Small Business Tax Briefs: May 2018
IRS Audit Techniques Guides provide clues to what may come up if your business is audited
IRS examiners use Audit Techniques Guides (ATGs) to prepare for audits — and so can small business owners. Many ATGs target specific industries, such as construction. Others address issues that frequently arise in audits, such as executive compensation and fringe benefits. These publications can provide valuable insights into issues that might surface if your business is audited.
What do ATGs cover? The IRS compiles information obtained from past examinations of taxpayers and publishes its findings in ATGs. Typically, these publications explain:
- The nature of the industry or issue,
- Accounting methods commonly used in an industry,
- Relevant audit examination techniques,
- Common and industry-specific compliance issues,
- Business practices,
- Industry terminology, and
- Sample interview questions.
By using a specific ATG, an examiner may, for example, be able to reconcile discrepancies when reported income or expenses aren’t consistent with what’s normal for the industry or to identify anomalies within the geographic area in which the taxpayer resides.
What do ATGs advise? ATGs cover the types of documentation IRS examiners should request from taxpayers and what relevant information might be uncovered during a tour of the business premises. These guides are intended in part to help examiners identify potential sources of income that could otherwise slip through the cracks.
- Other issues that ATGs might instruct examiners to inquire about include:
- Internal controls (or lack of controls),
- The sources of funds used to start the business,
- A list of suppliers and vendors,
- The availability of business records,
- Names of individual(s) responsible for maintaining business records,
- Nature of business operations (for example, hours and days open),
- Names and responsibilities of employees,
- Names of individual(s) with control over inventory, and
- Personal expenses paid with business funds.
For example, one ATG focuses specifically on cash-intensive businesses, such as auto repair shops, check-cashing operations, gas stations, liquor stores, restaurants and bars, and salons. It highlights the importance of reviewing cash receipts and cash register tapes for these types of businesses.
Cash-intensive businesses may be tempted to underreport their cash receipts, but franchised operations may have internal controls in place to deter such "skimming." For instance, a franchisee may be required to purchase products or goods from the franchisor, which provides a paper trail that can be used to verify sales records.
Likewise, for gas stations, examiners must check the methods of determining income, rebates and other incentives. Restaurants and bars should be asked about net profits compared to the industry average, spillage, pouring averages and tipping.
Avoiding red flags. Although ATGs were created to enhance IRS examiner proficiency, they also can help small businesses ensure they aren’t engaging in practices that could raise red flags with the IRS. To access the complete list of ATGs, visit the IRS website. And for more information on the IRS red flags that may be relevant to your business, contact us.
Can you deduct business travel when it’s combined with a vacation?
At this time of year, a summer vacation is on many people’s minds. If you travel for business, combining a business trip with a vacation to offset some of the cost with a tax deduction can sound appealing. But tread carefully, or you might not be eligible for the deduction you’re expecting.
General rules. Business travel expenses are potentially deductible if the travel is within the United States and the expenses are "ordinary and necessary" and directly related to the business. (Foreign travel expenses may also be deductible, but stricter rules apply than are discussed here.)
Currently, business owners and the self-employed are potentially eligible to deduct business travel expenses. Under the Tax Cuts and Jobs Act, employees can no longer deduct such expenses. The potential deductions discussed below assume that you’re a business owner or self-employed.
Business vs. pleasure. Transportation costs to and from the location of your business activity may be 100% deductible if the primary reason for the trip is business rather than pleasure. But if vacation is the primary reason for your travel, generally none of those costs are deductible.
The number of days spent on business vs. pleasure is the key factor in determining whether the primary reason for domestic travel is business:
- Your travel days count as business days, as do weekends and holidays — if they fall between days devoted to business and it would be impractical to return home.
- Standby days (days when your physical presence is required) also count as business days, even if you aren’t called upon to work those days.
- Any other day principally devoted to business activities during normal business hours also counts as a business day.
- You should be able to claim business was the primary reason for a domestic trip if business days exceed personal days.
Deductible expenses. What transportation costs can you deduct? Travel to and from your departure airport, airfare, baggage fees, tips, cabs, etc. Costs for rail travel or driving your personal car are also eligible.
Once at the destination, your out-of-pocket expenses for business days are fully deductible. Examples of these expenses include lodging, meals (subject to the 50% disallowance rule), seminar and convention fees, and cab fare. Expenses for personal days aren’t deductible.
Keep in mind that only expenses for yourself are deductible. You can’t deduct expenses for family members traveling with you — unless they’re employees of your business and traveling for a bona fide business purpose.
Substantiation is critical. Be sure to accumulate proof of the business nature of your trip and keep it with your tax records. For example, if your trip is made to attend client meetings, log everything on your daily planner and copy the pages for your tax file. If you attend a convention or seminar, keep the program and take notes to show you attended the sessions. You also must properly substantiate all of the expenses you’re deducting.
Additional rules and limits apply to the travel expense deduction. Please contact us if you have questions.
