The 20% Business Deduction: Does Rental Real Estate (RRE) qualify?
As most taxpayers now know, the new tax laws signed into effect for 2018 have given us a special 20% business deduction (referred to as the Section 199A deduction).
The calculations behind the deduction are very simple for those making less than $157,500 ($315,000 if filing joint):
Wages & Salary from Employment – DOES NOT QUALIFY
Schedule C – Net Income from the Business
Schedule E – Will Depend (More on that Later)
S-Corporation – Amount of Ordinary Income On K-1 (May Include Rental Real Estate As Well, More on that later)
Partnership – Amount of Ordinary Income On K-1 (May Include Rental Real Estate As Well, More on that later)
Some Examples:
Joe works a normal 9-5 job and receives a $50,000 gross salary. None of this income will qualify for the business deduction because he is strictly an employee.
Jerry married and is a real estate agent and his total taxable income is $200,000. His Schedule C income as an agent is $150,000. He will receive a special business deduction of $30,000 this year (20% of his $150,000 Schedule C business income).
John is a real estate flipper making $200,000 per year. He is married. He runs his flipping business through an S-Corporation. He receives a $50,000 gross salary, leaving $150,000 as the company’s leftover business income. He will receive a special business deduction of $30,000 this year (20% of his $150,000 amount left over on his K-1).
Jeff purchases real estate, remodels them, rents them out, and sells after a year for capital gains. The capital gains will never qualify for the 20% deduction (as the deduction only applies to ordinary income). Jeff’s rental real estate may qualify, depending on several factors. One of which is his risk tolerance.
In what situations does RRE qualify for the 20% Business Deduction?
SIMPLE YET COMPLEX ANSWER: IT DEPENDS
Basically any trade or business outside of a list of certain service industries (and even those service industries still qualify just. In writing the original law, Congress defined the businesses that qualify for the 20% deduction as as long as taxable income is below the limits mentioned earlier in the article).
So, the main question is….”Does RRE fall under the definition of any trade or business?”
In an audit, the IRS generally starts by answering that question as *no*, and will push the burden onto the taxpayer to prove otherwise. Even in cases where a good argument is put forth, the IRS will often still reject the taxpayer’s claim and require they appeal to the next level of review.
In appeals, these cases almost always result in an argument over a part of the Tax Code called “IRC 162”.
Why is IRC 162 so important?
IRC 162 states:
“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business….”
The IRS has frequently come back to referencing this “trade or business” phrase when allowing other certain deductions and positions, with respect to rental real estate.
In August of 2018, the IRS released what are called “Proposed Regulations”. Proposed Reg’s are written by the IRS, explaining ahead of time how they plan on enforcing rules written by Congress, especially in situations where the code is unclear.
Many taxpayers wrote to the IRS, requesting clarification as to whether they planned on allowing RRE to be grouped under the definition of “trade or business”.
The IRS’ answer? They would be relying on IRC 162 to define a trade or business. In other words, they will most likely disallow the deduction if taxpayer’s attempt to take it on RRE.
They did explicitly state ONE situation where RRE would absolutely qualify. In situations where a taxpayer owns real estate being used by a “normal” business, they would permit the 20% business deduction.
Ex., John the real estate flipper decides to buy a commercial building under an LLC separate from his flipping S-Corp. John’s flipping corporation pays rent to his LLC owning his commercial building. The IRS has explicitly said they will permit the resulting net income to qualify for the 20% deduction.
In any other RRE situation than this, the IRS will point to IRC 162.
OK, so IRC 162 is pretty vague and gives us very little clarity as well. Where else do we go for help?
Answer: The Tax Courts
The tax courts further define “trade or business” as
“…an activity conducted with ‘continuity and regularity’ and with the primary purpose of earning income or making profit.”
The term above comes from a court case that further went on to define a trade or business as an activity that is not sporadic or hobby-like. Per the tax court, simply engaging into a profit is not enough. There must be an ongoing participation and demand from the taxpayer. Passive, turnkey activities likely would not translate well when referencing the tax laws.
So where does that put us with respect to RRE?
It would appear that investors who have real estate portfolios that require continued and regular involvement would make for good qualification for the 20% business deduction.
