© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Income Taxes

1

Chapter 9

Deductions: Employee and Self-Employed-Related Expenses

2

The Big Picture (slide 1 of 2)

• Morgan, a recent college graduate who majored in finance, has accepted a job with Kite Corporation. – The job is in sales and will require travel and some

entertainment (i.e., business lunches). • She will be based in a major metropolitan area in

another state. – Kite has no available space in the locale, so she will have

to maintain her own work facility.– In addition to her salary, Morgan will receive a travel

allowance.• However, Kite has made it clear that the allowance will not cover

all of her travel expenses.

3

The Big Picture (slide 2 of 2)

• Morgan is delighted with the new job since it will enable her to maintain a flexible work schedule. – Furthermore, working out of her own apartment

avoids a time-consuming and costly commute.

• What are some of the income tax problems presented by this situation?– Read the chapter and formulate your response.

4

Employee vs. Self-Employed(slide 1 of 2)

• Business expenses for self-employed persons are deductible for AGI– Reported on Schedule C

• Unreimbursed business expenses for employees are generally deductible from AGI subject to 2% of AGI floor– Reported on Form 2106 (Employee Business

Expenses) and Schedule A (Itemized Deductions)

5

Employee vs. Self-Employed(slide 2 of 2)

• Person is classified as an employee if:– Subject to will and control of another with respect

to what shall be done and how it shall be done– Another furnishes tools or the place of work– Income based on time spent rather than task

performed

6

Employee Expenses

• Fall into one of the following categories:– Transportation– Travel– Moving– Education– Entertainment– Other

7

Transportation Expenses(slide 1 of 2)

• Transportation expense defined– Very limited, only from job site to job site and

commuting to/from temporary work place– Commuting from home to work and back is

nondeductible• Exceptions:

– Additional costs incurred to transport heavy tools

– Employees with more than one job

8

Transportation Expenses(slide 2 of 2)

• Amount deductible– Actual expenses

• Must keep adequate records of all expenses and depreciation is limited, or

– Automatic mileage method• 56 cents per mile for business miles for 2014

– Adjustment to basis of auto is required for depreciation considered allowed

• Plus parking, tolls, etc.

• Adequate documentation of mileage required

9

The Big Picture - Example 9

Commuting Expense• Return to the facts of The Big Picture on p. 9-1.

• Because Morgan will have an office in her home, the apartment will be her principal place of business. – Thus, any transportation from her home to

business sites will not be disallowed as a commuting expense

10

The Big Picture - Example 11

Automatic Mileage Method • Return to the facts of The Big Picture on p. 9-1. • During Morgan’s senior year in college, her parents

gave her one of the family cars—a 2009 Chevrolet Impala. – Morgan has no idea as to the car’s original cost or the

odometer reading at the time the car was registered in her name.

– She has, however, kept track of the miles driven for business since she accepted her new job.

• Morgan should use the automatic mileage method in claiming business use of the car.

11

Travel Expenses (slide 1 of 2)

• Travel expense defined– Expenses while “away from tax home” overnight

on business– Includes transportation, lodging, meals, and

miscellaneous expenses

12

Travel Expenses (slide 2 of 2)

• “Away from home” requirement– Need not be a 24-hour period but must be longer

than ordinary work day and taxpayer will need to rest during release time

– Being “away” should be a temporary situation (not in excess of 1 year)

– “Tax Home” generally means business location, post, or station of the taxpayer

– Some exceptions are allowed under new Regulations

13

Restrictions on Travel Expenses (slide 1 of 2)

• Convention travel expenses– No deduction for travel unless directly related to

taxpayer’s trade or business• Example: Doctor attending out-of-town seminar on

estate planning would not have deductible travel expenses

– Restrictions apply to the deductibility of travel expenses of the taxpayer’s spouse or dependent

• Generally, accompaniment by the spouse or dependent must serve a bona fide business purpose, and

• The expenses must be otherwise deductible

14

Restrictions on Travel Expenses (slide 2 of 2)

