Moving Expenses-Part I--Moving to start a new job? Or moving to start a business in another town? Or planning on reimbursing employees for moving expenses? Then check this article first.
Intercompany Loans--You do business using two or more companies. If one company makes a loan another, there can be serious tax consequences.
General Accounting Office Issues IRS Audit Statistics--There are some interesting statistics on audit percentages, length of audits, etc.
Accounting Basics--Accrued Expenses--Accrual accounting isn't that difficult. Here's a simple explanation to the basics of accruing expenses.
In Brief:--Tax, business, and personal finance tips.
The tax rules for deducting moving expenses incurred in connection with your employment have changed a number of times in recent years. There are restrictions, but the law does allow a deduction for a number of expenses--if you can qualify. And, while there are limits on what expenses are deductible, there's no limit on the dollar amount. Since the cost of a move can be substantial, this article is a must read. The deduction is available to both employees and self-employed individuals. For example, you're a self-employed contractor. For various reasons you decide to move your business to a town 60 miles away. If all the other requirements are met, your personal moving expenses (that otherwise qualify), should be deductible. And, an employer who reimburses an employee for moving expenses can exclude certain amounts from the employee's income. That amounts to a tax-free perk to the employee. This is the first of two articles on these expenses.
Note. You're an employee even if you're the sole owner of a regular or S corporation, as long as you do regular work for the corporation. You're considered self-employed if you do business as a sole proprietorship, partnership, or LLC.
Related to Start of Work
The first requirement is that your move must be closely related in time and in place to the start of work at your new job location. You can generally consider moving expenses incurred within one year from the date you first reported to work at the new location as closely related in time. It is not necessary that you arrange to work before moving to a new location, as long as you actually do go to work.
If you do not move within one year, you generally cannot deduct the expenses unless you can show that circumstances existed that prevented the move within that time. For example, you delayed your move 18 months after beginning work at a new location so that your daughter could complete high school. That's an acceptable reason.
You can generally consider your move closely related in place if the distance from your new home to the new job location is not more than the distance from your former home to the new job location. A move that does not meet this requirement may qualify if you can show that:
Distance Test
Your move will meet the distance test if your new main job location is at least 50 miles farther from your former home than your old main job location was from your former home. For example, if your old job was 3 miles from your former home, your new job must be at least 53 miles from that former home.
The distance between a job location and your home is the shortest of the more commonly traveled routes between them. The distance test considers only the location of your former home. It does not take into account the location of your new home.
Example--You move to a home home less than 50 miles from your former home because you changed job locations. Your old job was 3 miles from your former home. Your new job is 60 miles from that home. Because your new job is 57 miles farther from your former home than the distance from your former home to your old job, you meet the 50-mile test.
If you go to work full time for the first time, your place of work must be at least 50 miles from your former home to meet the distance test. If you go back to full-time work after a substantial period of part-time work or unemployment, your place of work must also be at least 50 miles from your former home.
Your main job location is usually the place where you spend most of your working time. A new job location is a new place where you will work permanently or indefinitely rather than temporarily. If there is no one place where you spend most of your working time, your main job location is the place where your work is centered. For example, where you report for work or are otherwise required to base your work.
If you have more than one job at anytime, your main job location depends on the facts. The more important factors to be considered are:
Time Test
You must also meet one of the following time tests.
Employees. If you are an employee, you must work full time for at least 39 weeks during the first 12 months after you arrive in the general area of your new job location. Count only your full-time work as an employee, not any time as a self- employed person. You do not have to work for the same employer for the 39 weeks, nor do you have to work the 39 weeks in a row. However, you must work within the same general commuting area.
Self-employed. In this case you must work full time for at least 39 weeks during the first 12 months and for a total of at least 78 weeks during the first 24 months after you arrive at your new job location. For this time test, count any full-time work you do as an employee or as a self-employed person. You do not have to work for the same employer or be self-employed in the same trade or business for the 78 weeks.
If you're both self-employed and an employee, you must determine which job you spend the most time on and use the appropriate rule.
Full-time work. Whether you work full time during any week depends on what is usual for your type of work in your area. For example, you are a psychologist and maintain office hours 4 days a week. You are considered full time if maintaining office hours 4 days a week is usual for other self-employed psychologists in the area.