Consider the sliding scale below for a good illustration of how to determine whether you will qualify:
The most extreme form of passive investment are those who rely on property management to conduct day to day participation and involvement. An investor with one rental under management is extremely unlikely to meet any standard of continual and regular activity.
Many of our clients take the form of a landlord owning 3-4 rentals while assuming all forms of management. Is participation continual and regular? If so, and a good case can be made based on the facts and circumstances, the 20% business deduction may stick. Is participation sporadic? If so, you won’t get far in the tax courts.
A handful of our clients have no day job, and manage their own rental real estate full-time. There is no other source of income. RRE is their only profession and only source of income. There are no managers, no outside parties to relieve the client of continual and regular involvement. In cases like these, the IRS would likely have a difficult time labeling the taxpayer as anything but a trade or business.
So, does RRE qualify? It will likely depend on several factors:
Taxpayer’s level of involvement (continued/regular vs. sporadic)
Taxpayer’s alternative sources of income & time commitments elsewhere
Reliance on, and presence of third parties to conduct normal activities of RRE activity (property managers)
Maintenance nature of the RRE (A class properties likely require less time and effort, whereas high-maintenance C class properties likely require more)
Furthermore, the deduction isn’t a make-it-or-break-it benefit for most RRE investors. In the example of the taxpayer with 3-4 rental properties, let’s say he nets $10,000 of taxable income. The deduction is $2,000. If the taxpayer is in the 20% bracket, that’s $400 of tax savings.
In short, there’s no crystal clear path to taking the deduction for most RRE investors. Every investor’s situation is different and warrants different analysis of the facts. Years from now, many taxpayers will likely fight their way through the tax courts, providing us with better case law and legal precedent to rely on. Until then, proceed with caution!
Happy New Year to all of our clients! For many of you, I’m sure improved record keeping & audit proofing your records is a resolution for 2018.
To help you with your record keeping resolution for 2018, I have shared with you 10 Important Audit Cases I have seen over the years. Some of these were experiences with our own clients. Several others are experiences shared with us from other accountants. All names and dates have been changed for confidentiality reasons.
These case studies are good examples of hot button audit issues I see most frequently. Use these to patch up soft spots in your records and better audit proof yourself for the New Year:
1) Mileage Logs
The Issue:
When having us prepare his 2015 tax return, George submitted 14,300 miles driven on his business vehicle for the tax year. He maintained he used a mileage log to come up with his figure. The standard mileage rate for 2015 was $0.54 per mile, so his deduction claimed was $7,722.00
Where It Goes Wrong:
The IRS hand picks George’s business for audit, specifically his deduction for mileage driven for his rental real estate business. When pressed for his mileage log in audit, George admits he cannot locate his mileage log and is having difficulty substantiating his mileage claimed on the original tax return.
The Result:
As expected, the IRS threatens to disallow the deduction in full. We proposed to the IRS to allow George to attempt to reconstruct a mileage log based off of whatever documentation he maintained during 2016. Emails, calendars, day planners, schedules of tenant calls were all proposed as contemporaneously kept data to help reconstruct a log sufficient to verify mileage. Furthermore, we requested that George not reconstruct for 12 months, but just a single month as a smaller sample size. The IRS agreed to this procedure.
George was able to reconstruct 1 month of mileage data based off of this information. His work produced evidence of 800 miles driven for business purposes during this month. Multiplied by 12, his work produced an annual business mileage total of 9,600. Taking that figure and applying the $0.54 per mile business deduction gave George a final deduction of $5,184.00. The IRS disallowed the difference of $2,538 claimed on the original filing. George was in the 20% tax bracket for 2016. As a result, his additional tax plus penalty and interest approached $603.54 as a result of the deduction being reduced.
The Fix:
The IRS actually does not require every mileage driven for business purposes be substantiated by the taxpayer. There is a special method called “The Cohen Rule” that permits the sampling procedure described above. In George’s case, he was lucky enough to have access to old emails, calendars, and appointment books to show where he was and the distance from his workplace for an entire month. Furthermore, he was able to track that entire month and annualize his result to help prove a 12 month total.
In the case of our clients, we recommend you do the following to properly substantiate your business mileage:
Choose a 90 day period to track mileage. Although 1 month was acceptable in George’s case, the IRS can always exercise more strict discretion as to what they consider an adequate sample size.