• Education travel expenses– Travel as a form of education is not deductible

• Example: Spanish language professor traveling to Spain to work on the language would not have deductible travel expenses

• Example: Spanish history professor traveling to Spain to study historical documents available only in Spanish museums would have deductible travel expenses

15

Combined Business/Pleasure Travel(slide 1 of 4)

• Only actual expenses for business are deductible– Meals, lodging and other expenses must be

allocated between business and personal days

• Deductibility of transportation costs depends on whether the trip is domestic or foreign

16

Combined Business/Pleasure Travel(slide 2 of 4)

• For domestic travel– If primary purpose of trip is business,

transportation is deductible in full – If primary purpose is pleasure, no deduction for

transportation allowed, but other expenses (e.g., lodging) associated with business days are deductible

17

Combined Business/Pleasure Travel(slide 3 of 4)

• For foreign travel– Transportation expenses must be allocated between

business and personal unless:• Trip is 7 days or less,

• Less than 25% of time was for personal purposes, or

• Taxpayer had no substantial control over arrangements for the trip

18

Combined Business/Pleasure Travel(slide 4 of 4)

• Travel days are considered business days

• Weekends, legal holidays and intervening days are business days if both the preceding and succeeding days are business days

• If trip is primarily for pleasure, no transportation expenses are deductible

19

Moving Expenses

• Deductible for moves in connection with the commencement of work at a new principal place of work

• Two tests must be met for moving expenses to be deductible– Distance test – Time test

20

Moving Expenses - Distance Test

• Distance from old home to new job must be at least 50 miles farther than from old home to old job

• New home location not relevant for decision

21

Example of Distance Test

• Gail lived 20 miles from her old job

• Gail’s new job is 75 miles from her old home

• Gail meets the distance test

OldJob

OldJob

New Job

New Job

Old Residence

Old Residence

20 mi.20 mi.

75 mi.75 mi.

22

Moving Expenses - Time Test (slide 1 of 2)

• Taxpayer must be full-time employee for 39 weeks in the 12-month period following the move, or

• Self-employed must work in new location for 78 weeks during the next two years following the move– 39 of the weeks must be in the first 12 months

• Test waived if die, disabled, discharged, or transferred

23

Moving Expenses - Time Test (slide 2 of 2)

• If time test not met during taxable year, two alternatives:– Take the deduction in year moved. If test is not

met in following year, either:• Include the amount deducted in gross income in the

following year, or

• File amended return for year of move

– Alternatively, wait until time test is met and then file amended return for year of move

24

Deductible Moving Expenses

• ‘‘Qualified’’ moving expenses include reasonable expenses of:– Moving household goods and personal effects to

new location– Expenses of travel for taxpayer and family to new

location• Lodging• Actual auto costs (not depreciation) or mileage rate of

$.235 per mile for each car in 2014

– Meals are not deductible as moving expense

25

Tax Treatment of Moving Expenses

• Unreimbursed moving expenses are deductible for AGI

• Reimbursement or payment by employer:– For qualified moving expenses, amount is

excluded from gross income, but no deduction for related expenses

– For nonqualified moving expenses, amount is included in gross income and no deduction is allowed

26

The Big Picture - Example 29

Moving Expenses • Return to the facts of The Big Picture on p. 9-1.

• Even though this is her first job, Morgan will be entitled to a moving expense deduction. – This presumes that she is not reimbursed by Kite

Corporation for these expenses. – The mileage on her car also is allowed.

• Her deduction is for AGI and can be claimed even if she chooses the standard deduction option.

