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
The recent riots around the country have resulted in many storefronts, office buildings and business properties being destroyed. In the case of stores or other businesses with inventory, some of these businesses lost products after looters ransacked their property. Windows were smashed, property was vandalized, and some buildings were burned to the ground. This damage was especially devastating because businesses were reopening after the COVID-19 pandemic eased.
A commercial insurance property policy should generally cover some, or all, of the losses. (You may also have a business interruption policy that covers losses for the time you need to close or limit hours due to rioting and vandalism.) But a business may also be able to claim casualty property loss or theft deductions on its tax return. Here’s how a loss is figured for tax purposes:
Your adjusted basis in the property
Any salvage value
Any insurance or other reimbursement you receive (or expect to receive).
Losses that qualify
A casualty is the damage, destruction or loss of property resulting from an identifiable event that is sudden, unexpected or unusual. It includes natural disasters, such as hurricanes and earthquakes, and man-made events, such as vandalism and terrorist attacks. It does not include events that are gradual or progressive, such as a drought.
For insurance and tax purposes, it’s important to have proof of losses. You’ll need to provide information including a description, the cost or adjusted basis as well as the fair market value before and after the casualty. It’s a good time to gather documentation of any losses including receipts, photos, videos, sales records and police reports.
Finally, be aware that the tax code imposes limits on casualty loss deductions for personal property that are not imposed on business property. Contact us for more information about your situation.
© 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
The IRS recently released the 2021 inflation-adjusted amounts for Health Savings Accounts (HSAs).
An HSA is a trust created or organized exclusively for the purpose of paying the “qualified medical expenses” of an “account beneficiary.” An HSA can only be established for the benefit of an “eligible individual” who is covered under a “high deductible health plan.” In addition, a participant can’t be enrolled in Medicare or have other health coverage (exceptions include dental, vision, long-term care, accident and specific disease insurance).
In general, a high deductible health plan (HDHP) is a plan that has an annual deductible that isn’t less than $1,000 for self-only coverage and $2,000 for family coverage. In addition, the sum of the annual deductible and other annual out-of-pocket expenses required to be paid under the plan for covered benefits (but not for premiums) cannot exceed $5,000 for self-only coverage, and $10,000 for family coverage.
Within specified dollar limits, an above-the-line tax deduction is allowed for an individual’s contribution to an HSA. This annual contribution limitation and the annual deductible and out-of-pocket expenses under the tax code are adjusted annually for inflation.
Inflation adjustments for 2021 contributions
In Revenue Procedure 2020-32, the IRS released the 2021 inflation-adjusted figures for contributions to HSAs, which are as follows:
Annual contribution limitation. For calendar year 2021, the annual contribution limitation for an individual with self-only coverage under a HDHP is $3,600. For an individual with family coverage, the amount is $7,200. This is up from $3,550 and $7,100, respectively, for 2020.
High deductible health plan defined. For calendar year 2021, an HDHP is a health plan with an annual deductible that isn’t less than $1,400 for self-only coverage or $2,800 for family coverage (these amounts are unchanged from 2020). In addition, annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) can’t exceed $7,000 for self-only coverage or $14,000 for family coverage (up from $6,900 and $13,800, respectively, for 2020).
A variety of benefits
There are many advantages to HSAs. Contributions to the accounts are made on a pre-tax basis. The money can accumulate year after year tax free and be withdrawn tax free to pay for a variety of medical expenses such as doctor visits, prescriptions, chiropractic care and premiums for long-term-care insurance. In addition, an HSA is “portable.” It stays with an account holder if he or she changes employers or leaves the work force. For more information about HSAs, contact your employee benefits and tax advisor.
© 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
The Coronavirus Aid, Relief, and Economic Security (CARES) Act eliminates some of the tax-revenue-generating provisions included in a previous tax law. Here’s a look at how the rules for claiming certain tax losses have been modified to provide businesses with relief from the novel coronavirus (COVID-19) crisis.
Basically, you may be able to benefit by carrying a net operating loss (NOL) into a different year — a year in which you have taxable income — and taking a deduction for it against that year’s income. The CARES Act includes favorable changes to the rules for deducting NOLs. First, it permanently eases the taxable income limitation on deductions.
