News Archives - Page 6 of 18

How renting out a vacation property will affect your taxes

March 21, 2024/in News, Tax Tips - Individual/by Encore Partners Team

Are you dreaming of buying a vacation beach home, lakefront cottage or ski chalet? Or perhaps you’re fortunate enough to already own a vacation home. In either case, you may wonder about the tax implications of renting it out for part of the year.

Count the days

The tax treatment depends on how many days it’s rented and your level of personal use. Personal use includes vacation use by your relatives (even if you charge them market rate rent) and use by nonrelatives if a market rate rent isn’t charged.

If you rent the property out for less than 15 days during the year, it’s not treated as “rental property” at all. In the right circumstances, this can produce significant tax benefits. Any rent you receive isn’t included in your income for tax purposes (no matter how substantial). On the other hand, you can only deduct property taxes and mortgage interest — no other operating costs and no depreciation. (Mortgage interest is deductible on your principal residence and one other home, subject to certain limits.)

If you rent the property out for more than 14 days, you must include the rent you receive in income. However, you can deduct part of your operating expenses and depreciation, subject to several rules. First, you must allocate your expenses between the personal use days and the rental days. For example, if the house is rented for 90 days and used personally for 30 days, then 75% of the use is rental (90 days out of 120 total days). You would allocate 75% of your maintenance, utilities, insurance, etc. costs to rental. You would allocate 75% of your depreciation allowance, interest and taxes for the property to rental as well. The personal use portion of taxes is separately deductible. The personal use portion of interest on a second home is also deductible if the personal use exceeds the greater of 14 days or 10% of the rental days. However, depreciation on the personal use portion isn’t allowed.

Income and expenses

If the rental income exceeds these allocable deductions, you report the rent and deductions to determine the amount of rental income to add to your other income. If the expenses exceed the income, you may be able to claim a rental loss. This depends on how many days you use the house personally.

Here’s the test: if you use it personally for the greater of more than 14 days, or 10% of the rental days, you’re using it “too much,” and you can’t claim a loss. In this case, you can still use your deductions to wipe out rental income, but you can’t go beyond that to create a loss. Any unused deductions are carried forward and may be usable in future years.

If you’re limited to using deductions only up to the amount of rental income, you must use the deductions allocated to the rental portion in the following order:

Interest and taxes,
Operating costs, and
Depreciation.

If you “pass” the personal use test (that is, you don’t use the property personally more than the greater of the figures listed above), you must still allocate your expenses between the personal and rental portions. In this case, however, if your rental deductions exceed rental income, you can claim a loss. (The loss is “passive,” however, and may be limited under the passive loss rules.)

Plan ahead for best results

As you can see, the rules are complex. Contact us if you have questions or would like to plan ahead to maximize deductions in your situation.

Important: Filing for Tax Extensions Before Original Due Dates

March 11, 2024/in News, Tax Tips - Individual/by Encore Partners Team

As we approach the tax season, I want to ensure that you’re fully informed about the strategies we’re implementing to manage your tax filings effectively, especially considering the recent storms and flooding in January in San Diego County.

Given the IRS’s extension due to the storms and flooding in San Diego County, San Diego County taxpayers have been granted an extended filing due date of June 17, 2024, for their 2023 federal income tax returns along with the payment dues listed below. While this extension provides some leeway, we want to take a proactive approach to ensure your tax matters are handled smoothly and without any potential issues.

Individual income tax returns and payments normally due on April 15, 2024.
2023 contributions to IRAs and health savings accounts for eligible taxpayers.
2024 estimated tax payments normally due on April 15, 2024.
Quarterly payroll and excise tax returns normally due on Jan. 31 and April 30, 2024.
Calendar-year partnership and S corporation returns normally due on March 15, 2024.
Calendar-year corporation and fiduciary returns and payments normally due on April 15, 2024.
Calendar-year tax-exempt organization returns normally due on May 15, 2024.
Also, penalties for failing to make payroll and excise tax deposits due on or after Jan. 21, 2024, and before Feb. 5, 2024, will be abated as long as the deposits were made by Feb. 5, 2024.