Choose a 90 day period that is a fair representation of the entire year. Don’t cherry pick the quarter you know will have the greatest volume of trips, calls, appointments, etc.
In the case of our S-Corporation clients, we recommend they cut themselves a reimbursement check from their business account before the end of the year for their annualized total. Sole proprietors (non-incorporated) can simply report their mileage to us come tax time.
The IRS will also like to see some evidence for total mileage driven on the vehicle during the year. Oil change records, tire rotation records, invoices etc. from your auto repair man will help with this.
“Estimating” your mileage and providing during tax season will always have its perils. Keeping track of mileage for a fraction of the year is a happy medium towards ensuring a smooth audit.
Check Out www.mileiq.com for a great smartphone app that will automatically track your mileage for you. I highly recommend.
2) Meals & Entertainment
The Issue:
Leo is a client of ours who operates a successful realtor business. In 2012, he decided to engage our firm for the first time. With his tax return, he submitted approximately $5,000 of meals & entertainment expenses for the year. Considering his full time profession, where networking is critical towards generating profit, $5,000 of meals & entertainment is not unusual. He insisted he maintained all receipts for his expenditures.
Where It Goes Wrong:
Leo did a fantastic job retaining receipts for every meals & entertainment expenditure claimed on his return. What he failed to realize is that the threshold for substantiating meals & entertainment expenditures is much greater than a normal expenditure. In addition to maintaining receipts, every meals & entertainment expenditure must also include:
Description of the customer, client, or associate present at the meal or entertainment,
Business purpose of the meal or entertainment, and
Profit Motive for providing the meal or entertainment.
Each time Leo would conduct a closing with a client or discuss his services with a potential client, he would treat that client to lunch or dinner. He had failed to write on the back of the receipt the name of the client, the business purpose (discussed closings) and the profit motive (opportunity for commission). Thus, he was left with nothing more than a box of receipts showing he spent $5,000 on cheeseburgers.
The Result:
The IRS was surprisingly lenient on Leo and allowed him to connect some of these costs to or around the time of closings he conducted for some of his clients. He was able to substantiate roughly $3,000 of his original $5,000 claimed. The remaining $2,000 was not permissible. Since 50% of meals & entertainment are deductible, this resulted in a $1,000 deduction disallowance. At his 25% bracket and 15% self employment tax bracket, this meant a $400.00 tax bill. With penalty and interest, the final amount owed was $575.60.
The Fix:
At the conclusion of a business meal and entertainment, be diligent about writing who you’re with, the business purpose, and profit motive. Although the IRS agent in Leo’s case was generous in allowing him to retrace certain meals, most agents will reserve the right to disallow in the event certain information is missing.
3) Retaining Receipts
The Issue:
In 2015, Jack purchased a distressed building for $20,000 that required a full gutting and rehab. During the year, he spent approximately $80,000 completely redoing all mechanicals, dry walling, flooring and finishes.
He ended up selling the property for $150,000 which was a tremendous success for his very first real estate project. Jack itemized all costs on a spreadsheet and provided to us so we could calculate and report his $50,000 of gain on his return.
A year later, the IRS randomly selected his return for audit. Specifically, they wished to see how he calculated his gain.
Jack did an excellent job of providing all bank statements requested and a ledger of all of his expenditures on the deal. Everything on his ledger and bank statements matched the original information submitted to us to prepare his return.
Where It Goes Wrong:
The very first document you will receive from the IRS if audited, is called an “Information Document Request” or IDR for short. If the IRS chooses to audit any portion of the return that includes expenses, they will provide very standard language in every audit about how best to document expenditures:
Proper documentation is defined as:
Copy of the receipt showing that an expense was incurred (receipt, statement, or invoice). This document must clearly show what was purchased, who purchased it, the date it was purchased, the amount of the purchase, and address of property expense was incurred for.
Proof of payment (cancelled checks, credit card statements, loan documents, bank statement, etc.). It will be the responsibility of the taxpayer to match the payment to the expenses, as this office will not perform that research.
The incurrence and payment for an expense does not constitute a business expense. The taxpayer must show a direct relationship with the business activity and the expense must be shown to be ordinary, necessary, and reasonable to the activity being conducted.
