of course, even though your child can withdraw Roth contributions without adverse tax consequences, the best strategy is to leave as much of the Roth balance as possible untouched until retirement to accumulate a larger tax-free sum.

The only tax law requirement for your child when making an annual Roth IRA contribution is having earned income for the year that at least equals what’s contributed for that year. There’s no age restriction. For the 2024 tax year, your child can contribute to an IRA or Roth IRA the lesser of:

  • His or her earned income, or
  • $7,000.

Making modest Roth contributions can add up over time. For example, suppose your child contributes $1,000 to a Roth IRA each year for four years. The Roth account would be worth about $32,000 in 45 years when he or she is ready to retire, assuming a 5% annual rate of return. If you assume an 8% return, the account would be worth more than three times that amount.

Caveats

Hiring your child can be a tax-smart idea. However, your child’s wages must be reasonable for the work performed. Be sure to maintain the same records as you would for other employees to substantiate the hours worked and duties performed. These include timesheets, job descriptions and W-2 forms. Contact us with any questions you have about employing your child at your small business.

Consider borrowing from your corporation but structure the deal carefully

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If you own a closely held corporation, you can borrow funds from your business at rates that are lower than those charged by a bank. But it’s important to avoid certain risks and charge an adequate interest rate.

Basics of this strategy

Interest rates have increased over the last couple years. As a result, shareholders may decide to take loans from their corporations rather than pay higher interest rates on bank loans. In general, the IRS expects closely held corporations to charge interest on related-party loans, including loans to shareholders, at rates that at least equal applicable federal rates (AFRs). Otherwise, adverse tax results can be triggered. Fortunately, the AFRs are lower than the rates charged by commercial lenders.

It can be advantageous to borrow money from your closely held corporation to pay personal expenses. These expenses may include your child’s college tuition, home improvements, a new car or high-interest credit card debt. But avoid these two key risks:

1. Not creating a legitimate loan. When borrowing money from your corporation, it’s important to establish a bona fide borrower-lender relationship. Otherwise, the IRS could reclassify the loan proceeds as additional compensation. This reclassification would result in an income tax bill for you and payroll tax for you and your corporation. (However, the business would be allowed to deduct the amount treated as compensation and the corporation’s share of related payroll taxes.)

Alternatively, the IRS might claim that you received a taxable dividend if your company is a C corporation. That would trigger taxable income for you with no offsetting deduction for your business.

Draft a formal written loan agreement that establishes your unconditional promise to repay the corporation a fixed amount under an installment repayment schedule or on demand by the corporation. Take other steps such as documenting the terms of the loan in your corporate minutes.

2. Not charging adequate interest. The minimum interest rate your business should charge to avoid triggering the complicated and generally unfavorable “below-market loan rules” is the IRS-approved AFR. (There’s an exception to the below-market loan rules if the aggregate loans from a corporation to a shareholder are $10,000 or less.)

Current AFRs

The IRS publishes AFRs monthly based on market conditions. For loans made in July 2024, the AFRs are:

  • 4.95% for short-term loans of up to three years,
  • 4.40% for mid-term loans of more than three years but not more than nine years, and
  • 4.52% for long-term loans of over nine years.

These annual rates assume monthly compounding of interest. The AFR that applies to a loan depends on whether it’s a demand or term loan. The distinction is important. A demand loan is payable in full at any time upon notice and demand by the corporation. A term loan is any borrowing arrangement that isn’t a demand loan. The AFR for a term loan depends on the term of the loan, and the same rate applies for the entire term.

An example

Suppose you borrow $100,000 from your corporation with the principal to be repaid in installments over 10 years. This is a term loan of over nine years, so the AFR in July would be 4.52% compounded monthly for 10 years. The corporation must report the loan interest as taxable income.

On the other hand, if the loan document gives your corporation the right to demand full repayment at any time, it’s a demand loan. Then, the AFR is based on a blended average of monthly short-term AFRs for the year. If rates go up, you must pay more interest to stay clear of the below-market loan rules. If rates go down, you’ll pay a lower interest rate.

Term loans for more than nine years are smarter from a tax perspective than short-term or demand loans because they lock in current AFRs. If rates drop, a high-rate term loan can be repaid early and your corporation can enter into a new loan agreement at the lower rate.

Avoid adverse consequences

Shareholder loans can be complicated, especially if the loan charges interest below the AFR, the shareholder stops making payments or the corporation has more than one shareholder. Contact us about how to proceed in your situation.

