Protect your business with meticulous records

If you run a business, you know that you need to support expenses with detailed records. To be deductible, every expense on your tax return might have to be defended if your company is subject to an audit. Plus, failing to operate in a businesslike manner, complete with good records,  might lead the IRS to deem the activity a hobby rather than a business — and your expenses may be limited or disallowed.

While there’s no one right way to keep business records, some types of expenses do require more details. For example, records relating to automobile expenses, travel, meals and office-at-home costs are subject to special requirements or limitations.

To claim deductions, an activity must be engaged in for profit

For a business expense to be deductible, the taxpayer must establish that the primary objective of the activity is making a profit. The expense must also be substantiated and be an “ordinary and necessary” business expense. In one court case (Gaston v. IRS, 2021), a taxpayer claimed deductions that created a loss, which she used to shelter other income from tax.

She engaged in various activities that included acting in the entertainment industry and selling jewelry. The IRS found her activities were more like hobbies than businesses engaged in for profit and it disallowed her deductions.

The taxpayer did, however, have some success when she took her case to the U.S. Tax Court. The court found that she was engaged in the business of acting for profit during the years at issue, though not all of the claimed expenses were ordinary and necessary business expenses. The court allowed deductions for expenses including headshots, casting agency fees and lessons to enhance the taxpayer’s acting skills. But the court disallowed other deductions because it found insufficient evidence “to firmly establish a connection” between the expenses and the business.

In addition, the court found that that taxpayer didn’t prove that she engaged in her jewelry sales activity for profit. She didn’t operate it in a businesslike manner, spend sufficient time on it or seek out expertise in the jewelry industry. Therefore, all deductions related to that activity were disallowed.

We can help

Contact us if you need assistance retaining adequate business records. Taking a meticulous, proactive approach can protect your deductions and prevent the IRS from viewing your business as a hobby.

Sidebar:

Proper records are required

In another case, a taxpayer worked as a contract emergency room doctor at a medical center. He also started a business to provide emergency room physicians overseas. On Schedule C of his tax return, he deducted expenses related to his home office, travel, driving, continuing education, cost of goods sold and interest. The IRS disallowed most of the deductions.

In U.S. Tax Court, the doctor used charts to illustrate his expenses but didn’t provide receipts or other substantiation showing the expenses were actually paid. He also failed to account for the portion of expenses attributable to personal activity.

The court disallowed the deductions, stating that his charts weren’t enough and didn’t substantiate that the expenses were ordinary and necessary in his business. It noted that “even an otherwise deductible expense may be denied without sufficient substantiation.” The doctor also didn’t qualify to take home office deductions because he didn’t prove it was his principal place of business. (Elbasha v. IRS, 2022)

  © 2023

Qualifying for the home office deduction

In recent years, many people have pivoted to working from home, and that brings up tax questions. If you’re one of those people, you might wonder, “Can I claim the home office deduction on my 2022 tax return?”

The short answer is: only if you’re self-employed. Employees can’t currently claim home office expenses, and even self-employed taxpayers must follow strict rules to claim deductions.

Numerous write-offs

If you qualify, you can deduct the “direct expenses” of a home office. This includes the costs of painting or repairing the home office and depreciation deductions for furniture and fixtures used there. You can also deduct the “indirect” expenses of maintaining the office. This includes the allocable share of utility costs, depreciation and insurance for your home, as well as the allocable share of mortgage interest, real estate taxes and casualty losses.

In addition, if your home office is your “principal place of business,” the eligible costs of traveling between your home office and other work locations are deductible transportation expenses, rather than nondeductible commuting costs.

Tests for deductibility

You can deduct your expenses if you meet any of these three tests:

  1. Principal place of business.You’re entitled to deductions if you use your home office, exclusively and regularly, as your principal place of business. Your home office is your principal place of business if it satisfies one of two tests. You satisfy the “management or administrative activities test” if you use your home office for administrative or management activities of your business, and you meet certain other requirements. You meet the “relative importance test” if your home office is the most important place where you conduct business, compared with all the other locations where you conduct that business.
  2. Meeting place.You’re entitled to home office deductions if you use your home office, exclusively and regularly, to meet or deal with patients, clients or customers. The patients, clients or customers must physically come to the office.
  3. Separate structure.You’re entitled to home office deductions for a home office, used exclusively and regularly for business, that’s located in a separate unattached structure on the same property as your home. For example, this could be in an unattached garage, artist’s studio or workshop.