Who is affected?

This extended due date applies to taxpayers who have their address in San Diego County. However, it is possible an affected taxpayer may not have an IRS address of record located in the disaster area, for example, because they moved to the disaster area after filing their return. In these kinds of unique circumstances, the affected taxpayer could receive a late filing or late payment penalty notice from the IRS for the postponement period. The taxpayer should call the number on the notice to have the penalty abated.

In addition, the IRS will work with any taxpayer who lives outside the disaster area but whose records necessary to meet a deadline occurring during the postponement period are located in the affected area. Taxpayers qualifying for relief who live outside the disaster area need to contact the IRS at 866-562-5227. This also includes workers assisting the relief activities who are affiliated with a recognized government or philanthropic organization.

Filing Extensions by the Original Due Dates:

To provide you with the utmost certainty and to avoid any unnecessary complications, we are planning to file extensions by the original due dates for your tax returns. This approach guarantees that your extended filing date will be either September 15, 2024, or October 15, 2024, depending on your entity type and personal return requirements.

Why We’re Taking This Step:

Relying solely on the extended due date of June 17, 2024, poses a risk. Should there be a need to seek an extension beyond this date and it is not filed by March 15, 2024 or April 15, 2024, most of the cases, we would be required to file the extension request on paper. This not only introduces potential delays but also additional hassle for both you and our team.

The most prudent action is to file electronically by the original due dates to ensure a hassle-free process. This preemptive measure avoids the complexities of paper filing and ensures everything is in order for your 2023 tax filings.

Reminder About Extensions and Payments:

It’s important to remember that while an extension grants additional time to file, it does not extend the time to pay any taxes owed. The IRS urges those who need an extension beyond the initial extended due date to request it electronically by March 15, 2024, and April 15, 2024, to avoid needing paper filing. Please note that any payments due are still required by June 17, 2024. For more information, you can visit www.IRS.gov/extensions.

Our team is here to assist you through this process and to ensure that your tax filing experience is as smooth and efficient as possible. Our team has been sending the extension reminder along with any payment vouchers if required. We believe that taking these steps now will provide you with peace of mind and a clear path forward in managing your tax obligations.

Should you have any questions or require further clarification, please do not hesitate to reach out. Your peace of mind and financial well-being are our top priorities, and we are here to support you every step of the way.

Better tax break when applying the research credit against payroll taxes

March 7, 2024/in News, Tax Tips - Business/by Encore Partners Team

The credit for increasing research activities, often referred to as the research and development (R&D) credit, is a valuable tax break available to certain eligible small businesses. Claiming the credit involves complex calculations, which we’ll take care of for you.

But in addition to the credit itself, be aware that there are two additional features that are especially favorable to small businesses:

Eligible small businesses ($50 million or less in gross receipts for the three prior tax years) may claim the credit against alternative minimum tax (AMT) liability.
The credit can be used by certain smaller startup businesses against their Social Security payroll and Medicare tax liability.

Let’s take a look at the second feature. The Inflation Reduction Act (IRA) has doubled the amount of the payroll tax credit election for qualified businesses and made a change to the eligible types of payroll taxes it can be applied to, making it better than it was before the law changes kicked in.

Election basics

Subject to limits, your business can elect to apply all or some of any research tax credit that you earn against your payroll taxes instead of your income tax. This payroll tax election may influence you to undertake or increase your research activities. On the other hand, if you’re engaged in — or are planning to undertake — research activities without regard to tax consequences, you could receive some tax relief.

Many new businesses, even if they have some cash flow, or even net positive cash flow and/or a book profit, pay no income taxes and won’t for some time. Thus, there’s no amount against which business credits, including the research credit, can be applied. On the other hand, any wage-paying business, even a new one, has payroll tax liabilities. Therefore, the payroll tax election is an opportunity to get immediate use out of the research credits that you earn. Because every dollar of credit-eligible expenditure can result in as much as a 10-cent tax credit, that’s a big help in the start-up phase of a business — the time when help is most needed.

