If you operate a small business, or you’re starting a new one, you probably know you need to keep records of your income and expenses. In particular, you should carefully record your expenses in order to claim the full amount of the tax deductions to which you’re entitled. And you want to make sure you can defend the amounts reported on your tax returns if you’re ever audited by the IRS or state tax agencies.
Certain types of expenses, such as automobile, travel, meals and office-at-home expenses, require special attention because they’re subject to special recordkeeping requirements or limitations on deductibility.
It’s interesting to note that there’s not one way to keep business records. In its publication “Starting a Business and Keeping Records,” the IRS states: “Except in a few cases, the law does not require any specific kind of records. You can choose any recordkeeping system suited to your business that clearly shows your income and expenses.”
That being said, many taxpayers don’t make the grade when it comes to recordkeeping. Here are three court cases to illustrate some of the issues.
Case 1: Without records, the IRS can reconstruct your income
If a taxpayer is audited and doesn’t have good records, the IRS can perform a “bank-deposits analysis” to reconstruct income. It assumes that all money deposited in accounts during a given period is taxable income. That’s what happened in the case of the business owner of a coin shop and precious metals business. The owner didn’t agree with the amount of income the IRS attributed to him after it conducted a bank-deposits analysis.
But the U.S. Tax Court noted that if the taxpayer kept adequate records, “he could have avoided the bank-deposits analysis altogether.” Because he didn’t, the court found the bank analysis was appropriate and the owner underreported his business income for the year. (TC Memo 2020-4)
Case 2: Expenses must be business related
In another case, an independent insurance agent’s claims for a variety of business deductions were largely denied. The Tax Court found that he had documentation in the form of cancelled checks and credit card statements that showed expenses were paid. But there was no proof of a business purpose.
For example, he made utility payments for natural gas, electricity, water and sewer, but the records didn’t show whether the services were for his business or his home. (TC Memo 2020-25)
Case number 3: No records could mean no deductions
In this case, married taxpayers were partners in a travel agency and owners of a marketing company. The IRS denied their deductions involving auto expenses, gifts, meals and travel because of insufficient documentation. The couple produced no evidence about the business purpose of gifts they had given. In addition, their credit card statements and other information didn’t detail the time, place, and business relationship for meal expenses or indicate that travel was conducted for business purposes.
“The disallowed deductions in this case are directly attributable to (the taxpayer’s) failure to maintain adequate records,“ the court stated. (TC Memo 2020-7)
We can help
Contact us if you need assistance retaining adequate business records. Taking a meticulous, proactive approach to how you keep records can protect your deductions and help make an audit much less painful.
© 2020 Covenant CPA
Machine learning increasingly is being used to discover fraud schemes. With this type of artificial intelligence (AI), the technology learns or improves in accuracy through experience, rather than through additional programming. If you already use AI in your business, you’re probably somewhat familiar with how machine learning works. But here’s a quick overview of its application in fraud detection.
New approaches needed
More and more, businesses rely on digitization to deliver the goods and services their customers want. Unfortunately, digitization also makes it easier both for cybercriminals and stakeholders, such as employees, vendors and customers, to steal. Preventing fraud in the digital age requires new approaches.
Machine learning is one such approach. Traditional rules-based fraud detection software flags transactions — such as purchase orders of a certain type or over a certain amount — that are suspicious according to static rules. On the other hand, fraud detection software that includes machine learning uses large sets of historical data to “learn,” or create algorithms about the patterns associated with new fraud schemes, enabling it to detect fraud in the future.
Step by step
For a machine to learn, its users must follow certain procedures. After the software is enabled to capture historical transaction data — and the more data, the better — the company using it reviews the data to ensure it presents an accurate picture of transactions. The software then applies algorithms to identify potentially suspicious items. This process creates the first fraud detection model. The software analyzes the same set of data repeatedly and produces new models for the company to review. The company provides feedback on each model to help the software develop better algorithms.
Through this process, the model learns what constitutes fraud and the number of false positives should drop significantly. In the end, the company selects the most accurate fraud detection model to put into production.
If you have the technical capabilities, you may be able to develop a customized machine learning program for fraud detection in-house. We can help if you don’t. Contact us.
