Archive for Receipts

Do You Own Multiple Businesses? Consider this Tax Advice for Passive Losses

Any time one of your businesses experiences a loss, you want to be able to claim those losses on your tax return. Unfortunately, the passive loss rules can stand in the way of these deductions, unless you plan ahead. In case you don’t already know the passive loss rules, here’s a breakdown of the requirements for deducting passive losses:

  1. You must participate materially in the business that has losses in order to deduct those losses (or if you group the business with another, you must actually participate in the group); or
  2. If you do not participate materially in the business, you must have other sources of passive income that you can deduct the losses against.

Grouping to Claim Passive Losses

Here’s a likely scenario. A medical doctor owns a medical practice, and she would like to open a physical therapy business, but she does not plan to actually work at the new business. Someone else will handle management of this business, and employees will provide the services. The doctor understands that the business will likely lose money for the first couple of years.

However, the doctor does not have any other source of passive income; her only other business is the medical practice in which she actively participates. Therefore, she has to figure out some other way to avoid passive loss rules and claim her deductions. Aside from deducting the losses from other passive income, she could also wait to deduct the losses in total when she gets rid of her entire interest in this passive business.[1] But, she doesn’t want to do that—she wants the deductions now because she doesn’t plan on selling this business for quite some time.

As you can see from the above points, one option for getting around passive loss rules is to form a group from the multiple businesses you own. So, in order to deduct those losses, she groups her new physical therapy business with her medical practice. “Wait a minute,” you may say. Even if she groups these two businesses together, doesn’t the physical therapy business still have only passive income?

It turns out that in order to meet the material participation requirements, you can group your business together to form suitable economic units.[2] That means the businesses and business activities within the grouping must make sense together based on these factors (quoted from IRS Publication 925):[3]

  1. The similarities and differences in the types of trades or businesses,
  2. The extent of common control,
  3. The extent of common ownership,
  4. The geographical location, and
  5. The interdependencies between or among activities.

Note that each business may conduct multiple sets of activities, and any entity structure may group its businesses or activities into one.[4] Even if you are the sole owner of three business that conduct four separate business activities, you can group all of these into one. Your material participation in the grouping then allows passive loss deductions for any of the business activities.

If you want to take advantage of such a common ownership grouping, you’ll need to make the election on your tax return and attach a disclosure statement.[5] Additionally, you’ll need to attach a statement with your tax return for any year that you add another activity to an existing group or regroup a grouping that was inappropriate. If you group inappropriately and don’t follow the requirements, you could end up losing your deductions because the activities will be treated separately.

Your disclosure statements should include the names, addresses, and employer identification numbers for each of the businesses being grouped together. Once you’ve made the election to group, you’re good to go with claiming deductions on an activity’s passive losses, so long as you meet the material participation requirements for the group. What that typically means is you have to participate in the combined businesses for at least 500 hours per year. Going back to our doctor, if she works at the medical practice for 1,968 hours in the course of a year and never does any work at the physical therapy business, she has met the 500-hour test for the entire group.

Not everyone has two business interests that make sense together as an economic unit. If you, like the doctor, are considering opening a second business, but your second business operates in a completely different way from the first, you may not be able to take advantage of grouping. When that’s the case, you should ask yourself, “Is it even worth it to start a business I cannot deduct losses for?” Remember, your tax deductions can make a big difference in your yearly profit.

Basically, you want to make sure the plans you make for your business ventures are the best choices for your bottom-line. Grouping elections are easy to make for the single-owner business, and the rules apply to real estate rentals, as well. So, if you have taxable income you’d like to offset, grouping may be a solution for your business.

  1. IRC Section 469
  2. Reg. Sections 1.469-4(a); 1.469-5T(a)(1)
  3. Reg. Section 1.469-4(c)(2).
  4. Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), Catalog Number 83479V, p. 4-2.
  5. Rev. Proc. 2010-13

Own Two Cars? Claim Business Tax Deductions on Both!

If you use your car for business, you’re well aware by now that you can deduct your business mileage. If you have a tax-deductible home office, you can even deduct your commute to and from work each day. But, did you know that you might also be able to claim expenses for more than one vehicle? For business owners who fit the requirements, you can significantly increase your tax savings with deductions on both your vehicles.

Marriage Status Makes a Difference

It seems like married couples often get the most benefits when it comes to tax savings, but deducting business mileage for two vehicles is actually easier for the single folks. A single person who drives more than one car has a good chance of deducting expenses for both. The married person, on the other hand, will have a bit of a harder time justifying this deduction on their tax return. It can be done, though.

Here’s what you need to prove for the deduction if you’re married:

  1. You drive more miles than your spouse.
  2. Most of your miles are business miles.
  3. The two vehicles are of comparable value.

Figuring Out if You Qualify

So, either you’re a single person with two cars, or a married person who uses both vehicles for business miles. Either way, you’ll need to know four numbers regarding your vehicles and mileage. They are:

  1. How many business miles you drive,
  2. How many total miles you drive,
  3. The cost of each vehicle, and
  4. The estimated proceeds if you were to sell each of the vehicles.

These numbers should be pretty easy to produce. After all, you are keeping track of your business mileage already, right?

Get ready for some really easy math. It turns out the deductions work the same regardless of whether you’re married, single, a sole proprietor, or the owner of a corporation. No matter your circumstance, you can take those four numbers above and determine whether the two car deduction creates an advantage for you.

Tip: One thing that does make a difference is if you have the car on a lease. In the case of a lease, you must use IRS mileage rates and cannot use the formula below.

How to Do the Math

Let’s do an example. For this example, you own two cars: Yellow Car and Blue Car. Yellow Car cost you $23,000 and Blue Car cost you $21,000, so you know those numbers for the formula already.[1]

Say you used to drive only one of the cars for business purposes, and you drove a total of 28,000 miles. In this scenario, you drive Yellow Car 30,000 total miles and Blue Car 8,000 total miles, for a grand total of 38,000. That gives you 93.3 percent business use for Yellow Car and 0 percent business use for Blue Car.

Given this scenario, you are putting more miles on Yellow Car, so it will be worth less at the time of sale—$2,000. Blue Car could sell for $5,000. These numbers, of course, will be an educated guess. Now, you get your total tax deduction by calculating the net cost of your vehicle (purchase price minus sale price), and then multiplying by your business-use percentage. For the single-car scenario, your deduction equals $19,593.

Now, let’s see what happens if you start dividing your business mileage between two vehicles. Your 28,000 business miles are now divided between two cars—14,000 miles each. And, your total mileage is also divided between both vehicles—19,000 total miles each (the grand total remains the same, 38,000 miles). This means you are now driving both vehicles for business use 73.7 percent of the time.

Your estimated sales proceeds in this case are $3,500 for each vehicle, since they are being driven the same number of miles. Now what are the tax deductions for each car? Yellow Car: $19,500 (net cost, or basis minus proceeds) multiplied by 73.7 percent equals $14,372. Blue Car: $17,500 multiplied by 73.7 percent equals $12,898. This gives you a total tax deduction of $27,270.