Eligible businesses

To qualify for the election a taxpayer must:

Have gross receipts for the election year of less than $5 million, and
Be no more than five years past the period for which it had no receipts (the start-up period).

In making these determinations, the only gross receipts that an individual taxpayer considers are from the individual’s businesses. An individual’s salary, investment income or other income aren’t taken into account. Also, note that an entity or individual can’t make the election for more than six years in a row.

Limits on the election

The research credit for which the taxpayer makes the payroll tax election can be applied against the employer portion of Social Security and Medicare. It can’t be used to lower the FICA taxes that an employer withholds and remits to the government on behalf of employees. Before a provision in the IRA became effective for 2023 and later years, taxpayers were only allowed to use the payroll tax offset against Social Security, not Medicare.

The amount of research credit for which the election can be made can’t annually exceed $500,000. Prior to the IRA, the maximum credit amount allowed to offset payroll tax before 2023 was only $250,000. Note, too, that an individual or C corporation can make the election only for those research credits which, in the absence of an election, would have to be carried forward. In other words, a C corporation can’t make the election for the research credit to reduce current or past income tax liabilities.

These are just the basics of the payroll tax election. Keep in mind that identifying and substantiating expenses eligible for the research credit itself is a complex task. Contact us about whether you can benefit from the payroll tax election and the research tax credit.

Tax-wise ways to take cash from your corporation while avoiding dividend treatment

February 29, 2024/in News, Tax Tips - Business/by Encore Partners Team

If you want to withdraw cash from your closely held corporation at a low tax cost, the easiest way is to distribute cash as a dividend. However, a dividend distribution isn’t tax efficient since it’s taxable to you to the extent of your corporation’s “earnings and profits,” but it’s not deductible by the corporation.

5 different approaches

Thankfully, there are some alternative methods that may allow you to withdraw cash from a corporation while avoiding dividend treatment. Here are five possible options:

1. Salary. Reasonable compensation that you, or family members, receive for services rendered to the corporation is deductible by the business. However, it’s also taxable to the recipient(s). The same rule applies to any compensation (in the form of rent) that you receive from the corporation for the use of property. In either case, the amount of compensation must be reasonable in relation to the services rendered or the value of the property provided. If it’s excessive, the excess will be nondeductible and treated as a corporate distribution.

2. Fringe benefits. Consider obtaining the equivalent of a cash withdrawal in fringe benefits that are deductible by the corporation and not taxable to you. Examples are life insurance, certain medical benefits, disability insurance and dependent care. Most of these benefits are tax-free only if provided on a nondiscriminatory basis to other employees of the corporation. You can also establish a salary reduction plan that allows you (and other employees) to take a portion of your compensation as nontaxable benefits, rather than as taxable compensation.

3. Capital repayments. To the extent that you’ve capitalized the corporation with debt, including amounts that you’ve advanced to the business, the corporation can repay the debt without the repayment being treated as a dividend. Additionally, interest paid on the debt can be deducted by the corporation. This assumes that the debt has been properly documented with terms that characterize debt and that the corporation doesn’t have an excessively high debt-to-equity ratio. If not, the “debt” repayment may be taxed as a dividend. If you make cash contributions to the corporation in the future, consider structuring them as debt to facilitate later withdrawals on a tax-advantaged basis.

4. Loans. You may withdraw cash from the corporation tax-free by borrowing money from it. However, to avoid having the loan characterized as a corporate distribution, it should be properly documented in a loan agreement or a note and be made on terms that are comparable to those on which an unrelated third party would lend money to you. This should include a provision for interest and principal. All interest and principal payments should be made when required under the loan terms. Also, consider the effect of the corporation’s receipt of interest income.