© 2020 Covenant CPA
Transferring a family business to the next generation requires a delicate balancing act. Estate and succession planning strategies aren’t always compatible, and family members often have conflicting interests. By starting early and planning carefully, however, it’s possible to resolve these conflicts and transfer the business in a tax-efficient manner.
Ownership vs. management succession
One reason transferring a family business is such a challenge is the distinction between ownership and management succession. From an estate planning perspective, transferring assets to the younger generation as early as possible allows you to remove future appreciation from your estate, minimizing estate taxes. However, you may not be ready to hand over the reins of your business or you may feel that your children aren’t yet ready to take over.
There are several ways owners can transfer ownership without immediately giving up control, including:
- Using a family limited partnership (FLP),
- Transferring nonvoting stock, or
- Establishing an employee stock ownership plan.
Another reason to separate ownership and management succession is to deal with family members who aren’t involved in the business. It’s not unusual for a family business owner to have substantially all of his or her wealth tied up in the business.
Providing heirs outside the business with nonvoting stock or other equity interests that don’t confer control can be an effective way to share the wealth with them while allowing those who work in the business to take over management.
Conflicting financial needs
Another challenge presented by family businesses is that the older and younger generations may have conflicting financial needs. Fortunately, strategies are available to generate cash flow for the owner while minimizing the burden on the next generation. They include:
An installment sale. This provides liquidity for the owner while improving the chances that the younger generation’s purchase can be funded by cash flows from the business. Plus, so long as the price and terms are comparable to arm’s-length transactions between unrelated parties, the sale shouldn’t trigger gift or estate taxes.
A grantor retained annuity trust (GRAT). By transferring business interests to a GRAT, the owner obtains a variety of gift and estate tax benefits (provided he or she survives the trust term) while enjoying a fixed income stream for a period of years. At the end of the term, the business is transferred to the owner’s children or other beneficiaries. GRATs are typically designed to be gift-tax-free.
An installment sale to an intentionally defective grantor trust (IDGT). Essentially a properly structured IDGT allows an owner to sell the business on a tax-advantaged basis while enjoying an income stream and retaining control during the trust term. Once the installment payments are complete, the business passes to the owner’s beneficiaries free of gift taxes.
Each family business is different, so it’s important to identify appropriate strategies in light of your objectives and resources. We’d be pleased to help.
© 2020 Covenant CPA
Restaurants and entertainment venues have been hard hit by the novel coronavirus (COVID-19) pandemic. One of the tax breaks that President Trump has proposed to help them is an increase in the amount that can be deducted for business meals and entertainment.
It’s unclear whether Congress would go along with enhanced business meal and entertainment deductions. But in the meantime, let’s review the current rules.
Before the pandemic hit, many businesses spent money “wining and dining” current or potential customers, vendors and employees. The rules for deducting these expenses changed under the Tax Cuts and Jobs Act (TCJA), but you can still claim some valuable write-offs. And keep in mind that deductions are available for business meal takeout and delivery.
One of the biggest changes is that you can no longer deduct most business-related entertainment expenses. Beginning in 2018, the TCJA disallows deductions for entertainment expenses, including those for sports events, theater productions, golf outings and fishing trips.
50% meal deductions
Currently, you can deduct 50% of the cost of food and beverages for meals conducted with business associates. However, you need to follow three basic rules in order to prove that your expenses are business related:
- The expenses must be “ordinary and necessary” in carrying on your business. This means your food and beverage costs are customary and appropriate. They shouldn’t be lavish or extravagant.
- The expenses must be directly related or associated with your business. This means that you expect to receive a concrete business benefit from them. The principal purpose for the meal must be business. You can’t go out with a group of friends for the evening, discuss business with one of them for a few minutes, and then write off the check.
- You must be able to substantiate the expenses. There are requirements for proving that meal and beverage expenses qualify for a deduction. You must be able to establish the amount spent, the date and place where the meals took place, the business purpose and the business relationship of the people involved.
It’s a good idea to set up detailed recordkeeping procedures to keep track of business meal costs. That way, you can prove them and the business connection in the event of an IRS audit.
