Contents Publication 535 Important Changes for 1999 ...... 1 Cat. No. 15065Z Department Important Changes for 2000 ...... 2 of the Treasury Business 1. Deducting Business Expenses .. 2 2. Employees' Pay ...... 5 Internal Revenue 3. Meals and Lodging Furnished to Service Expenses Employees ...... 8

4. Fringe Benefits ...... 9 For use in preparing 5. Employee Benefit Programs ...... 17 6. Retirement Plans ...... 20 1999 Returns 7. Rent Expense ...... 24

8. Interest ...... 26

9. Taxes ...... 32

10. Insurance ...... 33

11. Costs You Can Deduct or Capitalize ...... 36

12. Amortization ...... 40

13. Depletion ...... 47

14. Business Bad Debts ...... 51

15. Electric and Clean-Fuel Vehicles 53

16. Other Expenses ...... 57

17. How To Get More Information ... 63

Index ...... 65

Introduction This publication discusses common business expenses and explains what is and is not deductible. The general rules for deducting business expenses are discussed in the opening chapter. The chapters that follow cover specific expenses and list other publi- cations and forms you may need.

Important Changes for 1999 The following items highlight some changes in the tax law for 1999.

Standard mileage rate. The standard mile- age rate for the cost of operating your car, van, pickup, or panel truck in 1999 is 321/2 cents a mile for all business miles driven be- fore April 1. The rate is 31 cents a mile for business miles driven after March 31. See chapter 16.

Health insurance deduction for the self- employed. For 1999, this deduction in- creases to 60% of the amount you paid for health insurance for yourself and your family. After 2001, the deduction will increase again. See chapter 10.