5. Property sales. You can withdraw cash from the corporation by selling property to it. However, certain sales should be avoided. For example, you shouldn’t sell property to a more than 50% owned corporation at a loss, since the loss will be disallowed. And you shouldn’t sell depreciable property to a more than 50% owned corporation at a gain, since the gain will be treated as ordinary income, rather than capital gain. A sale should be on terms that are comparable to those on which an unrelated third party would purchase the property. You may need to obtain an independent appraisal to establish the property’s value.

Minimize taxes

If you’re interested in discussing any of these ideas, contact us. We can help you get the maximum out of your corporation at the minimum tax cost.

Taking your spouse on a business trip? Can you write off the costs?

February 22, 2024/in News, Tax Tips - Business/by Betty Kim

A recent report shows that post-pandemic global business travel is going strong. The market reached $665.3 billion in 2022 and is estimated to hit $928.4 billion by 2030, according to a report from Research and Markets. If you own your own company and travel for business, you may wonder whether you can deduct the costs of having your spouse accompany you on trips.

Is your spouse an employee?

The rules for deducting a spouse’s travel costs are very restrictive. First of all, to qualify for the deduction, your spouse must be your employee. This means you can’t deduct the travel costs of a spouse, even if his or her presence has a bona fide business purpose, unless the spouse is an employee of your business. This requirement prevents tax deductibility in most cases.

If your spouse is your employee, you can deduct his or her travel costs if his or her presence on the trip serves a bona fide business purpose. Merely having your spouse perform some incidental business service, such as typing up notes from a meeting, isn’t enough to establish a business purpose. In general, it isn’t enough for his or her presence to be “helpful” to your business pursuits — it must be necessary.

In most cases, a spouse’s participation in social functions, for example as a host or hostess, isn’t enough to establish a business purpose. That is, if his or her purpose is to establish general goodwill for customers or associates, this is usually insufficient. Further, if there’s a vacation element to the trip (for example, if your spouse spends time sightseeing), it will be more difficult to establish a business purpose for his or her presence on the trip. On the other hand, a bona fide business purpose exists if your spouse’s presence is necessary to care for a serious medical condition that you have.

If your spouse’s travel satisfies these requirements, the normal deductions for business travel away from home can be claimed. These include the costs of transportation, meals, lodging, and incidental costs such as dry cleaning, phone calls, etc.

What if your spouse isn’t an employee?

Even if your spouse’s travel doesn’t satisfy the requirements, however, you may still be able to deduct a substantial portion of the trip’s costs. This is because the rules don’t require you to allocate 50% of your travel costs to your spouse. You need only allocate any additional costs you incur for him or her. For example, in many hotels the cost of a single room isn’t that much lower than the cost of a double. If a single would cost you $150 a night and a double would cost you and your spouse $200, the disallowed portion of the cost allocable to your spouse would only be $50. In other words, you can write off the cost of what you would have paid traveling alone. To prove your deduction, ask the hotel for a room rate schedule showing single rates for the days you’re staying.

And if you drive your own car or rent one, the whole cost will be fully deductible even if your spouse is along. Of course, if public transportation is used, and for meals, any separate costs incurred by your spouse aren’t deductible.

Have questions?

You want to maximize all the tax breaks you can claim for your small business. Contact us if you have questions or need assistance with this or other tax-related issues.

Stay Safe and Informed During Southern CA Winter Storms

February 8, 2024/in News, Tax Tips - Business, Tax Tips - Individual/by Betty Kim

Dear Valued Clients and Colleagues,

I hope you’re doing well and staying dry amidst the severe winter storms sweeping through Southern California. We understand that these weather conditions can bring unexpected challenges, not least of which may include delays or difficulties in gathering necessary tax documents.

Please know that during this turbulent time, our primary concern is for the safety and well-being of our clients. We recognize that the storms may impact your ability to meet certain deadlines or gather documents required for tax preparation. We want to assure you that we are here to assist and support you through these challenges.