What if you spend money on food and beverages at an entertainment event? The IRS has clarified that taxpayers can still deduct 50% of food and drink expenses incurred at entertainment events, but only if business was conducted during the event or shortly before or after. The food-and-drink expenses should also be “stated separately from the cost of the entertainment on one or more bills, invoices or receipts,” according to the guidance.
Another related tax law change involves meals provided to employees on the business premises. Before the TCJA, these meals provided to an employee for the convenience of the employer were 100% deductible by the employer. Beginning in 2018, meals provided for the convenience of an employer in an on-premises cafeteria or elsewhere on the business property are only 50% deductible. After 2025, these meals won’t be deductible at all.
As you can see, the treatment of meal and entertainment expenses became more complicated after the TCJA. It’s possible the deductions could increase substantially under a new stimulus law, if Congress passes one. We’ll keep you updated. In the meantime, we can answer any questions you may have concerning business meal and entertainment deductions.
© 2020 Covenant CPA
Economists will look back on 2020 as a year with a distinct before and after. In early March, most companies’ sales projections looked a certain way. Just a few weeks later, those projections had changed significantly — and not for the better.
Because of the novel coronavirus (COVID-19) pandemic, businesses across a variety of industries are revising their sales compensation models. Nonprofit workforce researchers WorldatWork released a report in late April indicating that 36% of organizations had begun addressing sales compensation in light of the crisis, and another 49% were developing plans to do so.
If your company is considering changes to how it compensates sales staff in a drastically changed economy, here are three of the most common actions being implemented according to the survey:
1. Adjusting sales quotas. Of the organizations surveyed, 46% were adjusting their quotas to account for the pandemic’s impact. For many businesses, this means providing “quota relief” to salespeople who find themselves in a reluctant buying environment. Of course, any adjustment should be based on a realistic and detailed forecast of what your sales will likely look like for the current period and upcoming ones.
2. Modifying performance measures. The report indicates that 44% of organizations will modify how they measure the performance of their sales staffs. Whereas a sales quota is a time-bound target assigned to an individual, performance measures encompass much wider metrics.
For example, you might want to amend your average deal size to account for more conservative buying during the pandemic. This metric is typically calculated by dividing your total number of deals by the total dollar amount of those deals. Also look at conversion rate (or win rate), which measures what percentage of leads ultimately become customers. Scarcer leads will likely lead to a lower rate.
3. Lowering plan thresholds. Survey results showed 36% of organizations intend to lower the plan thresholds for their sales teams. From a compensation plan perspective, a threshold describes what performance level qualifies the employee for a specified payout. This includes a max threshold to identify outstanding sales performances during a given period.
The pandemic-triggered economic downturn serves as a prime, even extreme, example of the kinds of external, macroeconomic factors that can alter the effectiveness of a plan threshold. When looking into corrective action, it’s critical to go beyond the usual adjustments and conduct analyses specific to your company’s size, market and industry outlook.
Setting sales compensation has never been a particularly straightforward endeavor. Businesses often tweak their approaches over time or even implement completely new ways when competitively necessary — and this is during normal times. Our firm can help you assess your sales figures since the pandemic hit, forecast upcoming ones and design a compensation model that’s right for you.
© 2020 Covenant CPA
The IRS has issued guidance clarifying that certain deductions aren’t allowed if a business has received a Paycheck Protection Program (PPP) loan. Specifically, an expense isn’t deductible if both:
- The payment of the expense results in forgiveness of a loan made under the PPP, and
- The income associated with the forgiveness is excluded from gross income under the Coronavirus Aid, Relief, and Economic Security (CARES) Act.
The CARES Act allows a recipient of a PPP loan to use the proceeds to pay payroll costs, certain employee healthcare benefits, mortgage interest, rent, utilities and interest on other existing debt obligations.
A recipient of a covered loan can receive forgiveness of the loan in an amount equal to the sum of payments made for the following expenses during the 8-week “covered period” beginning on the loan’s origination date: 1) payroll costs, 2) interest on any covered mortgage obligation, 3) payment on any covered rent, and 4) covered utility payments.
The law provides that any forgiven loan amount “shall be excluded from gross income.”