Time test not yet met. You can deduct your moving expenses on your 1999 return even if you have not yet met the time test by the date your 1999 return is due. You can do this if you expect to meet the 39-week test in 2000, or the 78-week test in 2000 or 2001. If you deduct moving expenses but do not meet the time test by 2000 or 2001, you must either:
Exceptions to the time test. You do not have to meet the time test if your job at the new location ends because of death or disability or you are transferred for your employer's benefit or laid off for a reason other than willful misconduct. For this exception, you must have obtained full-time employment, and you must have expected to meet the test at the time you started the job.
Next issue. What expenses are deductible, what forms to use, reimbursing employees, and more.
You do business through two corporations. One has excess cash and the other is desperately in need of funds. Corporation A "loans" corporation B $30,000. Sounds innocent enough? Unfortunately, it's not. In fact, there can be some disastrous tax consequences lurking in this transaction.
Bona fide debt. The first thing an IRS agent looks at when he sees such a transaction is whether or not there is a bona fide debt. In many, if not most cases, a good agent will try (and often succeed) in getting the "debt" reclassified as an equity contribution. We've discussed this issue in the past. Here's the list of factors an agent will look at:
This list isn't exhaustive. And the IRS and the courts don't have to look at all the factors. They can focus on just a few, or weigh one or more much more heavily than others.
Corporation-to-corporation loans. Let's look at the original question. You're the sole shareholder of Madison Inc., a regular corporation. Madison has extra funds so it loans $30,000 to Chatham Inc., also a regular corporation where you're the sole shareholder. In more than one case the IRS has said that what really happened is a dividend from Madison to you followed by a capital contribution to Chatham. That means the full amount of the loan would be taxable income to you. In addition, repayments by Chatham to Madison could be considered a dividend to you.
You won't have this problem if Madison and Chatham are part of a consolidated group of companies. For example, Madison is the parent (shareholder) of Chatham. There are some other benefits to operating as a consolidated group. Talk to your tax advisor.
There may be other ways to avoid the problem above. One of the first steps is to make sure the loan will pass a test using the factors listed above. And it also helps if there's a bona fide business purpose for an intercompany loan. The ultimate solution, unfortunately, depends on a number of factors. Your tax advisor should be able to provide answers in your particular situation.
S corporation loans. A potentially bigger problem looms for S corporations. It involves the basic requirements for S corporation stock. There are a number of restrictions on stock in an S corporation--who can own such stock (generally only individuals), how many shareholders are allowed (75), and the fact that only a single class of stock is allowed. If any of these requirements (there are several others) are violated, the S corporation election will be terminated.
The IRS regulations (Sec. 1.1361-1(l)(5)) provide for a "straight debt" safe harbor. That means, if the debt meets the requirements below, there's no chance the IRS will try to recharacterize the debt as a second class of stock.
Straight debt means a written unconditional obligation, regardless of whether embodied in a formal note, to pay a sum certain on demand, or on a specified due date, and where:
Look at the last requirement. The debt must be held by an individual, estate, or qualifying trust. Using our Madison Inc. and Chatham Inc. example but assuming that Chatham is an S corporation, if Madison loans money to Chatham the last requirement will be violated. It doesn't matter if Madison is a C or an S corporation.
The debt may avoid being characterized as a second class of stock even if it doesn't meet the safe harbor definition above, but now you've got to be very careful. For example, convertible debt may be acceptable if it meets certain requirements. (Refer your tax advisor to Reg. Sec. 1.1361-1(l)(4)(iv).) And other debt may also avoid the second class of stock problem, but now you've got to make sure the debt meets the requirements of a bona fide debt.
There's a safe harbor for short-term unwritten advances that don't exceed $10,000 in total at any time during the taxable year of the corporation, are treated as debt by both parties, and are expected to be repaid within a reasonable time, even if the advances might be classified as equity, that is, wouldn't meet the bona fide debt definition above.
Note. Call options, warrants or similar instruments can also cause a problem.
Final caution. This is one area you don't want to make a mistake. The consequences can be costly. An S corporation could lose its S corporation status. If your tax advisor has all the facts, he can quickly tell you if you're going to get into trouble.