Should you find yourself in need of additional time, have questions regarding your tax preparation or services, or if there are any specific issues you’re facing due to the weather, please feel free to reach out to us. Our team is prepared to offer the flexibility and support needed to navigate this period, including extending deadlines where possible or assisting in document retrieval and tax filing procedures.

Furthermore, if you have any immediate concerns or questions, whether tax-related or pertaining to how the storms might affect your financial planning, our lines are open. We’re committed to providing the guidance and assistance you require to manage your tax obligations and ensure your financial well-being during such challenging times.

Your safety is important to us, so please take all necessary precautions to protect yourself and your loved ones during the storms. We look forward to continuing to serve you and are ready to help in any way we can.

Stay safe and take care!!

Betty Kim, CPA

Managing Partner

9 tax considerations if you’re starting a business as a sole proprietor

January 31, 2024/in News, Tax Tips - Business/by Betty Kim

When launching a small business, many entrepreneurs start out as sole proprietors. If you’re launching a venture as a sole proprietorship, you need to understand the tax issues involved. Here are nine considerations:

1. You may qualify for the pass-through deduction. To the extent your business generates qualified business income, you’re currently eligible to claim the 20% pass-through deduction, subject to limitations. The deduction is taken “below the line,” meaning it reduces taxable income, rather than being taken “above the line” against your gross income. However, you can take the deduction even if you don’t itemize deductions and instead claim the standard deduction. Be aware that this deduction is only available through 2025 unless Congress acts to extend it.

2. You report income and expenses on Schedule C of Form 1040. The net income will be taxable to you regardless of whether you withdraw cash from the business. Your business expenses are deductible against gross income and not as itemized deductions. If you have losses, they’ll generally be deductible against your other income, subject to special rules related to hobby losses, passive activity losses, and losses from activities in which you weren’t “at risk.”

3. You must pay self-employment taxes. For 2024, you pay self-employment tax (Social Security and Medicare) at a 15.3% rate on your net earnings from self-employment up to $168,600, and Medicare tax only at a 2.9% rate on the excess. An additional 0.9% Medicare tax (for a total of 3.8%) is imposed on self-employment income in excess of $250,000 for joint returns, $125,000 for married taxpayers filing separate returns, and $200,000 in all other cases. Self-employment tax is imposed in addition to income tax, but you can deduct half of your self-employment tax as an adjustment to income.

4. You generally must make quarterly estimated tax payments. For 2024, these are due April 15, June 17, September 16, and January 15, 2025.

5. You can deduct 100% of your health insurance costs as a business expense. This means your deduction for medical care insurance won’t be subject to the rule that limits medical expense deductions.

6. You may be able to deduct home office expenses. If you work from a home office, perform management or administrative tasks there, or store product samples or inventory at home, you may be entitled to deduct an allocable part of certain expenses, including mortgage interest or rent, insurance, utilities, repairs, maintenance, and depreciation. You may also be able to deduct travel expenses from a home office to another work location.

7. You should keep complete records of your income and expenses. Specifically, you should carefully record your expenses in order to claim all the tax breaks to which you’re entitled. Certain expenses, such as automobile, travel, meals, and home office expenses, require extra attention because they’re subject to special recordkeeping rules or deductibility limits.

8. You have more responsibilities if you hire employees. For example, you need to get a taxpayer identification number and withhold and pay over payroll taxes.

9. You should consider establishing a qualified retirement plan. The advantages are that amounts contributed to it are deductible at the time of the contributions and aren’t taken into income until they’re withdrawn. You might consider a SEP plan, which requires minimal paperwork. A SIMPLE plan is also available to sole proprietors and offers tax advantages with fewer restrictions and administrative requirements. If you don’t establish a retirement plan, you may still be able to contribute to an IRA.

Turn to us

Contact us if you want additional information regarding the tax aspects of your business, or if you have questions about reporting or recordkeeping requirements.

A cost segregation study may cut taxes and boost cash flow

November 14, 2023/in News, Tax Tips - Business/by Betty Kim

Is your business depreciating over 30 years the entire cost of constructing the building that houses your enterprise? If so, you should consider a cost segregation study. It may allow you to accelerate depreciation deductions on certain items, thereby reducing taxes and boosting cash flow.