You may also be able to deduct the expenses of certain storage space for storing inventory or product samples. If you’re in the business of selling products at retail or wholesale, and if your home is your sole fixed business location, you can deduct home expenses allocable to space that you use to store inventory or product samples.

Know the limitations

The amount of home office deductions for self-employed taxpayers is subject to various limitations. Proper planning is key to claiming the maximum deduction for your home office expenses. Contact us if you’d like to discuss your situation.

  © 2023

Throwing snowballs at a mountain of debt

Many people start the year intending to get out of debt, yet end the year owing just as much, if not more. One approach that might yield success is called “throwing snowballs.”

Under this method, you organize your debts from the lowest balance to the highest balance and begin paying off the debt on top of the list. The idea is to throw as many “snowballs” as you can at that first creditor until the debt is gone.

While you hurl these snowballs, pay the minimum amount to your other creditors. With this strategy, you should avoid trying to send an extra $20 or so a month to each one. If you want to contribute extra money, throw it at your primary target.

Once the first debt is paid off, you should have even more money to send to the next one. Over time, you can start heaving bigger and bigger snowballs at the remaining targets because, as you pay off each debt, you’ll have more money to pay toward remaining debts.

The objective is to start an avalanche of payoffs until your debts disappear. Under this method, the best predictor of success isn’t the number of dollars you pay off but rather the number of accounts that you close.

Please note: There’s some debate on the practicality of throwing snowballs. Opponents argue that you should first pay off debts with the highest interest rates. We can help you plan a debt-reduction strategy that’s right for you.

  © 2023

6 key tax Q&As for 2023

Right now, you may be more concerned about your 2022 tax bill than you are about how to handle your personal finances in the new year. However, as you deal with your annual tax filing, it’s a good idea to also familiarize yourself with pertinent amounts that may have changed for 2023.

Not all tax figures are adjusted for inflation. And even if they are, during times of low inflation the changes may be slight. When inflation is higher, as it currently is, the changes are generally more substantial. In addition, some tax amounts can change only with new tax legislation. Here are six commonly asked (and answered) Q&As about 2023 tax-related figures:

  1. How much can I contribute to an IRA for 2023? If you’re eligible, you can contribute up to $6,500 a year to a traditional or Roth IRA (up from $6,000 in 2022). If you’re age 50 or older, you can make another $1,000 “catch-up” contribution.
  2. I have a 401(k) plan through my job. How much can I contribute to it? For 2023, you can contribute up to $22,500 to a 401(k) or 403(b) plan. You can make an additional $7,500 catch-up contribution if you’re age 50 or older. (These figures for 2022 were $20,500 and $6,500, respectively).
  3. I sometimes hire a babysitter and a cleaning person. Do I have to withhold and pay FICA tax on the amounts I pay them? In 2023, the threshold for when a domestic employer must withhold and pay FICA for babysitters, house cleaners and other domestic employees has increased to $2,600 for 2023 (up from $2,400).
  4. How much do I have to earn in 2023 before I can stop paying Social Security on my salary? The Social Security tax wage base is $160,200 for 2023, up from $147,000 for 2022. That means that you don’t owe Social Security tax on amounts earned above that. (You must pay Medicare tax on all amounts that you earn.)
  5. I didn’t qualify to itemize deductions on my last tax return. Will I qualify for 2023? The Tax Cuts and Jobs Act eliminated the tax benefit of itemizing deductions for many people by increasing the standard deduction and reducing or eliminating various deductions. For 2023, the standard deduction amount is $27,700 for married couples filing jointly (up from $25,900 for 2022). For single filers, the amount is $13,850 (up from $12,950) and, for heads of households, it’s $20,800 (up from $19,400).