Business use of your home. You may be able to deduct expenses for your home office even if it is not where you perform your most important business activities or spend most Useful Items the cost of goods sold, you cannot deduct it of your business time. See chapter 1. You may want to see: again as a business expense. The following are types of expenses that go into figuring cost of goods sold. Photographs of missing children. The Publication Internal Revenue Service is a proud partner with the National Center for Missing and Ex- Ⅺ 334 Tax Guide for Small Business • The cost of products or raw materials in your inventory, including the cost of hav- ploited Children. Photographs of missing Ⅺ children selected by the Center may appear 463 Travel, Entertainment, Gift, and ing them shipped to you. in this publication on pages that would other- Car Expenses • The cost of storing the products you sell. wise be blank. You can help bring these Ⅺ 525 Taxable and Nontaxable Income Direct labor costs (including contributions children home by looking at the photographs • to pension or annuity plans) for workers and calling 1–800–THE–LOST (1–800–843– Ⅺ 529 Miscellaneous Deductions who produce the products. 5678) if you recognize a child. Ⅺ 536 Net Operating Losses • Factory overhead expenses. Ⅺ 538 Accounting Periods and Methods Under the uniform capitalization rules, you Ⅺ 542 Corporations may have to include certain indirect costs of Important Changes Ⅺ 547 Casualties, Disasters, and Thefts production and resale in your cost of goods (Business and Nonbusiness) sold. Indirect costs include rent, interest, for 2000 taxes, storage, purchasing, processing, re- Ⅺ The following items highlight some changes 587 Business Use of Your Home packaging, handling, and administrative in the tax law for 2000. (Including Use by Day-Care Pro- costs. This rule on indirect costs does not viders) apply to personal property you acquire for Ⅺ resale if your average annual gross receipts Standard mileage rate. The standard mile- 925 Passive Activity and At-Risk Rules (or those of your predecessor) for the pre- age rate for the cost of operating your car, Ⅺ 936 Home Mortgage Interest ceding 3 tax years are not more than $10 van, pickup, or panel truck in 2000 is 32.5 Deduction million. cents per mile for each business mile. For more information, see the following. Ⅺ 946 How To Depreciate Property Meal expense deduction subject to “hours • Cost of goods sold—chapter 6 of Publi- of service” limits. For 2000, this deduction Form (and Instructions) cation 334. increases to 60% of the reimbursed meals • Inventories—Publication 538. your employees consume while they are Ⅺ Sch A (Form 1040) Itemized De- subject to the Department of Transportation's ductions • Uniform capitalization rules—section 1.263A of the regulations. “hours of service” limits. See chapter 16. Ⅺ 5213 Election To Postpone Determination as To Whether the Taxable income limit for certain percent- Presumption Applies That an Capital Expenses age depletion. For tax years beginning after Activity Is Engaged in for Profit 1999, percentage depletion on the marginal You must capitalize, rather than deduct, some See chapter 17 for information about get- production of oil or natural gas is limited to costs. These costs are a part of your invest- ting publications and forms. taxable income from the property figured ment in your business and are called “capital without the depletion deduction. See chapter expenses.” There are, in general, three types 13. of costs you capitalize. What Can 1) Going into business. Be Deducted? 2) Business assets. 3) Improvements. To be deductible, a business expense must be both ordinary and necessary. An ordinary Recovery. Although you generally cannot 1. expense is one that is common and accepted take a current deduction for a capital ex- in your trade or business. A necessary ex- pense, you may be able to take deductions pense is one that is helpful and appropriate for the amount you spend through a method Deducting for your trade or business. An expense does of depreciation, amortization, or depletion. not have to be indispensable to be considered These methods allow you to deduct part of Business necessary. your cost each year over a number of years. It is important to separate business ex- In this way you are able to “recover” your Expenses penses from the following. capital expense. See Amortization (chapter 12) and Depletion (chapter 13) in this publi- 1) The expenses used to figure the cost of cation. For information on depreciation, see goods sold. Publication 946. 2) Capital expenses. Introduction 3) Personal expenses. Going Into Business The costs of getting started in business, be- This chapter covers the general rules for de- If you have an expense that is partly fore you actually begin business operations, ducting business expenses. Business ex- TIP for business and partly personal, are capital expenses. These costs may in- penses are the costs of carrying on a trade separate the personal part from the clude expenses for advertising, travel, or or business. These expenses are usually business part. wages for training employees. deductible if the business is operated to make a profit. If you go into business. When you go into Cost of Goods Sold business, treat all costs you had to get your Topics If your business manufactures products or business started as capital expenses. This chapter discusses: purchases them for resale, some of your ex- Usually you recover costs for a particular penses are for the products you sell. You use asset through depreciation. Generally, you • What can be deducted these expenses to figure the cost of the goods cannot recover other costs until you sell the you sold during the year. You deduct these business or otherwise go out of business. • How much can be deducted costs from your gross receipts to figure your However, you can choose to amortize certain gross profit for the year. You must maintain costs for setting up your business. See Going • When to deduct inventories to be able to determine your cost Into Business in chapter 12 for more infor- • Not-for-profit activities of goods sold. If you use an expense to figure mation on business start-up costs. Page 2 Chapter 1 Deducting Business Expenses If you do not go into business. If you are Business motor vehicles. You usually in the normal course of your trade an individual and your attempt to go into capitalize the cost of a motor vehicle you buy or business, or business is not successful, the expenses you to use in your business. You can recover its c) A separate structure (not attached had in trying to establish yourself in business cost through annual deductions for depreci- to your home) you use in con- fall into two categories. ation. nection with your trade or business. There are dollar limits on the depreciation 1) The costs you had before making a de- you may claim each year on passenger au- You do not have to meet the exclusive use cision to acquire or begin a specific tomobiles used in your business. See Publi- test if you use part of your home in either of business. These costs are personal and cation 463. the following ways. nondeductible. They include any costs Repairs you make to your business vehi- incurred during a general search for, or cle are deductible expenses. However, 1) For the storage of inventory or product preliminary investigation of, a business amounts you pay to recondition and overhaul samples. or investment possibility. a business vehicle are capital expenses. 2) As a day-care facility. 2) The costs you had in your attempt to acquire or begin a specific business. Roads and driveways. The costs of building Beginning in 1999, your home office will These costs are capital expenses and a private road on your business property and qualify as your principal place of business if you can deduct them as a capital loss. the cost of replacing a gravel driveway with you meet the following requirements. a concrete one are capital expenses you may If you are a corporation and your attempt be able to depreciate. The cost of maintain- 1) You use the office exclusively and regu- to go into a new trade or business is not ing a private road on your business property larly for administrative or management successful, you may be able to deduct all is a deductible expense. activities of your trade or business. investigatory costs as a loss. Tools. Unless the uniform capitalization rules 2) You have no other fixed location where The costs of any assets acquired during you conduct substantial administrative your unsuccessful attempt to go into business apply, amounts spent for tools used in your business are deductible expenses if the tools or management activities of your trade are a part of your basis in the assets. You or business. cannot take a deduction for these costs. You have a life expectancy of less than one year. will recover the costs of these assets when For more information, see Publication 587. you dispose of them. Machinery parts. Unless the uniform cap- italization rules apply, the cost of replacing Business use of your car. If you use your short-lived parts of a machine to keep it in Business Assets car in your business, you can deduct car ex- good working condition and not to add to its penses. If you use your car for both business The cost of any asset you use in your busi- life is a deductible expense. and personal purposes, you must divide your ness is a capital expense. There are many expenses based on mileage. Only your ex- different kinds of business assets, such as Heating equipment. The cost of changing penses for the miles you drove the car for land, buildings, machinery, furniture, trucks, from one heating system to another is a cap- business are deductible as business ex- patents, and franchise rights. You must capi- ital expense and not a deductible expense. penses. talize the full cost of the asset, including You can deduct actual car expenses, freight and installation charges. Personal Expenses which include depreciation (or lease pay- If you produce certain property for use in ments), gas and oil, tires, repairs, tune-ups, your trade or business, capitalize the pro- Generally, you cannot deduct personal, living, insurance, and registration fees. Instead of duction costs under the uniform capitalization or family expenses. However, if you have an figuring the business part of these actual ex- rules. See section 1.263A–2 of the regu- expense for something that is used partly for penses, you may be able to use the standard lations for information on those rules. business and partly for personal purposes, mileage rate to figure your deduction. For divide the total cost between the business 1999, the standard mileage rate is 321/2 cents and personal parts. You can deduct as a a mile for all business miles driven before Improvements business expense only the business part. The costs of making improvements to a April 1. The rate is 31 cents a mile after March For example, if you borrow money and 31. business asset are capital expenses, if the use 70% of it for business and the other 30% improvements add to the value of the asset, If you are self-employed, you can also for a family vacation, generally you can de- deduct the business part of interest on your appreciably lengthen the time you can use it, duct as a business expense only 70% of the or adapt it to a different use. You can deduct car loan, state and local personal property tax interest you pay on the loan. The remaining on the car, parking fees, and tolls, whether repairs that keep your property in a normal 30% is personal interest that is not deductible. efficient operating condition as a business or not you claim the standard mileage rate. See chapter 8 for information on deducting You can use the nonbusiness part of the expense. interest and the allocation rules. Improvements include new electric wiring, personal property tax to determine your de- a new roof, a new floor, new plumbing, duction for taxes on Schedule A (Form 1040) Business use of your home. If you use part if you itemize your deductions. bricking up windows to strengthen a wall, and of your home in your business, you may be lighting improvements. For more information on car expenses and able to claim part of the expenses of main- the rules for using the standard mileage rate, taining your home as a business expense. see Publication 463. Restoration plan. Capitalize the cost of re- These expenses include mortgage interest, conditioning, improving, or altering your insurance, utilities, repairs, and depreciation. property as part of a general restoration plan The business use of your home must meet to make it suitable for your business. This specific requirements before you can take any applies even if some of the work would by of these expenses as business deductions. How Much itself be classified as repairs. To qualify to claim expenses for the busi- ness use of your home, you must meet the Can Be Deducted? Replacements. You cannot deduct the cost following tests. You cannot deduct more for a business ex- of a replacement that stops deterioration and pense than the amount you actually spend. adds to the life of your property. Capitalize 1) Your use of the business part of your There is usually no other limit on how much that cost and depreciate it. home must be: you can deduct if the amount is reasonable. Treat amounts paid to replace parts of a a) Exclusive, However, if your deductions are large enough machine that only keep it in a normal operat- to produce a net business loss for the year, ing condition like repairs. However, if your b) Regular, the amount of tax loss may be limited. equipment has a major overhaul, capitalize c) For your trade or business, AND and depreciate the expense. Recovery of amount deducted. If you re- 2) The business part of your home must be cover part of an expense in the same tax year one of the following: for which you have claimed a deduction, re- Capital or Deductible Expenses duce your expense deduction by the amount a) Your principal place of business, To help you distinguish between capital and of the recovery. If you have a recovery in a deductible expenses, several different items b) A place where you meet or deal later year, include the recovered amount in are discussed below. with patients, clients, or customers income. However, if part of the deduction for Chapter 1 Deducting Business Expenses Page 3 the expense did not reduce your tax, you do ported. The two basic methods are the cash you must pay the expense before you can not have to include all the recovery in income. method and an accrual method. deduct it. The deduction by an accrual Exclude an amount equal to the part that did For more information on accounting method payer is allowed when the corre- not reduce your tax. methods, see Publication 538. sponding amount is includible in income by For more information on recoveries and the related cash method payee. See Related the tax benefit rule, see Publication 525. Cash method. Under the cash method of Persons in Publication 538. accounting, you deduct business expenses in Payments in kind. If you provide services the tax year you actually paid them, even if to pay a business expense, the amount you you incur them in an earlier year. can deduct is the amount you spend to pro- Not-for-Profit vide the services. It is not what you would Accrual method. Under an accrual method have paid in cash. of accounting, you generally deduct business Activities Similarly, if you pay a business expense expenses when you become liable for them, If you do not carry on your business or in- in goods or other property, you can deduct whether or not you pay them in the same vestment activity to make a profit, there is a only the amount the property costs you. If year. All events that set the amount of the limit on the deductions you can take. You these costs are included in the cost of goods liability must have happened, and you must cannot use a loss from the activity to offset sold, do not deduct them as a business ex- be able to figure the amount of the expense other income. Activities you do as a hobby, pense. with reasonable accuracy. or mainly for sport or recreation, come under Economic performance rule. Under an this limit. So does an investment activity in- Limits on losses. If your deductions for an accrual method, you generally cannot deduct tended only to produce tax losses for the in- investment or business activity are more than or capitalize business expenses until eco- vestors. the income it brings in, you have a net loss. nomic performance occurs. If your expense The limit on not-for-profit losses applies to There may be limits on how much, if any, of is for property or services provided to you, or individuals, partnerships, estates, trusts, and the loss you can use to offset income from for your use of property, economic perform- S corporations. It does not apply to corpo- other sources. ance occurs as the property or services are rations other than S corporations. Not-for-profit limits. If you do not carry provided, or as the property is used. If your In determining whether you are carrying on your business activity with the intention of expense is for property or services you pro- on an activity for profit, all the facts are taken making a profit, you cannot use a loss from vide to others, economic performance occurs into account. No one factor alone is decisive. it to offset other income. See Not-for-Profit as you provide the property or services. Among the factors to consider are whether: Activities, later. At-risk limits. Generally, a deductible Example. Your tax year is the calendar 1) You carry on the activity in a business- loss from a trade or business or other year. In December 1999, the Field Plumbing like manner, income-producing activity is limited to the in- Company did some repair work at your place vestment you have “at risk” in the activity. You of business and sent you a bill for $150. You 2) The time and effort you put into the ac- are “at risk” in any activity for the following paid it by check in January 2000. If you use tivity indicate you intend to make it prof- items. an accrual method of accounting, deduct the itable, $150 on your tax return for 1999 because all 3) You depend on income from the activity 1) The money and adjusted basis of prop- events that set the amount of liability and for your livelihood, erty you contribute to the activity. economic performance occurred in that year. If you use the cash method of accounting, you 4) Your losses are due to circumstances 2) Amounts you borrow for use in the ac- can deduct the expenses on your 2000 return. beyond your control (or are normal in the tivity if: start-up phase of your type of business), a) You are personally liable for repay- Prepayment. You cannot deduct expenses 5) You change your methods of operation ment, or in advance, even if you pay them in advance. in an attempt to improve profitability, This rule applies to both the cash and accrual b) You pledge property (other than methods. It applies to prepaid interest, pre- 6) You, or your advisors, have the knowl- property used in the activity) as se- paid insurance premiums, and any other ex- edge needed to carry on the activity as curity for the loan. pense paid far enough in advance to, in ef- a successful business, fect, create an asset with a useful life For more information, see Publication 925. 7) You were successful in making a profit extending substantially beyond the end of the Passive activities. Generally, you are in in similar activities in the past, current tax year. a passive activity if you have a trade or busi- 8) The activity makes a profit in some ness activity in which you do not materially Example. In 1999, you sign a 10-year years, and how much profit it makes, and participate during the year, or a rental activity. lease and immediately pay your rent for the Deductions from passive activities generally first 3 years. Even though you paid the rent 9) You can expect to make a future profit can only offset your income from passive ac- for 1999, 2000, and 2001, you can deduct from the appreciation of the assets used tivities. You cannot deduct any excess de- only the rent for 1999 on your current tax re- in the activity. ductions against your other income. In addi- turn. You can deduct on your 2000 and 2001 tion, you can take passive activity credits only tax returns the rent for those years. from tax on net passive income. Any excess Limit on Deductions loss or credits are carried over to later years. Contested liabilities. Under the cash and Losses For more information, see Publication 925. method, you can deduct a contested liability If your activity is not carried on for profit, take Net operating loss. If your deductions only in the year you pay the liability. Under deductions only in the following order, only to are more than your income for the year, you an accrual method, you can deduct contested the extent stated in the three categories, and, may have a “net operating loss.” You can use liabilities, such as taxes (except foreign or if you are an individual, only if you itemize a net operating loss to lower your taxes in U.S. possession income, war profits, and ex- them on Schedule A (Form 1040). other years. See Publication 536 for more in- cess profits taxes), in the tax year you pay the formation. See Publication 542 for information liability (or transfer money or other property about net operating losses of corporations. Category 1. Deductions you can take for to satisfy the obligation) or in the tax year you personal as well as for business activities are settle the contest. However, to take the de- allowed in full. For individuals, all nonbusi- duction in the year of payment or transfer, you ness deductions, such as those for home must meet certain conditions. See Contested mortgage interest, taxes, and casualty losses, When Can Liability in Publication 538 for more informa- belong in this category. Deduct them on the tion. appropriate lines of Schedule A (Form 1040). an Expense You can only deduct a casualty loss on Related persons. Under an accrual method property you own for personal use to the ex- Be Deducted? of accounting, you generally deduct expenses tent it is more than $100 and all these losses When an expense can be deducted depends when you incur them, even if you have not exceed 10% of your adjusted gross income. on your accounting method. An accounting paid them. However, if you and the person See Publication 547 for more information on method is a set of rules used to determine you owe are related persons and the person casualty losses. For the limits that apply to when and how income and expenses are re- you owe uses the cash method of accounting, mortgage interest, see Publication 936. Page 4 Chapter 1 Deducting Business Expenses Category 2. Deductions that do not result in More than one activity. If you have several you carry on the activity. If you show 3 (or an adjustment to the basis of property are undertakings, each may be a separate activity 2) years of profit at the end of this period, your allowed next, but only to the extent your gross or several undertakings may be one activity. deductions are not limited under these rules. income from the activity is more than the de- The following are the most significant facts If you do not have 3 (or 2) years of profit, the ductions you take (or could take) for it under and circumstances in making this determi- limit can be applied retroactively to any year the first category. Most business deductions, nation. in the 5-year (or 7-year) period with a loss. such as those for advertising, insurance pre- Filing Form 5213 automatically extends miums, interest, utilities, wages, etc., belong • The degree of organizational and eco- the period of limitations on any year in the in this category. nomic interrelationship of various under- 5-year (or 7-year) period to 2 years after the takings. due date of the return for the last year of the Category 3. Business deductions that de- • The business purpose that is (or might period. The period is extended only for de- crease the basis of property are allowed last, be) served by carrying on the various ductions of the activity and any related de- but only to the extent the gross income from undertakings separately or together in a ductions that might be affected. the activity is more than deductions you take business or investment setting. (or could take) for it under the first two cate- gories. The deductions for depreciation, • The similarity of various undertakings. amortization, and the part of a casualty loss The IRS will generally accept your char- an individual could not deduct in category (1) acterization of several undertakings as one belong in this category. Where more than one activity, or more than one activity, if supported 2. asset is involved, divide depreciation and by facts and circumstances. these other deductions proportionally among those assets. If you are carrying on two or more TIP different activities, keep the de- Employees' Pay Individuals must claim the amounts in ductions and income from each one TIP categories (2) and (3) as miscella- separate. Figure separately whether each is neous deductions on Schedule A a not-for-profit activity. Then figure the limit (Form 1040). They are subject to the on deductions and losses separately for each 2%-of-adjusted-gross-income limit. See Pub- activity that is not for profit. Introduction lication 529 for information on this limit. You can generally deduct the pay you give your employees for the services they perform Example. Ida is engaged in a not-for- Presumption of Profit for your business. The pay may be in cash, profit activity. The income and expenses of An activity is presumed carried on for profit if property, or services. It may include wages, the activity are as follows: it produced a profit in at least 3 of the last 5 salaries, vacation allowances, bonuses, tax years including the current year. Activities commissions, and fringe benefits. Gross income ...... $3,200 that consist primarily of breeding, training, This chapter provides information about Minus expenses: showing, or racing horses are presumed car- deductions allowed for various kinds of pay. Real estate taxes ...... $700 ried on for profit if they produced a profit in Chapters 3, 4, and 5 provide additional infor- Home mortgage interest ...... 900 at least 2 of the last 7 tax years including the mation about the treatment of certain benefits Insurance ...... 400 current year. You have a profit when the you furnish to employees. Utilities ...... 700 gross income from an activity is more than the For information about determining who is Maintenance ...... 200 an employee and about employment taxes Depreciation on an automobile ...... 600 deductions for it. Depreciation on a machine ...... 200 3,700 If a taxpayer dies before the end of the on your employees' pay, see Publication 15, 5-year (or 7-year) period, the period ends on Circular E, Employer's Tax Guide, and Publi- Loss ...... $ 500 the date of the taxpayer's death. cation 15–A, Employer's Supplemental Tax Ida must limit her deductions to $3,200, If your business or investment activity Guide. For information about deducting em- the gross income she earned from the activ- passes this 3- (or 2-) years-of-profit test, pre- ployment taxes paid on your employees' ity. The limit is reached in category (3), as sume it is carried on for profit. This means it wages, see chapter 9. follows: will not come under these limits. You can take You can claim the following employ- all your business deductions from the activity, TIP ment credits if you hire individuals Limit on deduction ...... $3,200 even for the years that you have a loss. You who meet certain requirements. Category 1: Taxes and interest ...... $1,600 can rely on this presumption in every case, Category 2: Insurance, utilities, and unless the IRS shows it is not valid. • Empowerment zone employment credit. maintenance ...... 