Growing your business with a new partner

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There are several financial and legal implications when adding a new partner to a partnership. Here’s an example to illustrate: You and your partners are planning to admit a new partner. The new partner will acquire a one-third interest in the partnership by making a cash contribution to the business. Assume that your basis in your partnership interests is sufficient so that the decrease in your portions of the partnership’s liabilities because of the new partner’s entry won’t reduce your basis to zero.

More complex than it seems

Although adding a new partner may appear to be simple, it’s important to plan the new person’s entry properly to avoid various tax problems. Here are two issues to consider:

1. If there’s a change in the partners’ interests in unrealized receivables and substantially appreciated inventory items, the change will be treated as a sale of those items, with the result that the current partners will recognize gain. For this purpose, unrealized receivables include not only accounts receivable, but also depreciation recapture and certain other ordinary income items. To avoid gain recognition on those items, it’s necessary that they be allocated to the current partners even after the entry of the new partner.

2. The tax code requires that the “built-in gain or loss” on assets that were held by the partnership before the new partner was admitted be allocated to the current partners and not to the entering partner. In general, “built-in gain or loss” is the difference between the fair market value and basis of the partnership property at the time the new partner is admitted.

The upshot of these rules is that the new partner must be allocated a portion of the depreciation equal to his or her share of the depreciable property, based on current fair market value. This will reduce the amount of depreciation that can be taken by the current partners. The other outcome is that the built-in gain or loss on the partnership assets must be allocated to the current partners when the partnership assets are sold. The rules that apply in this area are complex, and the partnership may have to adopt special accounting procedures to cope with the relevant requirements.

Follow your basis

When adding a partner or making other changes, a partner’s basis in his or her interest can undergo frequent adjustment. It’s important to keep proper track of your basis because it can have an impact on these areas:

  • Gain or loss on the sale of your interest,
  • How partnership distributions to you are taxed, and
  • The maximum amount of partnership loss you can deduct.

We can help

Contact us if you’d like assistance in dealing with these issues or any other issues that may arise in connection with your partnership.

When do valuable gifts to charity require an appraisal?

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If you donate valuable items to charity and you want to deduct them on your tax return, you may be required to get an appraisal. The IRS requires donors and charitable organizations to supply certain information to prove their right to deduct charitable contributions.

How can you protect your deduction?

First, be aware that in order to deduct charitable donations, you must itemize deductions. Due to today’s relatively high standard deduction amounts, fewer taxpayers are itemizing deductions on their federal returns than before the Tax Cuts and Jobs Act became effective in 2018.

If you clear the itemizing hurdle and donate an item of property (or a group of similar items) worth more than $5,000, certain appraisal requirements apply. You must:

  • Get a “qualified appraisal,”
  • Receive the qualified appraisal before your tax return is due,
  • Attach an “appraisal summary” to the first tax return on which the deduction is claimed,
  • Include other information with the return, and
  • Maintain certain records.

Keep these definitions in mind. A “qualified appraisal” is a complex and detailed document. It must be prepared and signed by a qualified appraiser. An “appraisal summary” is a summary of a qualified appraisal made on Form 8283 and attached to the donor’s return.

While courts have allowed taxpayers some latitude in following these rules, you should aim for exact compliance.

The qualified appraisal isn’t submitted to the IRS in most cases. Instead, the appraisal summary, which is a separate statement prepared on an IRS form, is attached to the donor’s tax return. However, a copy of the appraisal must be attached for gifts of art valued at $20,000 or more and for all gifts of property valued at more than $500,000, other than inventory, publicly traded stock and intellectual property. If an item of art has been appraised at $50,000 or more, you can ask the IRS to issue a “Statement of Value” that can be used to substantiate the value.

What if you don’t comply with the requirements?

The penalty for failing to get a qualified appraisal and attach an appraisal summary to the return is denial of the charitable deduction. The deduction may be lost even if the property was valued correctly. There may be relief if the failure was due to reasonable cause.

Are there exceptions to the requirements?

A qualified appraisal isn’t required for contributions of:

  • A car, boat or airplane for which the deduction is limited to the charity’s gross sales proceeds,
  • Stock in trade, inventory or property held primarily for sale to customers in the ordinary course of business,
  • Publicly traded securities for which market quotations are “readily available,” and
  • Qualified intellectual property, such as a patent.

Also, only a partially completed appraisal summary must be attached to the tax return for contributions of:

  • Nonpublicly traded stock for which the claimed deduction is greater than $5,000 and doesn’t exceed $10,000, and
  • Publicly traded securities for which market quotations aren’t “readily available.”

What if you have more than one gift? 

If you make gifts of two or more items during a tax year, even to multiple charitable organizations, the claimed values of all property of the same category or type (such as stamps, paintings, books, stock that isn’t publicly traded, land, jewelry, furniture or toys) are added together in determining whether the $5,000 or $10,000 limits are exceeded.