So the question arises: If you pay for the above expenses with PPP funds, can you then deduct the expenses on your tax return?
The tax code generally provides for a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Covered rent obligations, covered utility payments, and payroll costs consisting of wages and benefits paid to employees comprise typical trade or business expenses for which a deduction generally is appropriate. The tax code also provides a deduction for certain interest paid or accrued during the taxable year on indebtedness, including interest paid or incurred on a mortgage obligation of a trade or business.
No double tax benefit
In IRS Notice 2020-32, the IRS clarifies that no deduction is allowed for an expense that is otherwise deductible if payment of the expense results in forgiveness of a covered loan pursuant to the CARES Act and the income associated with the forgiveness is excluded from gross income under the law. The Notice states that “this treatment prevents a double tax benefit.”
More possibly to come
Two members of Congress say they’re opposed to the IRS stand on this issue. Senate Finance Committee Chair Chuck Grassley (R-IA) and his counterpart in the House, Ways and Means Committee Chair Richard E. Neal (D-MA), oppose the tax treatment. Neal said it doesn’t follow congressional intent and that he’ll seek legislation to make certain expenses deductible. Stay tuned.
© 2020 Covenant CPA
Thanks to affordable technology, more and more companies have been allowing employees to work remotely in recent years. It’s become feasible to procure laptops, set up security protocols, use cloud servers and rely on employees’ home Wi-Fi connections to create functional virtual workspaces. In turn, many of these businesses have lowered overhead costs such as office rent and utilities.
Of course, with the onset of the coronavirus (COVID-19) pandemic, many companies have had to mandate that any employees who can work from home do so. As a result, virtual team building has become more important than ever.
Ensure consistency of processes and expectations
When employees work from home, many of the processes they use to complete tasks and fulfill duties may change slightly — or even drastically — to fit the technology used to execute them. This can cause confusion and lead to mistakes or conflicts that affect employee morale.
Make sure every virtual team develops and follows processes that produce results consistent with those generated on your physical premises. Doing so may require a concerted effort that slows productivity temporarily while everyone gets on the same page.
Meanwhile, reinforce with workers that your expectations of them are the same whether they work on-site or remotely. They shouldn’t feel as if they must work extra hard from home to “prove themselves,” but they do need to demonstrate that they’re getting things done.
Hold regular meetings — and “irregular” ones
Among the biggest challenges for work-from-home employees is feeling disconnected from their fellow team members. Brief, regularly scheduled Web-based meetings are a good way to address this dilemma. These gatherings allow everyone to see or hear one another (or both) and provide employees with the opportunity to voice concerns and contribute ideas.
If a given team is relatively new at working remotely, or you just want to bring any group of employees closer together, you could also hold special meetings specifically geared toward team building. There’s a wide variety of icebreakers, games and activities that teams can use to learn more about each other and to gain comfort in communicating.
For example, you can invite participants to share stories and photos of their pets, hold trivia contests or even sing karaoke. Just be sure to tailor such team-building efforts to your company’s culture and be wary of pushing remote workers too far out of their comfort zones.
Find a way
Whether your business has had employees working remotely for years or just recently had to ask workers to stay home because of COVID-19, there are plenty of ways to help them communicate better and enhance their performance as a team. We offer assistance in measuring productivity and making smart investments in the right team-building technology.
© 2020 Covenant CPA
A natural place to turn when disaster strikes is insurance. The very reason you pay premiums and deal with the paperwork is to have these risk management policies in place when necessary. But, when it comes to business interruption coverage, you may have to adjust your expectations if you intend to file a claim because of the novel coronavirus (COVID-19) pandemic.
Business interruption insurance generally provides cash flow to cover revenues lost and expenses incurred while normal operations are suspended because of an applicable event. So, many business owners are now asking an unavoidable question: Is the COVID-19 pandemic an applicable event?
Many insurers are saying no, claiming the “force majeure” legal defense. This refers to situations in which unexpected external circumstances prevent a party to a contract — in this case, the insurance company — from meeting its obligations.