So, if the total amount of your itemized deductions (such as charitable gifts and mortgage interest) is less than the applicable standard deduction amount, you won’t itemize for 2023.

  1. How much can I give to one person without triggering a gift tax return in 2023? The annual gift exclusion for 2023 is $17,000 (up from $16,000 in 2022). This amount is only adjusted in $1,000 increments, so it typically increases only every few years.

These are only some of the tax figures that may apply to you. For more information about your tax picture, or if you have questions, don’t hesitate to contact us.

  © 2023

Are you at risk for investment fraud?

Many perpetrators of investment fraud know how to push the right psychological buttons to entice their “marks” to buy worthless or nonexistent securities. You can mitigate the risks by asking a few questions, performing some research and consulting with trusted advisors.

Beware

Be alert for these common scams:

Pyramid and Ponzi. The con artist promises high returns, often in a short period, yet there’s no actual investment product. Instead, the scheme relies on continually recruiting new participants whose money is used to pay “returns” to earlier participants. As the scheme grows, it becomes increasingly difficult to attract enough new investors and pay old ones. Eventually it collapses and most participants lose everything.

Pump and dump. Fraudsters use false or misleading statements to recruit investors and boost the price of an obscure and usually low-priced stock. When the stock rises to a certain level, the crooks dump their shares and disappear. The stock price plummets, leaving investors with nearly worthless holdings.

Advance fee. Individuals holding a failed investment are targeted. A fraudster may offer, for example, to take a losing stock off your hands for an attractive price provided you pay an up-front fee. Once you pay the fee, the thief vanishes.

Know the signs

Be suspicious of investments that offer guaranteed returns or remarkably consistent returns even during turbulent times. Avoid unregistered securities sold by unlicensed individuals or investments that lack documentation (for example, a prospectus).

You can verify a professional’s credentials with the U.S. Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) and state securities agencies. If you’re tempted to invest with an unknown “broker” or buy an unfamiliar stock, FINRA’s website (finra.org) offers a variety of points to double-check before engaging in the transaction.

Most investments must be registered before they can be sold to the public, so plug the security’s name into the SEC’s EDGAR database (sec.gov/edgar.shtml). Keep in mind that registration alone doesn’t guarantee that an investment is legitimate or appropriate.

Defend!

Ultimately, the best defense against investment fraud is to work with financial advisors you know and trust. If you receive a “hot tip,” always run it by at least one trusted advisor before plunking down any money.

  © 2023

Are you at risk of retirement plan leakage?

Generally, the term “leakage” has negative connotations. So, it’s not surprising that the same is true in the context of retirement planning, where leakage refers to pre-retirement early withdrawals from a retirement account. Now, as a business owner who sponsors a qualified retirement plan, you might say, “Well, that’s my participants’ business. Not mine.”

However, there are valid reasons to address the issue with employees who participate in your plan.

Does it matter?

For starters, leakage can lead to higher plan expenses. Fees are often determined on a per-account or per-participant basis. When a plan loses funds to leakage, total assets and individual account sizes shrink, which tends to hurt administrative efficiency and raise costs.

More broadly, if your employees are taking pre-retirement withdrawals, it could indicate they’re facing unusual financial challenges. These issues may have a negative impact on productivity and work quality and leave them unable to retire when they planned to.

The stress surrounding COVID-19 may account for part of the financial need. And more recently, the “Great Resignation” could lead some workers to draw out retirement funds to live on or use to start a business of their own.

What can you do?

The most important thing business owners can do to limit leakage is to educate and remind employees about how pre-retirement withdrawals can diminish their accounts and delay their anticipated retirement dates. While you’re at it, consider providing broader financial education to help workers better manage their money, amass savings, and minimize or avoid the need for early withdrawals.

Some companies offer emergency loans that are repayable through payroll deductions to reduce the use of retirement funds. Others have revised their plan designs to limit the situations under which plan participants can take out hardship withdrawals or loans.