1,300 2,900 • Indian employment credit. Available for Category 3 ...... $ 300 Using the presumption later. If you are starting an activity and do not have 3 (or 2) The $300 for depreciation is divided be- • Welfare-to-work credit. years showing a profit, you may want to take tween the automobile and machine, as fol- advantage of this presumption later, after you • Work opportunity credit. lows: have the 5 (or 7) years of experience allowed $600 However, you must reduce your deduction for ϫ $300 = $225 depreciation for the automobile by the test. $800 employee wages by the amount of any em- You can choose to do this by filing Form ployment credits you claim. For more infor- $200 5213. Filing this form postpones any deter- ϫ $300 = $75 depreciation for the machine mation about these credits, see Publication $800 mination that your activity is not carried on for 954, Tax Incentives for Empowerment Zones profit until 5 (or 7) years have passed since and Other Distressed Communities. you started the activity. The basis of each asset is reduced ac- cordingly. Form 5213 must be filed within 3 The $1,600 for category (1) is deductible TIP years of the due date of your return Topics in full on the appropriate lines for taxes and for the year in which you first carried This chapter discusses: interest on Schedule A (Form 1040). Ida adds on the activity, or, if earlier, within 60 days of the remaining $1,600 (the total of categories receiving written notice from the Internal • Tests for deductibility (2) and (3)) to her other miscellaneous de- Revenue Service proposing to disallow de- • Kinds of payments ductions on Schedule A (Form 1040) that are ductions attributable to the activity. subject to the 2%-of-adjusted-gross-income limit. Useful Items You may want to see: Partnerships and S corporations. If a The benefit gained by making this choice partnership or S corporation carries on a is that the IRS will not immediately question not-for-profit activity, these limits apply at the whether your activity is engaged in for profit. Form (and Instructions) partnership or S corporation level. They are Accordingly, it will not restrict your de- Ⅺ W–2 Wage and Tax Statement reflected in the individual shareholder's or ductions. Rather, you will gain time to earn partner's distributive shares. a profit in 3 (or 2) out of the first 5 (or 7) years Ⅺ 1099–MISC Miscellaneous Income Chapter 2 Employees' Pay Page 5 See chapter 17 for information about get- Individual salaries. You must base the test gram that does not favor highly compensated ting publications and forms. of whether a salary is reasonable on each employees as to eligibility or benefits. See individual's salary and the service performed, Exclusion of Certain Fringe Benefits in chap- not on the total salaries paid to all officers or ter 4 for the definition of a highly compen- all employees. For example, even if the total sated employee. amount you pay to your officers is reason- An award is not a qualified plan award if Tests for Deductibility able, you cannot deduct an individual officer's the average cost of all the employee To be deductible, your employees' pay must entire salary if it is not reasonable based on achievement awards given during the tax year be an ordinary and necessary expense and the items listed above. (that would be qualified plan awards except you must pay or incur it in the tax year. These for this limit) is more than $400. To figure this and other requirements that apply to all busi- average cost, do not take into account awards ness expenses are explained under What Test 2—For Services of very small value. Can Be Deducted? and When Can an Ex- Performed Exclusion from employee's wages. If the cost of employee achievement awards pense Be Deducted? in chapter 1. You must be able to prove the payment was you give an employee is not more than the In addition, the pay must meet both of the made for services actually performed. following tests. limits, you can exclude the awards from the employee's wages. • Test 1. The pay must be reasonable. If the awards cost more than the amount you can deduct, include in the employee's • Test 2. The pay must be for services Kinds of Payments wages the larger of the following amounts. performed. Some of the ways you may provide pay to your employees are discussed next. • The part of the cost of the awards you If these tests are met, the form or method of cannot deduct (up to the awards' fair figuring the pay does not affect its deductibil- market value). ity. For example, bonuses and commissions Awards • The amount by which the fair market based on sales or earnings and paid under You can generally deduct amounts you pay an agreement made before the services were value of the awards is more than the to your employees as awards, whether paid amount you can deduct. performed are generally deductible. in cash or property. However, if you give property to an employee as an employee Do not include the remaining value of the Employee-shareholder salaries. If a cor- achievement award, your deduction may be awards in the employee's wages. poration pays an employee who is also a limited. shareholder a salary that is unreasonably high considering the services actually per- Employee achievement awards. Your de- Bonuses duction for the cost of employee achievement formed by the employee-shareholder, the ex- You can deduct a bonus paid to an employee awards given to any one employee during the cessive part of the salary may be treated as if you intended the bonus as additional pay tax year is subject to the following limits. a constructive distribution of earnings to the for services, not as a gift, and the services employee-shareholder. For more information were actually performed. It does not matter on corporate distributions to shareholders, • $400 for awards that are not qualified plan awards. whether you pay the bonus in cash, property, see Publication 542, Corporations. or a combination of both. However, for you to • $1,600 for all awards, whether or not deduct the amount as employee pay, the total qualified plan awards. bonuses, salaries, and other pay must be Test 1—Reasonable reasonable for the services performed. In- Determine the reasonableness of pay by the Include the cost that is not more than the clude the bonus in the employee's wages. facts. Generally, reasonable pay is the above limits on the “Other deductions” line of amount that like enterprises ordinarily would your tax return or business schedule. An employee achievement award is an Gifts of nominal value. If, to promote em- pay for the services under similar circum- ployee goodwill, you distribute turkeys, hams, stances. item of tangible personal property that meets all the following requirements. or other merchandise of nominal value to your You must be able to prove the pay is employees at holidays, the value of these reasonable. Base this test on the circum- • It is given for length of service or safety items is not salary or wages. You can deduct stances that exist when you contract for the achievement. the cost of these items as a business expense services, not those existing when the rea- even though the employees do not include sonableness is questioned. If the pay is ex- • It is awarded as part of a meaningful the items in income. cessive, you can deduct only the part that is presentation. If you distribute cash, gift certificates, or reasonable. • It is awarded under conditions and cir- similar items readily convertible to cash, the cumstances that do not create a signif- value of these items is additional wages or Factors to consider. To determine if pay is icant likelihood of disguised pay. salaries, regardless of the amount or value. reasonable, consider the following items and any other pertinent facts. Length-of-service award. An award will not qualify as a length-of-service achievement Education Expenses • The duties performed by the employee. award if either of the following applies. If you pay or reimburse education expenses for an employee enrolled in a course not re- • The volume of business handled. • The employee receives the award during quired for the job or not otherwise related to his or her first 5 years of employment. • The character and amount of responsi- the job, deduct the payment as wages. You bility. • The employee received a length-of- must include the payment in the employee's service award (other than one of very wages, and it is subject to FICA and FUTA • The complexities of your business. small value) during that year or in any of taxes and income tax withholding. However, • The amount of time required. the prior 4 years. if the payment is part of a qualified educa- tional assistance program, these rules may • The general cost of living in the locality. Safety achievement award. An award not apply. See chapter 5. will not qualify as a safety achievement award • The ability and achievements of the indi- If you pay or reimburse education ex- if it is given to either of the following. vidual employee performing the service. penses for an employee enrolled in a job- related course, you can deduct the payment • The pay compared with the amount of 1) A manager, administrator, clerical em- as a noncompensatory business expense. gross and net income of the business, ployee, or other professional employee. Since this expense would be deductible if as well as with distributions to share- 2) More than 10% of the employees during paid by the employee, it is called a working holders if the business is a corporation. the year, excluding those listed in (1). condition fringe benefit. Do not include a working condition fringe benefit in an em- • Your policy regarding pay for all of your Qualified plan award. This is an em- ployee's wages. Working condition fringe employees. ployee achievement award that you awarded benefits are discussed in more detail in • The history of pay for each employee. as part of an established written plan or pro- chapter 4. Page 6 Chapter 2 Employees' Pay Employee Benefit Programs • Discounts on property or services. • Meals you must furnish to crew members of a commercial vessel under a federal You can generally deduct amounts you spend • Memberships in country clubs or other social clubs. law. This includes crew members of on employee benefit programs as a business commercial vessels operating on the expense. Employee benefit programs include • Tickets to entertainment or sporting Great Lakes, the Saint Lawrence the following. events. Seaway, or any U.S. inland waterway if meals would be required under federal • Accident and health plans (including Include your deduction for fringe benefits law had the vessel been operated at sea. medical savings accounts). on your tax return or business schedule in This does not include meals you furnish • Adoption assistance. whatever category the cost falls. For exam- on vessels primarily providing luxury wa- ple, if you allow an employee to use a car or ter transportation. • Cafeteria plans. other property you lease, deduct the cost of • Dependent care assistance. the lease as a rent or lease expense. If you • Meals you furnish on an oil or gas plat- own the property, include your deduction for form or drilling rig located offshore or in • Educational assistance. its cost or other basis as a section 179 de- Alaska. This includes meals you furnish • Group-term life insurance coverage. duction or a depreciation deduction. at a support camp that is near and inte- For more information about fringe bene- gral to an oil or gas drilling rig located in • Welfare benefit funds. fits, see chapter 4. Also, see Employee Ben- Alaska. efit Programs, earlier, and Meals and Lodg- Claim your deduction for these programs ing, later, in this chapter. on the “employee benefit programs” line of Property your tax return or business schedule. How- ever, if you provide dependent care by oper- Loans or Advances If you transfer property (including your com- ating a dependent care facility for your em- pany's stock) to an employee as payment for You generally can deduct as employee pay ployees, deduct your costs in whatever services, you can deduct it as wages. The a loan or advance you make to an employee categories they fall (depreciation, utilities, amount you can deduct, and the amount you that you do not expect the employee to repay salaries, etc.). must include in the employee's wages, is its if it is for personal services actually per- For more information about employee fair market value on the date of the transfer formed. The total must be reasonable when benefit programs, see chapter 5. Also, see minus any amount the employee paid for the you add the loan or advance to the employ- Fringe Benefits and Meals and Lodging, later property. You treat the deductible amount as ee's other pay, and it must meet the tests for in this chapter. received in exchange for the property, and deductibility, discussed earlier. However, if you must recognize any gain or loss realized the employee performs no services, treat the Group-term life insurance. You cannot de- on the transfer. Your gain or loss is the dif- amount you advanced to the employee as a ference between the fair market value of the duct the cost of group-term life insurance if loan, which you cannot deduct. you are directly or indirectly the beneficiary property and its adjusted basis on the date of the policy. of transfer. Below-market interest rate loans. On cer- tain loans you make to an employee or A corporation recognizes no gain or Limit on deduction for welfare benefit shareholder, you are treated as having re- ! loss when it pays for services with its funds. Your deduction for the cost of em- ceived interest income and as having paid CAUTION own stock. ployee benefit programs provided under a compensation or dividends equal to that in- welfare benefit fund is limited to the fund's terest. See Below-Market Loans in chapter You can claim the deduction only for your qualified cost for the tax year. However, if 8 for more information. your contributions to the fund are more than tax year in which the employee includes the its qualified cost, you can carry the excess property's value in income. The employee is over to the next tax year. deemed to have included the value in income Meals and Lodging if you report it on Form W–2 in a timely A welfare benefit fund is a funded plan (or You can usually deduct the cost of furnishing a funded arrangement having the effect of a manner. meals and lodging to your employees. How- These rules also apply to property trans- plan) that provides welfare benefits to your ever, you can generally deduct only 50% of employees, independent contractors, or their ferred to an independent contractor, generally your costs of furnishing meals. reported on Form 1099–MISC. beneficiaries. Welfare benefits are any ben- Deduct the cost on your tax return or efits other than deferred compensation or business schedule in whatever category the Restricted property. If the property you transfers of restricted property. expense falls. For example, if you operate a transfer for services is subject to restrictions Qualified cost. Generally, this is the total restaurant, deduct the cost of the meals you that affect its value, you generally cannot de- of the following amounts, reduced by the furnish to your employees as part of the cost duct it and do not report gain or loss until it after-tax income of the fund. of goods sold. If you operate a nursing home, is substantially vested in the recipient. How- motel, or rental property, deduct the costs of ever, if the recipient pays for the property, you • The cost you would have been able to furnishing lodging to an employee as ex- must report any gain at the time of the trans- deduct using the cash method of ac- penses for utilities, linen service, salaries, fer up to the amount paid. counting if you had paid for the benefits depreciation, etc. “Substantially vested” means the property directly. For more information about meals and is not subject to a substantial risk of forfeiture. The contributions added to a reserve ac- lodging furnished to employees, see chapter • The recipient is not likely to have to give up count that are needed to fund claims in- 3. his or her rights in the property in the future. curred but not paid as of the end of the year for supplemental unemployment Deduction limit on meals. You can gener- benefits, severance pay, or disability, ally deduct only 50% of the costs of furnishing medical, or life insurance benefits. meals to your employees. However, you can Reimbursements deduct the full costs of the following meals. for Business Expenses For more information, see sections 419(c) You can generally deduct the amount you pay and 419A of the Internal Revenue Code and • Meals that qualify as a de minimis fringe or reimburse employees for business ex- the related regulations. benefit, as discussed in chapter 4. penses they incur for you for items such as • Meals whose value you must include in travel and entertainment. However, your de- Fringe Benefits an employee's wages. For more infor- duction for meal and entertainment expenses mation, see chapter 3. is usually limited to 50% of the payment. A fringe benefit is a form of pay provided to If you make the payment under an ac- any person for the performance of services • Meals you furnish to your employees at countable plan, deduct it in the category of by that person. You can deduct the cost of the work site when you operate a res- the expense paid. For example, if you pay an fringe benefits you provide. The following are taurant or catering service. employee for travel expenses incurred on examples of fringe benefits. • Meals you furnish to your employees as your behalf, deduct this payment as a travel part of the expense of providing recre- expense on your tax return or business The use of a car. • ational or social activities, such as a schedule. See the instructions for the form • Flights on airplanes. company picnic. you file for information on which lines to use. Chapter 2 Employees' Pay Page 7 If you make the payment under a nonac- You determine the value using the rules ex- emergency calls during the meal period. countable plan, include it in your employee's plained in chapter 4. However, you must be able to show that wages and deduct it as wages on your tax This chapter explains a special rule that these emergency calls have occurred or return or business schedule. allows you to exclude the value of meals and can reasonably be expected to occur. See Travel, Meals, and Entertainment in lodging from an employee's wages if you • Meals you furnish during working hours chapter 16 for more information about de- meet certain tests. See chapter 4 for infor- because the nature of your business re- ducting reimbursements and an explanation mation on excluding the value of certain stricts your employee to a short meal of accountable and nonaccountable plans. meals as a de minimis fringe benefit. period (such as 30 or 45 minutes), and For information about deducting the cost the employee cannot be expected to eat of meals and lodging furnished to an em- elsewhere in such a short time. For ex- Sick Pay ployee, see chapter 2. ample, meals can qualify if the peak You can deduct amounts you pay to your workload occurs during the normal lunch employees for sickness and injury, including hour. But if the reason for the short meal lump-sum amounts, as compensation. How- period is to allow the employee to leave ever, your deduction is limited to amounts not earlier in the day, the meal will not qualify. compensated by insurance or other means. Exclusion From Employee Wages • Meals you furnish during work hours be- cause your employee could not otherwise Vacation Pay You can exclude from an employee's wages eat proper meals within a reasonable Vacation pay is an amount you pay or will pay the value of meals and lodging you, or a third period of time. For example, meals can to an employee while the employee is on va- party on your behalf, furnish to the employee qualify if there are insufficient eating fa- cation. It includes an amount you pay an or the employee's spouse or dependents if cilities near the place of employment. employee even if the employee chooses not you meet all the following tests. • Meals you furnish to a restaurant or other to take a vacation. Vacation pay does not in- food service employee for each meal clude any sick pay or holiday pay. • Test 1. You furnish the meals or lodging period in which the employee works, if You can ordinarily deduct vacation pay on your business premises. you furnish the meals during, immediately only in your tax year in which the employee • Test 2. You furnish the meals or lodging before, or immediately after work hours. actually receives it. This rule applies regard- for your convenience. For example, if a waitress works through less of whether you use the cash method or the breakfast and lunch periods, you can an accrual method of accounting. • Test 3. In the case of lodging (but not exclude from her wages the value of the However, you can deduct vacation pay in meals), you require your employee to breakfast and lunch you furnish in your your tax year in which the employee earns it accept the lodging on your business restaurant for each day she works. if it is vested by the end of that year and the premises as a condition of his or her employment. employee actually receives it within 21/2 • Meals you furnish immediately after months after the end of that year. Generally, However, if an employee can choose to working hours that you would have fur- vacation pay is vested if it is payable under receive additional pay instead of meals or nished during working hours for a sub- an oral or written vacation pay plan that you lodging, you must include the value of the stantial nonpay business reason but that, told your employees about before the tax year meals or lodging in the employee's wages. because of the work duties, were not and its amount and your liability for it are The examples at the end of this chapter will eaten during working hours. certain. help you apply these tests. • All meals you furnish to employees on your business premises if more than half The value of meals and lodging you of these employees are furnished meals TIP properly exclude from an employee's for a substantial nonpay business reason. wages is not subject to social security, Medicare, and federal unemployment taxes, or income tax withholding. Meals you furnish to promote goodwill, 3. boost morale, or attract prospective em- ployees. These meals are considered fur- Test 1—On Your nished in your business for pay reasons. They Meals and are not furnished for your convenience unless Business Premises you also have a substantial nonpay business Lodging This generally means the place of employ- reason for furnishing the meals. ment. For example, meals and lodging you Furnished to furnish to a household employee in your pri- Meals furnished on nonworkdays or with vate home are furnished on your business lodging. The value of meals you furnish on premises. Similarly, meals you furnish to any nonworkday is normally not furnished for Employees cowhands while herding cattle on land you your convenience. However, if your employ- lease or own are furnished on your business ees must occupy lodging on your business premises. premises as a condition of employment, as discussed later under Test 3—Lodging Re- Test 2—For Your quired as a Condition of Employment, do not Important Reminder treat the value of any meal you furnish on the Convenience business premises as wages. Meals furnished on your business prem- Whether you furnish meals or lodging for your ises. If you furnish meals to employees on convenience as an employer depends on all Meals with a charge. The fact that you your business premises and more than half the facts and circumstances. You furnish the charge for the meals and that your employees of these employees are furnished the meals meals or lodging to your employee for your may accept or decline the meals is not taken for your convenience, then all the meals are convenience if you do this for a substantial into account in determining whether meals considered furnished for your convenience. business reason other than to provide the are furnished for your convenience. See Test 2—For Your Convenience under employee with additional pay. This is true If you furnish meals for which you charge Exclusion From Employee Wages. This even if a law or an employment contract pro- the employees a flat amount whether or not means that you can exclude the value of all vides that they are furnished as pay. A written they eat the meals, do not include the flat the meals from the employees' wages. statement that the meals or lodging are for amount you charge in your employees' your convenience is not sufficient. wages. Whether the value of the meals is wages depends on whether you meet Tests Substantial nonpay reasons. The following 1 and 2. If you do not meet both of these Introduction meals are furnished for a substantial nonpay tests, you must include the value of the meals If you furnish meals or lodging to an em- business reason. in your employees' wages whether it is more ployee, or to anyone else in connection with or less than the amount you charged. If no the employee's services, you must generally • Meals you furnish during working hours evidence indicates otherwise, the value of the include the value in the employee's wages. so your employee will be available for meals is the amount you charged for them. Page 8 Chapter 3 Meals and Lodging Furnished to Employees premises, they rarely leave the hospital during This chapter also discusses some special Test 3—Lodging Required their meal period. Since the hospital furnishes rules that allow you to exclude the value of as a Condition of meals to its employees to have more than half certain fringe benefits from an employee's of them available for emergency calls during wages. See chapters 3 and 5 for information Employment meal periods, the hospital does not include on excluding the value of certain other bene- This means that you require your employees the value of these meals in the wages of any fits from wages. to accept the lodging because they need to of its employees. For information about deducting the cost live on your business premises to be able to of fringe benefits, see chapter 2. properly perform their duties. Examples in- Example 5 (Lodging). A hospital gives Joan, clude employees who must be available at an employee of the hospital, the choice of all times and employees who could not per- Topics living at the hospital free of charge or living This chapter discusses: form their required duties without being fur- elsewhere and receiving a cash allowance in nished the lodging. addition to her regular salary. If Joan chooses • General information It does not matter whether you must fur- to live at the hospital, the hospital must in- nish the lodging as pay under the terms of clude the value of the lodging in her wages • The general valuation rule an employment contract or a law fixing the because she is not required to live at the • Special valuation rules terms of employment. hospital to properly perform the duties of her • Exclusion of certain fringe benefits from You may furnish the lodging to your em- employment. ployees with or without a charge. If you employee income charge a flat amount for lodging whether or not the employee accepts it, do not include the flat charge in the employee's wages. Useful Items Whether the value of the lodging is wages You may want to see: depends on whether you meet Tests 1, 2, and 3. If you do not meet all of these tests, you 4. Publication must include the value of the lodging in your employees' wages whether it is more or less Ⅺ 15 Circular E, Employer's Tax Guide than the amount you charged for it. If no evi- Fringe Benefits Ⅺ 15–A Employer's Supplemental Tax dence indicates otherwise, the value of the Guide lodging is the amount you charged for it. Form (and Instructions) Examples Ⅺ W–2 Wage and Tax Statement These examples will help you determine Important Change whether to include in your employees' wages for 1999 Ⅺ 1099–MISC Miscellaneous Income the value of meals or lodging you furnish to See chapter 17 for information about get- them. Vehicle cents-per-mile rule. The standard ting publications and forms. mileage rate you can use under the vehicle Example 1 (Meals). You operate a restau- cents-per-mile rule to value the personal use rant business. You furnish your employee, of a car, van, pickup, or panel truck you pro- Carol, who is a waitress working 7 a.m. to 4 1 vide to an employee in 1999 is 32 /2 cents a General Information p.m., two meals during each workday. You mile for all personal miles driven before April A fringe benefit is a form of pay provided to encourage but do not require Carol to have 1. The rate is 31 cents a mile for personal her breakfast on the business premises be- any person for the performance of services miles driven after March 31. See Vehicle by that person. For the rules discussed in this fore starting work. She must have her lunch Cents-Per-Mile Rule. on the premises. Since Carol is a food service chapter, treat a person who agrees not to employee and works during the normal perform services (such as under a covenant breakfast and lunch periods, do not include not to compete) as performing services. the value of her breakfast and lunch in her Examples of fringe benefits you may pro- wages. Important Reminders vide include the following items. • The use of a car. Example 2 (Meals on nonworkdays). The Meals furnished to employees. If the value facts are the same as in Example 1, except of meals you provide at your eating facility for • Flights on airplanes. employees can be excluded from their wages that you also allow Carol to have meals on • Discounts on property or services. your business premises without charge on her because you furnish them for your conven- days off. You must include the value of these ience, your revenue from the meals is con- • Memberships in country clubs or other meals in her wages. sidered to equal the facility's direct operating social clubs. costs for them. This means that you may be Tickets to entertainment or sporting able to treat the meals as a de minimis fringe • Example 3 (Meals). Frank is a bank teller events. who works from 9 a.m. to 5 p.m. The bank benefit and deduct all of their cost. See De Minimis (Minimal) Fringe. furnishes his lunch without charge in a cafe- Provider of fringe benefit. You are the teria the bank maintains on its premises. The provider of a fringe benefit if it is provided for bank furnishes these meals to Frank to limit Qualified transportation fringe benefits in services performed for you. You may be the his lunch period to 30 minutes, since the place of pay. You can exclude qualified provider of the benefit even if it was provided bank's peak workload occurs during the transportation fringe benefits from an em- by another person. For example, you are the normal lunch period. If Frank got his lunch ployee's wages even if you provide them in provider of a fringe benefit your client or cus- elsewhere, it would take him much longer place of pay. See Qualified Transportation tomer provides to your employee for services than 30 minutes, and the bank strictly en- Fringe. the employee performs for you. forces the time limit. The bank does not in- Nonemployer provider. You do not have clude the value of these meals in Frank's to be the employer of the recipient to be the wages. provider of a fringe benefit. For example, you Introduction may provide fringe benefits to an independent Example 4 (Meals). A hospital maintains a If you provide a fringe benefit to an employee, contractor as a client or customer of the con- cafeteria on its premises where all of its 230 you must generally include the value in the tractor. employees may get meals at no charge dur- employee's wages. This chapter explains the ing their working hours. The hospital furnishes valuation rules for fringe benefits that you in- Recipient of benefit. Your employee or meals to have 120 employees available for clude in an employee's wages. However, it some other person who performs services for emergencies. Each of these employees is at does not cover all the exceptions to these you is the recipient of a fringe benefit provided times called upon to perform services during rules, or the rules that apply to the use of an for those services. Your employee may be the the meal period. Although the hospital does aircraft. For more information, see section recipient of the benefit even if it is provided not require these employees to remain on the 1.61–21 of the regulations. to someone who did not perform services for Chapter 4 Fringe Benefits Page 9 you. For example, your employee may be the miles driven unless the employee can prove 3) If you provide vehicles to more than one recipient of a fringe benefit you provide to a the vehicle could have been leased on a employee, you do not have to use the member of the employee's family. cents-per-mile basis. (However, see Vehicle same special rule for each employee. If The recipient does not have to be your Cents-Per-Mile Rule, later.) you provide a vehicle for use by more employee. For example, the recipient may be than one employee (for example, an a partner, director, or independent contractor. employer-sponsored van pool), you can In this chapter, the term “employee” includes use any special rule. However, you must any recipient of a fringe benefit unless stated use that rule for all employees who share otherwise. Special use of the vehicle. Valuation Rules 4) You can use the formulas in the special Including benefits in pay. Unless the law rules only with those rules. When you says otherwise, you must include the value You may be able to use special valuation rules instead of the general valuation rule to properly apply a special rule to a fringe of fringe benefits in the recipient's pay. benefit, the IRS will accept your value for If the recipient of a taxable fringe benefit value certain fringe benefits, including the use of any vehicle or eating facility you provide. that fringe benefit. However, if you do is your employee, the benefit is subject to not properly apply a special rule, or if you employment taxes and must be reported on The special valuation rules include the fol- lowing rules. use a special rule but are not entitled to Form W–2. However, you can use special do so, the IRS will use the general valu- rules to withhold, deposit, and report the em- ation rule to value the fringe benefit. ployment taxes. See Publication 15 and • Automobile lease rule. Publication 15–A for more information. • Commuting rule. More information. For more information on If the recipient of a taxable fringe benefit • Employer-operated eating facility rule. the special valuation rules, including those not is not your employee, the benefit is not sub- discussed in this chapter (such as the rules ject to employment taxes. However, you may • Unsafe conditions commuting rule. for aircraft), see section 1.61–21(c)-(k) of the have to report it on Form 1099–MISC and you regulations. may have to withhold income tax under the • Vehicle cents-per-mile rule. backup withholding rules. See the Instructions for Forms 1099, 1098, 5498, and W–2G for Conditions for use. When reporting fringe Automobile Lease Rule more information. benefits, you can choose to use any of the special rules. However, neither you nor the If you provide an employee with an automo- employee may use a special rule to value any bile for an entire calendar year, you can use benefit unless one of the following conditions the automobile's annual lease value to value is met. the benefit. If you provide an employee with General an automobile for less than an entire calendar 1) You treat the value of the benefit as year, the value of the benefit is either a pro- Valuation Rule wages for reporting purposes by the due rated annual lease value or the daily lease You generally must include in an employee's date of the return (including extensions) value. Include the lease value in the employ- wages the amount by which the fair market for the tax year you provide the benefit. ee's wages unless it is excluded from gross value of a fringe benefit is more than the sum income by law. of the following amounts. 