As you can see, providing an IRS agent with simply the bank or credit card statements showing the existence of an expenditure occurring is not enough to properly document an expense. Such statements show the expense did occur, but a receipt or invoice states why it occurred and for what purpose.
The Result:
Almost every IRS agent we have worked with has stuck true to this language. Agents will not accept just bank or credit card statements (which is a common misunderstanding amongst clients). You must have additional information to supply to the agent to show why the charge is related to your business. In Jack’s case, the agent initially disallowed nearly $50,000 of his rehab costs on his business due to his not retaining any of his receipts related to his material purchases.
Fortunately, Jack did most of his shopping for supplies at the same Lowe’s store. Jack requested an additional two weeks from the agent to contact his Lowe’s for copies of all receipts charged to his card over the past year. The agent was gracious enough to allow him additional time (which is abnormal as most agents will disallow and request you take your concerns to appeals, which is quite costly). Jack was able to substantiate all but $15,000 of his material costs with receipts. His bracket was 20% for the year, and was assessed a $3,000 disallowance. After penalties and taxes, his final amount owed was $3,910.10.
The Fix:
Save all receipts! With the advent of Dropbox, iCloud, and other free electronic storage spaces, most of our clients simply scan and save their receipts online and hope to never need to find them again.
IRS Publication 463 does state that any single transactions less than $75.00 do not require a receipt to be retained, as long as some other electronic record exists to verify the expenditure. In situations like these for minor expenses, a bank or credit card statement is adequate.
4) Cash Receipts Recognized as Revenue
The Issue:
In 2014, Kenny ran a restaurant business. Each day, his cashiers would ring up customer sales in the form of credit cards and cash receipts. From time to time, Kenny would pay for food supplies or small expenditures with the cash from the cash register, which totaled about $10,000 for the year. At the end of the year, Kenny would submit to us his books showing his income and expenses. He would also submit to us a separate spreadsheet giving an accounting of expenses paid for the business outside of the business bank account. This spreadsheet included the expenses paid for with cash from the cash register in the amount of $10,000.
Where It Goes Wrong:
The IRS audited Kenny and asked him if he received cash from customers outside of his business bank account for revenue, to which Kenny confirmed. The IRS also had Kenny walk through his normal routine of how cash recorded as revenue on his books. Kenny explained how each day he would clear all but $100.00 from the register and deposit it to his business bank account. Once deposited to the business bank account, the cash receipts would be recorded as income. Kenny also disclosed that from time to time he would use that cash to directly pay for certain expenses.
The problem with Kenny’s accounting process was his failure to recognize that cash is considered taxable not when deposited to his business bank account, but when received. Despite his best efforts to deposit daily cash into his business bank account, he failed to realize that the $10,000 of cash used for business expenditures should have first been recognized as revenue on his books, despite never hitting his business bank account. By submitting to us his $10,000 of expenses paid outside of the business bank account, he was right in claiming these costs as a deduction but wrong in failing to disclose this was paid with cash not yet recognized as revenue earned by the business.
The Result:
The IRS required Kenny to pick up the $10,000 of cash used to pay for expenses as revenue upon audit. Kenny was in the 25% bracket, so his tax assessment was $2,500. After penalty and interest, his total bill was $3,345.60.
The Fix:
One of the very first questions the IRS asks taxpayers in an audit is whether or not they receive any of their revenue in cash. Despite a taxpayer’s best of intentions, collecting cash from customers, tenants, clients, etc. and not directly depositing to a business bank account is a recipe for disaster.
Cash is easy to forget, lose, or conceal. The IRS knows this and is highly skeptical of any taxpayer who receives income in the form of cash and does not sweep cash receipts to a bank account of record immediately upon receipt.
For those of you who operating in a business that receives cash as income, keep your life simple. Deposit these amounts quickly and regularly to your business bank account. It ensures an easy and smooth audit, knowing 100% of your income makes its way to bank accounts.
5) Home Office Deduction
The Issue:
In 2015, Tim was a contract dentist. He performed his dentistry work at an office outside of his home and he performed occasional tasks at his home office. He paid rent for his office outside of the home. For 2015, he claimed a home office deduction for the office in his home against his dentistry income.