You just added an extra $7,677 to your tax deduction! When you file your tax return, these deductions will be claimed (and adjusted) under depreciation, Section 179 expensing, and/or gain or loss on sales. These three elements equal the business percentage of the net cost of your vehicle. Before you decide to start using two cars for business, run the numbers through this easy formula, and see if it would save you money. Regardless of whether you claim these deductions using IRS mileage, actual expenses, or Section 179 expensing, the formula accurately determines whether claiming expenses for two vehicles is a better solution for you.

  1. If you traded in an older vehicle for one of these, you may want to use the adjusted basis rather than the original basis, or cost of the vehicle.

Thinking about Buying a Business? Your Opportunities for Tax Deductions Have Already Begun!

Are you aware of business start-up deductions? If you’re not, you should find out right away! You don’t want to miss out on these tax-deductible activities that are only valid when you’re starting a new business. In fact, you don’t have to start your own business; you can get these tax benefits from simply buying a business. Fortunately, this article deals you in on the details.

It Pays to Plan

Before you even purchase your new business, you can start keeping track of your deductible expenses. That’s right, you are eligible for deductions related to merely thinking about your soon-to-be business. Here’s an example. Let’s say you invite a friend to dinner because she purchased her business only a few years ago, and you’d like to find out more about what goes into starting a newly purchased company. That dinner is deductible because you have a business purpose for the expense—you are seeking necessary information for your venture. These expenses are called “start-up expenses”.

Whether you create or buy a business, you will by necessity go through an investigatory phase. If you don’t do this, you may want to reconsider going into business for yourself! However, the rules about how deductions work are a little different in each situation, so we’ll stay focused on the process for purchasing an existing company.

Basically, you are going to incur expenses while you analyze your options and make a decision about what kind of (and then which) business to buy. That is the extent of the investigatory phase. After that, start-up expenses stop, and you begin tracking business expenses.

Here’s a breakdown of the steps and what expenses you may be looking at:

  • Investigating Possible Businesses—First of all, let’s make clear that when we say “buy a business”, we are talking about actually purchasing an active business, not buying corporate stock. If during this period, you spend $41,000 to analyze and review your options, you can begin writing off those expenses the day the escrow closes on your purchase. You get a $5,000 write-off on the first day, and $200 each month after for the 180 months.[1]
  • Identifying Your Prospective Business—In order to take advantage of the expenses for your investigatory phase, you must identify the business you plan to purchase. If after investigating the possibilities, you do not identify a target business, you will not be eligible for any deductions. At the point when you identify your target business, your investigative expenses stop. In the event that you identify a target business but do not end up buying it, you are still eligible for acquisition and facilitative costs, but not the investigative costs.
  • Buying the Business—Once you have identified the business and move forward with purchase, any additional expenses are considered capitalization rather than start-up costs. These are costs that you cannot benefit from until you later sell or leave your business. The IRS has what is called a “bright-line rule” regarding the date your research of possible businesses ends and acquisition activities begin.[2] It is either 1) the date of your letter of intent (or similar documentation), or 2) the date that a binding written contract is executed between you and the target business (unless board approval is required, in which case it’s the date terms are approved by the board or its authorized committee). The IRS will go with whichever of these two dates is earlier.[3]

Take a look at that last bit about the bright-line rule. That means that if you hire an accounting firm, for instance, to investigate your target company, the firm may continue to provide services to you after you submit a letter of intent. The accounting firm will make a financial analysis in the investigatory phase, but it also could review the target company’s books and records after that point. Only the services provided before submission of your letter of intent count as start-up costs.[4] The additional services are capital costs.

Of course, the IRS never makes things easy, so there is an exception to the above bright-line rule. It wouldn’t be tax law if there weren’t, right? You see, some expenses are inherently facilitative, meaning they cannot be counted as investigatory expenses. What about the bright-line date, you may say. It doesn’t matter. Facilitative expenses are capital costs regardless of the date you incurred them. Here are some examples that are inherently facilitative to a purchase:[5]

  • Appraisal costs
  • The cost of a formal written evaluation of the transaction
  • The cost to have a purchase agreement prepared
  • Any costs necessary to obtain shareholder approval
  • Costs for negotiating the transaction
  • Costs for structuring the transaction
  • Any costs for conveying property, such as title registration or transfer taxes

When Corporations Are Involved

Things are always a little trickier when corporations are the entities making the transaction. You may find yourself in one or both of the following situations: you could be purchasing a corporation, and/or your corporation may be the buyer. Let’s look at a few scenarios.

  • You Only Buy Common Stock—If you take over a corporation through common stock, any investigatory expenses are not deductible. This is because you have gained an investment rather than an actual business or trade interest.[6]
  • You Buy Stock Plus Assets—If stock purchase is included in the process to fully take over a corporation, that is a different matter. When you acquire a business’s assets, even when stock is also exchanged, you are eligible for start-up deductions and amortization.
  • Your Corporation Is the AcquirerUnlike the sole proprietor, who claims start-up expenses on the Schedule C, an S or C corporation will claim these expenses on the corporate tax return. Always keep in mind that your corporation is a separate entity from you. Do not pay any of the costs incurred by your corporation. If you do, make sure the corporation reimburses you. Doing otherwise will cause headaches with your taxes.
  • You Form the New Business as CorporationWhen you do this, you incur organization expenses for setting up your company’s entity structure. This can include fees paid to incorporate, legal services required to set up the corporation, accounting services, and expenses related to organizational meetings for directors or stockholders. These costs are separate from investigatory costs and capitalization costs.[7] The good news is that they can be amortized just like start-up expenses. You claim up to $5,000 in the first year and amortize the remainder over 180 months.[8]

Now you know what to do as far as acquiring your business, but what if the business fails or is sold before you finish seeing the full benefits of amortization? No worries. For sole proprietors, you deduct the remaining (unamortized) costs as a business loss.[9] For corporations, both the unamortized start-up and organization costs are deducted on the corporation’s final tax return.[10]

Tax law is not written to slow down businesses, despite the fact that it can get complicated. On the contrary, legislators know that the opening of new businesses benefits the whole economy. That’s why your able to write-off expenses like the ones discussed here. Take advantage of it! The benefits are available so that you and your business can succeed.

  1. IRC Section 195(b).
  2. TD 9107.
  3. Reg. Section 1.263(a)-5(e).
  4. Reg. Section 1.263(a)-5(e)
  5. Reg. Section 1.263(a)-4(e)(2).
  6. H. R. Rep. No. 1278, 96th Cong., 2d Sess. 3, 9-13 (1980).
  7. Reg. Section 1.248-1(b)(2).
  8. Reg. Section 1.248-1T(a).
  9. IRC Section 195(b)(2).
  10. Liquidating Co., 33 BTA 1173.

Did You Know Your Car Can Accelerate Your Tax Savings?

Would you like thousands, or even tens of thousands, more dollars in tax deductions every year? Of course you would! To boost your deductions, you can count on your vehicle to be a deduction generator if you use it to drive from one business location to another. The only thing you have to do is keep the right records in order to prove your business mileage. Your tax records, like your car, require regular maintenance in order to function properly.