Insurers are also citing policy language that stipulates coverage applies only when a policyholder suffers a loss of income as a result of physical loss or damage to covered property. COVID-19 doesn’t qualify as a physical loss, they argue. In addition, insurers contend their policies don’t cover loss of income because of market conditions or an economic slowdown.
Lawsuits have already been filed challenging the insurance companies. Attorneys, representing business owners, are arguing that the recent rise of SARS, MERS and the Avian flu have given insurance companies ample opportunity to anticipate a global pandemic.
Attorneys have additionally pointed out that the virus can attach itself to physical surfaces. Thus, they contend, it does result in a physical loss as businesses are losing revenue and incurring expenses for disinfection and prevention.
As these lawsuits play out, you may wonder whether it’s worth your time to file a business interruption claim related to the pandemic. The answer depends on your policy’s language, as well as the facts and circumstances of your company’s situation.
To decide whether and how to proceed, review your policy carefully. Look at the type of losses covered, as well as exclusions and limitations. You may want to consult an attorney, as insurance policy language and structure can be confusing.
If you decide to move ahead with a claim, you’ll need to document the adverse financial impact of the pandemic, including:
- Loss of income, as defined under your policy,
- Customer attrition rates, and
- Incremental expenses incurred, such as site security or cleaning services.
Many policies require policyholders to notify the insurer of a loss within a certain period, so you may need to move quickly.
Even before the COVID-19 crisis, receiving a payout for a business interruption claim was typically not a cut-and-dried affair. Suffice to say, doing so hasn’t gotten any easier. We can help you assess and document financial losses and expenses before deciding whether to file a claim.
© 2020 Covenant CPA
As a result of the coronavirus (COVID-19) crisis, your business may be using independent contractors to keep costs low. But you should be careful that these workers are properly classified for federal tax purposes. If the IRS reclassifies them as employees, it can be an expensive mistake.
The question of whether a worker is an independent contractor or an employee for federal income and employment tax purposes is a complex one. If a worker is an employee, your company must withhold federal income and payroll taxes, pay the employer’s share of FICA taxes on the wages, plus FUTA tax. Often, a business must also provide the worker with the fringe benefits that it makes available to other employees. And there may be state tax obligations as well.
These obligations don’t apply if a worker is an independent contractor. In that case, the business simply sends the contractor a Form 1099-MISC for the year showing the amount paid (if the amount is $600 or more).
No uniform definition
Who is an “employee?” Unfortunately, there’s no uniform definition of the term.
The IRS and courts have generally ruled that individuals are employees if the organization they work for has the right to control and direct them in the jobs they’re performing. Otherwise, the individuals are generally independent contractors. But other factors are also taken into account.
Some employers that have misclassified workers as independent contractors may get some relief from employment tax liabilities under Section 530. In general, this protection applies only if an employer:
- Filed all federal returns consistent with its treatment of a worker as a contractor,
- Treated all similarly situated workers as contractors, and
- Had a “reasonable basis” for not treating the worker as an employee. For example, a “reasonable basis” exists if a significant segment of the employer’s industry traditionally treats similar workers as contractors.
Note: Section 530 doesn’t apply to certain types of technical services workers. And some categories of individuals are subject to special rules because of their occupations or identities.
Asking for a determination
Under certain circumstances, you may want to ask the IRS (on Form SS-8) to rule on whether a worker is an independent contractor or employee. However, be aware that the IRS has a history of classifying workers as employees rather than independent contractors.
Businesses should consult with us before filing Form SS-8 because it may alert the IRS that your business has worker classification issues — and inadvertently trigger an employment tax audit.
It may be better to properly treat a worker as an independent contractor so that the relationship complies with the tax rules.
Be aware that workers who want an official determination of their status can also file Form SS-8. Disgruntled independent contractors may do so because they feel entitled to employee benefits and want to eliminate self-employment tax liabilities.
If a worker files Form SS-8, the IRS will send a letter to the business. It identifies the worker and includes a blank Form SS-8. The business is asked to complete and return the form to the IRS, which will render a classification decision.
Contact us if you receive such a letter or if you’d like to discuss how these complex rules apply to your business. We can help ensure that none of your workers are misclassified.
© 2020 Covenant CPA