Where It Goes Wrong:
During an audit of Tim’s business, the IRS pointed out that in order to claim the home office deduction, a taxpayer must show his home office has regular and exclusive use, and is the principal place of his business. Tim’s leasing of dentistry space outside of his home had compromised his deduction as he failed to show his home office was the principal place of his business and could not prove he used his home office regularly.
The Result:
The home office deduction was rather small – a $1,200 allowance. After being disallowed, Tim’s tax, penalty, and interest amounted to roughly $451.22.
The Fix:
We have clients that who successfully argue for the deductibility of a home office, despite having another office out of the home. In order to deduct two offices, a taxpayer must show that the home office itself is used frequently and has a purpose for certain tasks that can’t be reasonably performed at the office outside of the home.
Another client of ours is a real estate agent who pays desk fees for space at a brokerage to handle paperwork for commissions, and meet with other agents to discuss deals. Due to the space limitations of her desk at the brokerage, our real estate agent client utilizes her home office as a place to meet clients to go through paperwork and review contracts. Because she meets several clients throughout the work week, she can show not only regular use but a necessary use for certain tasks that can’t be performed at another business location.
If trying to claim a home office deduction while paying for a separate office outside of the home, be sure to document heavily your purpose for each.
6) Cell Phones & Internet
The Issue:
Jerry is a small business owner and uses his personal cell phone and his home internet line for business. Jerry pays for his entire cell phone bill and his cable/internet bill out of his business account on the basis that he uses both for business purposes.
Where It Goes Wrong:
Jerry’s small business has been selected for random audit by the IRS. Specifically, the IRS has chosen to audit Jerry’s $3,000 expense for “utilities” on his Schedule C. Jerry provides a ledger and receipts to the IRS to show he really did incur the expense and paid for it out of his business account. The IRS agrees the documentation has shown the expense has been paid for but points out that Jerry does not have a separate cell phone or internet line just for the business. Jerry admits and agrees with the IRS finding, but argues that he should still be entitled to a portion of the deduction due to the majority of his phone & internet use being for business.
The Result:
The IRS agent examining Jerry’s case allowed Jerry a 60% deduction of both his cell phone and home internet bill for tax purposes. This resulted in 40% of his $3,000 deduction being disallowed, which resulted in a $1,200 final disallowance of the deduction.
Jerry was in the 25% bracket for the year in question. This means the tax owed on this disallowance was $300.00. Jerry also owed interest and a 20% penalty on the disallowance to boot. Jerry’s final bill was $412.56 after calculation for tax, penalty, and interest.
The Fix:
Similar to the case of meals & entertainment, certain expenses to an individual will need to be paid, even if the business never exists. Thus, the need to document or take reasonable positions is crucial. For our clients who do not have separate cell phone or internet lines for their business, we recommend only taking a deduction for a portion of these costs for tax purposes. Taking the full deduction puts the burden on you to prove 0% of your cell phone and 0% of your home internet bill has personal use attached to it (which is highly unlikely in 2018).
For folks who have their own separate cell phone or internet line, the IRS rarely challenges this deduction.
For folks who have S-Corporations, a special nuance exists for personal cell phone or internet. Physical reimbursement checks should be cut from the company to the shareholder for the % of cell phone or internet use. Had Jerry put his business in an S-Corporation, the company would have cut him a check each month, quarter, year, etc. for 60% of his cell phone and internet use.
7) Bank Reconciliations
The Issue:
In 2013, Morty ran an auto detailing business. He would clean the vehicles himself and each time he would receive payment from a customer for a sale, he would record his sale in a simple spreadsheet. In addition to auto detailing, he also offered additional cleaning products and accessories for cards for sale within his small storefront.
His girlfriend, Helen, would usually work the counters of the storefront helping customers choose accessories and collecting payments for them. Morty would rely on Helen to provide him with her own accounting of all sales during the day.
During tax season, Morty would provide us his spreadsheet of sales, as well as Helen’s own accounting of product sales. Both were combined to determine revenue reported on Morty’s Schedule C for the year.
Where It Goes Wrong:
Helen was great with the customers and extremely poor in keeping track of the sales. Worse yet, Morty never bothered reconciling his bank statements against his own spreadsheet to account for all deposits hitting his business bank account. Had Morty taken the time to cross check all bank deposits against both his and Helen’s spreadsheets, he could have ensured all income was properly reported.
As you would guess, the IRS randomly selected Morty’s Schedule C business for audit.
