Partnership Late Filing Penalty – Rev Proc 84-35 and TEFRA

I have written two prior posts on this issue, and there has been a lot of discussion and important contributions from readers, so I wanted to compile all the information in one post.

The Basics:

Partnerships and entities taxed as partnerships (LLC, LLP, etc) are required to file annual returns by 4/15.  A five month extension is available, making the final deadline 9/15.  Strict penalties are assessed by the IRS if you file late.

The penalty is currently $195 “per partner, per month” that the return is late.  This can add up really fast, and average late filing penalties result in several thousand dollars of non-deductible fees that the IRS is making more and more difficult to get removed.

It does not matter if your business taxed as a partnership did not make any money or never really took off – if you registered for an EIN# or have filed previous returns, you need to follow through and returns annually.  The IRS is not going to listen to they type of excuses.

Abatement Option #1 – Rev Proc 84-35

If the partners or LLC/LLP members filed their personal returns timely (4/15 or extended and filed by 10/15), then you may have a get out jail card that has been available for over a decade now and provides automatic penalty abatement.

Here is the complete list of factors:

  • The partnership has to be a domestic partnership,
  • have 10 or fewer partners (husband and wife and their estate are treated as one partner),
  • all partners have to be natural persons (other than a nonresident alien) or an estate of a deceased partner,
  • each partner’s share of each partnership item has to be the same as their share of every other item,
  • all partners need to have timely filed their income tax returns, and
  • all the partners need to have fully reported their share of the income, deductions, and credits of the partnership on their timely filed income tax returns.

If you meet all these requirements, your first response to a partnership late filing penalty letter from the IRS needs to look like this sample letter.

Now, it seems the IRS has grown tired of Rev Proc 84-35 abatement requests, as they have been trying to shift the discussion of penalty abatement to “reasonable cause”.  Do not let them do this!  Rev Proc 84-35 is available if you meet the criteria.  Even if you have claimed it several years, do not let them try to claim that they cannot abate the penalty or get you side-tracked with a reasonable cause argument – stick to citing Rev Proc 84-35 until you get your abatement.

Important!  This does not work for S corporations and LLCs taxed as S corporations.  A similar Rev Proc for automatic abatement was unfortunately never created for them.  For more information, read my post on S corp late filing abatement.

Abatement Option #2 – The TEFRA Complication

A few years ago, the IRS was looking to raise revenue (they have lavish parties in Disneyland to pay for) and employed a new tactic to reduce partnership late filing penalty abatements.  They found that if a partnership had filed a TEFRA election, that they would not be eligible to use Rev Proc 84-35 to request abatement.  Suddenly, many CPAs who submitted standard Rev Proc 84-35 abatement requests were receiving denials with the IRS claiming the client had filed a TEFRA election.

For all the background on this complication, read my penalty update blog post, but the short story is that the IRS would claim the election was filed clear back in 2002 or earlier, and the client had to dig up a copy of the tax return to prove the election was not made or put together a letter – signed by all partners/members – stating that a TEFRA election had never been filed.  Even then, it often took many letters back and forth or messages on the now defunct IRS eServices resolution service.

I have personally dealt with this issue several times and was able to get abatement in each case; however, I have not had to deal with it in over a year.  Fortunately, some PDXCPA blog readers have had some more current experience, and there was really good information shared in the comments section of the prior posts.  Specifically, Melissa F. Hill, CPA provided a sample abatement letter and backup documentation that became a popular request on this blog.  The documents she has been emailing to readers are available below:

I like Melissa’s sample letter, as that is how you should frame you argument – cite Rev Proc 84-35 and then maintain that a TEFRA election was never filed and request they provide their proof of the election.  A letter signed by all partners maintaining that the election has never been filed helps as well.

Sometimes they will respond with a tax year that they claim the TEFRA election was made in, but then they will claim that it will take them awhile to get a copy from archives.  If you are organized and have a copy of the return, send them a copy and continue to maintain your assertion that the election was not filed and that Rev Proc 84-35 should apply.  You may have to be persistent and put up a strong fight for abatement, but keep trying and do not let them bring up reasonable cause.