27

Education Expenses (slide 1 of 3)

• Education expenses of an employee are deductible if they are incurred:– To maintain or improve existing skills, or– To meet express requirements of the employer or

requirements imposed by law to retain employment status

28

Education Expenses (slide 2 of 3)

• Education expenses of an employee are not deductible if they are incurred:– To meet minimum educational standards for

existing job, or– To qualify taxpayer for new trade or business

29

Education Expenses (slide 3 of 3)

• Education expenses include:– Tuition– Books– Supplies– Transportation– Travel (including lodging and 50% meals)

30

Deduction For Qualified Tuition and Related Expenses (slide 1 of 3)

• A deduction is allowed for AGI for qualified tuition and related expenses involving higher education (i.e., postsecondary)

31

Deduction For Qualified Tuition and Related Expenses (slide 2 of 3)

• The maximum deduction depends on filing status and Modified AGI

32

Deduction For Qualified Tuition and Related Expenses (slide 3 of 3)

• Qualified tuition and related expenses include whatever is required for enrollment– Usually, student activity fees, books, room and

board are not included

• Expenses need not be work related

• Deduction is not available for married persons filing separately

33

The Big Picture - Example 32

Education Expenses • Return to the facts of The Big Picture on p. 9-1.

• After starting her new job, Morgan enrolls in the night program of a local law school.– Although Morgan does not plan to practice law,

she feels that a law degree would advance her career.

• Except for the tuition she pays (see the discussion of § 222), none of her expenses relating to the education will be deductible.

34

Entertainment Expenses(slide 1 of 3)

• Deductions are very restricted due to abuse possibilities– Deductible amount allowed:

• 50% of meals and entertainment costs including related taxes, tips, cover charges, parking fees, and room rental fees

• 100% of transportation costs

– Amounts cannot be lavish or extravagant– In certain situations, the 50% cutback for meals is

eased for certain, very limited, types of employees

35

Entertainment Expenses(slide 2 of 3)

• The 50% cutback rule has a number of exceptions, such as:– Situations where full value of meals or

entertainment is included in income– Meals and entertainment are provided in a

subsidized eating facility or where the de minimis fringe benefit rule is met

– Employer-paid recreational activities for employees

• e.g., the annual Christmas party or spring picnic

36

Entertainment Expenses(slide 3 of 3)

• Entertainment expenses are classified as either:– Directly related to business

• Actual business meeting or discussion occurs during meal or entertainment

– Associated with business• Meal or entertainment that directly precedes or follows

business meeting or discussion

37

Restrictions on Entertainment Expenses (slide 1 of 3)

• Club dues– Generally not deductible

• Exception: Clubs formed for public service and community volunteerism (e.g., Kiwanis, Rotary)

– Business entertainment expenses incurred at club are still deductible (50%)

38

Restrictions on Entertainment Expenses (slide 2 of 3)

• Ticket purchases for entertainment– Amounts paid in excess of face value of ticket are

not deductible– Limitation on deductibility of luxury skybox

expenditures

39

Restrictions on Entertainment Expenses (slide 3 of 3)

• Business gifts– Business gifts of tangible personalty with a value

of $25 or less per person per year are deductible• Incidental costs (e.g., gift-wrapping) are not included in

the cost of the gift in applying the limit

– If the value is $4 or less (e.g., pen with company name) then not subject to $25 limit

• Gifts to employers or superiors are not deductible

40

Office in the Home(slide 1 of 2)

• Deductibility is very restricted due to abuse possibilities– Office must be used exclusively and on a regular

basis as:• The principal place of business, or

• A place of business used by clients, patients, or customers

– For employees, office must also be for the convenience of the employer

41

Office in the Home(slide 2 of 2)

• What constitutes “principal place of business”?– Home office qualifies as a principal place of

business if:• Taxpayer conducts admin. and mgmt. activities in the

home office, and

• There is no other fixed location where taxpayer conducts these activities

42

Office in the Home Deduction(slide 1 of 5)

• Deduction can be determined in either of two ways: – The regular (actual expense) method, or – The simplified (safe harbor) method

43

Office in the Home Deduction(slide 2 of 5)

• Regular method– Relevant expenses are categorized as direct or

indirect• Direct expenses benefit only the business part of the

home (e.g., the office is repainted)– Deducted in full

• Indirect expenses are for maintaining and operating the home

– Allocate between business and personal

44

Office in the Home Deduction(slide 3 of 5)

• Regular method– Allowable home office expenses cannot create a

loss• Amounts allowed as itemized deductions anyway

must be deducted first– e.g., mortgage interest & real estate taxes

– Any disallowed amounts are carried forward and used in future years subject to the same limitations