The tax laws for audits are actually pretty simple. The burden of proof to prove income rests on the IRS. The burden of proof to prove expenditures rests on the taxpayer. In order to meet their burden of proof, the IRS requests copies of all bank statements (both business and personal) of the taxpayer. The IRS will then add up all deposits during the year on all bank statements. After backing out the obvious non-taxable deposits such as bank to bank transfers, the IRS will then compare that net total against gross receipts reported on one’s 1040. If the total deposits exceed the gross receipts on one’s 1040, the IRS has successfully shifted the burden of proof of income to the taxpayer. If the taxpayer cannot prove that excess of reported income is non-taxable, it’s added back to the tax return as an increase to income. Tax, penalty, and interest will follow.
The Result:
The difference between Morty’s reported income and what was actually deposited was roughly $10,000. Morty was in the 20% bracket for the year, so his additional tax was $2,000.00. Morty’s Schedule C business was also subject to 15% self employment tax, which resulted in an additional $1,500 of self-employment tax. Total tax with penalty and interest amounted to $4,245.65. Helen also lost her job in the storefront.
The Fix:
Do yourself a favor and reconcile your bank statements against your records. Make sure what the bank says happened, actually happened in your record of income and expense. Under audit, the bank will be your saving grace, or your total undoing. Make sure the two of you agree!
8) Non Cash Charitable Giving
The Issue:
Frank frequently gives away boxes of old clothing, household items, and goods that his family no longer has a use for. His claim for total non-cash giving in 2015 was $3,000.00
Where It Goes Wrong:
Goodwill would normally give him a receipt confirming the date he gave items with no additional information provided beyond that. Several charities are notorious for not taking the time to fill out the items given. When audited, Frank provided copies of the receipts to the IRS with no further documentation to support the value for the items donated.
The Result:
Obviously, the IRS disallowed his deduction as providing receipts confirming the date of purchase did not help Frank substantiate proper value. His 25% bracket meant a $750 tax assessment. After penalties and interest, he was at about $915.66.
The Fix:
To help Frank, we introduced him to the website www.itsdeductible.com. This website hosted by Intuit, allows folks to select quantities of items given and automatically computes values of goods donated to arrive at a more precise calculation of deductions. Claiming a large, round value for donations of non-cash goods is often met with skepticism by the IRS. Having the ability to substantiate deductions by more accurately calculating the value of items given can give you ideal protection in the event of an audit.
9) Travel & Business Trips
The Issue:
Sue Ellen was a resident of California and owned a rental property in Ohio, where she originally grew up and her parents still resided.
Every summer, she would travel back to Ohio to stay with her parents. Her total flight cost, rental car and associated costs were approximately $3,000.00.
During this time, she would check up on her property to ensure it was still in good condition, ask the tenant if everything was ok, and do some occasional touch up and landscaping.
Each year, she would take a deduction for the annual cost of this trip.
Where It Goes Wrong:
The IRS picked up Sue Ellen’s return for audit in 2015 and questioned why she claimed significant travel costs for one week of travel for just one rental property. Sue Ellen described how she would spend the first day of her 5 day trip checking up on the property and the remaining 4 days “looking for additional properties”.
The Result:
The IRS did not accept this explanation and disallowed the deduction, considering it an unnecessary and excessive cost for tending to one property and attempting to scout for others. Sue Ellen’s 15% bracket meant $450 in additional tax. After penalty and interest, her final bill came out to $599.03.
The Fix:
Frequently, clients ask if they can “turn” a personal trip into a deductible business trip. On occasion, the client will try to throw the cost of bringing the family in as a package deal, thus raising the stakes. For a trip to be considered truly business by IRS standards, here are some guidelines to consider:
Primary Reason Rule
The primary reason for the trip is critical. In Sue Ellen’s case, it was obvious to the IRS that the primary reason for the trip was to see friends and family and not to tend to her single property. Even though business was conducted, it was incidental to the true purpose of the trip. In instances where it is clear the primary reason for a trip is personal, the entire cost of the trip is non-deductible.
The inverse of Sue Ellen’s trip would be allowable as a business deduction. For example, had Sue Ellen owned 10 rental properties instead of 1 and cut her trip down to 3 days instead of 5, her explanation could be more plausible. In this instance, perhaps an argument could be made that the primary purpose of expending the cost of a trip to is to check on a rather large portfolio of 10 properties. Seeing family and friends could possibly be argued as incidental.