Good luck!

Original post 1/5/09 – https://pdxcpa.wordpress.com/2009/01/05/partnership-late-filing-penalty-abatement/

Update post on TEFRA 10/1/12 – https://pdxcpa.wordpress.com/2012/10/01/partnership-late-filing-penalty-update/

The Minority Owner Report, Part 1- LLCs and Partnerships

I am by no means a “precog”, nor can always predict when minority ownership in a small business will result in disaster, but my 14 years of experience with small business clients has taught me a great deal about what not to do when structuring a business and offering ownership to employees.

If you are currently a minority owner (<50% interest) in an LLC taxed as a partnership or a traditional partnership, or you are being offered such ownership, you may want to consider running away from the ownership if certain warning signs are present.  Also, I highly recommend having your tax professional and/or lawyer look everything over before you sign anything.  Business ownership is a lot like marriage, so know what you are getting into.

Minority Ownership Warning Signs in LLCs and Partnerships

The entity does not increase guaranteed payments by 5% to cover self-employment tax

When an employee becomes a partner or LLC member, their tax burden increases substantially because of the self-employment tax.  Generally, an employee pays social security and Medicare tax of 7.65% on gross wages, and the employer pays another 7.65%.  However, an active partner or LLC member is considered self-employed and has to pay both the employee and employer portions of social security and Medicare tax, which total 15.3%.  Fortunately, the IRS allows a deduction for one half of the self-employment taxes paid (just like the deduction available to employers), which results in an approximate net rate of 12%.  This means that a employee who becomes a partner or LLC member will incur a tax increase of approximately 5%.

Most companies do the right thing and give an employee transitioning to ownership enough additional income to cover this 5% tax increase.  The most effective means of doing this is to provide the additional income to the new partner or LLC member in the form of an increase to their regular guaranteed payment.  Employees are accustomed to predictable cash flow and regular tax withholdings, so the transition to making quarterly estimated tax payments at a higher tax rate can be difficult.  Additional income that is guaranteed and paid on a regular basis is going to ease that transition and insure that there is a tangible benefit to ownership.

Unfortunately, a surprising number of partnerships and LLCs do not provide additional income to employees transitioning to minority ownership, and often it can result in ownership that is actually a detriment to them as a result of the additional tax.  Usually, future profits are promised when selling ownership to the employees, and in some businesses, this works very well when consistent profits easily eclipse the 5% tax burden.  However, taxable business profits can be very unpredictable due to current accelerated tax depreciation rules and other complications, and in order to distribute profits during the year when they are helpful to the owners, a business has to keep very accurate accounting records.  Owners have to pay estimated tax payments quarterly, so the unpredictability of having to rely on distributions of profits can create a lot of dissension among owners – especially during periods of low profits or losses.  The sad irony for these businesses who are unwilling to pay the additional 5% in income to partners/LLC members is that they often make ownership offers to employees for the sole purpose of keeping them at the company, and often the tax burden on the new owners does the exact opposite after several years of seeing no benefit to ownership.

The entity is providing capital interest ownership in exchange for services

Giving ownership to an employee in exchange for services can actually work very well if structured correctly and all parties are properly informed of the tax ramifications.  However, ideal situations like this rarely happen in the real world, and usually such an arrangement results in a surprise tax bill for the employee receiving ownership.  Avoiding such a disaster requires an understanding of the most common types of interests available in small business organized as LLCs.

Capital Interest – this is the default type of LLC interest, as it is a complete ownership that entitles the holder to a share of profits and losses as well as a share of the proceeds from the sale of the LLC’s assets if the LLC liquidates.  A capital interest is most commonly given to employees brought on for succession planning purposes.