General Accounting Office Issues IRS Audit Statistics
What are your chances of getting audited? That's one of the questions clients most often ask their tax preparers. The General Accounting Office recently issued some statistics on small businesses. The report was examined the tax requirements of small businesses, concentrating on the paperwork requirements and audit statistics. For the report, small businesses included all farmers and sole proprietorships and partnerships, S corporations, and regular corporations with assets of less than $5 million. The report noted that these businesses account for nearly half of all taxes the IRS collects annually. And, for tax year 1995, the GAO identified approximately 23.4 million businesses that filed returns. Of this population, 94% of partnerships reported total assets of less than $5 million, and 98% of S corporations reported total assets of less than $5 million. About 97% of U.S. corporations reported assets of less than $5 million in 1995. Sole proprietorships accounted for approximately 16.3 million of the nearly 23.4 million business filers.
Audit Statistics
According to IRS officials, the audit rate for small business taxpayers is higher than the overall rate because small businesses tend to have more compliance problems than other taxpayers. A common kind of problem that small businesses can face is in the area of employment tax compliance. A small business can fall short of operating capital, and, as a consequence, it may divert some or all of its estimated tax deposits or employment tax withholdings to make up the shortfall. According to IRS officials, the amount of these unpaid taxes, penalties, and interest can pyramid quickly. The danger is that a business that must rely on these funds for working capital is likely to have other liabilities and delinquencies that reflect financial problems so severe that it cannot recover.
We've reviewed the General Accounting Office report in detail and managed to extract some interesting statistics on audit rates, the percentage of audits with changes, etc. The results are presented in the tables below. Keep in mind that the data presented is for 1995, the latest year available. While the percentage of audits may have declined somewhat in recent years, the emphasis has changed little.
One thing is particularly noteworthy. Sole proprietorships have a far greater chance of being audited than partnerships (that would now include LLCs) and S corporations. While the accounting is somewhat more complex, that inconvenience and cost is probably more than offset by the lower probability of an audit.
Type of Business Size Audit Rate
Sole proprietorship Gross receipts < $25,000 3.2%
Receipts $25,000 to $100,000 2.6%
Receipts $100,000 and more 4.1%
All proprietorships 3.2%
Farmers Gross receipts <$100,000 1.3%
Receipts $100,000 and more 2.8%
All farmers 1.8%
Partnership All partnerships 0.6%
S corporation All S corporations 1.0%
Corporation Assets <$250,000 1.2%
Assets $250,000 to $1 million 3.5%
Assets $1 million to $5 million 7.8%
All corporations 2.1%
Notes:About 94% of partnerships and 98% of S corporations were small businesses in 1995 (i.e., they had less than $5 million in assets).
Average Less than 6-12 More than
Type of Business Length (days) 6 months months 12 months
Sole proprietorship 273 45.7% 32.5% 21.7%
Farm 221 69.1% 17.1% 13.8%
Partnership 754 30.1% 16.9% 52.9%
S Corporation 308 44.2% 28.7% 27.1%
Corporation 335 45.8% 27.2% 27.0%
Average, all businesses 288 46.2% 31.0% 22.8%
Notes:1. While the length of an audit may be 6 months, that doesn't mean day-to-day contact with an agent. The agent may be in your office for one day and come back several weeks later when you have assembled the requested information or he's gotten an answer from his superiors.
2. The IRS doesn't break out small partnerships in its database, so the number for partnerships may be misleading.
Audits recommending Audits recommending
Change No Change
Total Additional
Type of Business Audits taxes Refund Adjustment No adjustment
Proprietorship 298,609 63.8% 4.4% 15.7% 16.1%
Farmer 13,381 59.0% 6.7% 10.3% 23.9%
Corporation 35,011 52.4% 5.8% 17.0% 24.8%
All businesses 347,001 62.4% 4.6% 15.6% 17.3%
Notes:1. The data above is for small business audits closed in 1995. Of these, 67% resulted in a recommended change to the reported tax liability or refundable credits, while about 33% resulted in no change. some audits resulting in no change did result in changes to other return items deemed significant by IRS examiners. For example, net loss, which can be carried forward and claimed in future years, may have been overstated on the return and adjusted by the IRS. In addition, recommendations may be partially or fully overturned in IRS appeals or in court decisions.