45

Office in the Home Deduction(slide 4 of 5)

• Regular method– All home office expenses of an employee are misc.

itemized deductions, except those (such as interest and taxes) that qualify as other personal itemized deductions

– Home office expenses of a self-employed individual are trade or business expenses and are deductible for AGI

46

Office in the Home Deduction(slide 5 of 5)

• Simplified method– A home office expense deduction of $5 per square

foot is allowed • Since no more than 300 square feet can be counted, the

maximum deduction is limited to $1,500

– No deduction is allowed for depreciation or other actual expenses of operating the home

• Otherwise deductible amounts for interest and taxes may still be deducted in full

– No carryover of unused amounts is allowed

47

Other Employee Expenses

• A partial list of other employee expenses that are deductible includes:– Special clothing (uniforms)– Union dues– Professional expenses– Job hunting in same profession– Educator expenses (deductible for AGI)

• Limited to $250 per year for supplies, etc. of elementary and secondary school teachers

48

The Big Picture - Example 47 Job Hunting Expenses

• Return to the facts of The Big Picture on p. 9-1.

• Recall that Morgan conducted an extensive job search before obtaining her position with Kite Corporation. – Because this is her first job, the expenses she

incurred in the search are not deductible.

49

Contributions to Retirement Accounts (slide 1 of 2)

• Retirement plans fall into two major classifications depending on who is covered– For employees – usually follow one of two income

tax approaches• Most plans allow an exclusion from income for the

contributions the employee makes to the pension plan• Alternatively, using the approach followed by a

traditional IRA, a contributing employee is allowed a deduction for AGI

– Maximum deduction is $5,500 for 2014

50

Contributions to Retirement Accounts (slide 2 of 2)

• Retirement plans for self-employed taxpayers – Called Keogh (or H.R. 10) plans

• Follow the deduction approach of traditional IRAs

• Amounts contributed under a plan are deductible for AGI

51

Classification of Employee Expenses (slide 1 of 2)

• Depends on whether they are reimbursed and, if reimbursed, under what type of plan

52

Classification of Employee Expenses (slide 2 of 2)

• Employers can have three types of reimbursement plans– Accountable– Nonaccountable– No reimbursement is given

53

Accountable Plan (slide 1 of 2)

• Plan must require adequate accounting to the employer for expense reimbursed, and

• Any excess reimbursements must be returned to the employer

54

Accountable Plan (slide 2 of 2)

• Adequate accounting is– Submitting a record, with receipts, to the

employer, or– Using a per diem allowance that is not more than

the Federal per diem rate

• Employee reports no income and takes no deduction to the extent of the reimbursed expenses

55

Substantiation for Expenditures(slide 1 of 2)

• No deduction allowed for an expense if the taxpayer does not have adequate records for the expense– Therefore, taxpayers need to have good records for

employee or self-employed expenses• In some cases, use of per diem allowance will be

deemed substantiation

56

Substantiation for Expenditures(slide 2 of 2)

• Records should include:– The amount of the expense– The time and place of travel or entertainment (or

date of gift)– The business purpose of the expense– The business relationship of the taxpayer to the

person entertained (or receiving the gift)

57

Nonaccountable Plan

• Plan that does not require adequate accounting or return of excess reimbursement or both– Reimbursed amounts received under this plan are

included in gross income– Expenses are deductible from AGI as

miscellaneous itemized deductions subject to the 2% of AGI limitation

58

Unreimbursed Employee Expenses

• Expenses are deductible from AGI as miscellaneous itemized deductions subject to the 2% of AGI limitation– If employee could have received, but did not seek,

reimbursement for whatever reason, none of the employment-related expenses are deductible

59

Miscellaneous ItemizedDeductions

• Miscellaneous itemized deductions subject to the 2% of AGI limitation– Certain miscellaneous expenses must be added

together and the amount in excess of 2% of taxpayer’s AGI is deductible from AGI (i.e., itemized deduction reported on Sch. A)

