5 things you think are tax deductible that aren’t
The following are five areas that have proved notorious for causing confusion that leads to unpleasant surprises during tax audits.
Whereas every employee and business owner recognizes their need to pay taxes, this obligation has to be viewed in the context of a company’s principal objective: profit and shareholder return. No one should pay more taxes than they are required to as this takes away cash that would otherwise be applied to business growth or personal investment.
Fortunately, there are many business expenses that are eligible for tax deductions. That said, taxes are always a delicate issue. Taking advantage of tax deduction provisions requires adopting of a cautious and meticulous approach. Falling afoul of the Internal Revenue Service (IRS) either deliberately or inadvertently can have severe repercussions including interest and penalties.
There’s a fine line between tax savings and tax compliance. Many tax deductions are therefore guided by certain rules that define what you can and cannot do. Some have restrictions or limits. The following are five areas that have proved notorious for causing confusion that leads to unpleasant surprises during tax audits.
1. Gifts and Entertainment
Marketing is a broad term that covers a wide range of business activities including promotions, public relations, advertising, sales, product planning and market research. The extent of tax deductions on marketing costs depends on the classification of these costs. For example, some businesses do not categorize sales activities as a marketing cost. The categorization determines whether the company can claim a tax deduction for these expenses.
Marketing expenses such as gifts and promotional items (see Quality Logo Products for examples) may not always be tax deductible. If you host a potential client at a restaurant or give gifts to prospects or customers, you may not deduct the full cost. More specifically, if you take a customer out to lunch, you can only deduct the customer’s meal cost; your own meal will not qualify. The rationale here is that while you may be taking the client out to win them over, you too are in on the fun. At least, that’s what the IRS believes.
By default, the law imposes a tax on every gift individual gifts to someone. The donor is responsible for paying this tax. The gift could take various forms including property and money. The tax also applies to less obvious gifts such as the selling of an item at below its full value and issuing a loan at subsidized or no interest rate. That being said, tax laws are designed in a way that allows everyone to make up to a certain dollar amount of gifts each year.
There is a predefined limit on the amount of gift tax exclusion one is eligible for annually though this is adjusted for inflation each year. The limit is on a per-recipient and per-donor basis. For example, the 2017 gift tax exclusion limit is $14,000 meaning you can give gifts worth $14,000 each to multiple recipients. That also means a married couple can give as much as $28,000 to a single recipient assuming each partner contributes their maximum.
The price tag the IRS attaches to each gift is determined by its fair market value. Fair market value is what one would pay for the item when neither the buyer or seller is under duress. This thus excludes a fire sale. Ordinarily, the fair market value is the gift’s appraised value or its value when compared to similar items sold at the same point in time. There’s no dispute on the value of cash since it’s self-evident.
Gift tax laws also allow a married couple to transfer property and money between themselves freely. Individuals can gift their spouse with as much property or money as they wish without worrying about gift tax implications. There is, however, an exception: noncitizen spouses. Noncitizen spouses have limited to $149,000 in gifts annually. Anything beyond that is subject to tax.
Gifts meant to cover education tuition qualify for tax exclusion. However, educational gifts pertaining to accommodation, supplies, and books are not exempt and would count toward the overall annual gift tax exclusion total. A key condition to this exclusion is that donors must pay tuition directly to the school; exclusion is lost if the money is given to the student for onward transfer to the school.
Somewhat similar limitations apply to gifts covering medical expenses. A donor will be exempt from the gift tax if the money for the health insurance of medical care expenses is paid directly to the insurance company or medical facility.
2. Donations, Pledges, and Volunteerism
Donations have for many years been a popular avenue for claiming tax deduction. However, not all donations qualify. Eligibility depends on the nature of the recipient organization, any instructions you issue accompanying the donation, and any benefit you’ll derive from the donation.
If you donate to a 501(c)(3) nonprofit organization, you can only receive a deduction if the contribution was not accompanied by instructions over how the donation should be spent. If you donate to a 501(c)(6) trade association, the donation is not tax deductible at all.
If you sponsor a nonprofit’s event, that is considered a marketing expense and you can claim a deduction irrespective of the recipient’s organization specific tax status. If you donate $200 and are invited to a lunch as a result, you must subtract the lunch cost from the $200 donation.
The IRS has been increasingly apprehensive about cash donations and can disallow deduction on such gifts if it is weak or no documentation to support it. Throwing cash into a jar or collection plate risks being rejected even if it’s for a charitable cause. Political donations are not tax deductible.
The IRS only allows a deduction for the actual transfer of money and not merely promises to do so. This means if you pledge to give $360 to a charity each year via monthly donations of $30, you can only deduct the amount you paid in the tax year.
Whereas time is money, that principle doesn’t always apply when it comes to taxation. You cannot claim a tax deduction on the intangible contributions of time and effort you’ve made to charitable causes. This is irrespective of whether your volunteer activities involve performing the same tasks you do at work.
If you are an accountant and voluntarily do the books of the church you are a member of, you cannot deduct the time involved based on the hourly rate you ordinarily charge. However, you can deduct the out-of-pocket, documented, unreimbursed cost of any supplies you require to carry out the work. Mileage costs in connection with the activities can also qualify.
Note that there is a difference between volunteer services and pro bono services (the latter is tax deductible in some circumstances). Pro bono services are offered at cost or free and are meant to benefit the general public or a cause. While the term is most often associated with legal services, pro bono covers many other professional services.
From a taxation perspective, pro bono services must be donated to a charitable organization. They are services that would ordinarily have to be paid for. Volunteer services on the other hand are offered by individuals who wouldn’t usually charge for their skills and time.