2) The employee includes the value of the For this rule, automobile means any benefit in income by the due date of the four-wheeled vehicle manufactured primarily 1) Any amount the employee paid for the return for the year the employee receives for use on public streets, roads, and high- benefit. the benefit. ways. 3) The employee is not a control employee 2) Any amount the law excludes from in- Benefits excluded for business use. If the as defined later under Commuting Rule. come. employee uses the automobile for business, he or she may qualify to exclude part of the However, you and the employee may use 4) You demonstrate a good faith effort to lease value as a working condition fringe special rules to value certain fringe benefits. treat the benefit correctly for reporting benefit. You can reduce the amount of the (See Special Valuation Rules, later.) purposes. lease value by the working condition fringe If the law excludes a fringe benefit cost and include the net amount in the employee's from gross income, do not include in the em- Using the special rules. All of the following wages, or you can choose to include the en- ployee's wages the difference between the rules apply when you use the special rules. tire lease value. See Vehicle-allocation rules fair market value and the excludable cost of under Working Condition Fringe, later. that fringe benefit. If the law excludes a lim- 1) If you use one of the special rules to ited amount of the cost, however, include the value a benefit you provide to the em- fair market value of the fringe benefit that is ployee, the employee can use that spe- Annual Lease Value due to any excess cost. cial rule. If you do not use one of the Generally, you figure the annual lease value special rules, the employee can use a of an automobile as follows. special rule only if you do not treat the Fair market value (FMV). In general, you value of the benefit as wages for report- determine the FMV of a fringe benefit on the 1) Determine the FMV of the automobile ing purposes by the due date of the re- basis of all the facts and circumstances. The on the first date the automobile is avail- turn (including extensions) and one of FMV of a fringe benefit is the amount the able to any employee for personal use. the conditions listed in items (2) through employee would have to pay a third party in (4) above is met. In any case, the em- 2) Using the following Annual Lease Value an arm's-length transaction to buy or lease ployee can always use the general val- Table, read down column (1) until you the particular fringe benefit. uation rule discussed earlier. come to the dollar range within which the Neither the amount the employee consid- FMV of the automobile falls. Then read ers to be the value of the fringe benefit nor the 2) If you and the employee properly use a across to column (2) to find the annual cost you incur to provide the benefit deter- special rule, the employee must include lease value. mines its FMV. in gross income the value you determine under the rule minus any amount he or Annual Lease Value Table Employer-provided vehicles. In general, she paid you and any amount excluded (1) (2) the value of an employer-provided vehicle is by law from gross income. If you also Annual the amount the employee would have to pay properly determine the amount of the Automobile Lease a third party to lease the same or a similar employee's working condition fringe Fair Market Value Value vehicle on the same or comparable terms in benefit (explained later under Exclusion $0 to 999 ...... $ 600 the same geographic area where the em- of Certain Fringe Benefits), the em- 1,000 to 1,999 ...... 850 ployee uses the vehicle. A comparable lease ployee must include in gross income the 2,000 to 2,999 ...... 1,100 term would be the amount of time the vehicle net value you determined minus any 3,000 to 3,999 ...... 1,350 4,000 to 4,999 ...... 1,600 is available for the employee's use, such as amount he or she paid you. You and the 5,000 to 5,999 ...... 1,850 a 1-year period. employee can use the special rule to 6,000 to 6,999 ...... 2,100 Do not determine the value by multiplying determine the amount the employee 7,000 to 7,999 ...... 2,350 a cents-per-mile rate times the number of owes you. 8,000 to 8,999 ...... 2,600 Page 10 Chapter 4 Fringe Benefits 9,000 to 9,999 ...... 2,850 Items included in annual lease value table. 4-year lease term. The annual lease values 10,000 to 10,999 ...... 3,100 Each annual lease value in the table includes in the table are based on a 4-year lease term. 11,000 to 11,999 ...... 3,350 the FMV of maintenance and insurance for These values will generally stay the same for 12,000 to 12,999 ...... 3,600 13,000 to 13,999 ...... 3,850 the automobile. Do not reduce this value by the period that begins with the first date you 14,000 to 14,999 ...... 4,100 the FMV of any of these services that you did use this special rule for the automobile and 15,000 to 15,999 ...... 4,350 not provide. For example, do not reduce the ends on December 31 of the fourth full cal- 16,000 to 16,999 ...... 4,600 annual lease value by the FMV of a mainte- endar year following that date. 17,000 to 17,999 ...... 4,850 nance service contract or insurance you did Figure the annual lease value for each 18,000 to 18,999 ...... 5,100 not provide. (You can take into account the later 4-year period by determining the FMV 19,000 to 19,999 ...... 5,350 services actually provided for the automobile of the automobile on January 1 of the first 20,000 to 20,999 ...... 5,600 21,000 to 21,999 ...... 5,850 by using the general valuation rule discussed year of the later 4-year period and selecting 22,000 to 22,999 ...... 6,100 earlier.) the amount in column 2 of the table that cor- 23,000 to 23,999 ...... 6,350 Items not included. The annual lease responds to the appropriate dollar range in 24,000 to 24,999 ...... 6,600 value does not include the FMV of fuel you column 1. 25,000 to 25,999 ...... 6,850 provide to an employee for personal use, re- Using the special accounting rule. If 26,000 to 27,999 ...... 7,250 gardless of whether you provide it, reimburse you use the special accounting rule for fringe 28,000 to 29,999 ...... 7,750 its cost, or have it charged to you. You must benefits discussed in Publication 15–A, you 30,000 to 31,999 ...... 8,250 32,000 to 33,999 ...... 8,750 include the value of the fuel separately in the can figure the annual lease value for each 34,000 to 35,999 ...... 9,250 employee's wages. You can value fuel you later 4-year period at the beginning of the 36,000 to 37,999 ...... 9,750 provided at FMV or at 5.5 cents per mile for special accounting period that starts imme- 38,000 to 39,999 ...... 10,250 all miles driven by the employee. However, diately before the January 1 date described 40,000 to 41,999 ...... 10,750 you cannot value at 5.5 cents per mile fuel in the previous paragraph. 42,000 to 43,999 ...... 11,250 you provide for miles driven outside the For example, assume that you use the 44,000 to 45,999 ...... 11,750 United States (including its possessions and special accounting rule and that, beginning 46,000 to 47,999 ...... 12,250 48,000 to 49,999 ...... 12,750 territories), Canada, and Mexico. on November 1, 1998, the special accounting 50,000 to 51,999 ...... 13,250 If you reimburse an employee for the cost period is November 1 to October 31. You 52,000 to 53,999 ...... 13,750 of fuel, or have it charged to you, you gener- elected to use the automobile lease valuation 54,000 to 55,999 ...... 14,250 ally value the fuel at the amount you reim- rule as of January 1, 1999. You can refigure 56,000 to 57,999 ...... 14,750 burse, or the amount charged to you if it was the annual lease value on November 1, 2002, 58,000 to 59,999 ...... 15,250 bought at arm's length. rather than on January 1, 2003. For vehicles with an FMV of more than If you have 20 or more automobiles, see $59,999, the annual lease value equals (.25 section 1.61–21(d)(3)(ii)(D) of the regulations. Transferring an automobile from one em- × the FMV of the automobile) + $500. If you provide any service other than ployee to another. Unless the primary pur- maintenance and insurance for an automo- pose of the transfer is to reduce federal taxes, bile, you must add the FMV of that service to Fair market value. The FMV of the auto- you can refigure the annual lease value the annual lease value of the automobile in based on the FMV of the automobile on Jan- mobile is the amount a person would pay to determining the value of the benefit. buy it from a third party, in an arm's-length uary 1 of the calendar year of transfer. transaction, in the area in which the vehicle However, if you use the special account- is bought or leased. That amount includes all Consistency rules. If you adopt the auto- ing rule for fringe benefits discussed in Pub- purchase expenses, such as sales tax and mobile lease rule for an automobile, the fol- lication 15–A, you can refigure the annual title fees. lowing rules apply. lease value (based on the FMV of the auto- If you have 20 or more automobiles, see mobile) at the beginning of the special ac- 1) You must adopt it by the first day you section 1.61–21(d)(5)(v) of the regulations. counting period in which the transfer occurs. make the automobile available to any See section 1.61–21(d)(2)(ii) of the regu- If you do not refigure the annual lease value, employee for personal use. However, lations if you and the employee own or lease the employee cannot refigure it. the following exceptions apply. the automobile together. You do not have to include the FMV of a a) If you adopt the commuting rule Prorated annual lease value. If you provide telephone or any specialized equipment when you first make the automobile an automobile to an employee for continuous added to, or carried in, the automobile if the available to any employee for per- periods of 30 or more days but less than an equipment is necessary for your business. sonal use, you can change to the entire calendar year, you can prorate the an- However, include the value of specialized automobile lease rule on the first nual lease value. Figure the prorated annual equipment in the FMV if the employee to day for which you do not use the lease value by multiplying the annual lease whom the automobile is available uses the commuting rule. value by a fraction, using the number of days specialized equipment in a trade or business of availability as the numerator and 365 as the other than yours. b) If you adopt the vehicle cents-per- denominator. Neither the amount the employee consid- mile rule when you first make the If you provide an automobile continuously ers to be the value of the fringe benefit nor automobile available to any em- for at least 30 days, but the period covers 2 your cost for either buying or leasing the au- ployee for personal use, you can calendar years (2 special accounting periods tomobile determines its FMV. However, see change to the automobile lease rule if you are using the special accounting rule for Safe-harbor value, next. on the first day on which the auto- fringe benefits discussed in Publication Safe-harbor value. You may be able to mobile no longer qualifies for that 15–A), you can use the prorated annual lease use a safe-harbor value as the FMV. For an rule. value or the daily lease value. automobile you bought at arm's length, the If you have 20 or more automobiles, see 2) You must use the rule for all later years section 1.61–21(d)(6) of the regulations. safe-harbor value is your cost, including tax, in which you make the automobile avail- title, and other purchase expenses. You can- If an automobile is unavailable to the em- able to any employee, except that you ployee because of his or her personal rea- not have been the manufacturer of the vehi- can use the commuting rule for any year cle. sons (for example, if the employee is on va- during which use of the automobile cation), you cannot take into account the For an automobile you lease, you can use qualifies. any of the following as the safe-harbor value. periods of unavailability when you use a pro- 3) You must continue to use the rule if you rated annual lease value. 1) The manufacturer's invoice price (in- provide a replacement automobile to the You cannot use a prorated annual cluding options) plus 4%. employee and your primary reason for lease value if the reduction of federal the replacement is to reduce federal ! CAUTION tax is the main reason the automobile 2) The manufacturer's suggested retail taxes. price minus 8% (including sales tax, title, is unavailable. and other expenses of purchase). 4) The employee can use the automobile lease rule only if the employee uses the Daily lease value. If you provide an auto- 3) The retail value of the automobile re- rule beginning with the first day on which mobile for continuous periods of one or more ported by a nationally recognized pricing the automobile is made available to the but less than 30 days, use the daily lease source if that retail value is reasonable employee for personal use (and the em- value to figure its value. Figure the daily lease for that automobile. ployer does not use the commuting rule). value by multiplying the annual lease value Chapter 4 Fringe Benefits Page 11 by a fraction, using four times the number of Any individual who owns (or is considered employees performing services relating to the days of availability as the numerator and 365 to own under section 318(a) of the Internal facility primarily on the eating facility prem- as the denominator. Revenue Code or principles similar to section ises. For example, the labor costs for cooks, However, you can apply a prorated annual 318(a) for entities other than corporations) 1% waiters, and waitresses are included in direct lease value for a period of continuous avail- or more of the FMV of an entity (the “owned operating costs. If an employee performs the ability of less than 30 days by treating the entity”) is considered a 1% owner of all other services both on and off premises, include automobile as if it had been available for 30 entities grouped with the owned entity under only the labor costs for the services per- days. Use a prorated annual lease value if it the rules of section 414(b), (c), (m), or (o). formed on premises. would result in a lower valuation than applying An employee who is an officer or director of the daily lease value to the shorter period of an employer is considered an officer or di- Do not include in direct operating availability. rector of all entities treated as a single em- ! costs the labor cost for a manager of ployer under section 414(b), (c), (m), or (o). CAUTION an eating facility who does not pri- A control employee of a government marily perform services on the eating facility Commuting Rule employer for 1999 is any: premises. Under this rule, the value of the commuting use of a vehicle you provide is $1.50 per 1) Elected official, or Individual meal subsidy method. Under one-way commute (that is, from home to work this method, the value of meals provided to 2) Employee whose pay was at least a particular employee during a calendar year or from work to home) for each employee who $110,700 for the year (the pay of a fed- commutes in the vehicle. is the total of the individual meal subsidies eral government employee at Executive you provide to that employee during that year. The term vehicle means any motorized Level V). wheeled vehicle, including an automobile, Figure the individual meal subsidy by multi- manufactured primarily for use on public plying the price charged for a particular meal For the commuting rule, the term “gov- by a fraction, using the total meal value as the streets, roads, and highways. ernment” includes any federal, state, or local You can use this special rule to figure numerator and the gross receipts of the eat- governmental unit and any of its agencies or ing facility for the calendar year as the de- commuting value if all the following require- instrumentalities. ments are met. nominator. Then subtract the amount paid Instead of using the above definitions, you by the employee for the meal. can choose to treat all of your highly com- 1) You own or lease the vehicle and pro- pensated employees as control employees. Meal charge required. You can use vide it to one or more employees for use For the definition of a highly compensated the individual meal subsidy method in your trade or business. ! employee, see Exclusion of Certain Fringe CAUTION only if there is a charge for each meal 2) For bona fide noncompensatory busi- Benefits, later. and the price charged each employee is the ness reasons, you require the employee same for any given meal. to commute in the vehicle. Employer-Operated 3) You establish a written policy under which you do not allow the employee to Eating Facility Rule use the vehicle for personal purposes, You can use this rule to determine the value Allocated total meal subsidy method. Un- other than for commuting or de minimis of taxable meals you provide at an der this method, you figure the value of meals personal use (such as a stop for a per- employer-operated eating facility for employ- provided to a particular employee by allocat- sonal errand on the way between a ees. For situations in which you do not have ing the total meal subsidy among the em- business delivery and the employee's to include the value of meals in an employee's ployees in any manner reasonable under the home). wages, see chapter 3 and the discussion un- circumstances. It is presumed reasonable for der De Minimis (Minimal) Fringe, later. you to allocate the total meal subsidy on a 4) The employee does not use the vehicle Under this rule, you first figure the total per-employee basis if you can show that you for personal purposes, other than com- meal value of meals provided at the facility. provided each employee with approximately muting and de minimis personal use. Then you use that value to figure the value the same number of meals at the facility. Total meal subsidy. This is the total 5) If this vehicle is an automobile, the em- for each employee under either of the follow- meal value (explained earlier) minus the ployee who must use it for commuting is ing two methods. gross receipts of the facility. not a control employee (defined later). 1) The individual meal subsidy method. Personal use of a vehicle is all use that is not 2) The allocated total meal subsidy Unsafe Conditions for your trade or business. method. An employer-provided vehicle generally Commuting Rule used each workday to carry at least three Under this rule, the value of the commuting Employer-operated eating facility. An employees to and from work in an employer- use of transportation you provide each em- employer-operated eating facility for employ- sponsored commuting pool meets require- ployee solely because of unsafe conditions ees is a facility that meets all the following ments (1) and (2) above. is $1.50 per one-way commute (that is, from conditions. home to work or from work to home). Chauffeur-driven vehicle. If the ve- You can use this special rule to figure hicle is a chauffeur-driven vehicle, you 1) You own or lease the facility. ! commuting value if all the following require- CAUTION cannot use the commuting valuation 2) You operate the facility. You are consid- ments are met. rule for any passenger. However, you can ered to operate the eating facility if you use it to value the commuting use of the have a contract with another to operate 1) The employee would ordinarily walk or chauffeur. it. use public transportation for commuting. 3) The facility is on or near your business 2) You establish a written policy under premises. which you do not allow the employee to use the transportation for personal pur- Control employees. A control employee of 4) You provide meals (food, drinks, and a nongovernment employer for 1999 is any poses other than commuting because related services) at the facility during, or of unsafe conditions. employee who: immediately before or after, the employ- ee's workday. 3) The employee does not use the trans- 1) Was a board- or shareholder-appointed, portation for personal purposes other confirmed, or elected officer of the em- Total meal value. The total meal value is than commuting because of unsafe ployer whose pay for the year was conditions. $70,000 or more, 150% of the direct operating costs of the eating facility. This total meal value is con- 4) The employee is a qualified employee. 2) Was a director of the employer, sidered the value of all meals provided at that 3) Received pay for the year of $145,000 facility for employees during the calendar This special valuation rule applies on a or more from the employer, or year. trip-by-trip basis. If the requirements are not Direct operating costs. The direct op- met for any trip, use the FMV of the trans- 4) Owned a 1% or more equity, capital, or erating costs of an eating facility are the costs portation to determine the amount to include profits interest in the employer. of food and drinks and the cost of labor for in the employee's wages. Page 12 Chapter 4 Fringe Benefits Transportation. This rule applies to trans- together, see section 1.61–21(e)(1)(iii) of the Mexico, the cents-per-mile rate includes the portation of a qualified employee to or from regulations. FMV of fuel you provide. If you do not provide work by any motorized wheeled vehicle (in- fuel, you can reduce the rate by no more than cluding an automobile) manufactured for use 5.5 cents. on public streets, roads, and highways. You For special rules that apply to fuel you or the employee must buy the transportation Apply the standard mileage rate only to provide for miles driven outside the United from a party that is not related to you. If the personal miles. Disregard business miles. States, Canada, and Mexico, see section employee buys it, you must reimburse the For example, if the employee drove 20,000 1.61–21(e)(3)(ii)(B) of the regulations. employee for its cost (for example, cabfare) personal miles and 35,000 business miles in The FMV of any other service you provide under a bona fide reimbursement arrange- the last 9 months of 1999, the personal use for a vehicle is not included in the cents-per- ment. value of the vehicle for those months is mile rate. Use the general valuation rule to $6,200 (20,000 × .31). value these services. Unsafe conditions. Unsafe conditions exist Personal use is any use of the vehicle if, under the facts and circumstances, a rea- other than use in your trade or business. Consistency rules. If you adopt the cents- sonable person would consider it unsafe for For the vehicle cents-per-mile rule, a ve- per-mile rule for an automobile, the following the employee to walk or use public transpor- hicle is any motorized wheeled vehicle, in- rules apply. tation at the time of day the employee must cluding an automobile, manufactured prima- 1) You must adopt it by the first day you commute. One factor indicating whether it is rily for use on public streets, roads, and make the automobile available to any unsafe is the history of crime in the ge- highways. ographic area surrounding the employee's employee for personal use. However, if you adopt the commuting rule when you workplace or home at the time of day the Regular use in your business. Determine employee commutes. first make the automobile available to whether a vehicle is regularly used in your any employee for personal use, you can trade or business on the basis of all the facts change to the cents-per-mile rule on the Qualified employee. A qualified employee and circumstances. A vehicle is regularly for 1999 is one who meets the following re- first day for which you do not use the used in your trade or business if it meets any commuting rule. quirements. of the following safe-harbor conditions. 2) You must use the rule for all later years 1) Performed services during the year. 1) At least 50% of the vehicle's total annual in which you make the automobile avail- 2) Was paid on an hourly basis. mileage is for your trade or business. able to any employee and the automo- bile qualifies, except that you can use 2) You sponsor a commuting pool that 3) Was not claimed under section 213(a)(1) the commuting rule for any year during generally uses the vehicle each workday of the Fair Labor Standards Act of 1938 which use of the automobile qualifies. to drive at least 3 employees to and from (as amended) to be exempt from the However, if the vehicle does not qualify work. minimum wage and maximum hour pro- for the cents-per-mile rule during a later visions. Infrequent business use of the vehicle, year, you can adopt for that year and 4) Was within a classification for which you such as for occasional trips to the airport or thereafter any other special rule for actually paid, or specified in writing you between your multiple business premises, is which the vehicle then qualifies. would pay, overtime pay of at least one not regular use of the vehicle in your trade 3) You must continue to use the rule if you and one-half times the regular rate pro- or business. provide a replacement automobile to the vided in section 207 of the 1938 Act. employee and your primary reason for 5) Received pay of not more than $70,000 Mileage rule. If you provide an employee the replacement is to reduce federal during the year. with a vehicle that you do not expect the taxes. employee to use regularly in your trade or 4) The employee can use the vehicle However, the employee will not be con- business but that meets the mileage rule, you cents-per-mile rule only if the employee sidered a qualified employee if you do not can use the cents-per-mile method to value uses the rule beginning with the first day comply with the recordkeeping requirements the benefit. A vehicle meets the mileage rule on which the automobile is made avail- concerning the employee's wages, hours, and for a calendar year if both of the following able to the employee for personal use other conditions and practices of employment requirements are met. (and the employer does not use the under section 211(c) of the 1938 Act and the commuting rule). related regulations. 1) The vehicle is actually driven at least 10,000 miles during the year. 2) The vehicle is used during the year pri- Vehicle Cents-Per-Mile Rule marily by employees. Under this rule, you determine the value of a vehicle you provide to an employee for per- Consider the vehicle used primarily by Exclusion of Certain sonal use by multiplying the standard mileage employees if they use it consistently for Fringe Benefits rate by the total miles the employee drives the commuting. For example, if only one em- vehicle for personal purposes. For 1999, the ployee uses a vehicle during the calendar Special rules allow you to exclude certain rate is 321/2 cents a mile for all personal miles year and that employee drives the vehicle at fringe benefits you provide to an employee driven before April 1. The rate is 31 cents a least 10,000 miles in that year, the vehicle from the employee's wages. You can exclude mile for personal miles driven after March 31. meets the mileage rule even if all miles driven under these rules all of the following fringe You can use the vehicle cents-per-mile by the employee are personal. Do not treat benefits. rule if either of the following requirements is use of the vehicle by an individual (other than met. the employee) whose use would be taxed to • A de minimis (minimal) fringe. the employee as use by the employee. If you • A no-additional-cost service. 1) You reasonably expect the vehicle to be own or lease the vehicle only part of the year, • An on-premises athletic facility. regularly used in your trade or business reduce the 10,000 mile requirement propor- throughout the calendar year (or for a tionately. • A qualified employee discount. shorter period during which you own or lease it). • A qualified moving expense reimburse- Items included in cents-per-mile rate. The ment. 2) The vehicle meets the mileage rule re- cents-per-mile rate includes the FMV of quirements discussed later. maintenance and insurance for the vehicle. • A qualified transportation fringe. Do not reduce the rate by the FMV of any • A working condition fringe. When you cannot use the cents- service included in the rate that you did not ! per-mile rule. You cannot use the provide. (You can take into account the ser- These are not the only employee CAUTION vehicle cents-per-mile rule for an au- vices actually provided for the vehicle by us- TIP benefits you can exclude from an tomobile first made available to an employee ing the general valuation rule discussed ear- employee's wages. For example, you for personal use in 1999 if the FMV of the lier.) can also exclude certain meals and lodging automobile is more than $15,500. If you and For miles driven in the United States, its you provide for your convenience and certain the employee own or lease the automobile territories and possessions, Canada, and benefits you provide through employee ben- Chapter 4 Fringe Benefits Page 13 efit programs. For more information, see • Occasional parties or picnics for employ- Reciprocal agreements. Employees can chapters 3 and 5. ees and their guests. exclude the value of a no-additional-cost ser- vice provided by an unrelated employer if all Except for the exclusions for de minimis • Occasional meals, meal money, or local the following tests apply. fringe benefits and qualified moving expense transportation fare, not based on hours reimbursements, the above exclusions do not worked, provided to an employee be- 1) The service is the same type of service apply if the tax treatment of the fringe benefit cause the employee is working overtime generally provided to customers in both is provided by another tax rule. For example, and, for meals and meal money, provided the line of business in which the em- these exclusions do not apply to employer- to enable the employee to work overtime. ployee works and the line of business in provided dependent care assistance or tuition • Holiday gifts, other than cash, with a low which the service is provided. reductions, the tax treatments of which are FMV. covered by other rules. However, if another 2) You and the employer providing the tax rule excludes a benefit from wages and • Occasional tickets for entertainment service have a written reciprocal agree- the exclusion is a limited amount of the ben- events. ment under which a group of employees efit's cost, an exclusion under the fringe ben- of each employer, all of whom perform efit rules may apply to the rest of the cost. • Coffee, doughnuts, or soft drinks fur- substantial services in the same line of The value of fringe benefits you properly nished to employees. business, may receive no-additional-cost services from the other employer. exclude from an employee's wages is not • Group-term life insurance payable on the subject to income tax withholding or social death of an employee's spouse or de- 3) Neither you nor the other employer in- security, Medicare, or federal unemployment pendent if the face amount is not more curs any substantial additional cost (in- (FUTA) tax. You do not report it as wages on than $2,000. cluding lost revenue) either in providing Form W–2. the service or because of the written agreement. Nondiscrimination rules. You cannot ex- If food or beverages you furnish em- clude a no-additional-cost service, a qualified TIP ployees qualify as a de minimis fringe employee discount, or a meal provided at an benefit, you can deduct their full cost. Employee. For this fringe benefit, employer-operated eating facility for employ- The 50% limit on deductions for the cost of “employee” includes any of the following per- ees from the wages of a highly compensated meals does not apply. See Deduction limit on sons. employee unless the benefit is available on meals under Meals and Lodging in chapter the same terms to: 2. 1) An individual currently employed by you.