The Documentation You Need

We can look at the court case of salesman, Marcus Crawford, for an example of what a difference minor deviances in documentation can make.[1] Crawford spent much of the work day driving to meet customers. He tried to defend is vehicle deductions in an amount greater than $20,000 by providing 1) destination notes on his daily calendar, and 2) saved gas receipts. Although this sounds like decent record keeping, the IRS rejected this documentation and Crawford got none of the deductions. Zero.

Unfortunately for Mr. Crawford, the IRS is pretty strict about documentation for vehicle deductions. Here’s what you actually need in order to qualify:[2]

  1. A mileage log
  2. Receipts that support your mileage log

Crawford’s proof didn’t work because it failed to document the true number of miles spent driving to each location and how the location was related to his business activities. A proper log divides mileage into the appropriate categories:

  • Personal mileage
  • Commuting mileage
  • Business mileage
  • Investment mileage
  • Rental property business mileage

Here’s a hypothetical example:

Note that rental property mileage should be calculated separately from other business mileage. This is so you can determine Section 179 expensing for your vehicle. Additionally, you see that the miles marked for the trip to the grocery store are zero. Why? It’s because the stop was located on the way between two other stops, so it does not generate any additional mileage.[3] Although the grocery trip is a personal stop, you would have had to drive the same distance from one office to the other whether you stopped for groceries or not.

In some cases, it may be more convenient to group the mileage together for multiple stops. This is perfectly fine as long as you document it that way. For example, a real estate professional may make a note indicating multiple stops to show the same client six different properties. These six stops can go together on one line of your mileage log.

Simplifying Your Record-Keeping by Sampling

Writing down every single stop you make every day for the entire year sounds fun, right? Not so much. If tracking your mileage is starting to sound like too much work to even be worth it, keep reading. Per the IRS, you are allowed to track your mileage for only part of the year, and then use that sample to calculate your total business mileage for the rest of the year. You have two options:[4]

  1. Keep a mileage log one week out of every month, or
  2. Keep a mileage log for three consecutive months.

By using the second option, you can log your mileage for one three-month period and then forget about it for the rest of the year. This is the better way to go because the one week a month method increases your risk of missing a month, and when that happens, the IRS no longer accepts your records. It does not accept “almost” with mileage logs.

There is one little catch. If you use the three consecutive months method, those months must be representative of your driving habits for the entire year. For those of you who work in a business with noticeable seasonal fluctuations in your business mileage, you’d better stick to the one week a month strategy.

Supporting Your Log

Okay, so you’ve logged your mileage and labeled its category for either three consecutive months, or one week out of each month for the year. You’re all set, right? Not so fast. The IRS isn’t so trusting that it will just accept the records you’ve individually recorded. So, you’ll have to back up your mileage sheets with evidence from other sources that match your records.

Some documents the IRS may request during an audit include:[5]

  • Inspection slips, repair receipts, and any other records that record your vehicle’s total mileage
  • A copy of your calendar or appointment book that indicates your business activities for the year
  • A copy of your mileage log

Each of these proofs will be cross-referenced with each other to ensure that everything matches up. That means if your gas receipt shows you were in Henderson, NV on a day your mileage log shows you staying in Riverside, CA, you’ve set off a red flag that may cancel your deductions.

What If You Don’t Keep Paper Records

Certainly many business people are switching over to digital record keeping. If you prefer to track mileage on an app, that’s no problem. However, it may be a good idea to keep paper print-outs as backup until you’re certain the app’s records meet the requirements of the IRS. Always keep some kind of backup of your digital records. You never know when a glitch, virus, or hacker may delete all your records, or render your app inactive.

Tracking your vehicle mileage isn’t too difficult once you set up a system for yourself. Remember, you only have to do it for part of the year. The IRS mileage rate for deductions is $0.56 per mile, so with the right documentation, you can claim thousands in deductions just by going about your normal work routine.

  1. Marcus O. Crawford, TC Memo 2014-156.
  2. IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses (2013), Dated Jan. 14, 2014, p. 25-27.
  3. Reg. Section 1.274-5T(c)(6)(i)(C).
  4. Reg. Section 1.274-5T(c)(3)(ii)(A).
  5. Internal Revenue Manual Exhibit 4.13.7-20 — Examination Documentation Requirements Paragraphs – Cont. 6 [09-01-2006].

Qualifying for Your Home Office Deduction—Simplified

You may know which expenses qualify for home office deductions, but are you savvy about the requirements for your office qualifying to take these deductions in the first place? In order to make home office deductions, your office must pass the “regular use” test. It’s just what it sounds like—a determination of whether you regularly do business from the office in your home.

What the IRS Says

The IRS states in its audit manual, “Regular use means that you use the exclusive business area on a continuing basis. The occasional or incidental business use of an area in your home does not meet the regular use test even if that part of your home is used for no other purpose.”[1] Obviously, setting up an area exclusive to your business, filling it with files, and never going in there will not cut it, but this definition does little to pinpoint exactly what does count.

According to the IRS, they consider your individual facts and circumstances when determining regular use.[2] Great, but that leaves things pretty vague when you’re trying to plan for your tax return. So, instead, we’ll take a look at court precedents to get a better idea of what exactly you need to do to get your deduction.

  • The Frankel CaseMax Frankel was the editor of The New York Times. In his case, he claimed that he used his home office to communicate by phone with prominent politicians at all levels of government, as well as community leaders and labor leaders. Records indicated that Frankel averaged a call per night, and Frankel stated that it may have taken several calls to complete a single discussion. The U.S. Tax Court decided in his favor, stating that the frequency was enough to qualify Frankel’s home office for regular use.[3]
  • The Green Case—Because of the circumstances of his work, and because many of his clients were unable to make calls during daytime hours, John Green took a large number of client phone calls at home after his regular work hours. This was a required condition of his employment. The calls averaged 2 ¼ hours per night, five nights per week. Again, the Tax Court decided the frequency met regular use requirements for a home office.[4]

Like any tax strategy, passing the regular use test requires one important item—sufficient evidence. Another court case, involving Anthony Cristo, illustrates this need. The court stated:[5]

“We do not suggest that the frequency or regularity of meetings or dealings must match the level we faced in Green in order to meet the requirements for regular use. However, in this case we have so little information that we cannot tell whether the facts, if we knew them, would satisfy any reasonable interpretation of regular use.”

What does this mean for you? It means that no matter how good a claim you have to regular use of the office in your home, you will lose out on those deductions if you can’t prove it with substantial evidence. The truth is you only need two pieces of evidence in order to prove regular use:

  1. A log recording how you spent your time, and
  2. Documents that support your log of time spent.

Your log can be as simple as keeping an appointment notebook or printed sheets from a calendar application. Note your schedule, including phone calls, meetings, opening mail/responding to business email, and any other business activities you complete at your home office. Next, you need something to corroborate with the log.