The bottom line is you must be careful to comply with the appraisal requirements or risk disallowance of your charitable deduction. Contact us if you have any further questions or want to discuss your charitable giving plans.

Selling an appreciated vacation home?

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Vacation homes in upscale areas may be worth way more than owners paid for them. That’s great, but what about taxes? Here are three scenarios to illustrate the federal income tax issues you face when selling an appreciated vacation home.

Scenario 1: You’ve never used the home as your primary residence

In this case, the home sale gain exclusion tax break (up to $250,000 or $500,000 for a married couple) is unavailable. Your vacation home sale profit will be treated as a capital gain.

If you’ve owned the property for more than one year, the gain will be taxed at no more than the 20% maximum federal rate on long-term capital gains (LTCGs), plus the net investment income tax (NIIT), if applicable. However, the 20% rate only applies to the lesser of:

  • Your net LTCG for the year, or
  • The excess of your taxable income, including any net LTCG, over the applicable threshold.

For 2024, the thresholds are $518,900 for single filers, $583,750 for married joint filers and $551,350 for heads of households. If your taxable income is below the applicable threshold, the maximum federal rate on net LTCGs is 15%.

If you also owe the 3.8% NIIT, the effective federal rate on some or all of your net LTCG will be 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%).

You may owe state income tax, too.

Scenario 2: You’ve rented out the vacation home

In this situation, you probably deducted depreciation for rental periods. If so, the federal rate on gain attributable to depreciation (so-called unrecaptured Section 1250 gain) can be up to 25%, assuming you’ve held the property for over one year. You may also owe the 3.8% NIIT on the unrecaptured Section 1250 gain. Any remaining gain will be taxed at the federal rates explained earlier.

Plus, if you rented out the vacation home but used it only a little for personal purposes, it has probably been classified as a rental property for federal tax purposes. If so, you may have had rental losses that couldn’t be deducted currently due to the passive activity loss (PAL) rules. You can deduct these suspended PALs when the property is sold.

Scenario 3: You used the vacation home as a principal residence for a time

In this case, you might be able to claim the tax-saving principal residence gain exclusion break. Specifically, if you owned and used the property as your principal residence for at least two years during the five-year period ending on the sale date, you probably qualify for the exclusion.

There’s another major qualification rule for the home sale gain exclusion tax break. The exclusion is generally available only when you’ve not excluded an earlier gain within the two-year period ending on the date of the later sale. In other words, you generally cannot claim the gain exclusion until two years have passed since you last used it.

Of course, if you have a really big gain from selling your vacation home, it may be too big to fully shelter with the gain exclusion — even if you qualify for the maximum $250,000/$500,000 break. Assuming you’ve owned the property for more than one year, the part of the gain that can’t be excluded will be an LTCG taxed under the rules explained earlier.

Conclusion

Taxes on vacation home sales can get complicated, and we haven’t covered all the potential issues here. However, the tax results are simple if you’ve never rented out the property and never used it as a principal residence. We can fill in the blanks in your situation and answer any questions that you may have.

When partners pay expenses related to the business

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It’s not unusual for a partner to incur expenses related to the partnership’s business. This is especially likely to occur in service partnerships such as an architecture or law firm. For example, partners in service partnerships may incur entertainment expenses in developing new client relationships. They may also incur expenses for: transportation to get to and from client meetings, professional publications, continuing education and home office. What’s the tax treatment of such expenses? Here are the answers.

Reimbursable or not

As long as the expenses are the type a partner is expected to pay without reimbursement under the partnership agreement or firm policy (written or unwritten), the partner can deduct the expenses on Schedule E of Form 1040. Conversely, a partner can’t deduct expenses if the partnership would have honored a request for reimbursement.

A partner’s unreimbursed partnership business expenses should also generally be included as deductions in arriving at the partner’s net income from self-employment on Schedule SE.

For example, let’s say you’re a partner in a local architecture firm. Under the firm’s partnership agreement, partners are expected to bear the costs of soliciting potential new business except in unusual cases where attracting a large potential new client is deemed to be a firm-wide goal. In attempting to attract new clients this year, you spend $4,500 of your own money on meal expenses. You receive no reimbursement from the firm. On your Schedule E, you should report a deductible item of $2,250 (50% of $4,500). You should also include the $2,250 as a deduction in calculating your net self-employment income on Schedule SE.

So far, so good, but here’s the issue: a partner can’t deduct expenses if they could have been reimbursed by the firm. In other words, no deduction is allowed for “voluntary” out-of-pocket expenses. The best way to eliminate any doubt about the proper tax treatment of unreimbursed partnership expenses is to install a written firm policy that clearly states what will and won’t be reimbursed. That way, the partners can deduct their unreimbursed firm-related business expenses without any problems from the IRS.

