As part of ThinkAdvisor’s Special Report, 23 Days of Tax Planning Advice: 2016, throughout the month of March, we are partnering with our ALM sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
What is a business expense deduction?
A business expense deduction is a deduction allowed for ordinary and necessary expenses paid or incurred in connection with an individual’s trade, business or profession. The deduction allowed under IRC Section 62(a)(1) for expenses of a trade or business is the provision which technically allows for business income to be taxed on a net income basis, whether it be a corporate business or the business of individual taxpayers operating as sole proprietors or partners. In the case of a sole proprietorship or partnership, IRC Section 62(a)(1) operates to assure that all trade or business expenses, deductible as delineated under specific IRC Sections, are effectively allowed as above-the-line deductions, rather than itemized deductions. In the case of a sole proprietor, all but a few of these expenses are deducted in Schedule C of Form 1040.
For purposes of determining whether an expense may be deducted as a business expense, an expense is considered to be “ordinary” if it is one that is commonly incurred in the trade or occupation of the taxpayer. An expense is “necessary” if it is found to be appropriate or helpful to the taxpayer’s business or occupation. Among the common expenses in this category are: employees’ salaries; office rent; interest on business loans; the cost of supplies and utilities; traveling; entertainment; advertising; and automobile expenses.
Generally, business expenses of a self-employed individual (sole proprietor, independent contractor, or professional) may be deducted from gross income to arrive at adjusted gross income. The deductions are taken on Schedule C of Form 1040 in computing the net gain or loss from the taxpayer’s business or profession.
The IRS has ruled that a full-time life insurance salesperson who is treated as a “statutory employee” for FICA purposes is not an “employee” for purposes of IRC Sections 62 and 67. Such individuals may thus treat unreimbursed business expenses as “above the line” deductions. This ruling was issued in part to clarify that taxpayers who are treated as “statutory employees” for FICA purposes (as are life insurance salespersons) are not necessarily treated as “employees” for other purposes. The term “statutory employee” refers to certain individuals described in IRC Section 3121(d)(3)(B), who are subject to FICA withholding requirements. The ruling’s effect was essentially limited to those individuals.
When is a taxpayer considered to be “away from home” for purposes of deducting business travel expenses? What if the taxpayer is away from the taxpayer’s residence for an extended period of time for business reasons?
The IRS requires that a taxpayer be away from the company’sprincipal place of business, rather than a residence, in order to deduct business travel expenses that would otherwise be personal in nature (such as food and lodging).The IRS has ruled that a taxpayer’s tax “home”—meaning principal place of business—is not limited to a specific building or worksite, but instead encompasses the entire city or general area in which the business is located.
In cases where a taxpayer is required to take extended business trips, determining the location of a taxpayer’s primary place of business becomes difficult, though for most taxpayers, the determination is simple because many taxpayers maintain a residence in the general vicinity of their primary place of business.For taxpayers who are required to travel often for business, such extended business travel raises the question as to where that taxpayer’s tax “home” is located.
Generally, in order for the taxpayer to deduct business-related travel expenses, the travel must be temporary in nature(“temporary” for these purposes has been statutorily interpreted to mean an employment period not exceeding one year).
In other words, if a taxpayer is assigned to a new work location for an indefinite period of time, the taxpayer’s principal place of business—and tax “home” for travel expense deduction purposes—is transferred to that new location.
Congress has clarified the issue so that Section 162 now specifically provides that a taxpayer will not be temporarily “away from home” for any period of employment that exceeds one year for tax years beginning after 1992.If the taxpayer can show that the business travel was realistically expected to last for one year or less, and that travel in fact does last for one year or less, the travel will be considered temporary.On the other hand, if the travel is realistically expected to last for more than one year, or there is no realistic expectation that the travel will last for less than one year, the travel will be considered indefinite regardless of whether it actually lasts for more than one year.
This statutory rule applies for taxpayers travelling for business reasons to a single location for more than one year.The distinction between indefinite and temporary business travel remains important in situations where the taxpayer’s business travel may include multiple travel locations over a period that exceeds one year.
Is a taxpayer entitled to a deduction for travel expenses when the taxpayer has multiple places of business?
If a taxpayer regularly conducts business in more than one location, a determination must be made as to which location is the “principal” place of business.This determination must be made by examining all the facts and circumstances of the particular case, but the IRS has identified the following factors as important:
(1) The total time spent at each of the business locations;
(2) The degree of business activities at each location; and
(3) Whether the financial return in each location is significant or insignificant.
Though all three factors are important, the IRS generally considers the amount of time spent at each location to be the most important factor.
For example, the Tax Court has held that a taxpayer who maintained a business in New York and another in Massachusetts was entitled to deduct expenses while travelling in New York because the taxpayer spent more of his time in Massachusetts.In situations where the taxpayer’s time is relatively evenly divided, all of the facts and circumstances will be analyzed to determine which place of business constitutes the taxpayer’s “principal” place of business.
Once the taxpayer’s principal place of business is determined, the general rules applicable in determining whether travel expenses are deductible are applied.Thus, a taxpayer can deduct expenses for meals and lodging while conducting business in a secondary business location if an overnight trip is required. Transportation expenses can be deducted between the principal and secondary places of business even if an overnight stay is not required. Expenses incurred while the taxpayer is in the vicinity of his principal place of business are not deductible.
When is a business-related entertainment or meal expense “ordinary and necessary” so that it may be deducted?
Whether a business-related entertainment or meal expense is ordinary and necessary is generally a question of fact.The courts have recognized that the taxpayer is entitled to exercise a certain degree of discretion in determining whether an expense is ordinary and necessary in the taxpayer’s particular business.
Expenditures are generally found to be sufficiently necessary if, based on all the facts and circumstances, they are “appropriate and helpful” to the taxpayer’s business.Expenditures are generally found to be sufficiently ordinary if they are made for “sound and normal” business expenses of a nature and amount determined by general commercial standards.
The Tax Court has allowed a deduction for entertainment expenses incurred by a bank that paid for private dinner parties at a country club (hosted by the bank’s officers) for its significant customers (“key people” from among the bank’s top five hundred clients and prospective clients in the upper echelon of the financial community).The court noted that, in this case, there was evidence that these customers were not being reached by more direct methods, so it was not unreasonable for the bank to resort to private entertainment in order to entice their business.
What limitations apply to prevent a taxpayer from deducting lavish or extravagant business-related entertainment expenses?
The prohibition on the deductibility of lavish or extravagant business-related expenses is tied to the notion that the expense must be reasonable in order to be deducted—a determination that is made based on the facts and circumstances of each individual case.Based on this premise, the courts have allowed taxpayers to deduct expenses that might be considered unreasonable in other contexts.
For example, the Tax Court has upheld a taxpayer’s deduction for expenses incurred in using a chauffeured Cadillac to provide local transportation for securities analysts and investment advisors in New York.
Conversely, the Tax Court has disallowed deductions for lease payments made on a Rolls Royce by a plastic surgeon.The court’s opinion reflects the importance of whether the expense is reasonable, rather than the level of extravagance displayed.In this case, the taxpayer-surgeon claimed that the Rolls Royce was used in advertising and promoting the quality of his services, and that he only used the car for business travel between the hospital and medical conventions.The Tax Court rejected the petitioner’s argument that the Rolls Royce would attract customers, finding that it had no reasonable relationship to his skill and performance as a plastic surgeon and that there was no evidence that any patients were attracted based on the leasing of the car.
– See ThinkAdvisor’s complete tax planning home page: 23 Days of Tax Planning Advice: 2016.