  • You say you responded to emails on this day at a certain time? Keep your sent emails. They’re time and date-stamped and prove that you were indeed responding to email.
  • You claim to have met a client at your home? You could keep a guest log and have the client sign in. Or, you could provide email correspondence of your client’s agreement to meet at that time.
  • You devoted 2 hours each evening to making and taking phone calls? This one is easy to prove. You simply need to provide your phone bill as documentation. Make sure you get a detailed copy.

Sure, keeping records is a pain in the butt. Just set up a routine now and stick with it. You can make it even easier by creating a checklist for yourself. Every day, go through the checklist and make sure you took care of logging and documenting your hours, that way you won’t forget anything. Once it becomes part of your routine, you’ll see that keeping emails or having people sign a guest log really isn’t all that hard—and your deductions may hinge upon it.

A Checklist to Get You Started

What do you need to do to comply with the IRS regular use rules?

  1. Use your home office more than 10 hours per week on average (this is a subjective number because the IRS has never given a specific amount of time required, but 10 hours seems to be a safe bet based on past cases).
  2. Build proof indicating that you actually did work for those 10 hours or more.

That’s it. It shouldn’t be too hard to find business activities you can do from your home office for just a couple of hours per day/night. This article already gives you a few easy ideas, as well as simple ways to document them. Start keeping good records now, and taking care of any tax issues that arise will be no problem.

  1. Internal Revenue Manual Exhibit 4.10.10-3 — Standard Explanation Paragraph 4814 Test for Home Office (Last Revised: 01-11-2011).
  2. Prop. Reg. Section 1.280A-2(h).
  3. Max Frankel v Commr., 82 TC 318.
  4. John W. Green v Commr., 78 TC 428; Rev on another issue, 52 AFTR 2d 83-5130, 707 F2d 404 (CA9, 5/31/1983).
  5. Anthony B. Cristo v Commr., TC Memo 1982-514.

Make Your Records Rock Solid to Avoid Audit

This article isn’t about any particular way to save money on your taxes. However, it will make a huge difference in your taxes no matter what strategy you use for your tax return. Even the absolute best tax methods can leave you at the mercy of an auditor when you don’t properly document and keep records. Sure, you may think it’s a hassle, but is putting in a few hours up-front on an organized record-keeping system worth thousands, even tens of thousands, of dollars in tax savings? You bet!

The Rules of Record Keeping

Here’s the fact—the IRS is never just going to take your word for it that you spent X number of dollars on justifiable and legal business expenses that are now tax-deductible on your return. Sorry, no documentation, no deduction.

So, with that in mind, here’s the first rule you need to know.

Rule #1 Always keep your accounts separate. In fact, you should have separate checking accounts for:

  • Each spouse,
  • Each corporation,
  • Each Schedule C business you report, and
  • Your rental properties (you may even want a few separate accounts for these if they are very different kinds of rentals).

How about an example of why this is so important. Let’s say you own a sole proprietorship, and you cover your spouse under a Section 105 medical reimbursement plan. If you’re using one checking account jointly for your household and your business, you would have to write the reimbursement check to yourself—and that negates your Section 105 plan.

That’s exactly how Darwin Albers lost out on deductions for his 105 plan.[1] Keep your business and personal accounts separate—just do it.

Rule #2 Earnings go to the account belonging to the business that earns the money. Do not take payments in your personal name. If you do, they cannot be assigned to your corporation. The person or entity that earns any given income is taxed for said income.[2] If you follow the rule above, then it’s easy not to mix personal receipts into your business account and vice versa. Although it’s possible to argue with the IRS that some receipts in a given account are not taxable, it’s not worth the frustration and wasted time.

Rule #3 Keep track of your deductible expenses each day. Don’t wait until two weeks from the purchase to write down your expenses (or save them in your file). For one thing, it increases the chance that you may miss something. For another, the IRS requires that deductible expenses are recorded within one week. The idea of doing daily record keeping may make you want to just toss your files over your shoulder (don’t—you’ll hate reorganizing them up later), but it really is good practice. After all, how hard is it to save a receipt and make a note about why you spent the amount?

Rule #4 Keep a log for each set of expenses. For most deductions, you need evidence that proves your business use or business purpose for the expense. Want to deduct vehicle expenses? Keep a log to track daily mileage. Want to deductions on your rental properties? You’d better keep track of how you materially participate in your real estate or how you qualify for status as a real estate professional. Planning to make deductions for your home office? Again, you need a log, this time to keep track of how many hours you spend working in that office. You’ll have to consistently spend more than 10 hours per week working from your home office in order to claim it on your tax return.[3] By keeping track on a daily basis, you can take advantage of the sampling method of calculating your deductions in some cases (such as vehicle mileage); this method allows you to take a sample from a three month period rather than calculating the exact sums.[4]

Rule #5 Keep track of travel and entertainment costs. For travel expenses, you have to prove (with documentation) where you were each day and why. Your business entertainment costs also need proper documentation, including what you spent money on, how much, when, and where the expense occurred. Your receipt will cover all of those, but you’ll additionally need to note who you entertained and why (i.e. the benefit to your business).

In the case that you operate your business as a corporation, you’ll have to turn the expenses in to your company. You can do this by paying with a corporate credit card, or you can have the corporation reimburse you for the expenses. Making sure the company pays is important; otherwise you’ll only get employee-business deductions for those expenses.

What to Remember

No matter what kind of business costs you incur, you need to remember these two primary pieces of information: 1) prove what you bought and 2) prove that you, in fact, paid for it. As mentioned above, a receipt or paid invoice covers the first part of this. In order to prove payment, you can use a credit card receipt or statement, canceled check, or bank statement (for electronic transfers). Note: An item is considered paid for when you charge it to your credit card, regardless of when you pay the amount to your card.[5]

Don’t pay with cash. It makes things more difficult for you. If you pay with cash, an auditor will want to know where the cash came from, how you can show cash trail and tie it to the payment, whether you can prove an ATM withdrawal, and most importantly, did you really pay for something in cash or are you just making up a deduction? Paying with pretty much any other method is much less of a hassle.

A Note on Petty Cash

Petty cash works for some small businesses. If it’s what you’re accustomed to and you haven’t had any problems, then by all means continue using the system. However, many small business owners end up kicking themselves in the pants with a petty cash system. You’ll likely find it easier to use a reimbursement system.

With the reimbursement system, your company simply writes you a check for the expense when you provide documentation for it (a receipt or expense report, for instance). Because you have to present documentation for reimbursement, you’re less likely to get caught without evidence for your spending, as you could with petty cash.

Statutes of Limitations and How Long to Keep Records

The IRS has statutes of limitations on when either you or it can make changes to a tax return (this is not just the period during which they can audit you). Here are the time frames given in IRS publications:[6]

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due.

Because these statutes of limitations also indicate how long the IRS can audit your return, you need to ensure that you hang on to all of your records until the risk of audit has passed. This could mean keeping records for a period of multiple years. In the case of assets, like office equipment and office buildings, the records are relevant throughout the asset’s entire depreciable class life. As long as you are still depreciating an asset, it will be in that year’s tax return. When using Section 179 to expense an asset, you also have a potential recapture throughout the depreciable class life.