Office in a partner’s home

Subject to the normal deduction limits under the home office rules, a partner can deduct expenses allocable to the regular and exclusive use of a home office for partnership business. The partner’s deductible home office expenses should be reported on Schedule E in the same fashion as other unreimbursed partnership expenses.

If a partner has a deductible home office, the Schedule E home office deduction can deliver multiple tax-saving benefits because it’s effectively deducted for both federal income tax and self-employment tax purposes.

In addition, if the partner’s deductible home office qualifies as a principal place of business, commuting mileage from the home office to partnership business temporary work locations (such as client sites) and partnership permanent work locations (such as the partnership’s official office) count as business mileage.

The principal place of business test can be passed in two ways. First, the partner can conduct most of partnership income-earning activities in the home office. Second, the partner can pass the principal place of business test if he or she:

  • Uses the home office to conduct partnership administrative and management tasks and
  • Doesn’t make substantial use of any other fixed location (such as the partnership’s official office) for such administrative and management tasks.

To sum up

When a partner can be reimbursed for business expenses under a partnership agreement or standard operating procedures, the partner should turn them in. Otherwise, the partner can’t deduct the expenses. On the partnership side of the deal, the business should set forth a written firm policy that clearly states what will and won’t be reimbursed, including home office expenses if applicable. This applies equally to members of LLCs that are treated as partnerships for federal tax purposes because those members count as partners under tax law.

Scrupulous records and legitimate business expenses are the key to less painful IRS audits

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We have been emphasizing to our clients that maintaining accurate records and taking advantage of proper deductions not only makes tax season less stressful but also sets the stage for effective long-term financial planning. This proactive approach helps to minimize the risk of errors or audits enabling your efficient and strategic tax planning.

If you operate a business, or you’re starting a new one, you know records of income and expenses need to be kept. Specifically, you should carefully record expenses to claim all the tax deductions to which you’re entitled. And you want to make sure you can defend the amounts reported on your tax returns in case you’re ever audited by the IRS.

Be aware that there’s no one way to keep business records. On its website, the IRS states: “You can choose any recordkeeping system suited to your business that clearly shows your income and expenses.” But there are strict rules when it comes to deducting legitimate expenses for tax purposes. And certain types of expenses, such as automobile, travel, meal and home office costs, require extra attention because they’re subject to special recordkeeping requirements or limitations on deductibility.

Ordinary and necessary

A business expense can be deducted if a taxpayer establishes that the primary objective of the activity is making a profit. To be deductible, a business expense must be “ordinary and necessary.” In one recent case, a married couple claimed business deductions that the IRS and the U.S. Tax Court mostly disallowed. The reasons: The expenses were found to be personal in nature and the taxpayers didn’t have adequate records for them.

In the case, the husband was a salaried executive. With his wife, he started a separate business as an S corporation. His sideline business identified new markets for chemical producers and connected them with potential customers. The couple’s two sons began working for the business when they were in high school.

The couple then formed a separate C corporation that engaged in marketing. For some of the years in question, the taxpayers reported the income and expenses of the businesses on their joint tax returns. The businesses conducted meetings at properties the family owned (and resided in) and paid the couple rent for the meetings.

The IRS selected the couple’s returns for audit. Among the deductions the IRS and the Tax Court disallowed:

  • Travel expenses. The couple submitted reconstructed travel logs to the court, rather than records kept contemporaneously. The court noted that the couple didn’t provide “any documentary evidence or other direct or circumstantial evidence of the time, location, and business purpose of each reported travel expense.”
  • Marketing fees paid by the S corporation to the C corporation. The court found that no marketing or promotion was done. Instead, the funds were used to pay several personal family expenses.
  • Rent paid to the couple for the business use of their homes. The court stated the amounts “were unreasonable and something other than rent.”

Retirement plan deductions allowed

The couple did prevail on deductions for contributions to 401(k) accounts for their sons. The IRS contended that the sons weren’t employees during one year in which contributions were made for them. However, the court found that 401(k) plan documents did mention the sons working in the business and the father “credibly recounted assigning them research tasks and overseeing their work while they were in school.” Thus, the court ruled the taxpayers were entitled to the retirement plan deductions. (TC Memo 2023-140)

Lessons learned

As this case illustrates, a business can’t deduct personal expenses, and scrupulous records are critical. Make sure to use your business bank account for business purposes only. In addition, maintain meticulous records to help prepare your tax returns and prove deductible business expenses in the event of an IRS audit.

Contact us if you have questions about retaining adequate business records.

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