1) All employees, or 2) An individual who stopped working for Employer-operated eating facility. The you as an employee because of retire- 2) A group of employees defined under a value of meals you provide to employees at ment or disability. reasonable classification you set up that an eating facility operated by you is a de does not favor highly compensated em- minimis fringe benefit only if the annual reve- 3) A surviving spouse of an individual who ployees. nue from the facility equals or exceeds the died while working for you as an em- direct operating costs of the facility. For the ployee or who stopped working for you Meals provided at an employer-operated eat- nondiscrimination requirements, see Nondis- as an employee because of retirement ing facility are discussed under De Minimis crimination rules, earlier. For definitions of an or disability. (Minimal) Fringe, next. employer-operated eating facility and direct If any benefit is discriminatory, include the operating costs, see Employer-Operated 4) Partner who performs services for a total value of the benefit, not only the value Eating Facility Rule, earlier. partnership. of the discriminatory part, in the wages of your Meals furnished for your convenience. highly compensated employees. If the value of the meals furnished at your Treat services you provide to the spouse Highly compensated employee. A eating facility for employees can be excluded or dependent child of an employee as pro- highly compensated employee for 2000 is an from the employees' wages under the rules vided to the employee. For this fringe benefit, employee who: explained in chapter 3, your revenue from the “dependent child” means any son, stepson, meals is considered to equal the facility's di- daughter, or stepdaughter who is a depend- 1) Was a 5% owner at any time during the rect operating costs for them. ent of the employee, or both of whose parents year or the preceding year, or have died and who has not reached age 25. Treat a child of divorced parents as a de- 2) Received more than $85,000 in pay for pendent of both parents. the preceding year. No-Additional-Cost Service Treat any use of air transportation by the When you apply requirement (2), you may If you provide an employee with the same parent of an employee as use by the em- choose to include only employees who were service you offer to customers in the ordinary ployee. This rule does not apply to use by the also in the top 20% of employees when course of the line of business in which the parent of a person considered an employee ranked by pay for the preceding year. employee performs substantial services, this because of item (3) above. service may be a no-additional-cost service. Do not include the value of the service in the De Minimis (Minimal) Fringe employee's wages if you do not incur any On-Premises An employee's wages do not include the substantial additional costs to provide the Athletic Facilities value of a de minimis fringe benefit. This service to the employee. (But see Nondis- benefit is any property or service you provide crimination rules, earlier, if the employee is You can exclude from an employee's wages to an employee that has so little value (taking highly compensated.) To determine additional the value of an on-premises gym or other into account how frequently you provide sim- costs include lost revenue, but do not reduce athletic facility you provide and operate if ilar benefits to your employees) that ac- the costs you incur by any amount the em- substantially all use during the calendar year counting for it would be unreasonable or ad- ployee paid for this service. is by employees, their spouses, and their de- ministratively impracticable. Cash, no matter Generally, no-additional-cost services are pendent children. how little, is never excludable as a de minimis excess capacity services, such as airline, bus, For this purpose, the term “employee” in- fringe, except for occasional meal money or or train tickets; hotel rooms; or telephone cludes the same individuals included as em- transportation fare as discussed next. services provided free or at a reduced price ployees for no-additional-cost services (de- Examples of de minimis fringes include to employees working in those lines of busi- scribed earlier). the following. ness. The exclusion does not apply if you make Generally, an employer's line of business access to the facility available to the general is determined by the Enterprise Standard In- public through the sale of memberships, the • Occasional typing of personal letters by dustrial Classification Manual (ESIC Manual) rental of the facility, or a similar arrangement. a company secretary. prepared by the Statistical Policy Division of The exclusion also does not apply to any • Occasional personal use of a company the U.S. Office of Management and Budget. athletic facility that is for residential use. For copying machine, if you sufficiently con- For more information, see section 1.132–4 of example, a resort with athletic facilities would trol its use. the regulations. not qualify. Page 14 Chapter 4 Fringe Benefits Qualified Deductible moving expenses do not ployee as defined earlier, you may be able to ! include any expenses for meals. exclude all or part of the benefit under other Employee Discount CAUTION fringe benefit rules (de minimis, working con- Do not include in an employee's wages the dition, etc.). value of a qualified employee discount. A For more information on deductible mov- qualified employee discount is a price re- ing expenses, see Publication 521, Moving Commuter highway vehicle. A commuter duction you give an employee on certain Expenses. highway vehicle is any highway vehicle that property or services you offer to customers in seats at least 6 adults (not including the the ordinary course of the line of business in Nonqualified reimbursements. Include any driver). In addition, you must reasonably ex- which the employee performs substantial reimbursements for moving expenses that are pect that at least 80% of the vehicle mileage services. For the rules on line of business, not qualified moving expense reimburse- will be for transporting employees between see No-Additional-Cost Service, earlier. If the ments in the employee's wages. This includes their homes and work place, with your em- employee is highly compensated, see Non- any payment for, or reimbursement of, ex- ployees occupying at least one-half of the discrimination rules, earlier. penses the employee deducted in a prior vehicle's seats (not including the driver's). However, a discount on real property year. (such as a building or land) or on personal Transit pass. A transit pass is any pass, property of a kind commonly held for invest- token, farecard, voucher, or similar item enti- ment (such as stocks or bonds) is not a Where to report reimbursements. Report any qualified moving expense reimburse- tling a person, free of charge or at a reduced qualified employee discount. The exclusion rate, to ride: does not apply where there is a reciprocal ments you paid directly to an employee in 1999 in box 13 of the employee's 1999 Form agreement under which another employer • Mass transit, or provides the discount. A qualified employee W–2. Use code “P” to identify the reimburse- discount also does not include any discount ments. Do not report any qualified moving • In a vehicle that seats at least 6 adults to the extent it is more than the following expense reimbursements you paid to a third (not including the driver) if a person in the amount. party on behalf of the employee or services business of transporting persons for pay that you furnished in kind to an employee. or hire operates it. Include any nonqualified moving expense 1) For a discount on property, your gross reimbursements with your employee's wages Mass transit may be publicly or privately op- profit percentage times the price you in box 1. charge customers for the property. erated and includes bus, rail, or ferry.