Here’s an example. You buy a desk for $1,500 and depreciate it over the MACRS life of seven years. This depreciation actually takes eight years, so you need the original purchase receipt in year eight in order to prove your deduction. Additionally, you will need to retain that purchase record for three years after that when the statute of limitations expires (for a total of eleven years). It works the same with Section 179, except that you also have recapture exposure during those eight years of depreciation.

Would you like an easy way to keep track of this? Just make a permanent file for any assets with a life greater than one year. This way, you don’t need to keep track of class lives or time frames on the statutes of limitations.

And, here’s another quick tip for keeping those records organized:

Simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. This method is for assets other than those you keep in your permanent file. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires. Each year, you move the drawers down one level and dump the one at the bottom of the line. You can also use this method for any employee tax files.

You see? It really isn’t all that difficult to keep your records straight. You’ll be thankful you did when it comes time to prepare your return.

  1. Darwin J. Albers v Commr., TC Memo 2007-144.
  2. United States v Basye, 410 U.S. 441, 449, 451 (1973); Lucas v Earl, 281 U.S. 111 (1930).
  3. John W. and Regina R. Z. Green v Commr., 78 TC 428 (1982), reversed on other grounds, 707 F2d 404 (CA9, 1983).
  4. IRS Reg. Section 1.274-5T(c)(3)(ii)(C), Example 1.
  5. E.g., Rev. Rul. 78-38; Rev. Rul. 78-39.
  6. IRS Pub., 583, Starting a Business and Keeping Records (Rev. January 2007), Record Keeping.

If You Have an IRS Audit Coming Up, Make Sure You Have the Tax Law on Your Side

When you have to go toe-to-toe with the IRS, make sure you keep the fight clean. The only way to succeed when arguing your case with an auditor is to follow the IRS’s own procedures. And, the primary way to do that is—you guessed it—keeping proper documentation. With this article, you’ll better understand where tax authority is derived, what rules the IRS must stick to, and what rules the IRS accepts.

Remember Who You’re Dealing With

As you prepare to make your case by checking the appropriate tax rules, remember that the auditor will be your primary audience. You want to build evidence that convinces the IRS. Although it’s possible that your audit could go to court, most do not. It is likely that the auditing process will stay with the IRS, so prepare yourself for that likely scenario.

A good place to start is with the IRS forms themselves, as well as guides, instructions, and other IRS publications. These are not a source of “substantial authority”,[1] but you can begin your research with them in order to get an overview of the particular tax issue you’re looking at. Just be sure you don’t end your research with these documents because they don’t always give the full story. When using these as part of your argument, however, you can be assured knowing that the IRS is unlikely to go against its own advice, even from a non-technical document.

Another type of non-technical documentation is internal IRS guides. These are made for employees, but copies are available to the public. Some examples include the Internal Revenue Manual, chief counsel advice, and audit manuals. They will give you an idea of how the auditor may be evaluating your situation.

Although both public and internal guides are easy to read compared to technical documents, you don’t have much support if you depend solely on them. To support your tax strategy more effectively, you’ll need a document with greater authority.

In order to make your best case, you should remember the following tax-document hierarchy:

  1. Statues and Regulations. Both the IRS and the courts can be persuaded by appropriate statutes and regulations.
  2. Case Law. Prior case law is often the next most convincing proof with the court.
  3. IRS Documents. For the IRS, the next best source is IRS documents, but some are better than others.

It is important to remember that tax laws change all the time. No matter how good you think your authority document is, it does little to help you if a more recent law has been enacted. New statutes even supersede prior Supreme Court rulings. When you need to back up your tax return during an audit, always make sure you check for any updates in the laws.

Here are some specific examples of good authority documents:

  • Tax CodesStatutes in the tax code are always the best authority with the IRS. If possible, find the particular statute (i.e. tax code provision) that specifically addresses your situation. Throughout the process, keeping your argument focused on that provision. As mentioned above, tax statutes are the highest authority in these situations, so if the relevant law does not uphold your case, then don’t try to use a next best authority. Instead, attempt to settle with as little payment due from you as possible. The time that another source of authority comes in handy is when the language in the pertinent tax code is too general (as it often is), and you need additional support for your tax strategy.
  • Treasury Regulations—Regulations have almost the same weight as statutes, but the statute takes precedence in the case of any differences between the two.[2] Regulations fall into one of three categories: 1) final, 2) temporary, or 3) proposed. When Congress passes a new statute, the Treasury drafts temporary regulations that are valid for three years. After that, they expire. However, for the period they are valid, temporary regulations are equal in authority to final regulations.[3] In addition, older temporary regulations never expired, and you may find some that are still being used. Proposed regulations carry less weight than the other two types. Their strength is in persuading the IRS because they represent its official position, but they don’t mean as much in court.

A note on out-of-date regulations: Treasury regulations are not updated every time the tax code changes. Because of this, it’s not uncommon to find regulations intended for a law that no longer exists or exists in a newer version. But, that doesn’t necessarily mean the IRS has stopped using the regulation. Even the courts may treat these as relevant law! The only way to know if a regulation is still in use is to research cases, legal treatises, and IRS documents.

Strategy for Talking to the IRS

At the start of your audit, you’re going to be discussing the issues with auditors and agents. These are the typical IRS worker bees. They are knowledgeable about what they do but will be mainly concerned with IRS documents. They probably won’t delve into statutes or court cases. If your case advances, you will then deal with the supervisors and officers, who bring in the tax code and regulations (and possibly court cases). Just remember that at all levels, IRS employees put emphasis on IRS documents.

One of the best sources to build your argument with is an official pronouncement from the IRS. These are sent out in the Internal Revenue Bulletin, which is “the authoritative instrument of the Commissioner of Internal Revenue for announcing official rulings and procedures.”[4] All of these bulletin pronouncements are binding for the IRS, so you have a good case if one of the pronouncements supports your audit strategy. The problem is that they can be confusing to read. You’ll want to make sure you’re clear on what the actual IRS position is.

Here are several types of official pronouncements that provide good backing (the highest on the list are the best sources):

  • Revenue Ruling—These are the IRS’s own examples of how they apply their rules to particular sets of facts.
  • Revenue Procedure—These are IRS instructions on how to use their documents. Revenue procedures also include updates to monetary amounts to adjust for inflation.
  • Acquiescence or Non-Acquiescence—A good item to have if you plan to use a court case as evidence, these are statements of IRS agreement or disagreement with a particular court ruling.
  • Notices and AnnouncementsProviding the least authority (but still useful) are notices and announcements, which indicate the IRS’s official position regarding present issues.

Non-binding documents can also be useful. If you’re uncertain about a tax strategy you plan to use, you can request a private letter ruling (PLR) from the IRS prior to filing your tax return.[5] This allows you to get the okay for your strategy before filing, thus avoiding tax penalties. You will have to pay for the PLR. Technical advice memoranda (TAM)[6], which can be initiated either by the IRS or by you, are also an option and have the same level of authority as a PLR.