In instances where it is clear the primary reason for a trip is business, but there is some or a limited personal element, the taxpayer must use the Pro-Ration rule to determine the deductibility of the trip.
Pro-Ration Rule
If the taxpayer can prove the primary reason for the trip is business, but some personal time is spent on the trip, the cost of the trip must be pro-rated somehow.
IRS Publication 463 specifically states that a taxpayer has the right to schedule a deductible business trip in which the primary reason for taking the trip is business. If incidental or additional personal time is added to the trip, then the cost of those specific days would be non-deductible, but not the travel costs of the trip to and back itself.
Substantiation
The IRS does not provide clear substantiation on how best to show whether a trip is primarily personal or business. We have recommended to clients in the past to keep an hourly itinerary of their trip to justify 8 hours of business conducted per day, during the majority of the working days of the trip. Establishing that the majority of the trip was spent working a full 8 hour working day can be critical in establishing a primarily business purpose for traveling.
Additional Considerations
The IRS generally does not allow taxpayers to deduct the cost of children or spouses unless the presence for a spouse or children also can clearly show a primary business purpose.
The rules are different (and actually more favorable) for foreign travel. The onus is still on the taxpayer to show why a trip abroad is ordinary and necessary for their business.
Cruise Ships & Luxury Water Travel have very specific limitations on the deductibility of the trip. The IRS views luxury water trips with great skepticism. We strongly recommend you contact your tax advisor prior if you are attempting to use luxury water travel as a deductible expense.
The rules for business travel are numerous and not all possibilities can be covered in this article. We always recommend you check with your tax advisor for special circumstances.
10) Form 1099 Reporting from Customers / Payers
The Issue:
In 2015, Dolores owned rental real estate within her LLC. Her LLC had its own EIN and reported all income and expenses on its own tax return. One of her properties was rented out to another small business that would issue her a 1099 for the $12,000 of rent paid each year.
Each year, Dolores would receive the 1099 and decide not to disclose it to us when preparing the returns. She reasoned that the $12,000 was already included on her LLC financials provided to us for the tax return, so no additional scrutiny was needed.
What Dolores did not notice (or seem to know was a potential issue) was that the tenant was reporting this 1099 to her, using her Social Security Number as the recipient of the income (as opposed to the EIN of the business).
Where It Goes Wrong:
The following year, the IRS audited Dolores, thinking she was not reporting $12,000 of rental income on her personal tax return for 2015. After our discovering the 1099 issued by her tenant was reported under her SSN, the reason for the IRS choosing to audit her made complete sense.
When a taxpayer receives a 1099 for income received from a payer, the IRS receives a copy of the identical form reported. The 1099 issued attaches that income to an identification number. Businesses have Employer Identification Numbers (EIN’s) to report 1099 income received and individuals have 1099 income received personally, reported under their SSN.
Because of how her tenant reported the rental income paid to her on the 1099, the IRS computers flagged her Form 1040 for audit as no rental income was reported under her SSN o the tax return.
The Result:
After careful explaining to the IRS, there was no additional tax owed. However, to absolve Dolores of additional tax, the audit had to be expanded into reviewing her partnership return as well. Expanding this audit resulted in our billable time also increasing as a result of going through the audit process a second time. While Dolores’ taxes did not go up as a result of the audit, her audit representation fees to us increased due to one simple mistake by the tenant reporting the 1099 for rental income. Add to that the additional stress and hassle, and this was a very costly process, emotionally.
The Fix:
Carefully examine your 1099’s issued to you by your payers. If you are reporting income on your LLC or corporation, ensure that your payer has the correct information on hand to match that income to the entity receiving the income. This is a very avoidable issue!
Those are our Top 10 Audit Issues we’ve most commonly seen and heard for 2017. We hope you find these case studies helpful in improving your internal record keeping processes.
Although the IRS has seen cuts to funding over the past several years, we are not seeing a decrease in the rates of audits. It’s important to us that our clients continue to shore up efforts to stay ready and prepared, in the event an audit occurs.
If you have any questions, always feel free to contact us. We are always happy to help.