Profits Interest – this interest is like the capital interest, except a profit interest holder does not receive liquidating distributions from the LLC.  In other words, it is only an interest in future profits of the LLC and there is no initial capital balance for the member.  A profits interest is often given to key employees much like stock options are given to employees of corporations.  It is often intended as a form of additional compensation and a method to retain key personnel.

If you receive a capital interest in exchange for services, it is treated as current compensation in an amount equal to the fair market value of the capital interest at the grant date.  The problem is that most small businesses owners organized as LLCs are not aware of this, and rarely do they tell their CPA about such transactions in advance, so it often becomes an ugly year-end or tax-time surprise for the recipient, as they have taxable income to recognize and no cash to pay the tax with.  To make matters worse, most small business owners have no idea what the fair market value of their LLC is, so the transaction becomes very complex can create many problems down the road if not done correctly.  As an employee being offered such an interest, I strongly recommend asking the LLC to involve their CPA and/or lawyer so that the compensation is determined ahead of time.  This will allow you plan accordingly and look into options like the 754 election that can minimize the tax impact.

If you are granted a profits interest in an LLC, no taxable income is recognized as long as the interest satisfies the Revenue Procedure 93-27 safe harbor rules.  Most LLCs that offer a profits interest have already had a CPA and/or lawyer setup it up so that the rules are met, so in most cases it is a good deal for the employee receiving the interest.  However, it is important to get some prior financial statements and/or tax returns so that you can know what to expect, as sometimes start-ups give profit interests and then go several years without any recognized profit.

The entity does not have a method of equalizing expenses

Single-owner businesses have it very easy in the area of expenses, as they can spend how they want without having to justify to other owners or worry about trying to keep things equal.  In multi-owner businesses, there is a constant problem with equalization, as business partners are usually wired differently when it comes to spending and often have different tastes.  One LLC member may be tech savvy with smart phones and tablets and another may still prefer a flip phone and a paper legal pad, so it is crucial for a minority owner that an LLC or partnership have an established method of expense equalization in place.

The most flexible method of expense equalization is to have the operating agreement specifically state that the LLC or partnership will not reimburse partners for certain expenses and that they are required to pay for these expenses.  As long as it is properly setup in this way, each partner or member can deduct their unreimbursed partnership expenses on their own 1040 tax return on Schedule E page 2.  This allows each partner or member to be as lavish or frugal as they want without having to worry about the expenses of the other owners.  Often, meals and entertainment, automobile, travel, and office expenses are treated in this fashion.

The second best method is devising a special allocation where certain expenses are allocated 100% to certain owners against their guaranteed payments.  This can be elaborate or just a simple calculation done with the tax return preparation, but either way – LLCs and partnerships are extremely flexible in this area.  Just make sure the allocation is decided on well in advance, as it is much more difficult to agree on after expenses have already been paid.

That’s it for LLCs and partnerships.  In Part 2, I will concentrate on minority ownership issues in S corporations.

Partnership Late Filing Penalty Update

NEW – 2/2/14 – We have added a new updated blog post on this topic with downloadable sample letters.

My original blog post – Partnership Late Filing Penalty Abatement – is one of the most popular articles here on PDXCPA, and that is due the fact that the IRS has become more and more agressive in assessing this penalty over the years.  In fact, last year I encountered some new problems in requesting abatement of these penalties, so an update on the subject is well overdue.