If you receive a PLR or TAM, you’ll see a disclaimer at the bottom that states “This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.” This is the IRS’s way of telling you that this is only their opinion on the law and that you should not rely on it. Regardless, these rulings (though not binding) are important guidance. Since it comes from the IRS, it is directly useful in dealing with auditors or agents. Furthermore, these documents can be useful in court if no better authority exists for the issue in dispute.

Speaking of court, when do prior court rulings come into play with the IRS? Here are two reasons you’ll want to include them in your research, even if your audit does not go to trial

  1. Lawyers are well-known for including as many words as possible, and their evidence is thorough. From case law, you can often find all of the regulations, statutes, and forms or other documents needed to support your own argument. Go ahead and pluck those citations right out of the case documents!
  2. If your audit goes to appeals (the highest level of review at the IRS), appeals officers will consider court cases when making their decision.

What If Your Case Goes to Court?

In the event that your case does go to court, your previous research for the auditing process will help immensely. For the most part, you’ll need all of the same types of documentation. The biggest difference is that prior court cases will now be a higher authority than IRS documents. Statutes and regulations will still be your best sources of documentation.

Be aware that your case will not necessarily go to tax court. Federal tax cases can also be taken to:

  • A federal district court,
  • A court of appeals,
  • The court of federal claims, or
  • The Supreme Court (but this is rare).

What is important when choosing the right cases as support for your tax strategy is to choose those that come from the same court your hearing is at, or those from a court of higher authority. Since the tax court specializes in tax law, it is the most cited source. Make sure you know how much authority your particular example case carries. The cases from tax court will be cited as follows:

  • T.C. or TCThis is a regular tax court decision, and the only kind that counts as official precedent.
  • T.C. Memo, TC Memo, or T.C.M.—The tax court memorandum can help your case, but they carry less authority.
  • T.C. Summary Opinion or TC Summary OpinionDocuments labeled summary opinions are not particularly helpful. They carry little authority and do not count as precedent.

It is possible to take your tax dispute to an appeals court after the initial hearing. Keep in mind that different judges make different judgments. That means what a judge in another jurisdiction decides may not be the same as the conclusion the judge in your circuit (i.e. region) comes to. In most circumstances, the tax court will rule in accordance with the circuit where your tax issue originated,[7] but the job of judges is to interpret the laws, and interpretation varies. Tread carefully by being as prepared as possible.

  1. Reg. Section 1.6662-4(d)(3)(iii).
  2. Mayo Foundation v U.S., 131 S.Ct. 704.
  3. IRC Section 7805(e).
  4. This is in the introduction of all bulletins. See a list at
  5. Rev. Proc. 2013-1.
  6. Reg. Section 601.105(e)(iii).
  7. Golsen v Commr., 54 T.C. 742.

You Can Deduct Your Vacation—Just Learn the Tax Rules!

Get ahead and get packed because you’re about to get advice on how to deduct your vacation expenses. We’re not talking about a lame, business conference vacation here. This is bona fide advice for getting legal tax advantages for even a luxury vacation. And, you can count the steps on one hand! It’s true. You only need to understand these five tax rules to legally deduct items like your plane ticket and hotel suite:

  • Business Motive—By a business motive, the IRS means a plan for how this trip will contribute to your ability to make a profit. The profit does not have to be immediate, but you should be able to show that you had a reasonable expectation of monetary gain from the trip.
  • Overnight Stay—As with any business travel, you can only deduct expenses for trips that last, at least, overnight.[1]
  • Importance of the Trip—Ask yourself this: are the business activities you will engage in during your trip important enough that you would take the trip purely for business reasons? If it would not make sense to take the trip, except for the personal pleasure of it, then you’ll have difficulty deducting the expenses.
  • Pass the Primary Purpose Test—This test applies to any business travel in the United States. Basically, you need to make sure that the majority of your days on vacation count as business days. To do this, you need to conduct business on more than 50 percent of the days you are away. Additionally, for any single day to count as a business day, your business activities must take up at least four hours of that day (half of a standard workday).
  • Keep Records—Most importantly, record everything about the trip, including notes about the other four rules above.

If you meet these five requirements, then you can justify the business purpose of your trip.

Doing Business in Luxury

It turns out that your business trips can be as luxurious as you desire. With the right planning, you can both accomplish important business tasks and take a well-deserved break. Consider some of the expenses that can be deducted when you follow the five rules:

  • Rental car expenses (even a Rolls-Royce, if you want!)
  • The best suite at your choice of hotel
  • Airfare (even first-class)
  • Boat tickets (cruise travel, too[2])

As you can see, there’s no need to skimp on luxury, relaxation, or adventure when you turn your vacation into a business trip. Plus, you get huge tax savings that are not available for a personal vacation.

Types of Deductions

Business travel allows for to primary types of deductions, transportation expenses and life expenses. The cost to actually travel to and from a location is always a full-expense deduction or no deduction at all. You cannot pare out part of the deduction for personal and part for business. Remember the rule about primary purpose? If you pass those requirements, then you’re clear to deduct all your transportation costs. However, if most of the days on your trip are personal days, then you cannot deduct any of those expenses, even if you conducted business on some days.

The second set of deductions, life expenses, refers to the costs associated with sustaining your life while you’re away from home. That includes your hotel stay (or other lodging) and your meals. Unlike the transportation deduction, however, life expenses can only be deducted on business days. So, if you take a whole day to visit a historic downtown district, any meals for that day and the hotel stay for that night are not deductible, even if the day before and after are devoted to business.

You can see why good record keeping is so important. The IRS is not just going to believe that you spent every day of a vacation in Maui taking care of business.

Getting Business Travel Right

The tax code is unhelpfully vague when it comes to what constitutes business travel. The language states that you can deduct expenses that are “ordinary and necessary” for conducting business.[3] Unfortunately for those of us trying to get the most from legal deductions without incurring the wrath of the IRS auditor, the courts don’t do much to narrow down these broad terms. To support the reasons for your travel deductions, the best you can do is check out the rulings in previous tax cases.

Let’s start with the kind of scenarios that succeed with deductions:

  • Meeting at a Resort—Charles Hinton III solely owned United Title Company, a North Carolina-based C corporation. Every year, he held an out-of-state board meeting in locations such as New Orleans, Las Vegas, and Puerto Rico. He only invited his corporate board members and certain business guests (e.g. bankers, real estate developers, real estate attorneys), as well as their spouse or guest. In addition to the meeting, attendees also discussed business topics, like underwriting policy.