2) For a discount on services, 20% of the Qualified parking. Qualified parking is price you charge customers for the ser- Qualified parking you provide to your employees on or vice. Transportation Fringe near your business premises. It also includes You can exclude qualified transportation parking on or near the location from which Determine your gross profit percentage fringe benefits from the wages of employees, your employees commute to work using mass based on all property you offer to customers up to certain limits. The following benefits, transit, commuter highway vehicles, or (including employee customers) in the ordi- which you can provide in any combination at carpools. It does not include parking at or nary course of your line of business and your the same time to an employee, are qualified near your employee's home. experience during the tax year immediately transportation fringe benefits. before the tax year in which the discount is Exclusion Limits available. To figure your gross profit percent- 1) A ride in a commuter highway vehicle age, subtract the total cost of the property between the employee's home and work For 2000, you may exclude from the wages from the total sales price of the property and place. of each employee up to: divide the result by the total sales price of the property. 2) A transit pass. 1) $65 per month for combined commuter highway vehicle transportation and The term “employee” includes the same 3) Qualified parking. individuals listed earlier under No-Additional- transit passes, and Cost Service. For special rules concerning Amounts you give to an employee for 2) $175 per month for qualified parking. employees of a leased section of a depart- these expenses under a bona fide re- ment store, see section 1.132–3(d) of the imbursement arrangement are also regulations. Excess benefits taxable. If, for any month, excludable. Cash reimbursements for transit the fair market value of a benefit is more than passes qualify only if a voucher or a similar its limit, include in the employee's wages only item that the employee can exchange only for the amount over the limit, minus any amount Qualified Moving a transit pass is not readily available for direct paid for the benefit by the employee. distribution by you to your employee. Expense Reimbursements Example 1. Each month, you provide a You can exclude from an employee's wages Benefit provided in place of pay. You can transit pass valued at $70 to your employee, any qualified moving expense reimburse- exclude qualified transportation fringe bene- Tom Travis. He does not pay you for any part ment. This is any amount you give the em- fits from an employee's wages even if you of the pass. Because the value of the transit ployee, directly or indirectly (including ser- provide them in place of pay. pass exceeds the limit, for each month you vices furnished in kind), as a payment for, or provide this pass you must include $5 in his a reimbursement of, expenses that would be wages for income and employment tax pur- Employee. You can provide qualified trans- deductible as moving expenses if your em- poses. ployee paid or incurred them. You should portation fringe benefits only to employees. make the reimbursements under rules similar The definition of employee includes com- Example 2. Each month, you provide to those described in chapter 16 for re- mon-law employees and other statutory em- qualified parking valued at $180 to Travis imbursements of expenses for travel, meals, ployees, such as officers of corporations. Ramon. He does not pay you for any part of and entertainment under accountable plans. Self-employed individuals, including partners, the parking. Because the value of the parking 2-percent shareholders in S corporations, exceeds the limit, for each month you provide sole proprietors, and other independent con- this parking you must include $5 in his wages Deductible moving expenses. Deductible tractors are not employees for purposes of for income and employment tax purposes. moving expenses include only the reasonable this fringe benefit. expenses of: Example 3. You provide qualified parking Relation to other fringe benefits. You with a fair market value of $200 per month to 1) Moving household goods and personal cannot exclude a qualified transportation your employees, but you charge the employ- effects from the former home to the new fringe benefit under the de minimis or working ees $25 per month. The value of the parking home, and condition fringe benefit rules. However, if you exceeds the limit by $25. You reduce that provide a local transportation benefit other excess benefit by the amount your employees 2) Traveling (including lodging) from the than by transit pass or commuter highway paid ($25). Do not include any amount in your former home to the new home. vehicle, or to a person other than an em- employees' wages. Chapter 4 Fringe Benefits Page 15 More Information Outplacement services. You can exclude vehicle. A marking on a license plate is not a from an employee's wages, as a working clear marking for this purpose. For more information on qualified transporta- condition fringe, the value of outplacement tion fringe benefits, including van pools, and services provided to the employee on the Unmarked law enforcement vehicles. The how to determine the value of parking, see basis of need if you get a substantial business governmental agency or department that Notice 94–3 in Cumulative Bulletin 1994–1. benefit from the services distinct from the owns or leases the vehicle and employs the benefit you would get from the payment of officer must authorize any personal use of an additional wages. Substantial business bene- unmarked law enforcement vehicle. The per- Working Condition Fringe fits include promoting a positive business im- sonal use must be necessary to help enforce You can exclude from an employee's wages age, maintaining employee morale, and the law, such as being able to report directly (as a working condition fringe benefit) the avoiding wrongful termination suits. from home to a stakeout site or to an emer- value of property and services you provide if You cannot exclude the value of services gency. Use for vacation or recreation trips the employee could deduct them as a trade that do not qualify as a working condition cannot qualify as an authorized use. or business or depreciation expense if he or fringe because the employee can choose to Law enforcement officer. A law she paid for them. receive cash or taxable benefits in place of enforcement officer is a full-time employee of For this fringe benefit, employee includes the services. If you maintain a severance a governmental unit that is responsible for any of the following persons. plan and permit employees to get outplace- preventing or investigating crimes involving ment services with reduced severance pay, injury to persons or property (including include in the employee's wages the differ- 1) An individual currently employed by you. catching or detaining persons for these ence between the unreduced severance and crimes). The law must allow the employee to 2) A partner who performs services for a the reduced severance payments. take all of the following actions. partnership. Demonstrator cars. All of the use of a 1) Carry firearms. 3) A director of your company. demonstrator car by your full-time auto 2) Execute search warrants. salesperson generally qualifies as a working 4) An independent contractor who performs condition fringe if the use is primarily to facil- 3) Make arrests (other than citizen's ar- services for you. itate the services the salesperson provided for rests). you and there are substantial restrictions on However, do not exclude from the com- personal use. For more information and the The employee must regularly carry pensation you pay to an independent con- definition of “full-time auto salesperson,” see firearms except when working undercover. A tractor who performs services for you the section 1.132–5(o) of the regulations. law enforcement officer includes an arson in- value of parking or the use of consumer vestigator if the investigator meets these re- goods that you provide in a product testing Qualified Nonpersonal- quirements. program. Also, do not exclude from the com- pensation you pay to a director the value of Use Vehicles Trucks and vans. A pickup truck or van is the use of consumer goods you provide in a All of an employee's use of a qualified not a qualified nonpersonal-use vehicle un- product testing program. nonpersonal-use vehicle qualifies as a work- less specially modified so it is not likely to be ing condition fringe. You can exclude the used more than minimally for personal pur- value of that use from the employee's wages. poses. The following are guidelines that a Vehicle-allocation rules. Generally, for an A qualified nonpersonal-use vehicle is any pickup truck or van can meet to be a qualified employer-provided vehicle, the amount you vehicle the employee is not likely to use more nonpersonal-use vehicle. Even if these can exclude as a working condition fringe is than minimally for personal purposes be- guidelines are not met, the vehicle may still the amount that would be allowable as a cause of its design. Qualified nonpersonal- qualify, based upon the facts. In that case, deductible business expense if paid by the use vehicles include all of the following vehi- contact the IRS for further guidance. employee. That is, if the employee uses the cles. Pickup truck. A pickup truck with a car for business, as well as for personal use, loaded gross vehicle weight not over 14,000 the value of the working condition fringe is the 1) Clearly marked police and fire vehicles. pounds qualifies if clearly marked with per- portion determined to be for business use of 2) Unmarked vehicles used by law manently affixed decals, special painting, or the vehicle. See Business use of your car enforcement officers if the use is officially other advertising associated with your trade, under Personal Expenses in chapter 1. Also, authorized. business, or function. It must meet either of see the special rules for certain demonstrator the following requirements. cars and qualified nonpersonal-use vehicles, 3) An ambulance or hearse used for its discussed later. specific purpose. 1) Be equipped with at least one of the fol- However, instead of excluding the value lowing items. 4) Any vehicle designed to carry cargo with of the working condition fringe related to the a loaded gross vehicle weight over deductible car expense, you may include the a) Hydraulic lift gate. 14,000 pounds. entire annual lease value in an employee re- b) Permanent tanks or drums. cipient's wages. The employee can then claim 5) Delivery trucks with seating for the driver any deductible business car expense as an only, or the driver plus a folding jump c) Permanent side boards or panels itemized deduction on his or her personal in- seat. that materially raise the level of the come tax return. This option is available only sides of the truck bed. 6) A passenger bus with a capacity of at if you use the automobile lease rule (dis- least 20 passengers used for its specific d) Other heavy equipment (such as cussed under Special Valuation Rules, ear- purpose. an electric generator, welder, boom, lier) to value the fringe benefit. or crane used to tow automobiles 7) School buses. and other vehicles). Educational assistance. If you pay the cost 8) Tractors and other special purpose farm 2) Be used primarily to transport a partic- of an employee's education, you may be able vehicles. ular type of load (other than over the to exclude the cost from the employee's public highways) in a construction, man- wages under the tax rules that apply to em- Clearly marked police or fire vehicles. A ufacturing, processing, farming, mining, ployer-provided educational assistance pro- police or fire vehicle is a vehicle, owned or drilling, timbering, or other similar oper- grams. Costs you cannot exclude under those leased by a governmental unit (or any of its ation for which it was specially designed rules may be excluded only if they qualify as agencies or instrumentalities), that a police or significantly modified. a working condition fringe. To qualify as a officer or fire fighter who is always on call working condition fringe, the cost of the edu- must use for commuting. The governmental Van. A van with a loaded gross vehicle cation must be a job-related expense that unit must prohibit any personal use (other weight not over 14,000 pounds qualifies if would be deductible by the employee if he or than commuting) of the vehicle outside the clearly marked with permanently affixed she paid it. For more information on educa- limit of the police officer's arrest powers or the decals, special painting, or other advertising tional assistance programs, see chapter 5. fire fighter's obligation to respond to an associated with your trade, business, or For more information on deductible education emergency. A police or fire vehicle is clearly function. It must have a seat for the driver expenses, see Publication 508, Tax Benefits marked if, through a painted symbol or words, only, or the driver and one other person, and for Work-Related Education. it is easy to see the vehicle is a police or fire either of the following items. Page 16 Chapter 4 Fringe Benefits 1) Permanent shelving that fills most of the programs. Exclusion from wages. You can generally cargo area. exclude benefits you provide to an employee under an accident or health plan from the 2) An open cargo area and the van always Topics This chapter discusses: employee's wages as you withhold, pay, and carries merchandise, material, or equip- report employment taxes. However, you can- ment used in your trade, business, or • Accident and health plans not exclude payments you make under a function. self-insured plan as a continuation of an em- • Adoption assistance ployee's wages during his or her absence Items Not Excludable • Cafeteria plans from work (sick pay). Treat these payments as wages. The following are examples of items you Dependent care assistance • Self-insured plans that favor highly cannot exclude from an employee's wages • Educational assistance compensated individuals. If your plan is a as working condition fringe benefits. • Group-term life insurance coverage self-insured plan and it favors highly com- 1) A service or property offered through a pensated individuals, you must include all or flexible spending account. A flexible part of the amounts you pay to these individ- spending account is an agreement that Useful Items uals in their wages. A self-insured plan is a plan that reim- gives employees over a time period a You may want to see: certain amount of unspecified noncash burses your employees for medical expenses not covered by an accident or health insur- benefits with a predetermined cash Publication value. ance policy. A highly compensated individual (for this Ⅺ 15–A Employer's Supplemental Tax purpose) is any of the following. 2) Any item for which the employee does Guide not have the necessary substantiation to deduct as a trade, business, or depreci- Ⅺ 503 Child and Dependent Care Ex- 1) One of the five highest paid officers. ation expense. penses 2) A shareholder who owns (directly or in- 3) Expenses the employee can deduct un- Ⅺ 968 Tax Benefits for Adoption directly) more than 10% in value of the der sections of the Internal Revenue Ⅺ 969 Medical Savings Accounts employer's stock. Code other than for trade or business (MSAs) expenses or depreciation. 3) Among the highest paid 25% of all em- ployees, other than those who can be 4) A physical examination program, even if Form (and Instructions) excluded from the plan. mandatory for some or all employees. Ⅺ W–2 Wage and Tax Statement For more information, see section 105(h) 5) A cash payment you made to the em- Ⅺ ployee unless you require the employee 5500 Annual Return/Report of Em- of the Internal Revenue Code and the related to do all of the following. ployee Benefit Plan regulations. See chapter 17 for information about get- a) Use the money for expenses for a ting publications and forms. Group health plan. This is a plan (including specific or prearranged activity that a self-insured plan) that provides medical are deductible as trade, business, care to your employees, former employees, or depreciation expenses. or their families. The plan can provide care b) Verify that he or she used the Accident and directly or through insurance, reimbursement, money for these expenses. or otherwise. Health Plans If your accident or health plan includes c) Return any unused money to you. coverage under a group health plan, you may This section provides basic tax information be subject to various excise taxes if the group about accident and health plans. health plan does not meet certain require- ments. Accident or health plan. This is an ar- Coverage requirements. A tax equal to rangement that provides benefits for your 25% of your group health plan expenses may employees, their spouses, and their depen- apply if the plan discriminates against ben- dents in the event of personal injury or sick- eficiaries with end-stage renal disease or be- ness. The benefits can be paid directly by cause of age or disability. For more infor- 5. you, through insurance, or through a trust or mation, see section 5000 of the Internal fund that provides benefits directly or through Revenue Code. insurance. Continuation-of-coverage require- Employee Accident and health benefits include the ments. A tax of up to $100 per beneficiary following items. Benefit may apply for each day the plan does not al- • Contributions to the cost of accident or low qualified beneficiaries who would other- health insurance. wise lose coverage because of certain events Programs to choose continuation coverage under the • Contributions to a separate trust or fund plan. This tax does not apply if you normally that provides accident or health benefits employ fewer than 20 employees. directly or through insurance. For more information, see section 4980B • Contributions to medical savings ac- of the Internal Revenue Code and the related Introduction counts. regulations. This chapter discusses some fringe benefits Other requirements. A tax of up to $100 • Payments or reimbursements of medical per beneficiary may apply for each day the (defined in chapter 4) you can provide to your expenses. employees as part of an employee benefit plan does not meet requirements that do all program. • Payments for specific injuries or illnesses the following. You can generally exclude a limited (such as the loss of the use of an arm amount of the cost of benefits you provide to or leg). • Increase portability by limiting the cir- an employee through certain employee ben- • Payments that replace or supplement cumstances under which the plan can efit programs from the employee's wages as wages during an absence from work due deny coverage for preexisting conditions. you withhold, pay, and report employment to illness or injury. • Ensure accessibility by barring the plan taxes. This chapter explains how to figure the from using an individual's health status to amount you can exclude from your employ- Special rules apply to accident or health deny coverage. ee's wages. See chapters 3 and 4 for infor- plans that include coverage under a group mation on excluding certain other benefits health plan or contributions to an employee's • Guarantee renewability under a multi- from wages. See chapter 2 for information medical savings account. These rules are employer plan by limiting the circum- about deducting the costs of employee benefit explained later. stances under which the plan can deny Chapter 5 Employee Benefit Programs Page 17 an employer continued access to cover- tain life insurance plans maintained by edu- b) A 5% owner of your business. age. cational institutions can be offered as a ben- c) A 1% owner of your business efit even though they defer pay. • Ensure an acceptable level of postpartum whose annual pay was more than The fact that your employee can choose care by obligating the plan to pay for a $150,000. minimum hospital stay for mothers and between cash and qualified benefits does not newborns following childbirth if the plan make the qualified benefits your employee To determine ownership in (2) above, treat otherwise provides benefits for hospital chooses to receive taxable to the employee. your employee as owning both his or her own stays in connection with childbirth. Qualified benefits. A qualified benefit is interest and any related person's interest. The a benefit that you can exclude from an em- term related person includes the employee's • Increase parity for mental health benefits ployee's wages because of specific tax rules, spouse, children, grandchildren, and parents. by preventing the plan from placing lower including those discussed in this chapter. It also includes any corporations, partner- limits on those benefits than on the plan's However, a cafeteria plan cannot offer schol- ships, estates, or trusts in which the em- medical and surgical benefits. arship or fellowship grants, educational as- ployee has at least a 5% interest. sistance, medical savings accounts, long- This tax does not generally apply if the term care insurance, or, generally, the fringe More information. For more information plan has fewer than two participants who are benefits discussed in chapter 4. current employees or if your plan is insured about cafeteria plans, see section 125 of the and you normally employ no more than 50 Internal Revenue Code and the related regu- Exclusion from wages. You can generally lations. employees. For more information, see section exclude the cost of providing qualified bene- 4980D and chapter 100 of the Internal Reve- fits to an employee under a cafeteria plan Recordkeeping requirements. If you nue Code. from the employee's wages as you withhold, maintain a cafeteria plan, you must pay, and report employment taxes. However, RECORDS keep complete records showing all Medical savings accounts. If your health certain group-term life insurance coverage the following. plan for your employees has a higher annual (discussed later) is subject to social security deductible than typical health plans, your and Medicare taxes. Also, adoption benefits 1) The number of your employees. employees may be able to set up medical are subject to social security, Medicare, and savings accounts (MSAs) to set aside money 2) The number of your employees eligible federal unemployment taxes. to participate in the plan. for medical expenses not reimbursable by the Plans that favor highly compensated plan. Generally, your employees can set up employees. If your plan favors highly com- 3) The number of your employees partic- MSAs only if you have 50 or fewer employees pensated employees as to eligibility to partic- ipating in the plan. and your high-deductible health plan has a ipate, contributions, or benefits, you must in- 4) The total cost of the plan during the year. limit on the annual out-of-pocket expenses clude in their wages the value of taxable that an employee must pay for covered ex- benefits they could have selected. A plan you 5) Your name, address, and taxpayer penses. maintain under a collective bargaining agree- identifying number (TIN). If you contribute to an employee's MSA, ment does not favor highly compensated treat your contribution as accident or health 6) The type of business in which you are employees. engaged. plan benefits up to the maximum annual A highly compensated employee (for this contribution allowed for that employee. Gen- purpose) is any of the following. You will need these records to file Form 5500 erally, this is 75% (65% for self-only cover- after the end of the plan year. age) of the health plan's annual deductible, 1) An officer. limited to the amount of the employee's wages. 2) A shareholder who owns more than 5% You may be subject to an excise tax if you of the voting power or value of all classes make a contribution to an employee's MSA of the employer's stock. Form 5500. If you maintain a cafeteria plan, during any calendar year and do not make you must file information about the plan each 3) An employee who is highly compensated year by the last day of the 7th month after the comparable contributions for all comparable based on the facts and circumstances. participating employees for each coverage plan year ends. Use Form 5500 and Schedule period during that year. The tax is 35% of the 4) A spouse or dependent of a person de- F (Form 5500). See the form instructions for total amount you contributed to MSAs that scribed in (1), (2), or (3). information on extensions of time to file. year. For more information, see Publication 969, Plans that favor key employees. If your Medical Savings Accounts (MSAs). plan favors key employees, you must include in their wages the value of taxable benefits Dependent they could have selected. A plan favors key employees if more than 25% of the total of the Care Assistance nontaxable benefits you provide for all em- Adoption Assistance ployees under the plan go to key employees. This section provides basic tax information You can exclude payments or reimburse- However, a plan you maintain under a col- about dependent care assistance programs. ments you make under an adoption assist- lective bargaining agreement does not favor ance program for an employee's qualified key employees. Dependent care assistance program. A adoption expenses from the employee's A key employee during 2000 is generally dependent care assistance program is a wages. The payments are not subject to in- an employee who is any of the following. separate written plan that provides dependent come tax withholding. However, they are care assistance only to your employees. subject to other employment taxes. For more 1) An officer having, for any year listed be- However, the plan will not be treated as a information, see Publication 968, Tax Benefits low, annual pay of more than the listed dependent care assistance program for as- for Adoption. amount. sistance provided to a highly compensated employee unless certain tests are met. See a) 1996 — $60,000 Assistance provided to a highly compensated b) 1997 — $62,500 employee, later. Dependent care assistance defined. Cafeteria Plans c) 1998 — $65,000 Dependent care assistance means the pay- This section provides basic tax information d) 1999 — $65,000 ment of, or the providing of, work-related about cafeteria plans. household and dependent care services. The e) 2000 — $67,500 services are work related only if: Cafeteria plan. A cafeteria plan is a written 2) A person who, for 2000 or any of the 4 1) They allow the employee to work, and plan that allows your employees to choose preceding years, was any of the follow- between receiving cash or certain qualified ing. 2) They are for a qualifying person's care. benefits. Generally, a cafeteria plan does not in- a) One of the 10 employees having This is basically the same as the work-related clude any plan that offers a benefit that defers annual pay of more than $30,000 expense test that the employee would use if pay. However, a cafeteria plan can include a and owning the largest interests in he or she paid the expenses and claimed the qualified 401(k) plan as a benefit. Also, cer- your business. dependent care credit. For more information, Page 18 Chapter 5 Employee Benefit Programs including the definition of the term “qualifying pensated employees under all your de- education involving sports, games, or hob- person,” see Qualifying Person Test and pendent care programs. To determine bies, unless the education: Work-Related Expense Test in Publication whether your programs meet this test, 503. do not consider the following. 1) Has a reasonable relationship to your business, or a) Employees who are under age 21 Exclusion from wages. You can exclude a and have not completed 1 year of 2) Is required as part of a degree program. limited amount of benefits you provide to an service. employee under a dependent care assistance Education expenses do not include the program from the employee's wages if you b) Employees excluded from your cost of tools or supplies (other than text- reasonably believe that the employee can program who are covered by a col- books) that your employee is allowed to keep exclude the benefits from gross income. The lective bargaining agreement if at the end of the course. Nor do they include amount you exclude is not subject to em- there is evidence that dependent the cost of lodging, meals, or transportation. ployment taxes. care assistance was a subject of An employee can generally exclude from good-faith bargaining. Exclusion from wages. You can exclude a gross income up to $5,000 of benefits re- limited amount of benefits you provide to an c) If you provide the benefits through ceived under a dependent care assistance employee under an educational assistance a salary reduction agreement, em- program each year. This limit is reduced to program from the employee's wages as you ployees whose pay is less than $2,500 for married employees filing separate withhold, pay, and report employment taxes. $25,000 before the reduction. returns. Exclusion limit. You can exclude from However, the exclusion cannot be more If all of these tests are not met, you must in- an employee's wages up to $5,250 of edu- than the earned income of either: clude the dependent care assistance pro- cational assistance each year. vided to each highly compensated employee Assistance over the limit. If you provide 1) The employee, or in his or her wages. an employee with more than $5,250 of edu- cational assistance during the year, you may 2) The employee's spouse. be able to exclude part or all of the excess Special rules apply to determine the earned as a working condition fringe benefit. See income of a spouse who is either a student Educational chapter 4. or not able to care for himself or herself. For Expiration date. This exclusion will not more information on the earned income limit, Assistance apply to expenses paid for courses beginning see Publication 503. after May 31, 2000. Assistance provided to a highly com- This section provides basic tax information about educational assistance programs. As this publication was being pre- pensated employee. Dependent care as- pared for print, Congress was con- sistance provided to a highly compensated ! Educational assistance program. An edu- CAUTION sidering legislation that would extend employee (as defined in chapter 4 under Ex- the expiration date of the educational assist- clusion of Certain Fringe Benefits) is treated cational assistance program is a separate written plan that provides educational assist- ance exclusion. For more information about as provided under a dependent care assist- this and other important tax changes, see ance program and can be excluded from the ance only to your employees. The program qualifies only if all of the following tests are Publication 553, Highlights of 1999 Tax employee's wages only if the following tests Changes. are met. met.