Can you eliminate the problem?

“Roughly 22% of net contributions made by those 50 or younger leaks out of the retirement savings system in a given year,” according to a 2021 report by the Joint Committee on Taxation. Some percentage of retirement plan leakage will probably always occur to some extent, but becoming aware of the problem and taking steps to minimize it are still worthwhile for any business.  We can answer questions you might have about leakage or other aspects of plan administration and compliance.

  © 2023

Smooth sailing: Tips for easier navigation through tax season

The IRS generally begins accepting the previous year’s individual tax returns in late January. Here are quick tips you can use to help speed tax processing and avoid hassles.

For starters, contact us soon for your tax preparation appointment. Gather all documents needed to prepare an accurate return, including W-2s, 1099 forms, and statements of interest paid or received. Failure to provide all of this information means a return is incomplete, which may then require additional processing and delay any refund that’s due.

Be accurate. Ensure that every name on your tax return is spelled correctly, and that each Social Security number on the return matches the number on the Social Security card. If you supply a bank account number, double check it.

Possible penalties

What if you file late or can’t pay your tax bill? Separate penalties apply for failing to pay and failing to file. Both are based on a percentage of the unpaid or late taxes. You can avoid late filing by obtaining an extension of the time to file (until October 16 this year). However, you must still pay any taxes due by the regular deadline or face possible penalties.

These penalties can be quite severe, but if the lateness occurs for a “reasonable cause,” such as illness, the IRS may excuse it. Contact us with your questions.  

What’s your taxpayer filing status?

For many people, December 31 means a New Year’s Eve celebration. However, from a tax perspective, it means thinking about the filing status you’ll use when filing your tax return for the year. The one you use depends partly on whether you’re married on that date.

The five statuses

When you file your federal tax return, you do so with one of five filing statuses. First, there’s “single” status, which is generally used if you’re unmarried, divorced or legally separated. A second status, “married filing jointly,” is for married couples who file a tax return together. If your spouse passes away, you can usually still file a joint return for that year. A third status, “married filing separately,” is for married couples who choose to file separate returns. In some cases, doing so may result in less tax owed.

“Head of household” is a fourth status. Certain unmarried taxpayers qualify to use it and potentially pay less tax. Finally, there’s a fifth status: “qualifying widow(er) with a dependent child.” It may be used if your spouse died during one of the previous two years and you have a dependent child. (Other conditions apply.)

Head of household

Let’s focus on head-of-household status because it’s often misunderstood and can be more favorable than filing as a single taxpayer. To qualify, you must “maintain a household” that, for more than half the year, is the principal home of a “qualifying child” or other relative that you can claim as a dependent.

A qualifying child is defined as someone who lives in your home for more than half the year and is your child, stepchild, foster child, sibling, stepsibling or a descendant of any of these. A qualifying child must also be under 19 years old (or a full-time student under age 24) and be unable to provide over half of his or her own support for the year.

Different rules may apply if a child’s parents are divorced. Also, a child isn’t a qualifying child if he or she is married and files jointly or isn’t a U.S. citizen or resident.

For head-of-household filing status, you’re considered to maintain a household if you live in it for the tax year and pay more than half the cost of running it. This includes property taxes, mortgage interest, rent, utilities, property insurance, repairs, upkeep and food consumed in the home. Medical care, clothing, education, life insurance and transportation aren’t included.

Under a special rule, you can qualify as head of household if you maintain a home for a parent even if you don’t live with the parent. To qualify, you must be able to claim the parent as your dependent.

Not always obvious

Filing status may seem obvious, but there can be situations when it warrants careful consideration. If you have questions about yours, contact us.

Sidebar: Can you be married and a head of household?

You must generally be unmarried to claim head-of-household status. However, if you’ve lived apart from your spouse for the last six months of the year, you have a qualifying child living with you and you maintain the household, you’re typically considered unmarried. In this case, you may be able to qualify as head of household.