All travel costs were deemed deductible, excluding those for the spouses and non-business guests. Otherwise, the trip was considered for business purposes because the interesting locations ensured that business guests chose to attend. Mr. Hinton’s corporation benefited from the business conversations and from the strengthening of relationships within the field.[4]

  • Expanding BusinessAlthough Raymond Jackson regularly traveled in his business’s sales territory, he was able to deduct travel expenses from outside his normal territory. The additional trips were intended to find new clients and expand his business, thus they were deductible as business travel.[5] Tip: If you are traveling to find initial clients for a new business, those must be considered start-up expenses.
  • The Seminar or ConventionConventions do provide an excellent excuse to travel, and most take place in areas that lend themselves to vacation activities. Because conventions are set up to be business activities, it is easy to justify your expenses as business-related. Just remember these guidelines: 1) the travel expenses to North American conventions are deductible as long as they advance the interests of your business; 2) any convention that consist of video lectures can only be deducted if the videos could only be viewed at the convention (they could not be streamed or downloaded from home); and 3) travel expenses cannot be deducted for seminars relating to your investment interests rather than your business or trade.[6]

Now, this next set of cases shows you what kinds of scenarios fail at qualifying for deductions (hint: you must have a substantial business reason for your trip):

  • Lack of Business Importance—A custom plywood manufacturer took customers on a trip to New Orleans for four days. The trip included attending the Super Bowl, going on a Mississippi River cruise, and hotel accommodations in the French Quarter. The court deemed the trip merely entertainment, stating that the sporadic business discussions were incidental.[7] The trip did not pass the rule about being important enough to take (and justify the expenses) without the personal element.
  • Lack of Business Motive—A minister took a tour group to Europe; however, no profit motive for the trip was evident.[8] Remember, a business trip must demonstrate the potential increase your company’s profit.
  • Lack of DocumentationA real estate salesperson lost out on deductions for five different trips because she did not keep records to sufficiently prove the business purpose of any of her travel costs.[9]

How can you avoid these scenarios? Just keep proper documentation of your trip and the expenses. It’s not difficult at all. Be sure to include 1) how much each expense cost; 2) when you departed and returned; 3) how many days you spent on business; 4) where you went; and 5) why your trip was business related or expected to generate profit. The IRS requires all of this information in order for your business travel deduction to qualify.[10] Most of this information can be found on your receipts, so keep those in a file. As far as defining your business purpose, you can simply put a note in the file or use some other dated note-keeping system.

You may not be able to include deductible expenses in every vacation, but now that you know the rules, you may start looking at your travels a little differently. If you can reasonably fit in business activities while enjoying yourself, it makes sense to take advantage of the tax savings. Review these five easy rules the next time a travel opportunity arises.

  1. Barry v Commr., 54 TC 1210, aff’d 435 F.2d 1290.
  2. Subject to luxury water travel limits, between $678 and $810 (varies by time of year) per day for 2015.
  3. IRC Section 162(a)(2).
  4. United Title Insurance Co., TC Memo 1988-38.
  5. Jackson v Commr., TC Memo 1975-301.
  6. IRC Section 274(h)(7).
  7. Danville Plywood Corp. v U.S., 899 F.2d 3.
  8. Blackshear v Commr., T.C. Memo 1977-231.
  9. Robinson v Commr., T.C. Memo 1963-209.
  10. Reg. Section 1.274-5T(b)(2).

Your Guide to Tax Deductions on Business Entertainment

When you own a business, you’re likely to entertain a few partners, associates, or clients throughout the year. These informal meetings are a great way to brainstorm ideas outside the office. It also allows you to build rapport with the people most important to your business. However, the IRS has rules for exactly where you can reasonably conduct business when it comes to tax-deductible business entertainment. Simply put, some places are considered a business setting, and others are not. Fortunately, the rules are pretty straightforward.

Entertaining in a Business Setting

What exactly constitutes a business setting? It used to be that a “quiet business meal” was a tax-deductible activity[1]. That meant you were not required to actually discuss business in order to get a deduction. Although that is no longer the case, the business meal has set standards for defining business settings.

A business setting, by IRS definition, is a place where you can discuss business without significant distractions from the conversation. Settings considered conducive to business talks include[2]:

  • At your home
  • At a restaurant or hotel dining room, as long as there is no distracting entertainment
  • At hotel bars or cocktail lounges, as long as there is no distracting entertainment

Basically, anywhere you can sit down and have a conversation without distraction constitutes a good setting for business discussions, as far as the IRS is concerned. The IRS also considers the hospitality room at conferences clearly to be a business setting; therefore, displaying or discussing your products there is always deductible entertainment that creates goodwill for your business[3].

To deduct your expenses, you must establish (through documentation) that the expenses were directly related to your actively conducting business or were attributable to an actual and substantial business discussion. This includes business meetings at a convention[4].

What exactly is entertainment that is directly related to business? It means that two things must be true prior to committing to the expenditure[5]:

  1. You expected a specific business benefit other than goodwill in the indefinite future, such as the generation of income (note that you do not have to actually get the expected result).
  2. You participated in an actual business meeting, discussion, negotiation, or authentic transaction at the location (or you were prevented from doing so by circumstances beyond your control).

Attending a convention or professional association meeting fits under these guidelines[6].

Entertaining in a Non-Business Setting

Occasionally, you may find yourself talking business in a location that the IRS does not approve for business entertainment. Do you remember that “no distracting entertainment” stipulation? If the IRS thinks a location offers little or no possibility for actively engaging in a business discussion, they don’t consider the meeting tax-deductible. These places include[7]:

  • Sporting events, theaters, night clubs, and social events (e.g., cocktail parties)
  • Meetings with a disinterested party (or parties) at a country club, athletic club, golf course, cocktail lounge, or vacation resort, even if other relevant parties are present
  • Restaurants, bars, or other dining establishments that have distracting entertainment

Putting the Rules in Practice

This advice should give you a basic understanding of which expenses you can deduct. How about a practical example? Let’s assume you have a friend who installed a new phone system for his business. This system both saves him money and makes his business look more professional. You decide to take your friend to lunch to discuss how he purchased the system, as well as how it works and is maintained.

In this case, your lunch with your friend is deductible because 1) it took place in a business setting and 2) you met with the intention of gaining a benefit to your business, which you may or may not have actually gotten.

In addition, you can also deduct entertainment expenses that are associated with a business discussion in your office, directly related entertainment (as defined above), or a convention or professional association meeting. For example, if you took that same friend to a golf resort directly following lunch, you may deduct the golf as associated entertainment. That’s handy information, right?

Associated entertainment is a legitimate business deduction because it is a way for you to build your business. If you and your associates or clients both like golf, then it makes sense to use golf as a way to build your business relationships. The only price you have to pay for these tax benefits is taking the time to thoroughly document your activities.

Recording Your Proof

As always, you will need to provide proper documentation regarding your tax-deductible business entertainment. Wherever you keep records for expenses, be sure to note all the details, including who attended, where you met, what was purchased, when it occurred, why the meeting was planned, and how much everything cost. By keeping the appropriate records, you audit-proof your directly related entertainment deduction.

As a final tip, be sure to record all this information within one week of the activity. One week qualifies your records with the IRS’s timely records safe harbor[8]. As long as you’ve kept notes, you don’t even need a receipt for expenses under $75[9]. So, get out there and enjoy yourself while you build up your company!

  1. Reg. Section 1.274-2(f)(2)(i).
  2. Reg. Section 1.274-2(f)(2)(i)(b).
  3. Reg. Section 1.274-2(c)(4).
  4. Reg. Section 1.274-2(a)(1).
  5. Reg. Section 1.274-2(c)(3).
  6. Reg. Section 1.274-2(d)(3).
  7. Reg. Section 1.274-2(c)(7).
  8. Reg. Section 1.274-5T(c)(2)(ii)(A).
  9. Reg. Section 1.274-5(c)(2)(iii).

