You’ve got a sharp pencil, a calculator and your tax forms—and a stack of receipts that you hope will reduce your tax burden. But take care: deducting the wrong things can land you in some seriously hot water.
“Some people think they can deduct all the utilities they use in their home because they have a home office. They think they can write off the entire family vacation because they stopped in to see one supplier during a seven-day trip,” says Karen Summerhays, CPA with The Summerhays Group. The IRS allows deduction of “ordinary and necessary” expenses for legitimate businesses, but excessive deductions can lead to audits—or even charges of fraud.
“The IRS uses ‘dif scores’ to compare income and expenses on a particular tax return to income and expenses on tax returns of similar sizes, locations and types of businesses,” explains Summerhays. “If a return does not fall within the ‘dif score’ averages, an audit is more likely.”
So writing off that vacation to Disneyland may trigger an audit. And if the audit reveals under-reporting of taxable income, the IRS can charge penalties and interest from the date the tax was due. “Since the IRS is still auditing 2008 returns, the interest alone could be substantial,” she says. “If the under-reporting exceeds 25 percent, the IRS can prosecute for fraud.”
Hot Button Issues
“Tax professionals keep track of the IRS’s current hot button issues,” says Summerhays. “For the past couple of years, the IRS has been particularly sensitive about owners of S corporations not taking enough wages.” Business owners using S corporations must pay themselves a reasonable salary and withhold employee taxes from that salary. They can then pay any remaining profit in the form of shareholder distributions, from which employee taxes need not be withheld.
The IRS may challenge shareholder salaries as “unreasonable” if they do not match prevailing rates of compensation for comparable positions, current economic conditions, and the nature, extent and scope of the employee’s work. For instance, the president of a company that nets several million dollars in annual profit who pays himself $50,000 in wages but takes home $400,000 in distributions might well face an IRS challenge.
“Another sensitive area is deduction of insurance premiums,” Summerhays explains. “Generally, small business owners cannot deduct premiums for life or disability insurance, and even deducting health insurance premiums can be tricky.”
Abusive Tax Schemes
The IRS has published examples of abusive tax schemes used by home-based businesses. Portions of that list include:
• Travel—Deducting travel, meals and entertainment under the guise that everyone is a potential client.
• Cars—Excessive car and truck expenses when the asset has been used for both business and personal use.
• Payments to Family Members—Deducting payments to family members for routine household tasks that are not ordinary and necessary to the operation of the business, such as taking out the trash, washing the car, answering the telephone, etc. Also, payments to family members that are excessive in relation to the services performed.
• Business Use of Home—A deduction for the business use of a home is limited to that area of the home that is used regularly and exclusively for business purposes. Promoters incorrectly claim that the “exclusive use” restriction can be avoided by placing business-related items in each room of the house.
• Medical Reimbursement Plans—Some have claimed that taxpayers can make their family’s medical expenses 100 percent deductible merely by employing their family members. But in order for the medical expenses to be deductible under a self-insured medical reimbursement plan, a bona fide employer-employee relationship must exist. In addition, the plan has to meet other requirements.
“Owners and employees of large businesses have many of the same issues with business expenses that small business owners have,” Summerhays explains. For instance, in the age of telecommuting, deductibility of home office expenses is an issue for owners and employees of all sizes of business.
When a trip involves both business and pleasure, the business activities should be carefully recorded. For instance, the round-trip airline expenses of a trip to Florida can be deducted if the primary purpose of the trip is business, but if the primary purpose of the trip is recreation, only the specific business activities in Florida can be deducted.
“When a car is used for both business and personal use, a mileage log is important to document the business miles,” she says.
IRS priorities shift and regulations change. To deduct as many expenses as possible without committing tax fraud, business owners and employees must either stay up-to-date on the tax laws themselves, or else hire a tax expert.
Publications from the IRS website are surprisingly clear and can help untangle deduction complexities. Some examples: Publication 587 on Home Offices and Publication 463 on Travel, Entertainment, Gift, and Car Expenses.