2. Partnerships and S corporations were excluded because audit results generally pass through to the individual business owners.
Audit Appeals and Petitions
As percent of As percent of audits
Type of business Number total audits recommending add'l taxes
Sole proprietorship 11,739 3.9% 6.2%
Farm 557 4.2% 7.1%
Partnership 1,031 14.6% 31.7%
S corporation 1,249 7.2% 15.7%
Corporation 3,615 10.3% 19.9%
All Businesses 18,216 4.9% 8.0%
Notes:According to IRS Appeals officials, the lower appeals rates for sole proprietorships and farms may reflect the fact that their returns generally involve less complex tax issues, which leads to fewer potential tax disagreements. Similarly, the officials attribute the much higher appeals rate for partnerships to the complexity of the tax laws affecting partnerships and their returns.
Accounting Basics--Accrued Expenses
Most small business owners don't want to use the accrual method of accounting. Owners cite two basic drawbacks. First, for tax purposes it means the business will probably be reporting income before the cash hits the bank. That means it'll also be paying taxes sooner. Second, the accrual method is more complicated.
Both statements are true, but neither one may be as bad as many owners believe. First, for many small businesses the accrual method isn't that complex. And, the only time you really have to worry about accruing income and expenses is when you're closing your books. For most small businesses, that's only at yearend. (You will have to accrue income and expenses quarterly if you're using the annualized method of computing your estimated taxes.) Second, while the IRS wants you to accrue income so that they can get more tax dollars upfront, you also get to accrue expenses and deduct them earlier. You still might be better off under the cash method, but for many businesses it's a moot point. If you have inventories, the IRS will require you to use the accrual method.
The Basics
The rationale for using the accrual method is that it better matches income and expenses. The theory is simple. You record revenue when the service is performed (or the order shipped). At the same time you record the accompanying expenses. In the case of a service, you might have purchased materials or hired an outside contractor, but not yet paid for the materials or the contractor's services. You want to accrue the cost of the materials or services so that it's an expense for the same period that you record the accrual of income.
Example--Madison Inc. purchases $1,900 worth of supplies December 1. The supplies last Madison only through the month of December (i.e., they're not inventoried). Madison has 45 days from the date it receives the invoice in which to pay. Upon receipt of the supplies, Madison would make the following entry:
Supplies $1,900
Accounts payable $1,900When Madison pays the bill in mid-January, it makes the following entry:
Accounts payable $1,900
Cash $1,900
If you're doing this on most accounting programs, you won't have to worry about the detail. Just record the purchase to set up the account payable and the check for payment to reverse the accounts payable amount. The program should take care of all the details.
What if there's no receiving report or purchase order to start the process? In fact, that's likely to be the situation for many businesses. In that case you might just wait for the invoice to arrive. This shouldn't be a problem, even if the invoice is a little late, since most small companies don't need to close their books that soon after the end of their accounting period.
Some expenses are trickier. For example, you pay employees based on a week of Monday through Friday. But this year the last day of the year is a Monday. Your total payroll for the week is $10,000. You've got to accrue payroll expense for one day. Since there are 5 days in the week, divide the total payroll by 5 to get the daily payroll. Here, that's $2,000. That's the amount you have to accrue. You probably won't be able to do this using the payables or purchases section of your accounting software. You'll have to make a journal entry. Sounds scary, but it's actually pretty easy. Here's the entry to accrue the salaries:
Salaries expense $2,000
Salaries payable $2,000
Remember, the first entry is the debit; the second entry is the
credit.When you cut the payroll checks at the end of the week in the new year, the total $10,000 is made up of two items. A payable of $2,000 from the old year, and an expense of $8,000 (for the 4 days in the new year) for the new year. Here's the journal entry you'll need:
Salaries expense $8,000
Salaries payable $2,000
Cash $10,000
The first entry is to record the expense. The second is a debit
to salaries payable to reverse the liability account. You have
to reduce that account since you're now paying the salaries you
accrued.There are other expenses that must be allocated between two years like salaries. Rent that is due on the 20th of December for the last 11 days of December and the first 20 days of January that's not paid until January. Or interest expense on a note. In this case, the allocation period may be even longer. For example, your brother loans your business $10,000 on August 1. You agree to pay him $900 interest when the note matures on July 31 of the next year. If you close your books monthly, prepare quarterly financials, etc., you'll have to make several accruals. For example, if you issue quarterly financials, you'll have to accrue 2 months of interest expense through the end of September. You'll accrue an additional 3 months when you close your books at the end of December. Thus, your account, Interest Expense Payable, will have accumulated 5 months of interest at the end of the year. Only when you pay your brother the $900 of interest on July 31 of next year will you clean out the account.