3. Home Office Costs and Cell Phone Bills
In the 1990s, home office expenses were viewed as a major red flag during tax audits. It was a different era then. With the coming of the internet revolution, the home office is no longer an outlandish or rare occurrence. Still, you must exercise caution when applying home office tax deductions. The IRS will zero in on anything that seems disproportionate and unusual.
For tax purposes, one of the first things you must do is define your actual home office space. This is the area dedicated to running your business. Once you’ve established this percentage, you can then return to your home’s electric, heating, and other bills and determine the amount that’s deductible as a cost of running the business.
Since measuring your home office space has such major tax repercussions, you shouldn’t do it yourself; there is always the possibility that you could shortchange yourself. Instead, hire a contractor who will provide you with a formal letter showing the exact square footage of the home office. This will come in handy if the IRS requires clarification on how you arrived at the figure.
Not every bill incurred at your home can be deducted as a home office expense. You cannot deduct purely personal services that have no direct implication on the operation of the business. These include landscaping, gardening and tree removal.
Just because you rent your home does not mean you cannot qualify for tax deduction. You can send your landlord an IRS Form 1099 at the start of each year that shows the proportion of rent you’re deducting. This can get a little complicated so check with your accountant to be sure you’re doing it right.
Ideally, you shouldn’t use your home computer for business. Rather, have one computer for personal use and a different one for business. Of course, this will not always be possible especially for bootstrapped startups. In such instances, you’ll need to calculate the proportion of time you use the computer for business purposes. This is a tedious and time-consuming exercise so if you have to take this option, make sure it’s for as short a time as possible before you can buy a new computer.
Cell phone bills qualify for tax deductions. Caution is however necessary. There is a tendency for employees and business owners to inadvertently or deliberately have many personal calls on their business line. A home office phone line is particularly prone to this. That’s why large phone bills attract intense scrutiny during tax audits.
Whereas there’s a reasonable expectation that some calls will be personal, the IRS will be keen on ascertaining that the overwhelming majority were business-related. If you work from home occasionally or regularly, it’s best to have a dedicated line for business calls.
4. Business Travel and Commuting Costs
Tax deductions are available for travel. The IRS, however, expects you to distinguish between business travel and leisure travel. The tax man views business travel as the cost of traveling from your ‘tax home’ to a different location for business, work or a professional engagement. The travel should be long and far enough for you to reasonably want to stop and rest along the way.
If you are traveling to look for work and as long as the job applied for is in the same line as your previous one, your trip can be considered business travel and qualifies for a tax deduction. If you are traveling on a short-term work assignment, you can deduct travel expenses only if the assignment will last less than a year.
Business travel expenses that can be deducted include transportation (plane, train, bus, taxi, car or even camel-back), baggage shipping, lodging, 50% of meal costs, laundry, business phone calls and business internet access.
If you take your family on vacation and in the process have a lunch meeting with a client, only the lunch is deductible. Since the initial goal of the trip was leisure, the majority of the travel costs do not qualify.
Business conventions may or may not qualify for a deduction. If the convention is in North America and relevant to your business, expenses are deductible. Conventions outside the continent attract much closer examination. The IRS requires a strong and plausible justification for deduction. Usually, the overseas convention must run for less than a week and you must prove that no part of your trip was a vacation.
If you take your spouse with you to an industry conference, your spouse’s air ticket will not be tax deductible unless they are an employee or partner of your business. If you choose to stay on after the end of the conference for a day or more, these extra days do not qualify for a deduction.
If you work two or more jobs per day, the cost of traveling from one job to the other may be tax deductible. The same applies to the expenses incurred traveling to an offsite business meeting and visits to clients and prospects.
On the other hand, and contrary to what some might expect, huge commuting distances alone are not considered sufficient reason for deduction. That means no matter how far from home your workplace might be, the IRS does not see this as legitimate grounds for deduction eligibility. Not even working during the commute will change that.
5. Work-Related Costumes or Uniforms
Work clothing is among the most contested tax deductions and is regularly rejected by the IRS. This doesn’t mean that you shouldn’t take advantage of it when you think it’s applicable. Actually, the tax deduction principles around uniforms and costumes are fairly straightforward.
First, the clothes should be ordinary (consistent with industry standards), necessary (essential for the performance of work) and required (ordered by employer or regulator). Second, if the uniform or costume is something you could comfortably wear away from your work area, it shouldn’t be written off. Only attire that is clearly only suitable for performing job duties should qualify for a deduction.
For example, if the waiters in a restaurant are required to wear black pants and a white shirt at all times, these work clothes will not qualify for a deduction. They can be worn outside the restaurant. However, if the pants or shirts have the restaurant’s logo, they can be tax deductible.
If you work in a dangerous environment where protective clothing is mandatory, you can claim a deduction. Industries where such protective wear is needed include construction, oil and gas drilling, and steam fitting. Some examples of protective gear are safety boots, safety glasses, work gloves, hard hats and fire-retardant outerwear.
So in a nutshell, a new suit wouldn’t be eligible for a write-off since it can be worn in places outside of work. Conversely, a clown suit, showgirl costume, firefighter uniform and custom branded apparel would qualify. Overall, for the vast majority of taxpayers, work uniforms and clothing will not be tax deductible.
In conclusion, it’s vital that your tax deduction is backed by a clear electronic or paper trail. Always work under the assumption that the IRS may ask you to provide proof or explanation.
Ergo, for each expense, ensure there’s credible documentation indicating the date of the transaction, amount and the purpose served. Documentation includes credit card statements, bank statements, and receipts. You may need to append notations that will remind you of the reason for the expense.
Keep personal and business expenses separate. Never settle personal bills using the business account. Do not use personal expenses to claim business tax deductions. Above all, keep your accountant and tax attorney in the loop to be certain you are doing the right thing.