  • First off, the base penalty amount has been increased to $195, so if you have a number of partners or members, this has become a very substantial penalty that seems to far outweigh the offense.
  • The IRS has been denying the standard abatement letters using Revenue Procedure 84-35 – especially for clients that have requested abatement several years in a row.  In priors years, the abatement had been fairly automatic, but last year they fought very hard in some cases to keep the penalties in place.
  • In talking to fellow tax practitioners from TaxQueries.com, I found that I was not being singled out by the IRS and that many others had received similar letters denying abatement and citing new arguments never raised before.
  • The most common new argument I encountered was that the IRS claimed that they could not consider our request for penalty waiver under Rev Proc 84-35 because their records indicated that the partnership elected to be subject to the consolidated audit procedures under IRC 6221 through IRC 6233.  Upon further inquiry, the IRS claimed that a TEFRA election (Form 8893) was filed in a prior year – usually about 10 years prior.
  • The IRS agents were very uncooperative with providing me with additional information, and they simply stated they would have to request a copy of the return from their records department.
  • Fortunately, my clients keep very good records and we pulled up copies of the return that the IRS claimed had a TEFRA election.  Sure enough, the return did not include Form 8893 or any other elections with regard to TEFRA.  After a lengthy phone call, they finally agree to abate the penalties if I faxed them a copy of the complete tax return in question.
  • In talking with the agent, I found that they had been trained on some new procedures earlier in the year, and the TEFRA election was something they were looking at on all abatement requests.  In this case, their records were simply incorrect regarding the TEFRA election, but had I not had a copy of the 10 year old return to prove that it was an error, the IRS might not have been willing to abate the penalty – especially since their records department had taken over a month without finding the return.

Over the next few months, the 2011 batch of late filing penalty letters will be mailed out, so it is important to be aware of some of these new tactics being employed by the IRS.  The standard abatement letter using Rev. Proc. 84-35 is something any business owner can prepare and send to the IRS in response to an initial late filing penalty letter.  However, if you get a denial letter citing a TEFRA election or another similar reason, make sure you engage a tax professional or lawyer to fight the IRS for you.  The IRS is no longer rolling over when they get abatement letters, so be prepared.

Attention S Corporation and LLC Procrastinators

There is less than a month until the final extended deadline for 2011 S corporation and LLC tax returns, and it is crucial you file on time to avoid late filing penalties.  If you have not sent in your 2011 data to your CPA or tax preparer, you might want to work on it this weekend instead of enjoying the summer weather (or lack thereof if you are in Portland this morning).

I have written numerous posts about the S corporation late filing penalty that can only be abated if you have no prior late filing history, and the partnership penalty that the IRS has recently been making more difficult to abate.  If you have never read up on this topic or had to deal with this issue, please take a few minutes and click on the links above to read about the penalties, as they can amount to thousands of dollars in unnecessary, non-deductible costs for your business.

Even though there are automatic abatement procedures in place for entities taxed as partnerships, you should not assume that if it has worked for you in prior years that it will work in the future.  Last year, the IRS made changes to their internal procedures with regard to how they dealt with late filed partnership returns, and I had many abatements challenged or denied that had been approved in prior years.  You can read about some specific problems on my TaxQueries.com post, but I believe the IRS will continue making it more and more difficult for partnership filers that continue to file late each year.

Make finishing your 2011 accounting work a priority this weekend!  Not only will your tax preparer appreciate it, but not having potential penalties hanging over you is even better.

 

Family Employee Payroll Tax Exemption Clarified

The IRS recently issued temporary and proposed regulations that extend tax savings to family-owned businesses that employ their minor children and are organized as single-member limited liability companies.  Essentially, it is nothing more than a clarification on a position that many taxpayers were already taking, but it is worth mentioning, as it is an important tax planning strategy that can produce huge tax savings with the right circumstances.

If you have a business structured as a sole proprietorship or partnership, and you have children that could work in your business, you could be eligible for some big tax savings.  For example, if you paid them up to $5,800 each (the amount of the 2011 standard deduction), they would not be subject to:

  • Federal income taxes on the income,
  • Employee social security tax (4.2% in 2011), or
  • Any Medicare tax (1.45%).

In addition, your business would not have to pay the following taxes:

  • Employer social security tax (6.2%),
  • Employer Medicare tax (1.45%),
  • Federal unemployment tax (.008% on first $7,000 of wages), and
  • Possibly state unemployment tax and other state payroll taxes.