There's another group of expenses that pose a different problem. These expenses may not have a bill. For example, you won't get a bill for your state or federal income taxes, annual filing fee, etc. Many small businesses pay the minimum income tax in a state. It may be $250, and it's not due until March 15. For federal (and other state) income taxes you may have to make an estimate of what you'll owe when the return is completed some months later. You won't receive a bill for any required payments to the company's pension plan. The best you might have is a reminder from a company that administers or set up your plan. Another common expense where there's no bill is depreciation and amortization expenses. (For more information on depreciation entries, see Accounting for Depreciation in our October 15, 1998 issue for more information.)
Fortunately, many of these expenses recur every year. Thus, you can look at last year's year-end adjusting entries for help. You can also ask your accountant.
While the theory is the same, the IRS makes a distinction between accounts payable and accrued expenses. Accounts payable generally consist of liabilities incurred for the purchase of goods or services to be resold by the business, but can cover other expenses. Accrued expenses include obligations such as salaries, wages, commissions, interest, taxes, etc. On many financial statements, no distinction is made. However, it is important to keep in mind that whether it's accounts payable or accrued expenses, these are current liabilities. That means the debts are payable within one year. Don't include notes payable to banks or other lenders in accounts payable.
The idea behind accruing an expense for accounting purposes is to match income and expenses in the same period. You should be able to apply the rules logically. That's not as true when it comes to accruing expenses for tax purposes. Not all items that should be accrued for financial statement purposes are valid accruals for income tax purposes. We'll discuss this in greater detail in our next issue.
Previously Reported In Daily Update
Considering an annulment? . . . An annulment might sound better than a divorce, but consider the tax consequences. If you get an annulment, it's as if you were never married. You may have to refile those tax returns you filed as married, joint. That's not the case with a divorce.
Installation costs . . . For tax purposes, there are two types of installation expenses. If you're buying a new machine, equipment, etc. the cost of the initial installation of equipment (shipping to site, site preparation, hookup, testing) must be capitalized and added to the cost of the machine. On the other hand, the same expenses incurred in a subsequent move (to another part of the plant, another plant, etc.) should be deductible as a regular expense.
Thinking of going public? . . . There are many valid reasons for doing so. However, it's not for every company. Public companies are subject to much more scrutiny. You'll have to endure many reporting requirements. If your only reason is to cash in on some of the news stories of 27-year olds becoming multimillionaires overnight, you might want to reconsider. While high-tech companies, and internet businesses in particular, have seen their shares soar, the stock of most traditional middle-market businesses have languished. There's just not much interest in a mid-sized manufacturer of household widgets with a history of less than spectacular growth. In fact, more than a few of these companies that were public have gone private. Going public makes sense if you need to diversify ownership and are growing rapidly (so that your stock commands a good price). Get good, independent, advice before jumping in.
Life insurance ratings . . . Generally, your life insurance premium will depend on a number of factors, primarily your age, health, and family medical history. But if you're looking for the lowest rates, the insurer may go much further. Nonsmokers, of course, will get a lower rate. If you smoke occasionally, but also exercise regularly, you may pay a lower premium than a person who smokes heavily and doesn't exercise. Your driving record may also be examined. Speeding tickets won't help; a drunk driving conviction will prove costly. Your recreational activities can also weigh against you. Private pilots, sky and scuba divers pay more. Some companies flatly refuse to provide coverage in such cases. For example, if you're killed in a plane crash while you're pilot in command, you're not covered. But don't lie (or even fudge) on the application. You don't want the insurance company to contest payment after you're dead.