Maximize Your Tax Deductions on Business Repairs

When you own business properties, they will occasionally require repairs; that’s just a fact of business ownership. So, whether you need to make repairs on your place of business or your rental buildings, keep these simple truths in mind:

  • You can either increase your net worth with tax-favored repairs.
  • Or, you can decrease your net worth with tax-impaired improvements.

Now, which would you prefer?

Boosting Your Net Worth with the Right Fixes

The fixes that you can label as repairs are vastly more valuable to you than those labelled improvements. That means you need to know the difference between the two so you can a real monetary difference. Of course, it’s important to note that this only applies to an office or rental building that you own.

Fortunately, the IRS released a guide on this subject titled Capitalization v Repairs[1]. Without this guide, some tax deductions linger in an indeterminate gray area, which can be infuriating when it comes time for tax preparation. If you don’t know how the IRS classifies a particular fix, you lose control of your money. However, with the right planning, you can classify particular fixes as repairs and regain that financial control.

Here’s an example of how tax-favored repairs work:

  • Scenario 1: You put an entirely new roof on your office building. Uh-oh! Now you have to depreciate that roof over thirty-nine years, which means you have lost quite a bit of money up-front.
  • Scenario 2: Instead of completely replacing the roof on your building, you replace thirty-five percent of the roof one year, twenty-five percent of the roof a couple years later, fifteen percent of it a few years after that, and then twenty-five percent the following year. Each of those repairs can be deducted immediately, leaving you with a hefty financial advantage.

Defining a Repair

Do you see the difference in the above scenarios? Repairing is maintaining or mending. It is a fix that keeps a property running in its ordinary and efficient operating condition. A repair[2] does not 1) add to a property’s value, or 2) prolong the life of the property by an appreciable measure. You see, a repair ensures that you can continue using a property for the purpose you obtained it for, as opposed to increasing the value for a possible sale in the future[3]. An improvement, on the other hand, is a fix that 1) increases the property’s value[4], 2) prolongs its useful life substantially[5], or 3) modifies the property for a novel use[6].

Take a look at this actual situation to get an idea of how these definitions might play out (numbers are not in today’s dollars). A man purchased a four-unit apartment building (with one tenant residing) that was in poor repair for $30,000 and spent $6,247 for a contractor to fix it up. The contract work included removing tree limbs that were rubbing the roof; repairing water damage; repairing electrical wiring; cleaning the carpets, floors, and exterior; repairing the front porch; and, installing new cabinet doors and new countertops.

When the owner was audited, the IRS deemed the entire amount an improvement. The owner, however, disagreed, and the Tax Court allowed $5,000 worth of repair deductions[7]. The court only required the owner to capitalize $1,247 for the new cabinet doors and countertops.

Why did the court side with the building owner? First, the court noted that a tenant was living in the building. This meant the property was commercially active at the time of the fixes. If you’re repairing a rental property, having tenants in the building is beneficial to your claim of making repairs. Second, the $5,000 in repairs was not considered a large amount of money compared to the initial $30,000 spent to purchase the property. That is, the court could justify the expense as repairs rather than improvements to increase the property value.

Note: There is no defined amount of money that distinguishes a repair from an improvement. Two people could make the same fixes for the same amount of money and get differing tax results. That is why it is important for you to document the facts surrounding your repairs and present those facts when making a case with your tax preparer.

Tips on Making a Case for Repairs

By following a few best practices, you can make it easier on yourself to get the right tax deductions. A good way to get a favorable result for deductions on repairs is to get separate invoices for repairs and improvements[8]. This is especially important when you are carrying out a large renovation project. The IRS specifically states in its audit technique guide that repairs are not considered repairs when they are made as part of a general rehabilitation project[9]. So, keep those invoices separate! In fact, you’ll give yourself a lot fewer headaches if you just hire different contractors to do the repair work at different times from the improvements.

Here are some additional tips:

  • Always Document the Reasons for Your Repairs—Repairs, by their nature, are preceded by an event that indicates their need. For instance, you repair a water pipe because it begins to leak, or you repaint an exterior because the weather has faded it. Record these reasons as evidence of the need for repairs.
  • Fix Only Small Parts at a Time—This is pretty self-explanatory. When you replace something in its entirety (i.e., putting on a new roof, replacing an entire wall, installing new flooring), you are making an improvement[10]. When you focus on simply fixing a part of that roof, wall, or floor, you are making a repair[11].
  • Use Comparable Materials—If you want your claim for tax deductible repair work to be accepted, you should replace worn materials with those of similar, or even less expensive, quality[12]. If you’re using higher quality materials, the work may be considered an improvement[13].
  • Consider the Reason for the Repair—Another aspect to consider when making a case for fixes to be considered repairs for tax purposes is the condition of part being fixed up. A repair can only be made to something that is worn out, deteriorating, or broken[14]. If you’re not restoring or replacing a damaged part of the property, or if work expands to parts of the property that are not damaged, it becomes an improvement.

What’s the Main Concern?

Why is the IRS so particular about whether you are making repairs or improvements? They suspect you may buy a property to renovate, and then write off the renovation as repair costs. In its audit technique guide, the IRS distinguishes between money used to “put” or to “keep” the property in efficient operating condition[15]. Simply stated, if improvements need to be made in order to put the property in efficient operating order, then they are capital improvements. But, if they are only made in order to keep the property in efficient operating order, then they are repairs and are tax deductible.

This is not to say that you should not consider making improvements to your properties. Indeed, if you plan to sell, improvements may be exactly what you need. However, this article is a helpful guide for how to get the most out of your tax deductions when you are attempting to repair the buildings you still use. With proper documentation, you can designate whether the work you have done on your buildings is considered a repair or an improvement, and that means you have the power to take control of how much of your money goes to taxes.

  1. IRS Audit Technique Guide, Capitalization v Repairs, LB&I-4-0910-023.
  2. Reg. Section 1.162-4.
  3. Illinois Merchants Trust Co. v. Commr., 4 B.T.A. 103, 106 (1926), acq.
  4. Reg. Section 1.263(a)-1(a)(1).
  5. Reg. Section 1.263(a)-1(b).
  6. Also see Reg. Section 1.263(a)-1(b).
  7. Roger Verl Jacobson v Commr., TC Memo 1983-719.
  8. E.g., Allen v Commr., 15 T.C.M. 464 (1956).
  10. Reg. Section 1.162-4; e.g., Ritter v Commr., 47-2 USTC Section 9378 (6th Cir. 1947) (new roof).
  11. E.g., Kingsley v Commr., 11 B.T.A. 296 (1928) (patching roof), acq.
  12. E.g., Illinois Merchants Trust Company v Commr., 4 B.T.A. 103 (1926).
  13. E.g., Abbot Worsted Mills, Inc. v Cagne, 42-2 USTC ¶ 9694 (D. N.H. 1942).
  14. Sanford Cotton Mills v Commr., 14 B.T.A. 1210 (1929) (portion of decayed floor replaced).