Not only is the payment exempt from almost all employee and employer payroll taxes, it also moves income that would have been taxed at your high marginal tax rate to your children’s rate, which in this case would be zero on the federal side.  Depending on the state, there may be a small amount of state income tax involved, but overall it is going to be very minimal in comparison to the tax that you would have paid at your marginal tax rate.

Better yet, the wages can be used to fund a Roth IRA, a college savings account, or school expenses that would have been paid with or without the payment for wages, so really it is a great benefit that doesn’t necessarily affect cash flow if you plan it out ahead of time.  Lastly, don’t forget the benefit of teaching your children work ethic and getting them involved in your business at a young age.  We work with many fourth-generation family-owned businesses, so this is an important benefit even without the tax exemption.

The Fine Print

What’s the catch?  Well, to make sure the payroll paid to your children will pass IRS scrutiny, the following steps need to be taken:

  • Your child actually has to perform the work,
  • The pay rate needs to be reasonable,
  • Actual paychecks have to be given to your child from the company, and
  • You need to document the work just like you would with any other hourly employee.

As to the type of work, it just needs to be ordinary and necessary for your business and reasonable considering the age of the child.  Have them clean your office or warehouse, file paperwork, or fill in on big projects that you would normally have to hire temporary workers for.  With today’s tech savvy teenagers, you can even have them help out with IT tasks or set up computers and devices.  Whatever you have them do, make sure you treat them just like an unrelated employee if you want to avoid problems with the IRS.

To qualify for exemption from employee and employer social security and Medicare taxes, your child has to be under the age of 18.  The exemption from federal unemployment tax lasts until they reach 21.  There are also many exceptions and details that apply depending on the type of business, and payroll tax reports and W-2s will have to be filed, so it is definitely something that you will need to discuss with your tax professional before starting.

The Recent Clarification by the IRS

Single-member limited liability companies (SMLLCs) are considered disregarded entities for tax purposes and are required to be reported on the member’s 1040 tax return using Schedule C, and up until this point the rules on this payroll tax exemption explicitly included sole proprietorships and partnerships.  The new proposed regulations now specifically include SMLLCs in the list of entities that can take the family employee tax exemption.  This is good news if you have a SMLLC and have been claiming the exemption, and for those that were hesitating because of the wording of the rule.

If you have a corporation, you are not eligible for the exemption; however, in most cases there would still be a tax benefit to paying wages to your children.

If you have a family-owned business in the Portland area and would like to find out more about this tax strategy and others like it, feel free to email or call me at 503.244.8844 to set up an appointment.

Accounting for Health Insurance Premiums

At this point in the year, many of you are now familiar with the Small Business Health Care Tax Credit.  If you qualified for the credit for 2010, you likely witnessed first hand all the extra information that is required for the credit calculation.  Below is an except from our recent newsletter on the tax credit.

Health Insurance Premium Bookkeeping
Much of the tax credit calculation revolves around eligible employee hours and wages; however, once an employer is determined to be eligible for the credit, much more information is needed with regards to the employer’s health insurance premiums.  Fortunately, a few simple procedural bookkeeping changes can greatly simplify this portion of the calculation:

  • Classification of owner and family member insurance – when posting health and dental insurance premium payments, make sure premiums for owners and their family members are posted to a separate sub-account of employee benefits.  These premiums are not included in the calculation, so it is important that they be separated.
  • Premiums for seasonal workers – even though it is important to classify seasonal worker wages and hours separately from eligible employees, their premiums are actually included in the calculation, so make sure their premiums are included with those for eligible employees.
  • Record coverage information in books – in order to finish the calculation, you have to report the type of coverage (single or family) and the number of employees with each coverage type.  To simplify this final step, be sure to note this information in the “memo” field in your books when recording the premium payment.  Typically, this information is provided on the bill from the insurance company, and it is much easier to record this each month than pull all the bills at year end.

For general information on the Small Business Health Care Tax Credit, refer to our post from last year.