Itemized deductions . . . Of those taxpayers who itemize, on average 99% deduct taxes, about 85% deduct interest, some 90% (96.5% for those with income over $200,000) deduct charitable contributions, but less than 10% deduct medical expenses. In fact, about 20% of taxpayers with AGI of $30,000 to $50,000 deduct medical expenses, but that percentage drops to 5% for taxpayers with AGI between $75,000 and $100,000, to 3% for AGI between $100,000 and $200,000 and to about 1% for those with AGI above $200,000.
House investigating unpaid payroll taxes . . . The General Accounting Office has reported that an estimated 1.9 million employers have collected $49 billion in payroll taxes from their employees but have not deposited that money with the government. In addition, trust fund penalties are now greater than $15 billion and 185,000 individuals have been found to be personally responsible for nonpayment of taxes. The GAO also reported that about 10% of the individuals with outstanding penalties have received $212 million in annual federal benefits. And some 12,700 businesses with unpaid payroll taxes have received about $3.5 billion in loans from the SBA. Congress may want the IRS to crack down on these taxpayers. It should be fairly easy to cross reference nonpayers with businesses and individuals receiving SBA loans, federal grants, government contracts, etc.
Foreign bank accounts can be trouble . . . Open a bank account in the Cayman Islands (or some other exotic locale) and avoid U.S. taxes. Sounds too good to be true? It is. As a U.S. citizen you're taxed on your worldwide income. It doesn't matter whether you earn the money in the states or in Fiji, you owe taxes to the Uncle Sam. Opening the bank account might allow you to evade taxes, but you'll find yourself in big trouble if you get caught. Recently, the IRS got the records for one bank in the Cayman Islands and caught about 1,000 tax evaders. They also got an insight into how such operations work. And, in a recent case (Jerry Lee Harvey, T.C. Memo. 1999-229) the Tax Court held that a drug smuggler had no Fourth Amendment privacy interest in foreign bank records that were obtained by the IRS.
Paying relatives' medical and tuition expenses . . . Making annual gifts to your children or other relatives of $10,000 ($20,000 if your spouse joins in the gift) makes sense. You reduce your estate without any tax consequences. There's an even better deal. If you pay medical and education expenses directly to the provider (i.e., the doctor for medical expenses; the college for tuition) there's no limit on the amount of the gift. None of it affects your estate/gift tax liability. Usually, it's grandma or grandpa paying college tuition. But children with assets may consider paying grandma's medical expenses. That can work to advantage if she has to sell highly appreciated assets to pay for medical care and she won't have any estate tax liability because her taxable estate is less than $650,000 (1999 amount). There are restrictions. For example, tuition qualifies, room and board does not. Check with your tax adviser or attorney.
Reverse mortgage loans . . . A reverse mortgage loan is a loan that is based on the value of your home and is secured by a mortgage on that house. Older citizens are using them more often to tap the equity in their home. The lending institution pays you the loan in installments over a period of months or years. The loan agreement may provide that interest will be added to the outstanding balance monthly as it accrues. If you're a cash method taxpayer, you deduct the interest on a reverse mortgage when you actually pay it, not when it is added to your outstanding loan balance. A reverse mortgage is generally subject to the home equity debt limits. That is, interest is deductible on only the first $100,000 of the mortgage. That could be a problem if the total interest is paid at once. Why? The interest could add up to $50,000 or more. Such a large deduction in one year could cause havoc with your tax planning. Talk to your tax advisor before paying off such a loan.
Units-of-production method of depreciation . . . Some of the depreciation rules can be very inequitable. For example, you may have to write off equipment over 7 years when the property has a useful life of only 3 years. While you can get a deduction for the undepreciated amount when you dispose of the property, you've lost the time value of money when you give up early depreciation deductions. You may have an option. You may be able to depreciate the equipment using the units-of-production method. Basically, you estimate how long the unit will last in machine hours, units produced, etc. Divide that into the cost of the equipment to get a cost per machine hour. Your depreciation for the year is the number of hours the machine is used times the cost per hour. You've got to be able to estimate the total hours available. That info may be available from the manufacturer. Then talk to your accountant to see if the approach will help you.
Copyright 1999 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536