Using an accountable plan
The TCJA changes some rules for deducting pass-through business losses
It’s not uncommon for businesses to sometimes generate tax losses. But the losses that can be deducted are limited by tax law in some situations. The Tax Cuts and Jobs Act (TCJA) further restricts the amount of losses that sole proprietors, partners, S corporation shareholders and, typically, limited liability company (LLC) members can currently deduct — beginning in 2018. This could negatively impact owners of start-ups and businesses facing adverse conditions.
Before the TCJA. Under pre-TCJA law, an individual taxpayer’s business losses could usually be fully deducted in the tax year when they arose unless:
- The passive activity loss (PAL) rules or some other provision of tax law limited that favorable outcome, or
- The business loss was so large that it exceeded taxable income from other sources, creating a net operating loss (NOL).
After the TCJA. The TCJA temporarily changes the rules for deducting an individual taxpayer’s business losses. If your pass-through business generates a tax loss for a tax year beginning in 2018 through 2025, you can’t deduct an "excess business loss" in the current year. An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of:
- Your aggregate business income and gains for the tax year, and
- $250,000 ($500,000 if you’re a married taxpayer filing jointly).
The excess business loss is carried over to the following tax year and can be deducted under the rules for NOLs.
For business losses passed through to individuals from S corporations, partnerships and LLCs treated as partnerships for tax purposes, the new excess business loss limitation rules apply at the owner level. In other words, each owner’s allocable share of business income, gain, deduction or loss is passed through to the owner and reported on the owner’s personal federal income tax return for the owner’s tax year that includes the end of the entity’s tax year.
Keep in mind that the new loss limitation rules apply after applying the PAL rules. So, if the PAL rules disallow your business or rental activity loss, you don’t get to the new loss limitation rules.
Expecting a business loss? The rationale underlying the new loss limitation rules is to restrict the ability of individual taxpayers to use current-year business losses to offset income from other sources, such as salary, self-employment income, interest, dividends and capital gains.
The practical impact is that your allowable current-year business losses can’t offset more than $250,000 of income from such other sources (or more than $500,000 for joint filers). The requirement that excess business losses be carried forward as an NOL forces you to wait at least one year to get any tax benefit from those excess losses.
If you’re expecting your business to generate a tax loss in 2018, contact us to determine whether you’ll be affected by the new loss limitation rules. We can also provide more information about the PAL and NOL rules.
Putting your child on your business’s payroll for the summer may make more tax sense than ever
If you own a business and have a child in high school or college, hiring him or her for the summer can provide a multitude of benefits, including tax savings. And hiring your child may make more sense than ever due to changes under the Tax Cuts and Jobs Act (TCJA).
How it works. By shifting some of your business earnings to a child as wages for services performed, you can turn some of your high-taxed income into tax-free or low-taxed income. For your business to deduct the wages as a business expense, the work done must be legitimate and the child’s wages must be reasonable.
Here’s an example: A sole proprietor is in the 37% tax bracket. He hires his 20-year-old daughter, who’s majoring in marketing, to work as a marketing coordinator full-time during the summer. She earns $12,000 and doesn’t have any other earnings.
The father saves $4,440 (37% of $12,000) in income taxes at no tax cost to his daughter, who can use her $12,000 standard deduction (for 2018) to completely shelter her earnings. This is nearly twice as much as would have been sheltered last year, pre-TCJA, when the standard deduction was only $6,350.
The father can save an additional $2,035 in taxes if he keeps his daughter on the payroll as a part-time employee into the fall and pays her an additional $5,500. She can shelter the additional income from tax by making a tax-deductible contribution to her own traditional IRA.
Family taxes will be cut even if an employee-child’s earnings exceed his or her standard deduction and IRA deduction. Why? The unsheltered earnings will be taxed to the child beginning at a rate of 10% instead of being taxed at the parent’s higher rate.
Avoiding the "kiddie tax." TCJA changes to the "kiddie tax" also make income-shifting through hiring your child (rather than, say, giving him or her income-producing investments) more appealing. The kiddie tax generally applies to children under age 19 and to full-time students under age 24. Before 2018, the unearned income of a child subject to the kiddie tax was generally taxed at the parents’ tax rate.
The TCJA makes the kiddie tax harsher. For 2018-2025, a child’s unearned income will be taxed according to the tax brackets used for trusts and estates, which for 2018 are taxed at the highest rate of 37% once taxable income reaches $12,500. In contrast, for a married couple filing jointly, the 37% rate doesn’t kick in until their taxable income tops $600,000. In other words, children’s unearned income often will be taxed at higher rates than their parents’ income.
But the kiddie tax doesn’t apply to earned income.
Other tax considerations. If your business isn’t incorporated or a partnership that includes nonparent partners, you might also save some employment tax dollars. Contact us to learn more about the tax rules surrounding hiring your child, how the kiddie tax works or other family-related tax-saving strategies.