Self-Employed Health Insurance Deduction Enhanced

When the Small Business Jobs Act (SBJA) came out in late September, I posted about this deduction on Twitter; however, I never had time to post a full summary because of the tax deadline.  Well, the tax deadline is history and it is time to start looking at some of the new tax changes passed this year and get ready to year-end tax planning.

This was my favorite tax change so far this year – especially since I recently joined the ranks of the self-employed – and it basically allows a self-employed individual to get the same type of pre-tax treatment for health insurance that is available to employees under 125 plans.  Under the SBJA, the self-employed health insurance deduction now reduces self-employment tax in addition to ordinary tax.  This is a great extra tax reduction for sole proprietors and active partnership and LLC/LLP owners.

What would this look like?  Let’s take an active member in a profitable LLC that pays family health insurance premiums of $1,200/month.  Under old rules, the total health insurance premiums for the year of $14,400 would be a deduction on the front of the 1040 on line 29; however, this would only be a deduction against ordinary tax.  Under the new rule, the LLC member would save approximately $2,000 in self-employment tax.  This is a great benefit as long as there is net income and some self-employment tax to offset, and it is definitely needed as small business owners usually pay fairly large monthly premiums for health insurance.

Even better – the new tax rule applies to the self-employed taxpayer’s first tax year beginning after December 31, 2009.  This means that when you are doing your year-end tax planning for 2010, you may find that you have an extra tax deduction this time around.

Read more about this deduction and the SBJA

Small Business Health Care Tax Credit

With all the new incentives out there for employers and recent tax law changes, most small business owners are likely feeling a little overwhelmed.  Between the COBRA subsidy, the HIRE act, and the new incentives & changes from the Health Care Reform Act – being an employer has become much more complicated.  In fact, if you are not keeping up on the changes and planning ahead – you could be missing out some credits and incentives that are available to your business.

One of the specific credits from the Health Care Reform Act that requires some current planning in 2010 is the Small Business Health Care Tax Credit, which is a 35% tax credit based on premiums paid to cover employees.  As the name suggests, you have to be a small business – one with fewer than 25 full-time employee equivalents (FTEs).  In addition, you have to pay average annual wages below $50,000 per FTE.  Lastly, as the employer, you have to pay health insurance premiums under a “qualifying arrangement”, which in simple terms means you pay a uniform percentage of not less than 50% of the premium cost of coverage for each enrolled employee.

I probably lost many business owners right there; however, after reading the fine print in the law you may find that you qualify after all.  The most important fine print: wages paid to business owners or their family members are not included in calculating the average wages or the number of employees.  This is very good news for corporations as the shareholder wages would have likely made most ineligible for the credit right off the bat.  This could work out well for small, family-owned businesses that provides health insurance and employs a number of non-family employees.

Then we hit the final hurdle – as an employer, do you pay at least 50% of the premium cost of coverage for all your employees?  Even if you do not pay a full 50% or even provide this employee benefit at all, you should at least run the calculation to see what your potential benefit would be.  It may be worth looking into.  Not only do you get a tax credit, but in this economy, such an employee benefit could be given in lieu of pay increases.

To calculate you potential tax credit, check out the calculator at smallbusinessmajority.org.

More detailed information on the tax credit:
IRS Q&A Page on the Small Business Health Care Tax Credit
White House Summary & Fact Sheet

2009 Year-End Tax Planning – Part 2

Year-End Tax Planning for Small Business Owners

For 2009, there are plenty of year-end tax planning opportunities available to the small business owner.  Some new provisions help businesses that have been dramatically affected by the recession while others help businesses that have had very a profitable year.  Below is a general overview of several of the more important planning opportunities.

Bonus Depreciation:

Many companies used the bonus depreciation provision in 2008; however, due to the current economic conditions, business owners are much more restrained with regard to capital expenditures than in prior years.  Nick Parsons, one of the partners at our firm, recommends concentrating on capital purchases that are needed and will help generate more profit for the business rather than just purchasing for the sake of tax savings.  He also recommends looking at purchases that will need to be made in the next five to six months and accelerating those purchases if possible before year-end.  Even if the business had a poor year, bonus depreciation could produce a tax loss and actual tax refunds with the new net operating loss carryback rules (see below).