Under an unfavorable provision included in the Tax Cuts and Jobs Act (TCJA), an NOL arising in a tax year beginning in 2018 and later and carried over to a later tax year couldn’t offset more than 80% of the taxable income for the carryover year (the later tax year), calculated before the NOL deduction. As explained below, under the TCJA, most NOLs arising in tax years ending after 2017 also couldn’t be carried back to earlier years and used to offset taxable income in those earlier years. These unfavorable changes to the NOL deduction rules were permanent — until now.
For tax years beginning before 2021, the CARES Act removes the TCJA taxable income limitation on deductions for prior-year NOLs carried over into those years. So NOL carryovers into tax years beginning before 2021 can be used to fully offset taxable income for those years.
For tax years beginning after 2020, the CARES Act allows NOL deductions equal to the sum of:
- 100% of NOL carryovers from pre-2018 tax years, plus
- The lesser of 100% of NOL carryovers from post-2017 tax years, or 80% of remaining taxable income (if any) after deducting NOL carryovers from pre-2018 tax years.
As you can see, this is a complex rule. But it’s more favorable than what the TCJA allowed and the change is permanent.
Carrybacks allowed for certain losses
Under another unfavorable TCJA provision, NOLs arising in tax years ending after 2017 generally couldn’t be carried back to earlier years and used to offset taxable income in those years. Instead, NOLs arising in tax years ending after 2017 could only be carried forward to later years. But they could be carried forward for an unlimited number of years. (There were exceptions to the general no-carryback rule for losses by farmers and property/casualty insurance companies).
Under the CARES Act, NOLs that arise in tax years beginning in 2018 through 2020 can be carried back for five years.
Important: If it’s beneficial, you can elect to waive the carryback privilege for an NOL and, instead, carry the NOL forward to future tax years. In addition, barring a further tax-law change, the no-carryback rule will come back for NOLs that arise in tax years beginning after 2020.
Past year opportunities
These favorable CARES Act changes may affect prior tax years for which you’ve already filed tax returns. To benefit from the changes, you may need to file an amended tax return. Contact us to learn more.
© 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
The law providing relief due to the coronavirus (COVID-19) pandemic contains a beneficial change in the tax rules for many improvements to interior parts of nonresidential buildings. This is referred to as qualified improvement property (QIP). You may recall that under the Tax Cuts and Jobs Act (TCJA), any QIP placed in service after December 31, 2017 wasn’t considered to be eligible for 100% bonus depreciation. Therefore, the cost of QIP had to be deducted over a 39-year period rather than entirely in the year the QIP was placed in service. This was due to an inadvertent drafting mistake made by Congress.
But the error is now fixed. The Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law on March 27, 2020. It now allows most businesses to claim 100% bonus depreciation for QIP, as long as certain other requirements are met. What’s also helpful is that the correction is retroactive and it goes back to apply to any QIP placed in service after December 31, 2017. Unfortunately, improvements related to the enlargement of a building, any elevator or escalator, or the internal structural framework continue to not qualify under the definition of QIP.
In the current business climate, you may not be in a position to undertake new capital expenditures — even if they’re needed as a practical matter and even if the substitution of 100% bonus depreciation for a 39-year depreciation period significantly lowers the true cost of QIP. But it’s good to know that when you’re ready to undertake qualifying improvements that 100% bonus depreciation will be available.
And, the retroactive nature of the CARES Act provision presents favorable opportunities for qualifying expenditures you’ve already made. We can revisit and add to documentation that you’ve already provided to identify QIP expenditures.
For not-yet-filed tax returns, we can simply reflect the favorable treatment for QIP on the return.
If you’ve already filed returns that didn’t claim 100% bonus depreciation for what might be QIP, we can investigate based on available documentation as discussed above. If there’s QIP that was eligible for 100% bonus depreciation, note that the IRS has, for past retroactive favorable depreciation changes, provided taxpayers with detailed guidance for how the benefit is claimed. Specifically, the IRS clarified how much flexibility taxpayers have in choosing between a one-time downward adjustment to income on their current returns or an amendment to the return for the year the QIP was placed in service. We will evaluate what your options are as anticipated IRS guidance for the QIP correction is released.
If you have any questions about how you can take advantage of the QIP provision, don’t hesitate to contact us.
© 2020 Covenant CPA