1) The benefits provided under the program 1) The program benefits employees who do not favor highly compensated em- qualify under rules set up by you that do ployees. not favor highly compensated employ- ees (as defined in chapter 4 under Ex- Group-Term Life 2) The program benefits employees who clusion of Certain Fringe Benefits). To qualify under rules set up by you that do determine whether your program meets Insurance Coverage not favor highly compensated employ- this test, do not consider employees ex- This section provides basic tax information ees. To determine whether your pro- cluded from your program who are cov- about group-term life insurance coverage. gram meets this test, do not consider the ered by a collective bargaining agree- following. ment if there is evidence that educational assistance was a subject of good-faith Group-Term Life Insurance a) Employees who are under age 21 bargaining. and have not completed 1 year of This is life insurance that meets all the fol- service. 2) The program does not provide more than lowing conditions. 5% of its benefits during the year for 1) It provides a general death benefit that b) Employees excluded from your shareholders or owners. A shareholder is not included in income. program who are covered by a col- or owner is someone who owns (on any lective bargaining agreement, if day of the year) more than 5% of the 2) You provide it to a group of employees. there is evidence that dependent stock or of the capital or profits interest care assistance was a subject of of your business. 3) It provides an amount of insurance to good-faith bargaining. each employee based on a formula that 3) The program does not allow employees prevents individual selection. This for- 3) The program does not provide more than to choose to receive cash or other ben- mula must use factors such as the em- 25% of its benefits during the year for efits that must be included in gross in- ployee's age, years of service, pay, or shareholders or owners. A shareholder come instead of educational assistance. position. or owner is someone who owns (on any day of the year) more than 5% of the 4) You give reasonable notice of the pro- 4) You provide it under a policy you carry stock or of the capital or profits interest gram to eligible employees. directly or indirectly. Even if you do not of your business. pay any of the policy's cost, you are Your program can cover former employees if considered to carry it if you arrange for 4) You give reasonable notice of the pro- their employment is the reason for the cover- payment of its cost by your employees gram to eligible employees. age. and charge at least one employee less 5) By January 31, you provide each em- Educational assistance defined. Edu- than, and at least one other employee ployee with a Form W–2 showing the cational assistance means amounts you pay more than, the cost of his or her insur- amount of dependent care assistance (if or incur for your employees' education ex- ance. Determine the cost of the insur- furnished in kind, its fair market value) penses. These expenses generally include ance, for this purpose, as explained un- provided to the employee during the the cost of books, equipment, fees, supplies, der Group-Term Life Insurance in preceding year. and tuition. However, these expenses do not Publication 15–A. include the cost of graduate-level courses of 6) The average benefits provided to your a kind normally taken by a person pursuing Employee. For this purpose, an employee is employees who are not highly compen- a program leading to an advanced academic one of the following. sated is at least 55% of the average or professional degree. Also, these expenses benefits provided to your highly com- do not include the cost of a course or other 1) A person who works for you whose legal Chapter 5 Employee Benefit Programs Page 19 relationship to you is that of an em- 2) They customarily work 20 hours or less a) One of the 10 employees having ployee. a week or 5 months or less in a calendar annual pay of more than $30,000 year. and owning the largest interests in 2) A full-time life insurance agent. your business. 3) They have not been employed for the 3) A person who was formerly your em- waiting period given in the policy. This b) A 5% owner of your business. ployee. waiting period cannot be more than 6 c) A 1% owner of your business months. whose annual pay was more than Effect of permanent benefits. Permanent $150,000. benefits are economic values you provide Accidental or other death benefits. A pol- under a life insurance policy that extend be- icy that provides accidental death benefits or To determine ownership in (2) above, treat yond one policy year, such as paid-up or cash death benefits other than general death ben- your employee as owning both his or her own surrender value. efits (travel insurance, for example), is not interest and any related person's interest. The Life insurance that includes permanent group-term life insurance. term “related person” includes the employee's benefits is group-term life insurance only if it spouse, children, grandchildren, and parents. meets certain conditions. For more informa- Policy covering employee's spouse or de- It also includes any corporations, partner- tion, see section 1.79–1 of the regulations. pendent. A policy that provides insurance ships, estates, or trusts in which the em- on the life of your employee's spouse or de- ployee has at least a 5% interest. The 10-employee rule. Generally, group- pendent is not group-term life insurance. A former employee who was a key em- term life insurance is life insurance that you However, you may be able to exclude the cost ployee upon retirement or separation from provide to at least 10 full-time employees at of this insurance from your employee's wages service is also a key employee. some time during the year. as a de minimis fringe benefit. See chapter Participation test. Your plan meets this For this rule, count employees who 4. test if all of the following are true. choose not to receive the insurance unless, to receive it, they must contribute to the cost 1) It benefits at least 70% of your employ- of benefits other than the group-term life in- Exclusion From Wages ees. surance. For example, count an employee You can generally exclude group-term life in- 2) At least 85% of those employees are not who could receive insurance by paying part surance coverage you provide to an em- key employees. of the cost, even if that employee chooses ployee from the employee's wages as you not to receive it. However, do not count an withhold income tax and pay federal unem- 3) It benefits employees who qualify under employee who must pay part or all of the cost ployment tax. In addition, you can exclude a a set of rules you set up that do not favor of permanent benefits to get insurance, un- limited amount of coverage for other employ- key employees. less that employee chooses to receive it. ment tax and reporting purposes. Exceptions. Even if you do not meet the Your plan also meets this test if it is part 10-employee rule, two exceptions allow you of a cafeteria plan (discussed earlier) and it Exclusion limit. You can generally exclude to treat insurance as group-term life insur- meets the participation test for those plans. from an employee's wages the cost of up to ance. When applying this test do not consider $50,000 of group-term life insurance cover- Under the first exception, you do not have employees who meet the following require- age. to meet the 10-employee rule if all the fol- ments. lowing conditions are met. Coverage over the limit. If you provide an 1) Have not completed 3 years of service. 1) If evidence that the employee is employee with more than $50,000 of cover- 2) Are part time or seasonal. insurable is required, it is limited to a age at any time during the year, you must medical questionnaire (completed by the include in the employee's wages the cost of 3) Are nonresident aliens who receive no employee) that does not require a phys- insurance that is more than the cost of U.S. source earned income from you. ical. $50,000 of coverage, reduced by any amount 4) Are not included in the plan but are in a the employee pays toward the insurance. unit of employees covered by a collective 2) You provide the insurance to all your Figure the cost of the insurance as explained bargaining agreement, if the benefits full-time employees or, if the insurer re- under Group-Term Life Insurance in Publica- provided under the plan were the subject quires the evidence mentioned in (1), to tion 15–A. of good-faith bargaining between you all full-time employees who provide evi- and employee representatives. dence the insurer accepts. Plans that favor key employees. Generally, 3) You figure the coverage based on either if your group-term life insurance plan favors Benefits test. Your plan meets this test a uniform percentage of pay or the key employees, you must include the entire if it does not favor key employees as to the insurer's coverage brackets. cost of the insurance in your key employees' type and amount of life insurance it provides. income. However, this rule generally does not Your plan does not favor key employees just Under the second exception, you do not apply to church plans. because the amount of insurance you provide have to meet the 10-employee rule if all the A plan favors key employees if it favors to your employees is uniformly related to their following conditions are met. them as to eligibility to participate or as to the pay. type and amount of benefits it provides. Apply 1) You provide the insurance under a the participation and benefits tests (discussed common plan covering your employees later) separately to your active and former and the employees of at least one other employees. employer who is not related to you. Key employee. A key employee during 2000 is an employee or former employee who 2) The insurance is restricted to, but man- is one of the following. 6. datory for, all your employees who be- long to or are represented by an organ- 1) An officer having, for any year listed be- ization (such as a union) that carries on low, annual pay of more than the listed Retirement substantial activities besides obtaining amount. insurance. a) 1996 — $60,000 Plans 3) Evidence of whether an employee is b) 1997 — $62,500 insurable does not affect an employee's eligibility for insurance or the amount of c) 1998 — $65,000 insurance that employee gets. d) 1999 — $65,000 Important Reminder To apply either exception, do not consider e) 2000 — $67,500 employees who were denied insurance for Contributions to a SEP-IRA or a SIMPLE any of the following reasons. 2) A person who, for 2000 or any of the 4 IRA. A SEP-IRA or a SIMPLE IRA cannot preceding years, was any of the follow- be designated as a Roth IRA. Contributions 1) They were 65 or older. ing. to a SEP-IRA or a SIMPLE IRA will not affect Page 20 Chapter 6 Retirement Plans the amount that an individual can contribute the Designated Financial Institu- to a Roth IRA. For information about Roth tion Rules) Deduction Limits IRAs, see Publication 590. The most you can deduct for employer con- Ⅺ 5305–SIMPLE Savings Incentive Match tributions for common-law employees is 15% Plan for Employees of Small Em- of the compensation paid to them during the ployers (SIMPLE) (for Use With a year from the business that has the plan. Introduction Designated Financial Institution) Ⅺ This chapter discusses retirement plans that 5500–EZ Annual Return of One- Deduction of contributions for yourself. you can set up and maintain for yourself and Participant (Owners and Their When figuring the deduction for employer your employees. Retirement plans are Spouses) Retirement Plan contributions made to your own SEP-IRA, savings plans that offer you tax advantages See chapter 21 for information about get- compensation is your net earnings from self- to set aside money for your own and your ting publications and forms. employment minus the following amounts. employees' retirement. In general, a sole proprietor or a partner 1) The deduction for one-half of your self- is treated as an employee for participating in employment tax. a retirement plan. Simplified Employee 2) The deduction for contributions to your SEP, SIMPLE, and qualified plans offer own SEP-IRA. you and your employees a tax favored way Pension (SEP) to save for retirement. You can deduct con- A simplified employee pension (SEP) is a The deduction for contributions to your tributions you make to the plan for your em- own SEP-IRA and your (net earnings) depend ployees. If you are a sole proprietor, you can written plan that allows you to make deduct- ible contributions toward your own and your on each other. For this reason, you determine deduct contributions you make to the plan for the deduction for contributions to your own yourself. You can also deduct trustees' fees employees' retirement without getting in- volved in more complex retirement plans. A SEP-IRA indirectly by reducing the contribu- if contributions to the plan do not cover them. tion rate called for in your plan. Use the Rate Earnings on the contributions are generally corporation also can have a SEP and make deductible contributions toward its employ- Worksheet for Self-Employed shown under tax free until you or your employees receive Qualified Plan to figure the rate. distributions from the plan in later years. ees' retirement. But some advantages avail- Under some plans, employees can have able to qualified plans, such as the special tax SEP and profit-sharing plans. If you also you contribute limited amounts of their treatment that may apply to lump-sum distri- contributed to a qualified profit-sharing plan, before-tax pay to a plan. These amounts (and butions, do not apply to SEPs. you must reduce the 15% deduction limit for the earnings on them) are generally tax free Under a SEP, you make the contributions that plan by the allowable deduction for con- until your employees receive distributions to a traditional individual retirement arrange- tributions to the SEP-IRAs of those partic- from the plan in later years. ment (called a SEP-IRA). ipating in both the SEP plan and the profit- In general, individuals who are employed SEP-IRAs are set up for, at a minimum, sharing plan. can also set up and contribute to individual each eligible employee. A SEP-IRA may have retirement arrangements (IRAs). to be set up for a leased employee, but need not be set up for an excludable employee. For SEP and other qualified plans. If you also more information, see Publication 560. contributed to any other type of qualified plan, Topics Form 5305–SEP. You may be able to use treat the SEP as a separate profit-sharing This chapter discusses: Form 5305–SEP in setting up your SEP. plan when applying the overall 25% deduction limit described in section 404(h)(3) of the Simplified employee pensions (SEPs) • Internal Revenue Code. • SIMPLE retirement plans Contribution Limits Contributions you make for a year to a com- • Qualified plans mon-law employee's SEP-IRA are limited to Employee contributions. Employees can the lesser of $30,000 or 15% of the employ- also make contributions of up to $2,000 to • Individual retirement arrangements their SEP-IRAs independent of the employer's (IRAs) ee's compensation. Compensation generally does not include your contributions to the SEP contributions. However, the employee's SEP, but does include certain elective defer- deduction for IRA contributions may be re- rals unless you choose not to include them. duced or eliminated because the employee is Useful Items covered by an employer retirement plan (the You may want to see: SEP plan). See Publication 590 for details. Annual compensation limit. You generally cannot consider the part of compensation of Publication an employee that is over $160,000 when you Salary Reduction Ⅺ 15 Circular E, Employer's Tax Guide figure your contribution limit for that em- ployee. Simplified Employee Ⅺ 533 Self-Employment Tax Pension (SARSEP) Ⅺ 560 Retirement Plans for Small Busi- More than one plan. If you also contribute ness (SEP, SIMPLE, and Keogh to a defined contribution retirement plan (de- An employer is no longer allowed to Plans) fined later), annual additions to an account ! set up a SARSEP. However, partic- are limited to the lesser of $30,000 or 25% CAUTION ipants in a SARSEP set up before Ⅺ 575 Pension and Annuity Income of the participant's compensation. When you 1997 (including employees hired after 1996) Ⅺ 590 Individual Retirement Arrange- figure this limit, your contributions to all of the can continue to have their employer contrib- ments (IRAs) (Including Roth plans must be added. Because a SEP is ute part of their pay to the plan. IRAs and Education IRAs) considered a defined contribution plan for purposes of this limit, your contributions to a A SEP can include a salary reduction SEP must be added to your contributions to (elective deferral) arrangement. Under the Form (and Instructions) defined contribution plans. arrangement, employees can choose to have Ⅺ W–2 Wage and Tax Statement you contribute part of their pay to their Reporting on Form W–2. Do not include SEP-IRAs. The income tax on the contribu- Ⅺ 5305–SEP Simplified Employee SEP contributions on Form W–2 unless there tion is deferred. This choice is called an Pension–Individual Retirement are contributions under a salary reduction ar- elective deferral, which remains tax free until Accounts Contribution Agreement rangement. distributed (withdrawn). Ⅺ 5305A–SEP Salary Reduction and Other This choice is available only if all the fol- Contributions for yourself. The annual Elective Simplified Employee lowing requirements are met. limits on your contributions to a common-law Pension–Individual Retirement employee's SEP-IRA also apply to contribu- Accounts Contribution Agreement • At least 50% of your eligible employees tions you make to your own SEP-IRA. How- choose the salary reduction arrangement. Ⅺ 5304–SIMPLE Savings Incentive Match ever, special rules apply when you figure your Plan for Employees of Small Em- maximum deductible contribution. See De- • You had 25 or fewer eligible employees ployers (SIMPLE) (Not subject to duction of contributions for yourself, later. (or employees who would have been eli- Chapter 6 Retirement Plans Page 21 gible if you had maintained a SEP) at any In either case, the maximum deductible sponsored retirement plan can set up a time during the preceding year. contribution would be $3,913.05 ($30,000 x SIMPLE plan. 13.0435%). • Each eligible highly compensated em- For more information on employer with- Eligible employee. Any employee who re- ployee's deferral percentage each year holding requirements, see Publication 15. ceives at least $5,000 in compensation during is no more than 125% of the average For more information on SEPs, see Pub- any 2 years preceding the plan year and is deferral percentage (ADP) of all non- lication 560. expected to earn at least $5,000 during the highly compensated employees eligible calendar year can choose to have his or her to participate (the ADP test). See Publi- employer make contributions to a SIMPLE cation 560 for the definition of a highly retirement account under a qualified salary compensated employee and information reduction arrangement. on how to figure the deferral percentage. SIMPLE Compensation. Compensation is the total Limit on elective deferrals. In general, the Retirement Plan wages required to be reported on Form W–2 total income an employee can defer under a plus elective deferrals. For a self-employed salary reduction arrangement included in a A SIMPLE plan (Savings Incentive Match individual, compensation is net earnings from SEP and certain other elective deferral ar- Plan for Employees) is a written salary re- self-employment. It does not include any rangements for 1999 is limited to the lesser duction arrangement that allows a small contribution made to the SIMPLE plan. of $10,000 or 15% of the participant's com- business (an employer with 100 or fewer pensation (as defined in Publication 560). employees) to make elective contributions to Any SIMPLE elective deferrals made This limit applies only to amounts that reduce a SIMPLE retirement account on behalf of TIP for an employee under a salary re- the employee's pay, not to any contributions each eligible employee. An eligible employer duction arrangement are included in from employer funds. (defined later) is generally not allowed to wages on the employee's Form W–2 for so- maintain another retirement plan. cial security and Medicare tax purposes only. Employment taxes. Elective deferrals that meet the ADP test are not subject to income Setting Up a SIMPLE Plan Contribution Limits tax in the year of deferral, but they are in- If an employer has 100 or fewer employees Contributions include employee elective cluded in wages for social security, Medicare, deferrals and employer contributions. The and unemployment (FUTA) tax purposes. who were paid at least $5,000 by the em- ployer in the preceding year, the employer employer must satisfy one of two contribution may be able to set up a SIMPLE retirement formulas: the matching contribution formula plan on behalf of eligible employees. The plan or a 2% nonelective contribution. No other Reporting SEP can be either of the following. contributions can be made to the SIMPLE Contributions on Form W–2 plan. These contributions, which are deduct- ible by the employer, must be made timely. Your contributions to an employee's SEP-IRA • A SIMPLE IRA for each eligible em- are excluded from the employee's income. ployee. Employee elective deferral limit. The Unless there are contributions under a salary • Part of a qualified cash or deferred ar- amount that the employee chooses to have reduction arrangement, do not include these rangement (a 401(k) plan). the employer contribute to a SIMPLE retire- contributions in your employee's wages on ment account on his or her behalf (elective Form W–2 for income, social security, or The SIMPLE plan generally must be the only deferrals) must not exceed $6,000 for any Medicare tax purposes. Your SEP contribu- retirement plan of the employer to which year and must be expressed as a percentage tions under a salary reduction arrangement contributions are made, or benefits are ac- of the employee's compensation. are included in your employee's Form W–2 crued, for service in any year beginning with for social security and Medicare tax purposes the year the SIMPLE plan becomes effective. only. Dollar-for-dollar employer matching con- Contributions to a SIMPLE plan are tributions. The employer must match all el- deductible by the employer and excluded igible employees' elective contributions on a Example. Jim's salary reduction ar- from the gross income of the employee. rangement calls for a deferral contribution dollar-for-dollar basis, up to 3% of the em- rate of 10% of his salary to be contributed by ployee's compensation. his employer as an elective deferral to Jim's Definitions If the employer chooses a matching SEP-IRA. Jim's salary for the year is $30,000 contribution of less than 3%, the per- (before reduction for the deferral). The em- ! SIMPLE retirement account. The SIMPLE CAUTION centage cannot be less than 1%. The ployer did not choose to treat deferrals as retirement account of an eligible employee is employer must notify the employee of the compensation under the arrangement. To an individual retirement plan that can be ei- lower percentage within a reasonable time figure the deferral amount, the employer ther an individual retirement account or an before the 60-day election period for the cal- multiplies Jim's salary of $30,000 by individual retirement annuity, as described in endar year. A percentage of less than 3% 9.0909%, the reduced rate equivalent of 10%, Publication 590. Employees' rights to the cannot be chosen for more than 2 years dur- to get the deferral amount of $2,727.27. (This contributions cannot be forfeited. ing a 5-year period. method is the same one that you, as a self- A SIMPLE plan can also be set up as a employed person, use to figure the contribu- 401(k) plan. See Publication 560 for informa- Nonelective contributions. In place of the tions you make on your own behalf.) See tion on how to adopt a SIMPLE plan as part dollar-for-dollar matching contributions, the Rate Worksheet for Self-Employed under of a 401(k) plan. employer can choose to make nonelective Qualified Plan. contributions of 2% of compensation on be- On Jim's Form W–2, his employer shows Qualified salary reduction arrangement. half of each eligible employee. Only total wages of $27,272.73 ($30,000 minus $160,000 of the employee's compensation $2,727.27), social security wages of $30,000, This is an arrangement that allows an eligible employee to choose, during the 60-day period can be taken into account when figuring the and Medicare wages of $30,000. Jim reports contribution limit. $27,272.73 as wages on his individual income before the beginning of any year, to have the tax return. employer make contributions (elective defer- An employer who chooses the 2% If his employer chooses to treat deferrals rals) to a SIMPLE retirement account on his ! contribution formula, must timely no- as compensation under the salary reduction or her behalf. An eligible employee may also CAUTION tify the employee (within the 60-day arrangement, Jim's deferral amount would be stop making elective deferrals at any time election period described earlier). $3,000 ($30,000 x 10%). In this case, the during the year. The employer must match employer uses the rate called for under the the employee's contributions or make none- Time limits for contributing funds. The arrangement (not the reduced rate) to figure lective contributions. No other types of con- employer must make the contribution to the the deferral and the ADP test. On Jim's Form tributions are allowed under a qualified salary SIMPLE account within 30 days after the end W–2, the employer shows total wages of reduction arrangement. of the month for which the payments to the $27,000 ($30,000 − $3,000), social security employee were deferred. The employer's wages of $30,000, and Medicare wages of Eligible employer. Any employer who has matching contributions must be made by the $30,000. Jim reports $27,000 as wages on 100 or fewer eligible employees in any year due date of the tax return, including exten- his return. and does not maintain another employer- sions, for the year. Page 22 Chapter 6 Retirement Plans Distributions (Withdrawals) pation in a plan for the other job. However, • Banks (including some savings and loan if you have an IRA, you may not be allowed associations and federally insured credit Distributions from a SIMPLE retirement ac- to deduct some or all of your IRA contribu- unions). count are subject to the IRA rules and are tions. See Publication 590. generally includible in income when with- • Insurance companies. drawn. Tax-free rollovers can be made from • Mutual funds. one SIMPLE account into another SIMPLE Kinds of Qualified Plans account or into an IRA. Early withdrawals There are two basic kinds of qualified retire- Adoption of a master or prototype plan does generally are subject to a 10% (or 25%) ad- ment plans: defined contribution and defined not mean that your plan is automatically ditional tax. benefit. qualified. It must still meet all of the quali- fication requirements stated in the law. Exceptions. A rollover to an IRA can be made tax free only after participating 2 years Defined Contribution Plan in the SIMPLE plan. A 25% additional tax for This plan provides for a separate account for Deduction Limit each person covered by the plan. Benefits are early withdrawal applies if funds are with- The limit on your deduction for contributions based only on amounts contributed to or al- drawn within 2 years of beginning partici- to a qualified plan depends on the kind of plan located to each account. pation. you have. There are three types of defined contri- Employee notification. The employer must bution plans: profit-sharing, stock bonus, and In figuring the deduction for contribu- notify each eligible employee of his or her money purchase pension. ! tions to these plans, you cannot take opportunity to make contributions under a CAUTION into account any contributions or SIMPLE plan. The employer must also notify Profit-sharing plan. This plan lets your em- benefits that are more than the limits dis- all eligible employees of the contribution al- ployees or their beneficiaries share in the cussed under Limits on Contributions and ternative that was chosen. This information profits of your business. The plan must have Benefits in Publication 560. must be provided before the beginning of the a definite formula for allocating the contribu- employee's 60-day election period. tions made to the plan among the participat- Defined contribution plans. The deduction ing employees and for distributing the funds limit for a defined contribution plan depends More information. This chapter does not in the plan. on whether it is a profit-sharing plan or a cover all the rules and exceptions that apply money purchase pension plan. to a SIMPLE IRA or a SIMPLE 401(k) plan. Stock bonus plan. This plan is similar to a Profit-sharing plan. Your deduction for See Publication 560 for additional information profit-sharing plan, but it can only be set up contributions to a profit-sharing plan cannot on excludable employees, reporting and dis- by a corporation. Benefits are payable in be more than 15% of the compensation from closure requirements, and other rules. See stock of the employer. the business paid (or accrued) during the year Form 5304–SIMPLE or Form 5305–SIMPLE to the common-law employees participating and their instructions, also. Money purchase pension plan. Under this in the plan. You must reduce this limit in fig- See Publication 590 for information about plan, your contributions are a stated amount uring the deduction for contributions you IRA rules, including those on the tax treat- or are based on a stated formula that is not make for your own account. See Deduction ment of distributions, rollovers, required dis- subject to your discretion. For example, your of contributions for yourself, later. tributions, and income tax withholding. formula could be 10% of each participating Money purchase pension plan. Your employee's compensation. Your contributions deduction for contributions to a money pur- to the plan are not based on your profits. chase pension plan is generally limited to 25% of the compensation from the business Qualified Plan Defined Benefit Plan paid during the year to a participating com- A qualified retirement plan is a written plan This is any plan that is not defined contribu- mon-law employee. You must reduce this limit you can set up for the exclusive benefit of tion plan. In general, a qualified defined in figuring the deduction for contributions you your employees and their beneficiaries. It is benefit plan must provide for set benefits and make for yourself, as discussed later. sometimes called a Keogh or HR–10 plan. your contributions to the plan are based on You, or you and your employees can actuarial assumptions. Generally, you will Defined benefit plans. An actuary must fig- make contributions to the plan. If your plan need continuing professional help to admin- ure the deduction for contributions to a de- meets the qualification requirements, you can ister a defined benefit plan. fined benefit plan since it is based on actuarial generally deduct your contributions to the assumptions and computations. plan. For more information, see Publication 560. Plan Approval Deduction of contributions for yourself. Your employees generally are not taxed You must adopt a written plan. The Internal To take a deduction for contributions you on your contributions or increases in the Revenue Service (IRS) will issue a determi- make to a plan for yourself, you must have plan's assets until they are distributed to nation or opinion letter regarding the plan's net earnings from the trade or business for them. However, certain loans made from qualification. The determination or opinion of which the plan was set up. qualified employer plans are treated as taxa- the IRS will be based on how the plan is Limit on deduction. If the qualified plan ble distributions. For more information, see written, not on how it operates. is a profit-sharing plan, your deduction for Publication 575. You are not required to request a deter- yourself is limited to the lesser of $30,000 or mination or opinion letter to get all the tax 13.0435% (15% reduced as discussed below) Qualification requirements. To be a qual- benefits of a plan. But, if your plan does not of your net earnings from the trade or busi- ified plan, the plan must meet many require- have a determination letter, you may want to ness that has the plan. If the plan is a money ments. They include the following. request one to ensure that your plan meets purchase plan, the deduction is limited to the the requirements for tax benefits. lesser of $30,000 or 20% (25% reduced as • Who must be covered by the plan. A request for a determination, opinion, or discussed below) of your net earnings. • How contributions to the plan are to be ruling letter can be complex. You may need Net earnings. Your net earnings must invested. professional help to complete the request. be from self-employment in a trade or busi- Also, the IRS charges a fee for issuing these ness in which your personal services are a • How contributions to the plan and bene- letters. Attach Form 8717, User Fee for Em- material income-producing factor. If you are fits under the plan are to be determined. ployee Plan Determination Letter Request, to a partner who only contributed capital and did • How much of an employee's interest in your application. not perform personal services, you cannot the plan must be guaranteed (vested). participate in the partnership's plan. Your net Master and prototype plans. It may be earnings do not take into account tax-exempt For more information, see Publication 560. easier for you to adopt an IRS-approved ex- income (or deductions related to that income), isting master or prototype retirement plan other than foreign earned income and foreign More than one job. If you are self-employed than to set up your own original plan. Master housing cost amounts. and also work for someone else, you can and prototype plans can be provided by the Your net earnings are your business gross participate in retirement plans for both jobs. following sponsoring organizations. income minus the allowable deductions from Generally, your participation in a retirement that business. Allowable deductions include plan for one job does not affect your partici- • Trade or professional organizations. contributions to the plan for your common-law Chapter 6 Retirement Plans Page 23 employees and your other business ex- Step 7 IRA and your circumstances. Generally, penses. Enter the smaller of step 5 or step 6. amounts in an IRA, including earnings and If you are a partner other than a limited This is your maximum deductible gains, are not taxed until they are distributed. contribution. Enter your deduction on partner, your net earnings include your dis- line 29, Form 1040 ...... In some cases, your earnings and gains may tributive share of the partnership income or not be taxed at all if they are distributed ac- loss (other than separately computed items cording to the rules. For more information on Example. You are a self-employed such as capital gains and losses) and any IRAs, see Publication 590. farmer and you have employees. The terms guaranteed payments you receive from the of your plan provide that you contribute partnership. If you are a limited partner, your 101/ 2 % (.105) of your compensation (defined net earnings include only guaranteed pay- earlier) and 101/2% of your common-law em- ments you receive for services rendered to ployees' compensation. Your net earnings or for the partnership. For more information, from line 36, Schedule F (Form 1040) are see Partners under Who Must Pay Self- $200,000. In figuring this amount, you de- Employment Tax in Publication 533. 7. ducted your common-law employees' pay of Net earnings do not include income $100,000 and contributions for them of passed through to shareholders of S corpo- $10,500 (101/ 2 % x $100,000). You figure your rations. Rent Expense self-employed rate and maximum deduction Adjustments. You must reduce your net for contributions on behalf of yourself as fol- earnings by the deduction for one-half of your lows. self-employment tax. Also, net earnings must be reduced by the deduction for contributions Rate Worksheet for Self-Employed you make for yourself. This reduction is made Introduction 1) Plan contribution rate as a decimal indirectly, as explained next. 1 This chapter discusses the tax treatment of (10 / 2 % = .105) ...... 0.105 Net earnings reduced by adjusting 2) Rate in line 1 plus 1 rent or lease payments you make for property contribution rate. You must reduce net (.105 + 1 = 1.105) ...... 1.105 you use in your business but do not own. It earnings by your deduction for contributions 3) Self-employed rate as a decimal also discusses how to treat other kinds of for yourself. The deduction and the net rounded to at least 3 decimal places payments you make that are related to your earnings depend on each other. You can (line 1 ÷ line 2) ...... 0.0950 use of this property. These include payments make the adjustment to your net earnings in- you make for taxes on the property, im- directly by reducing the contribution rate Deduction Worksheet for Self-Employed provements to the property, and getting a called for in the plan and using the reduced Step 1 lease. A discussion about capitalizing (in- rate to figure your maximum deduction for Enter the self-employed rate shown on cluding in the cost of property) certain rent contributions for yourself. line 3 above ...... 0.0950 expenses is at the end of the chapter. Annual compensation limit. You gen- Step 2 The rules in this chapter can apply to sole erally cannot take into account more than Enter your net earnings (net profit) from proprietors, partnerships, corporations, es- $160,000 of your compensation in figuring line 31, Schedule C (Form 1040); line tates, trusts, and any other entity that carries 3, Schedule C–EZ (Form 1040); line your contribution to a defined contribution 36, Schedule F (Form 1040); or line on a trade or business. plan. 15a, Schedule K–1 (Form 1065) ...... $200,000 Step 3 Topics Enter your deduction for self-employ- This chapter discusses: ment tax from line 27, Form 1040 ...... 7,180 Figuring Your Deduction Step 4 The definition of rent Use the following worksheet to find the re- Subtract step 3 from step 2 and enter • duced contribution rate for yourself. Make no the result ...... 192,820 • Taxes on leased property reduction to the contribution rate for any Step 5 Multiply step 4 by step 1 and enter the • The cost of getting a lease common-law employees. result ...... 18,318 Step 6 • Improvements by the lessee Rate Worksheet for Self-Employed Multiply $160,000 by your plan contri- • Capitalizing rent expenses 1) Plan contribution rate as a decimal bution rate. Enter the result but not 1 more than $30,000 ...... 16,800 (10 / 2 % = .105) ...... Step 7 2) Rate in line 1 plus 1 Useful Items (.105 + 1 = 1.105) ...... Enter the smaller of step 5 or step 6. 3) Self-employed rate as a decimal This is your maximum deductible You may want to see: rounded to at least 3 decimal places contribution. Enter your deduction on (line 1 ÷ line 2) ...... line 29, Form 1040 ...... $ 16,800 Publication Now that you have figured your self- Ⅺ 334 Tax Guide for Small Business employed rate, you can figure your maximum When to make contributions. To take a deduction for contributions for yourself by deduction for contributions for a particular Ⅺ 538 Accounting Periods and Methods completing the following steps. year, you must make the contributions not later than the due date, plus extensions, of Ⅺ 946 How To Depreciate Property Deduction Worksheet for Self-Employed your tax return for that year. See chapter 17 for information about get- ting publications and forms. Step 1 Enter the self-employed rate shown on More information. See Publication 560 for line 3 above ...... more information on retirement plans for small Step 2 business owners, including the self- Enter your net earnings (net profit) from employed. Publication 560 also discusses Rent line 31, Schedule C (Form 1040); line the reporting forms that must be filed for these 3, Schedule C–EZ (Form 1040); line plans. Rent is any amount you pay for the use of 36, Schedule F (Form 1040); or line property that you do not own. In general, you 15a, Schedule K–1 (Form 1065) ...... can deduct rent as an expense only if the rent Step 3 is for property that you use in your trade or Enter your deduction for self-employ- ment tax from line 27, Form 1040 ...... business. If you have or will receive equity in Step 4 Individual Retirement or title to the property, the rent is not deduct- Subtract step 3 from step 2 and enter ible. the result ...... Arrangements (IRAs) Step 5 An individual retirement arrangement (IRA) is Unreasonable rent. You cannot take a Multiply step 4 by step 1 and enter the a personal savings plan that allows you to set rental deduction for rents that are unreason- result ...... aside money for your retirement or for certain able. Ordinarily, the issue of reasonableness Step 6 Multiply $160,000 by your plan contri- education expenses. You do not have to set of the rent will not arise unless you and the bution rate. Enter the result, but not up IRAs for your employees or make contri- lessor are related. Rent paid to a related more than $30,000 ...... butions for them. You may be able to deduct person is reasonable if it is the same amount your contributions, depending on the type of you would pay to a stranger for use of the Page 24 Chapter 7 Rent Expense same property. A percentage rental is rea- of the property when you may exercise Leases over $250,000. Special rules are sonable if the rental paid is reasonable. For the option. Determine this value when provided for certain leases of tangible prop- some examples of persons that may be con- you make the agreement. erty. The rules apply if the lease calls for total sidered related, see Related Persons in payments of more than $250,000 and either You have an option to buy the property chapter 15. • of the following apply. at a nominal price compared to the total amount you have to pay under the lease. Rent on your home. If you rent rather than • Any rents are payable after the close of own a home and use part of your home as • The lease designates some part of the the calendar year following the calendar your place of business, you may be able to payments as interest, or part of the pay- year the use occurs. deduct the rent you pay for that part. You ments are easy to recognize as interest. • Rents increase during the lease. must meet the requirements for business use of your home. For more information, see Leveraged leases. Leveraged lease Generally, if these conditions exist, you Qualifying for a Deduction in Publication 587, transactions may be considered leases. Lev- must accrue rents for the periods to which the Business Use of Your Home (Including Use eraged leases generally involve three parties: rents are allocated under the lease. If a lease by Day-Care Providers). a lessor, a lessee, and a lender to the lessor. only contains a rent payment schedule, the Usually the lease term covers a large part of rents payable for a period during the lease the useful life of the leased property, and the are the rents allocated to that period. If the Rent paid in advance. Generally, rent paid lessee's payments to the lessor are enough lease allocates any rent to a calendar year in your trade or business is deductible in the to cover the lessor's payments to the lender. that is not payable until after the close of the year paid or accrued. If you pay rent in ad- If you plan to take part in what appears to succeeding calendar year, only the present vance, you can deduct only the amount that be a leveraged lease, you may want to get value of that rent should be accrued and in- applies to your use of the rented property an advance ruling. The following revenue terest on the unpaid rent accrues until the rent during the tax year. You can deduct the rest procedures contain the guidelines the IRS will is paid. For certain leases designed to of your payment only over the period to which use to determine if a leveraged lease is a achieve tax avoidance, the IRS may require it applies. lease for federal income tax purposes. the parties to accrue rent and interest on rent using the constant rental method. Example 1. In May, you leased a building for 5 years beginning July 1 and ending June • Revenue Procedure 75–21, in Cumula- 30 five years later. According to the terms of tive Bulletin 1975–1. the lease, your rent is $12,000 per year. You • Revenue Procedure 75–28, in Cumula- paid the first year's rent ($12,000) on June tive Bulletin 1975–1. Taxes on 30. You can deduct only $6,000 (6/12 × $12,000) for the rent that applies to the first • Revenue Procedure 76–30, in Cumula- Leased Property year. tive Bulletin 1976–2. If you lease business property, you can de- • Revenue Procedure 79–48, in Cumula- duct as additional rent any taxes that you Example 2. Last January you leased tive Bulletin 1979–2. have to pay to or for the lessor. When you property for 3 years for $6,000 a year. You can deduct these taxes as additional rent × paid the full $18,000 (3 $6,000) during the In general, the revenue procedures pro- depends on your accounting method. first year of the lease. Each year you can vide that, for advance ruling purposes only, deduct only $6,000, the part of the rent that the IRS will consider the lessor in a leveraged Cash method. If you use the cash method applies to that year. You can deduct the rest lease transaction to be the owner of the of accounting, you can deduct the taxes as ($12,000) over the remaining 2-year term of property and the transaction to be a valid additional rent only for the tax year in which the lease at $6,000 each year. lease if all the factors in the revenue proce- you pay them. dures are met, including the following. Lease or purchase. There may be in- Accrual method. If you use an accrual stances in which you must determine whether • The lessor must maintain a minimum method of accounting, you can deduct taxes your payments are for rent or for the purchase unconditional “at risk” equity investment as additional rent for the tax year in which you of the property. You must first determine in the property (at least 20%) during the can determine all of the following. whether your agreement is a lease or a con- entire lease term. ditional sales contract. If, under the agree- • That you have a liability for taxes on the ment, you acquired or will acquire title to or • The lessee may not have a contractual leased property. right to buy the property from the lessor equity in the property, you should treat the • How much the liability is. agreement as a conditional sales contract. at less than fair market value when the Payments made under a conditional sales right is exercised. • That economic performance occurred. contract are not deductible as rent expense. • The lessee may not invest in the property, Whether the agreement is a conditional The liability and amount of taxes are de- except as provided by Revenue Proce- termined by state or local law and the lease sales contract depends on the intent of the dure 79–48. parties. Determine intent based on the facts agreement. Economic performance occurs as and circumstances that exist when you make • The lessee may not lend any money to you use the property. the agreement. the lessor to buy the property or guaran- tee the loan used to buy the property. Example. Oak Corporation is a calendar Determining the intent. In general, an year taxpayer that uses an accrual method agreement may be considered a conditional • The lessor must show that it expects to of accounting. Oak leases land for use in its sales contract rather than a lease if any of the receive a profit apart from the tax de- business. Under state law, owners of real following is true. ductions, allowances, credits, and other property become liable (incur a lien on the tax attributes. property) for real estate taxes for the year on • The agreement applies part of each pay- January 1 of that year. However, they do not ment toward an equity interest that you The IRS may charge you a user fee for have to pay these taxes until July 1 of the next will receive. issuing a tax ruling. See Publication 1375 and year (18 months later) when tax bills are is- • You get title to the property upon the Revenue Procedure 2000–1 for more infor- sued. This means that property owners be- payment of a stated amount required mation. Revenue Procedure 2000–1 is in come liable for real estate taxes for a year under the contract. Internal Revenue Bulletin No. 2000–1. on January 1 of that year, but do not have to Leveraged leases of limited-use prop- pay them until July 1 of the next year. • The amount you pay to use the property erty. The IRS will not issue advance rulings Under the terms of the lease, Oak be- for a short time is a large part of the on leveraged leases of so-called limited-use comes liable for the real estate taxes when amount you would pay to get title to the property. Limited-use property is property not the tax bills are issued. Oak cannot deduct property. expected to be either useful to or usable by the real estate taxes as rent until the tax bill a lessor at the end of the lease term except is issued. This is when Oak's liability under • You pay much more than the current fair for continued leasing or transfer to a member the lease becomes fixed. rental value for the property. of the lessee group. See Revenue Procedure If, according to the terms of the lease, Oak • You have an option to buy the property 76–30 for examples of limited-use property is liable for the real estate taxes when the at a nominal price compared to the value and property that is not limited-use property. owner of the property becomes liable for Chapter 7 Rent Expense Page 25 them, Oak will deduct the real estate taxes ally need less space. The lessor agrees to • Produce real or tangible personal prop- as rent on its tax return for the earlier year. reduce your rent from $7,000 to $6,000 per erty for use in a trade or business or an This is the year in which Oak's liability under year and to release the excess space from activity engaged in for profit. the lease becomes fixed. the original lease. In exchange, you agree to pay an additional rent amount of $3,000, • Produce real or tangible personal prop- payable in 60 monthly installments of $50 erty for sale to customers. each. • Acquire property for resale. However, this rule does not apply to personal property You must capitalize the $3,000 and if your average annual gross receipts for Cost of amortize it over the 20-year term of the lease. the 3 previous tax years were not more Your amortization deduction each year will than $10 million. Getting a Lease be $150 ($3,000 ÷ 20). You cannot deduct the You may either enter into a new lease with $600 (12 × $50) that you will pay during each Indirect costs include amounts incurred for the lessor of the property or get an existing of the first 5 years as rent. renting or leasing equipment, facilities, or lease from another lessee. Very often when land. you get an existing lease from another lessee, Commissions, bonuses, and fees. Com- Example 1. You rent construction equip- besides paying the rent on the lease, you missions, bonuses, fees, and other amounts ment to build a storage facility. You must must pay the previous lessee money to get that you pay to get a lease on property you capitalize as part of the cost of the building the lease. use in your business are capital costs. You the rent you paid for the equipment. You re- If you get an existing lease on property must amortize these costs over the term of cover your cost by claiming a deduction for or equipment for your business, you must the lease. amortize any amount you pay to get that depreciation on the building. lease over the remaining term of the lease. Loss on merchandise and fixtures. If you Example 2. You rent space in a facility For example, if you pay $10,000 to get a sell at a loss merchandise and fixtures that to conduct your business of manufacturing lease and there are 10 years remaining on the you bought solely to get a lease, the loss is tools. You must include the rent you paid to lease with no option to renew, you can deduct a cost of getting the lease. You must capital- occupy the facility in the cost of the tools you $1,000 each year. ize the loss and amortize it over the remaining produce. The cost of getting a lease is not subject term of the lease. to the amortization rules that apply to section More information. For more information, 197 intangibles discussed in chapter 12. see the regulations under section 263A of the Internal Revenue Code. Option to renew. The term of the lease for amortization includes all renewal options if Improvements less than 75% of the cost of getting the lease is for the term remaining on the purchase by Lessee date. Treat as renewal options any period for If you add buildings or make other permanent which the lessee and lessor reasonably ex- improvements to leased property, depreciate pect the lease to be renewed. In determining the cost of the improvements using the mod- 8. the term of the lease remaining on the pur- ified accelerated cost recovery system chase date, do not include any period for (MACRS). Depreciate the property over its which the lessee may choose to renew, ex- appropriate recovery period. You cannot Interest tend, or continue the lease. Allocate the lease amortize the cost over the remaining term of cost to the original term and any option term the lease. based on the facts and circumstances. Make If you do not keep the improvements when the allocation using a present value compu- you end the lease, figure your gain or loss tation. For more information, see section based on your adjusted basis of the im- Introduction 1.178–1(b)(5) of the regulations. provements at that time. This chapter discusses the tax treatment of For more information, see the discussion business interest expenses. Example 1. You paid $10,000 to get a of MACRS in Publication 946. lease with 20 years remaining on it and two What are business interest expenses? options to renew for 5 years each. Of this Assignment of a lease. If a long-term lessee These are amounts charged for the use of cost, you paid $7,000 for the original lease who makes permanent improvements to land money that you borrowed for business activ- and $3,000 for the renewal options. Because later assigns all lease rights to you for money ities. $7,000 is less than 75% of the total cost of the and you pay the rent required by the lease, lease of $10,000 (or $7,500), you must the amount you pay for the assignment is a amortize the $10,000 over 30 years. That is capital investment. If the rental value of the Topics the remaining life of your present lease plus leased land increased since the lease began, This chapter discusses: the periods for renewal. part of your capital investment is for that in- Allocation of interest crease in the rental value. The rest is for your • Example 2. Assume the same facts as investment in the permanent improvements. • Interest you can deduct in Example 1, except that the amount that The part that is for the increased rental • Interest you cannot deduct applies to the original lease is $8,000. You value of the land is a cost of getting a lease, can amortize the entire $10,000 over the and you amortize it over the remaining term • Capitalization of interest 20-year remaining life of the original lease. of the lease. You can depreciate the part that • When to deduct interest The $8,000 cost of getting the original lease is for your investment in the improvements was not less than 75% of the total cost of the as discussed earlier. • Below-market loans lease (or $7,500).