Bonus Depreciation details:

  • Only available for NEW property, 20 year class life or less
  • Provision is scheduled to expire after 2009
  • Must be placed in service before year-end

Code Section 179 Depreciation:

Businesses with net taxable income are taking advantage of the new limits on 179 depreciation ($250k), which allow you to write-off the entire cost of the fixed asset within the year of purchase.  However, many businesses are looking at losses this year, so the bonus depreciation can be a better option.  Regardless, using the right mix of bonus and 179 depreciation can create a net operating loss that can be carried back five years under the new rules (see below).

One minor detail to keep in mind – unlike bonus depreciation, the property does not have to be new to qualify for 179 depreciation.

Vehicle Depreciation:

If a business is looking to buy a new vehicle in the next six months, accelerating the purchase before year-end could be very beneficial.  The luxury auto depreciation limits have been increased from $2,960 to $10,960 through 2009 thanks to bonus depreciation rules.  There are different rules for trucks, vans, and SUVs, but for a typical passenger car used more than 50% in business – this provides great tax savings.

Five Year Carryback of Net Operating Losses:

Many businesses affected by the recession have been able to make use of the expanded net operating loss carryback rules for the 2008 tax year, and many received substantial cash refunds that helped them with current cash flow problems.  Now the carryback rules have been extended for 2009 tax losses, which should bring some more immediate help.  However, the rules are a little more complicated this time around:

  • For 2008, the expanded carryback was only applicable to businesses with gross receipts under $15 million.  The net operating loss could be carried back up to five years and there were no further complications.
  • For 2009, the rule is expanded for all businesses, however, there are complications:
    • For businesses under the $15 million gross receipts limit, the 2009 NOL can be carried back up to 5 years even if the 2008 NOL was carried back under the prior rule.  The only difference is that for 2009, you can only use ½ of the taxable income in the fifth year.
    • For businesses over $15 million in gross receipts, they can use the extended NOL carryback for 2008 OR 2009, but not both years.  Also, like with small businesses, they can only use ½ of the taxable income in the fifth year.

Solo 401k Contributions / Profit – Sharing:

For small business owners that had a good year and are looking for tax deductions while putting away for retirement, the solo 401k is an excellent vehicle that many ignore because of the extra reporting requirements.  Small, family-owned businesses often use the SIMPLE IRA plan to put away up to $11,500 ($14,000 age 50 & older) under the 2009 limits.  However, given sufficient self-employment income, the same small business owner can put away up to $49,000 ($54,500 age 50 & older) using a solo 401k plan and also make the same contribution for the business owner’s spouse if they are involved in the business.  The are special requirements for the solo 401k, so it is definitely something you need to speak with a professional about before opening an account.  However, even if the solo 401k is not an option for you, there are other 401k plans that would still save you much more than with a SIMPLE IRA plan.

Office In Home and Mileage Deductions

There is often a lot of confusion surrounding an office in home and the mileage deduction and the difference between commuting and business miles.  I have heard many accountants over the years selling the deductions like in an infomercial, claiming that by simply setting up an office in the home used exclusively for the business that it will amazingly increase their auto deduction by 60%.  Plus, if you act now, they will throw in an exclusive tax table mouse pad and two free months of the tax savings newsletter…

Seriously though, while an office in home can increase your auto deduction in many cases, it is unfortunately not that simple – as is the case with the majority of IRS rules.  It is very important you understand all the requirements so that you can maximize your deduction without exposing yourself to audit risk.

I am not going to get into the details of business vehicle expenses in this post, but in general terms, business use of a vehicle does not includes personal or commuting miles.  Whether you use the standard mileage rate or the actual expense method, your deduction is limited to actual business use – which will be calculated based on your mileage log or reports from your mileage calculator app (for you iPhone enthusiasts).  For your standard business owner with rented office space outside the home who does not perform substantial administrative and management activity from a home office, the miles to and from the office each day are not deductible.  Depending on the business owner’s commute, this can be a significant portion of overall vehicle use, so you can see why this is a crucial issue.