Depreciation basics

Business buildings generally have a 39-year depreciation period (27.5 years for residential rental properties). In most cases, a business depreciates a building’s structural components, including walls, windows, HVAC systems, elevators, plumbing and wiring, along with the building. Personal property — including equipment, machinery, furniture and fixtures — is eligible for accelerated depreciation, usually over five or seven years. And land improvements, such as fences, outdoor lighting and parking lots, are depreciable over 15 years.

Frequently, businesses allocate all or most of their buildings’ acquisition or construction costs to real property, overlooking opportunities to allocate costs to shorter-lived personal property or land improvements. In some cases, the distinction between real and personal property is obvious. For example, computers and furniture are personal property. But the line between real and personal property is not always clear. Items that appear to be “part of a building” may in fact be personal property. Examples are removable wall and floor coverings, removable partitions, awnings and canopies, window treatments, decorative lighting and signs.

In addition, certain items that otherwise would be treated as real property may qualify as personal property if they serve more of a business function than a structural purpose. These include reinforced flooring that supports heavy manufacturing equipment, electrical or plumbing installations required to operate specialized equipment and dedicated cooling systems for data processing rooms.

Identifying and substantiating costs

A cost segregation study combines accounting and engineering techniques to identify building costs that are properly allocable to tangible personal property rather than real property. Although the relative costs and benefits of a cost segregation study depend on your particular facts and circumstances, it can be a valuable investment.

Speedier depreciation tax breaks

The Tax Cuts and Jobs Act (TCJA) enhanced certain depreciation-related tax breaks, which may also enhance the benefits of a cost segregation study. Among other changes, the law permanently increased limits on Section 179 expensing, which allows you to immediately deduct the entire cost of qualifying equipment or other fixed assets up to specified thresholds.

In addition, the TCJA expanded 15-year-property treatment to apply to qualified improvement property. Previously, this tax break was limited to qualified leasehold-improvement, retail-improvement and restaurant property. And the law temporarily increased first-year bonus depreciation from 50% to 100% in 2022, 80% in 2023 and 60% in 2024. After that, it will continue to decrease until it is 0% in 2027, unless Congress acts.

Making favorable depreciation changes

It isn’t too late to get the benefit of faster depreciation for items that were incorrectly assumed to be part of your building for depreciation purposes. You don’t have to amend your past returns (or meet a deadline for claiming tax refunds) to claim the depreciation that you could have already claimed. Instead, you can claim that depreciation by following procedures, in connection with the next tax return you file, that will result in automatic IRS consent to a change in your accounting for depreciation.

Cost segregation studies can yield substantial benefits, but they’re not the best move for every business. Contact us to determine whether this strategy would work for your business. We’ll judge whether a study will result in tax savings that are greater than the costs of the study itself.

Tax Return Red Flags for Schedule C Filers

October 25, 2023/in News, Tax Tips - Business, Tax Tips - Individual/by Betty Kim

In the complex landscape of business taxes, Schedule C expenses and entity optimization hold significant weight. Proper documentation and reconciliation, guided by a trusted accounting professional, are more than just best practices – they are vital for audit prevention and ensuring a successful financial trajectory.

Why Is This So Important?

Audit Triggers for Schedule C Filers: The IRS closely examines Schedule C filers to ensure the accuracy of reported income and deductions.

Specific scenarios increase the likelihood of triggering an audit:

Income exceeding $100,000
Taking disproportionately large deductions to offset income
Multiple-year hobby loss write-offs
Claiming 100% business use of a vehicle
Large deductions for meals, travel, and entertainment
Home office deductions
Claiming rental losses
Opting for the Research and Development Credit
Receipt of significant cash income (especially without filing Form 8300 for amounts over $10,000)

Entity Optimization: Choosing the right business entity affects your liability and how much you pay in taxes. For instance, an LLC might benefit a sole proprietor more than remaining a Schedule C filer. Making the right decision in entity selection can lead to tax savings.