60

Examples of Miscellaneous Itemized Deductions Subject to 2% Floor

• Most reimbursed expenses under a nonaccountable plan

• Unreimbursed employee expenses• Section 212 expenses not related to rents and

royalties• Tax return preparation fee• Hobby expenses• Investment expenses (except interest and taxes)

61

Examples of Miscellaneous Itemized Deductions Not Subject to 2% Floor

• Impairment-related work expenses of handicapped individuals

• Gambling losses to the extent of winnings

• Certain terminated annuity payments

62

Computing 2% of AGI Limitation (slide 1 of 2)

• Example Taxpayer, a single individual, provides the following

information for 2014• $30,000 AGI

• $ 6,500 deductible interest expense and taxes paid

• $ 1,500 employee business expenses, and

• $ 500 tax return preparation fee

63

Computing 2% of AGI Limitation(slide 2 of 2)

• Example (cont’d)Interest and taxes $6,500

Misc. expenses:Employee bus. exp. $1,500

Tax return prep. 500

Total $2,000

Less 2% AGI - 600 1,400

Itemized deductions $7,900

64

Refocus On The Big Picture (slide 1 of 5)

• Several tax issues might arise as a result of Morgan’s new job.– The first tax issue relates to the dependency exemption.

• If Morgan was living at home and accepted the job late in the year, she could qualify as a dependent of her parents.

– If so, they might also be able to claim the qualified tuition deduction (or the lifetime learning credit).

– If, however, her employment began early in the year, it may not be possible for her parents to claim her as a dependent either because

• She is not a qualifying child due to the self-supporting limitation, or

• She is not a qualifying relative due to the gross income limitation—see Chapter 3.

65

Refocus On The Big Picture (slide 2 of 5)

• Other tax issues would include the following.• Job hunting expenses - Morgan’s ‘‘extensive search’’ for employment

suggests that she may have incurred job hunting expenses– Such expenses are not deductible in a first job setting.

• Moving Expenses - Her qualified moving expenses are not so restricted. – Moving expenses are deductions for AGI.

• Office in the home deduction - Under the circumstances, Morgan is justified in claiming an office in the home deduction using either the regular method or the simplified method.– Under the regular method, the deduction would include a portion of the rent

and utilities paid and related maintenance costs.– The safe harbor method would allow Morgan $5 per square foot for business

space, but not more than 300 square feet, or $1,500.– Under either method, she would also be allowed depreciation (or expensing) of

office equipment and furnishings (e.g., computer, copier, desk, file cabinet).– She must be careful not to violate the ‘‘exclusive use’’ restriction.

66

Refocus On The Big Picture (slide 3 of 5)

• Travel – Morgan is required to travel as part of her job and so will use her car for business. – Thus, she will need to make a choice between the automatic mileage

method and the actual cost method. – Since her tax home is in her apartment, she will have no nondeductible

commuting expenses.

67

Refocus On The Big Picture (slide 4 of 5)

• Travel Allowance – Tax treatment depends on whether it is an accountable plan– If she renders an adequate accounting (and has to return any excess) to

Kite Corporation, then her allowance need not be reported on her Federal income tax return.

• Nonreimbursed amounts, however, must be allocated between meals and entertainment (subject to the 50% cutback) and other employment-related expenses.

• The balance is an itemized deduction subject to the 2 percent-of-AGI floor.– If she does not render an adequate accounting, the full allowance is

included in her gross income. • All of the meals and entertainment expenses are subject to the 50%

cutback, and • The total of all employment-related expenses is an itemized deduction

subject to the 2 percent-of-AGI floor.

68

Refocus On The Big Picture (slide 5 of 5)

• If Morgan started her job late in the year, it is unlikely that she will be in a position to itemize her deductions. – Instead, she will claim the standard deduction effectively

eliminating her ability to deduct any employment-related expenses.

• Morgan must maintain adequate substantiation regarding all of these employment related transactions. – Detailed records are particularly important in arriving at

the office in the home deduction and the business use of an automobile under the actual cost method.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 69

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu

SUNY Oneonta