How can these commuting miles be turned into business miles?

Well, it can be a bit complex when reading IRS Pub 587 as there are many requirements and exceptions, so I set up this office in home deduction mind map using FreeMind software, which walks through the first few pages of IRS Pub 587 and lays everything out visually.  If you look at the first three requirements, you’ll notice that you have probably heard about them before if you have a general understanding of the office in home.  Exclusive, regular, and business use are usually what most people focus on because the classic example you think of with office in home is the sole proprietor who uses their home as the sole business location.  However, most small or micro-businesses have office space at a location outside the home, so the fourth requirement that the home office be the principle place of business is the most crucial issue.  If this requirement can be met either through an exception or by re-arranging your business operations, then you have a qualifying office in home and mileage from that office to other business locations would qualify as business mileage.

How can you satisfy the principle place of business requirement?

In order for your home office to be considered the principle place of business, it must be used exclusively and regularly for administrative and management activities including:

  • Billing customers, clients, or patients
  • Keeping books and records
  • Ordering supplies
  • Setting up appointments
  • Forwarding orders or writing reports

This means that it must be the only location that these administrative and management activities are conducted.  However, there are some exceptions to this rule and situations where it is permissible for these activities to be performed outside of the office in home :

  • service providers can conduct administrative activities at other locations (payroll service, etc);
  • management and administrative work done in a non-fixed location like a car or hotel room is permissible;
  • administrative activities can be conducted at a fixed location outside the home office if occasional and minimal;
  • substantial non-administrative, non-management activities can be performed outside the home;
  • and even if suitable space is available outside the home for administrative and management activities, you can still choose the home office as the primary location for these activities.

If your home office does not qualify for any of these exceptions and is not the principle place of business, there are still two more exceptions that could help you:

  • If you physically meet with clients, patients, or customer in you home office – and it is substantial and integral to your business;
  • or your home office is a separate structure from the dwelling unit.

Meeting either of these exceptions will qualify your office in home even though it is not the principle place of business.  Again, this would make your mileage from the home office to the other business office deductible as business miles.  This can create significant tax savings, but you have to make sure you have a solid position as this issue does often come up in IRS audits.

Let’s look at an example…

Dr. Bob is a dentist who has two dental offices in the metro area and his commute is significant since he lives far outside the city.  Without a qualifying office in home, the commute to the an office and the commute home are personal and are non-deductible commuting miles.  Any trips made between the offices or for other business purposes during the day are deductible, but that long commute that is a majority of the miles driven is personal.

Now let’s assume that Dr. Bob has a large bonus room that he converts into a home office.  The office is not separate from his house, and he does not meet with patients at his home (for a number of reasons), so he must make the home office be the only place for administrative and management activities or meet one of the exceptions.  If Dr. Bob uses a third party service provider for billing and factoring, he and his wife complete the bookkeeping in QuickBooks at the home office, and his wife sets up appointments from the home office – then I think he would have a very solid position for a qualifying office in home and the mileage from the home office would be deductible.  However, if all the billing is done internally at one or both of the dental offices, or if an internal bookkeeper does a majority of bookkeeping at one of the dental offices, or the office managers at the two offices setup up all the appointments – then I think Dr. Bob is going to have a very weak case for arguing that his home office is the principle place of business.

Every case is going to be different and most business owners are not going to have clear-cut circumstances like our Dr. Bob; however, it is very important you go over this in detail with your CPA or accoutant to make sure you have a solid position for the auto expenses you are claiming.  With the technology available today, many business owners should be able to arrange their business so that the requirements are met.

If you like to discuss this with me or need help in laying out a strategy to maximize your tax deductions, feel free to email or call me at 503.244.8844 to find out more about our consulting services.