The Role of Accounting Professionals

Documentation: Accurate and timely documentation of expenses ensures that you take advantage of all legitimate deductions, reducing the chance of errors that might trigger an audit.
Reconciliation: Regular reconciliation of business accounts helps in early detection of discrepancies, ensuring that income and expenses align with bank and credit card statements.
Guidance: Professionals can offer advice on structuring your business, potential deductions, and best practices to remain compliant with IRS regulations.
Audit Support: In the unlikely event of an audit, having a professional by your side provides a sense of security. They can guide you through the process, answer questions, and ensure all paperwork is in order.

Proper handling of Schedule C expenses and entity optimization is not just about keeping the IRS at bay; it’s about ensuring that your business is on a secure and profitable path. Leveraging the expertise of an accounting professional can be a game-changer for your business’s financial health and success.

Stay informed, stay compliant, and remember – we’re here to help.

What types of expenses can’t be written off by your business?

October 6, 2023/in News, Tax Tips - Business/by Betty Kim

If you read the Internal Revenue Code (and you probably don’t want to!), you may be surprised to find that most business deductions aren’t specifically listed. For example, the tax law doesn’t explicitly state that you can deduct office supplies and certain other expenses. Some expenses are detailed in the tax code, but the general rule is contained in the first sentence of Section 162, which states you can write off “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

Basic definitions

In general, an expense is ordinary if it’s considered common or customary in the particular trade or business. For example, insurance premiums to protect a store would be an ordinary business expense in the retail industry.

A necessary expense is defined as one that’s helpful or appropriate. For example, let’s say a car dealership purchases an automated external defibrillator. It may not be necessary for the operation of the business, but it might be helpful and appropriate if an employee or customer suffers cardiac arrest.

It’s possible for an ordinary expense to be unnecessary — but, in order to be deductible, an expense must be ordinary and necessary.

In addition, a deductible amount must be reasonable in relation to the benefit expected. For example, if you’re attempting to land a $3,000 deal, a $65 lunch with a potential client should be OK with the IRS. (Keep in mind that the Tax Cuts and Jobs Act eliminated most deductions for entertainment expenses but retained the 50% deduction for business meals.)

Examples of taxpayers who lost deductions in court

Not surprisingly, the IRS and courts don’t always agree with taxpayers about what qualifies as ordinary and necessary expenditures. Here are three 2023 cases to illustrate some of the issues:

A married couple owned an engineering firm. For two tax years, they claimed depreciation of $76,264 on three vehicles, but didn’t provide required details including each vehicle’s ownership, cost and useful life. They claimed $34,197 in mileage deductions and provided receipts and mileage logs, but the U.S. Tax Court found they didn’t show any related business purposes. The court also found the mileage claimed included commuting costs, which can’t be written off. The court disallowed these deductions and assessed taxes and penalties. (TC Memo 2023-39)

The Tax Court ruled that a married couple wasn’t entitled to business tax deductions because the husband’s consulting company failed to show that it was engaged in a trade or business. In fact, invoices produced by the consulting company predated its incorporation. And the court ruled that even if the expenses were legitimate, they weren’t properly substantiated. (TC Memo 2023-80)

A physician specializing in gene therapy had multiple legal issues and deducted legal expenses of $360,295 for two years on joint Schedule C business tax returns. The Tax Court found that most of the legal fees were to defend the husband against personal conduct issues. The court denied the deduction for personal legal expenses but allowed a deduction for $13,000 for business-related legal expenses. (TC Memo 2023-42)

Proceed with caution

The deductibility of some expenses is clear. But for other expenses, it can get more complicated. Generally, if an expense seems like it’s not normal in your industry — or if it could be considered fun, personal or extravagant in nature — you should proceed with caution. And keep careful records to substantiate the expenses you’re deducting.

Consult with us for guidance.

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