  © 2022

The pros and cons of NQDC plans

Nonqualified deferred compensation (NQDC) plans allow participants to set aside large amounts of tax-deferred compensation while enjoying the flexibility to schedule distributions to align with their financial goals. However, the plans aren’t without risks so before you jump in, consider the pros and the cons.

What makes an NQDC plan different?

NQDC plans differ significantly from qualified defined contribution plans. The latter allows employers to contribute on their employees’ behalf and employees to direct a portion of their salaries into segregated accounts held in trust.

In addition, qualified defined contribution plans generally allow participants to direct their  investments among the plan’s available options. The plans are subject to the applicable requirements of the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. This includes annual contribution limits, early withdrawal penalties, required minimum distributions and nondiscrimination rules.

By contrast, an NQDC plan is simply an agreement with your employer to defer a portion of your compensation to a future date or dates. Many NQDC plans provide for matching or other employer contributions, while some permit only employer contributions. Such contributions may be subject to a vesting schedule based on years of service, performance or the occurrence of an event (such as a sale).

To avoid current taxation, NQDC plans must not be “funded,” and they can’t escape your employer’s creditors. The plan is secured only by your employer’s promise to pay. It’s possible to secure funds in a special trust, but they remain subject to creditors’ claims.

What are the pros?

Like qualified plans, NQDC plans allow you to defer income taxes on compensation until you receive it — although you may have to pay FICA taxes in the year the compensation is earned. NQDC plans also offer some advantages over qualified plans. That is, they may have no contribution limits.  Participants may enjoy greater flexibility to schedule distributions to fund financial goals such as retirement, without penalty for distributions before age 59½ or required distributions at a certain age.

From an employer’s perspective, NQDC plans are attractive because they can be limited to highly compensated employees and they don’t require compliance with ERISA’s reporting and administrative specifications. However, unlike contributions to qualified plans, deferred compensation isn’t deductible by the employer until it’s paid.

And the cons?

The biggest disadvantage of NQDC plans for participants is that deferred compensation isn’t shielded from the claims of the employer’s creditors, possible bankruptcy or insolvency. Also, you may not be able to take loans from the plan and can’t roll over distributions into an IRA, qualified plan or other retirement account. What’s more, there are limitations on the timing of deferral elections.

Is it right for you?

An NQDC plan offers attractive benefits, but it can be risky. Contact our firm to discuss how such a plan might affect your financial situation or whether it’s right for your company.

  © 2022

Have you considered a cost segregation study?

Because of the economic impact of inflation, many companies may need to conserve cash and not buy much equipment this year. As a result, you may not be able to claim as many depreciation tax deductions as in the past. However, if your company owns real property, there may be another approach to depreciation to consider: a cost segregation study.

Depreciation basics

Business buildings generally have a 39-year depreciation period (27.5 years for residential rental properties). Typically, companies depreciate a building’s structural components — including walls, windows, HVAC systems, plumbing and wiring — along with the building. Personal property (such as equipment, machinery, furniture and fixtures) is eligible for accelerated depreciation, usually over five or seven years. And land improvements, such as fences, outdoor lighting and parking lots, are depreciable over 15 years.

Often, businesses allocate all or most of their buildings’ acquisition or construction costs to real property, overlooking opportunities to allocate costs to shorter-lived personal property or land improvements. Items that appear to be “part of a building” may in fact be personal property. Examples include removable wall and floor coverings, removable partitions, awnings, canopies, window treatments, signs and decorative lighting.

Pinpointing costs

A cost segregation study combines accounting and engineering techniques to identify building costs that are properly allocable to tangible personal property rather than real property. Although the relative costs and benefits of a cost segregation study will depend on your particular facts and circumstances, it can be a valuable investment.

It may allow you to accelerate depreciation deductions on certain items, thereby reducing taxes and boosting cash flow. And, thanks to the Tax Cuts and Jobs Act, the potential benefits of a cost segregation study are even greater than they were years ago because of enhancements to certain depreciation-related tax breaks.

Worth a look

Cost segregation studies have costs all their own, but the potential long-term tax benefits may make it worth your while to undertake the process. Contact our firm for further details.

  © 2022