Cost of a modification agreement. You Useful Items may have to pay an additional “rent” amount You may want to see: over part of the lease period to change certain Capitalizing provisions in your lease. You must capitalize Publication these payments and amortize them over the Rent Expenses remaining period of the lease. You cannot Under the uniform capitalization rules, you Ⅺ 537 Installment Sales have to capitalize direct costs and an deduct the payments as additional rent, even Ⅺ if they are described as rent in the agreement. allocable part of most indirect costs that ben- 538 Accounting Periods and Methods efit or are incurred because of production or Ⅺ 550 Investment Income and Expenses Example. You are a calendar year tax- resale activities. payer and sign a 20-year lease to rent part Generally, you are subject to the uniform Ⅺ 936 Home Mortgage Interest of a building starting on January 1. However, capitalization rules if you do any of the fol- Deduction before you occupy it, you decide that you re- lowing. Page 26 Chapter 8 Interest Form (and Instructions) • The date the loan is repaid. proceeds of Loan B and $500 of unborrowed funds. She treats the $800 used for an in- Ⅺ Sch A (Form 1040) Itemized • The date the loan is reallocated to an- vestment as made entirely from the proceeds Deductions other use. of Loan C. Ⅺ Sch E Supplemental Income and Loss Edith treats the $600 used for personal Proceeds not disbursed to borrower. Even purposes as made from the remaining $200 Ⅺ Sch K–1 (Form 1065) Partner's Share if the lender pays the loan proceeds to a third proceeds of Loan C and $400 of unborrowed of Income, Credits, Deductions, party, the allocation of the loan is still based funds. Note that for the periods during which etc. on your use of the funds. This applies if you loan proceeds are held in the account, they Ⅺ pay for property, services, or anything else are treated as property held for investment. Sch K–1 (Form 1120S) Shareholder's by incurring a loan, or if you take property Share of Income, Credits, De- subject to a debt. Payments from checking accounts. ductions, etc. Generally, you treat a payment from a Ⅺ 1098 Mortgage Interest Statement Proceeds deposited in borrower's ac- checking or similar account as made at the count. Treat loan proceeds deposited in an time the check is written if you mail or deliver Ⅺ 3115 Application for Change in Ac- it to the payee within a reasonable period af- counting Method account as property held for investment. It does not matter whether the account pays ter you write it. You can treat checks written Ⅺ 4952 Investment Interest Expense interest. Any interest you pay on the loan is on the same day as written in any order. Deduction investment interest expense. If you withdraw Amounts paid within 30 days. If you the proceeds of the loan, you must reallocate receive loan proceeds in cash or if the loan Ⅺ 8582 Passive Activity Loss Limitations the loan based on the use of the funds. proceeds are deposited in an account, you See chapter 17 for information about get- can treat any payment (up to the amount of ting publications and forms. Example. Connie, a calendar-year tax- the proceeds) made from any account you payer, borrows $100,000 on January 4 and own, or from cash, as made from those pro- immediately uses the proceeds to open a ceeds. This applies to any payment made checking account. No other amounts are within 30 days before or after the proceeds deposited in the account during the year, and are received in cash or deposited in your ac- Allocation of Interest no part of the loan principal is repaid during count. The rules for deducting interest vary, de- the year. On April 1, Connie uses $20,000 If the loan proceeds are deposited in an pending on whether the loan proceeds are from the checking account for a passive ac- account, you can apply this rule even if the used for business, personal, investment, or tivity expenditure. On September 1, Connie rules stated earlier under Order of funds passive activities. If you use the proceeds of uses an additional $40,000 from the account spent would otherwise require you to treat the a loan for more than one type of expense, you for personal purposes. proceeds as used for other purposes. If you must make an allocation to determine the Under the interest allocation rules, the apply this rule to any payments, disregard amount of interest for each use of the loan's entire $100,000 loan is treated as property those payments (and the proceeds from proceeds. held for investment for the period from Janu- which they are made) when applying the rules Allocate your interest expense to the fol- ary 4 through March 31. From April 1 through stated under Order of funds spent. lowing categories. August 31, Connie must treat $20,000 of the If you received the loan proceeds in cash, loan as used in the passive activity and you can treat the payment as made on the • Trade or business interest $80,000 of the loan as property held for in- date you received the cash instead of the date you actually made the payment. • Passive activity interest vestment. From September 1 through De- cember 31, she must treat $40,000 of the loan • Investment interest as used for personal purposes, $20,000 as Example. Frank gets a loan of $1,000 on August 4 and receives the proceeds in cash. • Portfolio interest used in the passive activity, and $40,000 as property held for investment. Frank deposits $1,500 in an account on Au- • Personal interest gust 18 and on August 28 writes a check on Order of funds spent. Generally, you the account for a passive activity expense. In general, you allocate interest on a loan treat loan proceeds deposited in an account Also, Frank deposits his paycheck, deposits the same way you allocate the loan proceeds. as used (spent) before either of the following. other loan proceeds, and pays his bills during You allocate loan proceeds by tracing dis- the same period. Regardless of these other bursements to specific uses. • Any unborrowed amounts held in the transactions, Frank can treat $1,000 of the same account. deposit he made on August 18 as being paid The easiest way to trace disburse- on August 4 from the loan proceeds. In addi- TIP ments to specific uses is to keep the • Any amounts deposited after these loan tion, Frank can treat the passive activity ex- proceeds of a particular loan separate proceeds. pense he paid on August 28 as made from from any other funds. the $1,000 loan proceeds treated as depos- Example. On January 9, Edith opened a ited in the account. Secured loan. The allocation of loan pro- checking account, depositing $500 of the ceeds and the related interest is not generally proceeds of Loan A and $1,000 of unbor- Optional method for determining date affected by the use of property that secures rowed funds. The following table shows the of reallocation. You can use the following the loan. transactions in her account during the tax method to determine the date loan proceeds year. are reallocated to another use. You can treat Example. You secure a loan with prop- all payments from loan proceeds in the ac- erty used in your business. You use the loan Date Transaction count during any month as taking place on the proceeds to buy an automobile for personal January 9 $500 proceeds of Loan A and later of the following dates. use. You must allocate interest expense on $1,000 unborrowed funds the loan to personal use (purchase of the deposited • The first day of that month. automobile) even though the loan is secured January 13 $500 proceeds of Loan B by business property. deposited • The date the loan proceeds are deposited in the account. If the property that secures the loan February 18 $800 used for personal purposes TIP is your home, you generally do not February 27 $700 used for passive activity However, you can use this optional method allocate the loan proceeds or the re- June 19 $1,000 proceeds of Loan C only if you treat all payments from the account lated interest. The interest is usually deduct- deposited during the same calendar month in the same ible as qualified home mortgage interest, re- November 20 $800 used for an investment way. gardless of how the loan proceeds are used. Interest on a separate account. If you For more information, see Publication 936. December 18 $600 used for personal purposes have an account that contains only loan pro- Edith treats the $800 used for personal ceeds and interest earned on the account, Allocation period. The period for which a purposes as made from the $500 proceeds you can treat any payment from that account loan is allocated to a particular use begins on of Loan A and $300 of the proceeds of Loan as being made first from the interest. When the date the proceeds are used and ends on B. She treats the $700 used for a passive the interest earned is used up, any remaining the earlier of the following dates. activity as made from the remaining $200 payments are from loan proceeds. Chapter 8 Interest Page 27 Example. You borrowed $20,000 and or S corporation or to make a contribution to separately. This is because the loan proceeds used the proceeds of this loan to open a new the capital of one. and the interest expense must be allocated savings account. When the account had You must allocate the loan proceeds and depending on how the partner or shareholder earned interest of $867, you withdrew the related interest expense among all the uses the proceeds. $20,000 for personal purposes. You can treat assets of the entity. You can use any rea- This treatment of debt-financed distribu- the withdrawal as coming first from the inter- sonable method. If you purchase an interest tions follows the general allocation rules dis- est earned on the account, $867, and then in a partnership or S corporation (other than cussed earlier. For example, if a shareholder from the loan proceeds, $19,133 ($20,000 − by way of a contribution to capital), reason- uses distributed loan proceeds to invest in a $867). All of the interest charged on the part able methods include a pro rata allocation passive activity, that shareholder's portion of of the loan from the time it was deposited in based on the fair market value, book value, the entity's interest expense on the loan pro- the account until the time of the withdrawal is or adjusted basis of the assets, reduced by ceeds is allocated to a passive activity use. investment interest expense. The interest any debts allocated to the assets. Optional allocation method. The part- charged on the part of the proceeds used for If you contribute to the capital of a part- nership or S corporation can choose to allo- personal purposes ($19,133) from the time nership or S corporation, reasonable methods cate the distributed loan proceeds to other you withdrew it until you either repay it or re- ordinarily include allocating the debt among expenditures it makes during the tax year of allocate it to some other use is personal in- all the assets or tracing the loan proceeds to the distribution. This allocation is limited to the terest expense. The interest charged on the the entity's expenditures. amount of the other expenditures minus any loan proceeds you left in the account ($867) Treat the purchase of an interest in a loan proceeds already allocated to them. For continues to be investment interest expense partnership or S corporation as a contribution any distributed loan proceeds that are more until you either repay it or reallocate it to some to capital to the extent the entity receives any than the amount allocated to the other ex- other use. proceeds of the purchase. penditures, the rules in the previous para- graph apply. Loan repayments. When you repay any part Example. You purchase an interest in a How to report. If the entity does not use of a loan allocated to more than one use, treat partnership for $20,000 using borrowed the optional allocation method, it reports the it as being repaid in the following order. funds. The partnership's only assets include interest expense on the loan proceeds on the machinery used in its business valued at line on Schedule K–1 (Form 1065 or Form 1) Amounts allocated to personal use. $60,000 and stocks valued at $15,000. You 1120S) for “Other deductions.” The expense allocate the loan proceeds based on the value is identified on an attached schedule as “In- 2) Amounts allocated to investments and of the assets. Therefore, you allocate $16,000 terest expense allocated to debt-financed passive activities (other than those in- of the loan proceeds ($60,000/$75,000 × distributions.” The partner or shareholder cluded in (3) below). $20,000) and the interest expense on that claims the interest expense depending on 3) Amounts allocated to passive activities part to trade or business use. You allocate the how the distribution was used. in connection with a rental real estate remaining $4,000 ($15,000/$75,000 × If the entity uses the optional allocation activity in which you actively participate. $20,000) and the interest on that part to in- method, it reports the interest expense on the vestment use. loan proceeds allocated to other expenditures 4) Amounts allocated to former passive on the appropriate line or lines of Schedule activities. Reallocation. If you allocate the loan K–1. For example, if the entity chooses to 5) Amounts allocated to trade or business proceeds among the assets, you must make allocate the loan proceeds and related inter- use and to expenses for certain low- a reallocation if the assets or the use of the est to a rental activity expenditure, the entity income housing projects. assets change. will take the interest into account in figuring How to report. Individuals should report the net rental income or loss reported on their deductible interest expense on either Continuous borrowings. The following Schedule K–1. Schedule A or Schedule E of Form 1040, rules apply if you have a line of credit or depending on the type of asset (or expendi- similar arrangement. More information. For more information on ture if the allocation is based on the tracing allocating and reporting these interest ex- 1) Treat all borrowed funds on which inter- of loan proceeds) to which the interest ex- penses, see Notice 88–37 in Cumulative est accrues at the same fixed or variable pense is allocated. Bulletin 1988–1. Also see Notice 89–35 in rate as a single loan. For interest allocated to trade or business Cumulative Bulletin 1989–1. assets (or expenditures), report the interest 2) Treat borrowed funds or parts of bor- in Part II, Schedule E (Form 1040). On a rowed funds on which interest accrues separate line, put “business interest” and the at different fixed or variable rates as dif- name of the partnership or S corporation in ferent loans. Treat these loans as repaid column (a) and the amount in column (i). Interest You in the order shown on the loan agree- For interest allocated to passive activity ment. use, enter the interest on Form 8582 as a Can Deduct deduction from the passive activity of the You can generally deduct all interest you pay Loan refinancing. Allocate the replacement partnership or S corporation. Show any or accrue during the tax year on debts related loan to the same items to which the repaid deductible amount in Part II, Schedule E to your trade or business. Interest relates to loan was allocated. Make the allocation only (Form 1040). On a separate line, put “passive your trade or business if you use the pro- to the extent you use the proceeds of the new interest” and the name of the entity in column ceeds of the loan for a trade or business ex- loan to repay any part of the original loan. (a) and the amount in column (g). pense. It does not matter what type of prop- For interest allocated to investment use, erty secures the loan. You can deduct enter the interest on Form 4952. Carry any interest on a debt only if you meet all of the Partnerships deductible amount allocated to royalties to following requirements. and S Corporations Part II, Schedule E (Form 1040). On a sepa- rate line enter “investment interest” and the • You are legally liable for that debt. The following rules apply to the allocation of name of the partnership or S corporation in interest expense in connection with debt- column (a) and the amount in column (i). • Both you and the lender intend that the financed acquisitions of interests in partner- Carry the balance of the deductible amount debt be repaid. ships and S corporations. These rules also to line 13, Schedule A (Form 1040). apply to the allocation of interest expense in • You and the lender have a true debtor- Any interest allocated to proceeds used creditor relationship. connection with debt-financed distributions for personal purposes is generally not from partnerships and S corporations. deductible. Partial liability. If you are liable for part of These rules do not apply if the part- a business debt, you can deduct only your ! nership or S corporation is formed or Debt-financed distribution. A debt-financed share of the total interest paid or accrued. CAUTION used for the principal purpose of distribution occurs when a partnership or S avoiding the interest allocation rules. corporation borrows funds and allocates Example. You and your brother borrow those funds to distributions made to partners money. You are liable for 50% of the note. Debt-financed acquisitions. A debt- or shareholders. The distributed loan pro- You use your half of the loan in your busi- financed acquisition is the use of loan pro- ceeds and related interest expense must be ness, and you make one-half of the loan ceeds to purchase an interest in a partnership reported to the partners and shareholders payments. You can deduct your half of the Page 28 Chapter 8 Interest total interest payments as a business de- sen on your timely filed tax return for the tax Points. The term “points” is often used to duction. year in which the loan is issued. describe some of the charges paid by a bor- rower when the borrower takes out a loan or Mortgages. Generally, mortgage interest Example. On January 1, 1999, you took a mortgage. These charges are also called paid or accrued on real estate you own legally out a $100,000 discounted loan and received loan origination fees, maximum loan or equitably is deductible. However, rather $98,500 in proceeds. The loan will mature on charges, or premium charges. If any of these than deducting the interest currently, you may January 1, 2009 (a 10-year term), and the charges (points) are solely for the use of have to add it to the cost basis of the property $100,000 principal is payable on that date. money, they are interest. as explained later under Capitalization of In- Interest of $10,000 is payable on January 1 Because points are prepaid interest, you terest. of each year, beginning January 1, 2000. The cannot deduct the full amount in the year Statement. If you paid $600 or more of $1,500 OID on the loan is de minimis because paid. (For an exception for points paid on your mortgage interest (including certain points) it is less than $2,500 ($100,000 × .0025 × 10). home mortgage, see Publication 936.) In- during the year on any one mortgage, you You choose to deduct the OID on a straight stead, the points reduce the issue price of the generally will receive a Form 1098 or a simi- line basis over the term of the loan. Beginning loan and result in original issue discount, lar statement. You will receive the statement in 1999, you can deduct $150 each year for deductible as explained in the preceding dis- if you pay interest to a person (including a 10 years. cussion. financial institution or a cooperative housing corporation) in the course of that person's Constant-yield method. If the OID is not Partial payments on a nontax debt. If you trade or business. A governmental unit is a de minimis, you must use the constant-yield make partial payments on a debt (other than person for purposes of furnishing the state- method to figure how much you can deduct a debt owed IRS), the payments are applied, ment. each year. You figure your deduction for the in general, first to interest and any remainder If you receive a refund of interest you first year in the following steps. to principal. You can deduct only the interest. overpaid in an earlier year, this amount will This rule does not apply when it can be in- be reported in box 3 of Form 1098. You 1) Determine the issue price of the loan. ferred that the borrower and lender under- cannot deduct this amount. For information Generally, this is the amount of the pro- stood that a different allocation of the pay- on how to report this refund, see Refunds of ceeds of the loan. If you paid points on ments would be made. interest, later in this chapter. the loan (as discussed next), the issue Expenses paid to obtain a mortgage. price generally is the amount of the pro- Installment purchases. If you make an in- Certain expenses you pay to obtain a mort- ceeds reduced by the amount of the stallment purchase of business property, the gage cannot be deducted as interest. These points. contract between you and the seller generally expenses, which include mortgage commis- provides for the payment of interest. If no in- 2) Multiply the result in (1) by the yield to sions, abstract fees, and recording fees, are terest or a low rate of interest is charged un- maturity. capital expenses. If the property mortgaged der the contract, a portion of the stated prin- is business or income-producing property, 3) Subtract any qualified stated interest cipal amount payable under the contract may you can amortize, that is, deduct, the costs payments from the result in (2). This is be recharacterized as interest (unstated in- over the life of the mortgage. the OID you can deduct in the first year. terest). The amount recharacterized as inter- Prepayment penalty. If you pay off your est reduces your basis in the property and mortgage early and pay the lender a penalty To figure your deduction in any subse- increases your interest expense. For more for doing this, you can deduct the penalty as quent year, you start with the adjusted issue information on installment sales and unstated interest. price in step (1) above. To get the adjusted interest, see Publication 537. issue price, add to the issue price any OID Original issue discount. Original issue dis- previously deducted. Then follow steps (2) count (OID) is a form of interest. A loan and (3) above. (mortgage or other debt) generally has OID The yield to maturity (YTM) is generally Interest You when its proceeds are less than its principal shown in the literature you receive from your amount. The OID is the difference between lender. If you do not have this information, Cannot Deduct the stated redemption price at maturity and consult your lender or tax advisor. In general, Some interest payments cannot be deducted. the issue price of the loan. the YTM is the discount rate that, when used In addition, certain other expenses that may A loan's stated redemption price at ma- in computing the present value of all principal seem to be interest are not, and you cannot turity is the sum of all amounts (principal and and interest payments, produces an amount deduct them as interest. interest) payable on it other than qualified equal to the principal amount of the loan. You cannot currently deduct interest that stated interest. Qualified stated interest (QSI) generally must be capitalized and (except for corpo- Stated interest, in general, is qualified is stated interest that is unconditionally pay- rations) you generally cannot deduct personal stated interest if it is unconditionally payable able in cash or property (other than debt in- interest. in cash or property (other than another loan struments of the issuer) at least annually at of the issuer) at least annually over the term a single fixed rate. of the loan at a single fixed rate. Interest paid with funds borrowed from You generally deduct OID over the term Example. The facts are the same as in same lender. If you use the cash method of the loan. Figure the amount to deduct each the previous example, except that you deduct of accounting, you cannot deduct interest you year using the constant yield method, un- the OID on a constant yield basis over the pay with funds borrowed from the original less the OID on the loan is de minimis. term of the loan. The yield to maturity on your lender through a second loan, an advance, De minimis OID. The OID is de minimis loan is 10.2467%, compounded annually. For or any other arrangement similar to a loan. if it is less than one-fourth of 1% (.0025) of the 1999, you can deduct $93 [($98,500 × You can deduct the interest expense once stated redemption price of the loan at maturity .102467) − $10,000]. For 2000, you can de- you start making payments on the new loan. multiplied by the number of full years from the duct $103 [($98,593 × .102467) − $10,000]. When you make a payment on the new date of original issue to maturity (the term of loan, you first apply the payment to interest the loan). Loan or mortgage ends. If your loan or and then to the principal. All amounts you If the OID is de minimis, you can choose mortgage ends, you may be able to deduct apply to the interest on the first loan are one of the following ways to figure the amount any remaining OID in the tax year in which the deductible, along with any interest you pay you can deduct each year. loan or mortgage ends. A loan or mortgage on the second loan, subject to any limits that may end due to a refinancing, prepayment, apply. • On a constant-yield basis over the term foreclosure, or similar event. of the loan. Capitalized interest. You cannot deduct in- • On a straight line basis over the term of If you refinance with the same lender, terest you are required to capitalize under the the loan. ! you generally cannot deduct the re- uniform capitalization rules. See Capitaliza- CAUTION maining OID in the year in which the tion of Interest, later. In addition, if you buy • In proportion to stated interest payments. refinancing occurs, but you may be able to property and pay interest owed by the seller • In its entirety at maturity of the loan. deduct it over the term of the new mortgage (for example, by assuming the debt and any or loan. See Interest paid with funds borrowed interest accrued on the property), you cannot You make this choice by deducting the OID from same lender under Interest You Cannot deduct the interest. Add this interest to the in a manner consistent with the method cho- Deduct, later. basis of the property. Chapter 8 Interest Page 29 Commitment fees or standby charges. Fees you incur to have business funds avail- able on a standby basis, but not for the actual Capitalization When To use of the funds, are not deductible as inter- est payments. You may be able to deduct of Interest Deduct Interest them as business expenses. Under the uniform capitalization rules, you If the uniform capitalization rules, discussed If the funds are for inventory or certain generally must capitalize interest on debt earlier, do not apply to you, deduct interest property used in your business, the fees are equal to the amount of your expenditures to as follows. indirect costs and you must capitalize them produce real property or certain tangible per- under the uniform capitalization rules. For sonal property. The property must be more information on uniform capitalization Cash method. In general, you can deduct produced by you for use in your trade or only the interest you actually paid during the rules, see section 1.263A–8 through 1.263A– business or for sale to customers. Interest 15 of the regulations. tax year. You cannot deduct a promissory related to property that you acquire in any note you gave as payment because it is a manner other than by producing it is not promise to pay and not an actual payment. capitalized. Interest on income tax. Interest charged on Prepaid interest. Under the cash Interest you paid or incurred during the method, you generally cannot deduct any in- income tax assessed on your individual in- production period must be capitalized if the come tax return is not a business deduction terest paid before the year it is due. Interest property produced is designated property. paid in advance can be deducted only in the even though the tax due is related to income Designated property is any of the following. from your trade or business. Treat this inter- tax year in which it is due. est as a business deduction only in figuring Discounted loans. If interest or a dis- Real property. a net operating loss deduction. • count is subtracted from your loan proceeds, it is not a payment of interest and you cannot Penalties. Penalties on underpaid defi- • Tangible personal property with a class deduct it when you get the loan. ciencies and underpaid estimated tax are not life of 20 years or more. interest. You cannot deduct them. Generally, For more information, see Original issue you cannot deduct any fines or penalties. • Tangible personal property with an esti- discount (OID) under Interest You Can De- mated production period of more than 2 duct, earlier. years. Refunds of interest. If you pay interest Interest on loans with respect to life in- and then receive a refund in the same tax • Tangible personal property with an esti- year of any part of the interest, reduce your surance policies. For contracts issued be- mated production period of more than 1 fore June 9, 1997, you generally cannot de- interest deduction by the refund. If you re- year if the estimated cost of production ceive the refund in a later tax year, include the duct interest paid or accrued on a debt is more than $1 million. incurred with respect to any life insurance, refund in income if the deduction for the in- annuity, or endowment contract covering terest reduced your tax. You should include someone who is or was an employee, officer, Property you produce. You produce prop- in income only the amount of the interest de- or someone financially interested in your erty if you construct, build, install, manufac- duction that reduced your tax. business unless that person is a key person. ture, develop, improve, create, raise, or grow the property. Treat the property produced for Accrual method. You can deduct only in- For contracts issued or considered issued you under a contract as produced by you up terest that has accrued during the tax year. after June 8, 1997, you generally cannot de- to the amount you pay or incur for the prop- Prepaid interest. Under the accrual duct interest with respect to any life insur- erty. method, you generally cannot deduct any in- ance, annuity, or endowment contract that terest paid before it is due. Instead, deduct it covers any individual unless that individual is Capitalized interest. Treat capitalized inter- in the year in which it is due. a key person. est as a cost of the property produced. You Discounted loans. If interest or a dis- If the policy or contract covers a key per- recover the interest when you sell or use the count is subtracted from your loan proceeds, son, you can deduct the interest on up to property, or dispose of it under the rules that it is not a payment of interest and you cannot $50,000 of debt for that person. However, the apply to such transactions. If the property is deduct it when you get the loan. For more deduction for any month cannot be more than inventory, recover capitalized interest through information, see Original issue discount (OID) the interest figured using Moody's Corporate cost of goods sold. If the property is used in under Interest You Can Deduct, earlier. Bond Yield Average-Monthly Average Corpo- your trade or business, recover capitalized Tax deficiency. If you contest a federal rates (Moody's rate) for that month. interest through an adjustment to basis, de- income tax deficiency, interest does not ac- Who is a key person? A key person is preciation, amortization, or other method. crue until the tax year the final determination an officer or 20% owner. However, the num- of liability is made. If you do not contest the ber of individuals you can treat as key per- deficiency, then the interest accrues in the sons is limited to the greater of the following. Partnerships and S corporations. The in- year the tax was asserted and agreed to by terest capitalization rules are applied first at you. the partnership or S corporation level. The However, if you contest but pay the pro- • Five individuals. rules are then applied at the partners' or posed tax deficiency and interest, and you do shareholders' level to the extent the partner- • The lesser of 5% of the total officers and not designate the payment as a cash bond, ship or S corporation has insufficient debt to then the interest is deductible in the year paid. employees of the company or 20 individ- support the production or construction costs. uals. Related persons. If you use the accrual If you are a partner in a partnership or a method, you cannot deduct interest owed to shareholder in an S corporation, you may a related person who uses the cash method Pre-June 21, 1986 contracts. With a few have to capitalize interest you incur during the until payment is made and the interest is exceptions, otherwise allowable interest (not tax year for the production costs of the part- includible in the gross income of that person. in excess of the maximum rates set by law) nership or S corporation. You may also have The relationship is determined as of the end paid or accrued on debt with respect to con- to capitalize interest incurred by the partner- of the tax year for which the interest would tracts purchased before June 21, 1986, can ship or S corporation for your own production otherwise be deductible. If a deduction is de- be deducted no matter when the debt was costs. You must provide the required infor- nied under this rule, the rule will continue to incurred. mation in an attachment to the Schedule K–1 apply even if your relationship with the person Interest allocated to unborrowed policy to properly capitalize interest for this purpose. ceases to exist before the interest is includible cash value. Corporations and partnerships in the gross income of that person. See Re- generally cannot deduct any interest expense Additional information. The procedures for lated Persons in Publication 538. allocable to unborrowed cash values of life applying the uniform capitalization rules are insurance, annuity, or endowment contracts. beyond the scope of this publication. For This rules applies to contracts issued after more information, see section 1.263A–8 June 8, 1997, that cover someone other than through 1.263A–15 of the regulations and an officer, director, employee, or 20% owner. Notice 88–99 (as amended by Announcement Below-Market Loans For more information, see section 264(f) of 89–72). Notice 88–99 is in Cumulative Bulle- If you receive a below-market loan and use the Internal Revenue Code. tin 1988–2. Announcement 89–72 is in Cu- the proceeds in your trade or business, you mulative Bulletin 1989–1. may be able to deduct the forgone interest. Page 30 Chapter 8 Interest See Treatment of gift and demand loans and Limit on forgone interest for gift loans ability of the lender or the borrower will Treatment of term loans, later in this dis- of $100,000 or less. For gift loans between be determined by all the facts and cir- cussion. individuals, forgone interest treated as trans- cumstances. Consider all of the following A below-market loan is a loan on which ferred back to the lender is limited to the factors. no interest is charged or on which interest is borrower's net investment income for the charged at a rate below the applicable federal year. This limit applies if the outstanding a) Whether items of income and de- rate. A below-market loan generally is treated loans between the lender and borrower total duction generated by the loan offset as an arm's-length transaction in which you, $100,000 or less. If the borrower's net in- each other. the borrower, are treated as having received vestment income is $1,000 or less, it is b) The amount of the items. both of the following. treated as zero. This limit does not apply to a loan if the avoidance of any federal tax is c) The cost of complying with the below-market loan provisions if they • A loan in exchange for a note that re- one of the main purposes of the interest ar- were to apply. quires the payment of interest at the ap- rangement. plicable federal rate. d) Any reasons, other than taxes, for • An additional payment. Treatment of term loans. If you receive a structuring the transaction as a below-market term loan other than a gift loan, below-market loan. The additional payment is treated as a gift, you are treated as receiving an additional dividend, contribution to capital, payment of cash payment (as a dividend, etc.) on the Exception for certain loans to qualified compensation, or other payment, depending date the loan is made. This payment is equal continuing care facilities. The below-market on the substance of the transaction. to the loan amount minus the present value, interest rules do not apply to a loan made to For any period, forgone interest is: at the applicable federal rate, of all payments a qualified continuing care facility under a due under the loan. The same amount is continuing care contract if the lender (or treated as original issue discount on the loan. 1) The amount of interest that would be lender's spouse) is age 65 or older by the end See Original issue discount (OID) under In- payable for that period if interest accrued of the calendar year. For 1999, this exception terest You Can Deduct, earlier. on the loan at the applicable federal rate applies only to the part of the total outstanding and was payable annually on December amount of all loans from the lender (or lend- 31, minus Exceptions for loans of $10,000 or less. er's spouse) that does not exceed $137,000. The rules for below-market loans do not apply A qualified continuing care facility is 2) Any interest actually payable on the loan to certain loans on days on which the total one or more facilities that are designed to for the period. amount of outstanding loans between the provide services under continuing care con- borrower and lender is $10,000 or less. This tracts and where substantially all of the resi- Applicable federal rates are published exception applies only to the following. dents have entered into continuing care con- TIP by the IRS each month in the Internal tracts. In addition, substantially all of the Revenue Bulletin. You can also con- 1) Gift loans between individuals if the gift facilities used to provide services required tact an Internal Revenue Service office to get loan is not directly used to buy or carry under the continuing care contract must be these rates. income-producing assets. owned or operated by the loan borrower. A continuing care contract is a written 2) Compensation-related loans or contract between an individual and a qualified Loans subject to the rules. The rules for corporation-shareholder loans if the continuing care facility that meets all four of below-market loans apply to the following. avoidance of any federal tax is not a the following conditions. principal purpose of the interest ar- 1) Gift loans (below-market loans where the rangement. 1) The individual and/or the individual's forgone interest is in the nature of a gift). spouse must be entitled to use the facil- ity for the rest of their life or lives. 2) Compensation-related loans (below- This exception does not apply to a term loan described in (2) above that previously market loans between an employer and 2) The residential use must begin in a has been subject to the below-market loan an employee or between an independent separate, independent living unit pro- rules. Those rules will continue to apply even contractor and a person for whom the vided by the continuing care facility and if the outstanding balance is reduced to contractor provides services). continue until the individual (or individ- $10,000 or less. ual's spouse) is incapable of living inde- 3) Corporation-shareholder loans. pendently. The facility must provide var- Exceptions for loans without significant 4) Tax avoidance loans (below-market ious “personal care” services to the tax effect. The following loans are specif- loans where the avoidance of federal tax resident such as maintenance of the ically exempted from the rules for below- is one of the main purposes of the inter- residential unit, meals, and daily aid and market loans because their interest arrange- est arrangement). supervision relating to routine medical ments do not have a significant effect on the needs. 5) Loans to qualified continuing care facili- federal tax liability of the borrower or the ties under a continuing care contract lender. 3) The facility must be obligated to provide (made after October 11, 1985). long-term nursing care if the resident is 1) Loans made available by lenders to the no longer capable of living independ- general public on the same terms and ently. Except as noted in (5) above, these rules conditions that are consistent with the 4) The contract must require the facility to apply to demand loans (loans payable in full lender's customary business practices. provide the “personal services” and at any time upon the lender's demand) out- 2) Loans subsidized by a federal, state, or “long-term nursing care” without sub- standing after June 6, 1984, and to term municipal government that are made stantial additional cost to the individual. loans (loans that are not demand loans) available under a program of general made after that date. application to the public. Sale or exchange of property. Different rules generally apply to a loan connected with Treatment of gift and demand loans. If you 3) Certain employee-relocation loans. the sale or exchange of property. If the loan does not provide adequate stated interest, receive a below-market gift loan or demand 4) Certain loans to or from a foreign person, part of the principal payment may be consid- loan, you are treated as receiving an addi- unless the interest income would be ef- ered interest. However, there are exceptions tional payment (as a gift, dividend, etc.) equal fectively connected with the conduct of that may require you to apply the below- to the forgone interest on the loan. You are a U.S. trade or business and not exempt market interest rate rules to these loans. See then treated as transferring this amount back from U.S. tax under an income tax treaty. to the lender as interest. These transfers are Unstated Interest and Original Issue Discount considered to occur annually, generally on 5) Any other loan if the taxpayer can show in Publication 537. December 31. If you use the loan proceeds that the interest arrangement has no in your trade or business, you can deduct the significant effect on the federal tax li- More information. For more information on forgone interest each year as a business in- ability of the lender or the borrower. below-market loans, see section 7872 of the terest expense. The lender must report it as Whether an interest arrangement has a Internal Revenue Code and section interest income. significant effect on the federal tax li- 1.7872–5T of the regulations. Chapter 8 Interest Page 31 originally required. However, if you use an You can deduct taxes for these local accrual method and can deduct the tax before benefits only if the taxes are for maintenance, you pay it, the accrual date for federal income repairs, or interest charges related to those 9. tax purposes is the original accrual date. Use benefits. If part of the tax is for maintenance, the original accrual date for all future years repairs, or interest, you must be able to show as well. how much of the tax is for these expenses to Taxes claim a deduction for that part of the tax. Example. Your state imposes a tax on intangible and tangible personal property Example. City X, to improve downtown used in a trade or business conducted in the commercial business, converted a downtown state. This tax is assessed and becomes a business area street into an enclosed pedes- Introduction lien as of July 1. In 1999, the state, by legis- trian mall. The city assessed the full cost of lative action, changes the assessment and You can deduct various federal, state, local, construction, financed with 10-year bonds, lien dates from July 1, 2000, to December 31, and foreign taxes directly attributable to your against the affected properties. The city is 1999, for property tax year 2000. Because trade or business as business expenses. paying the principal and interest with the an- December 31 is earlier than the original ac- nual payments made by the property owners. You cannot deduct federal income crual date, the tax for federal income tax The assessments for construction costs ! taxes, estate and gift taxes, or state purposes accrues on July 1, 2000. are not deductible as taxes or as business CAUTION inheritance, legacy, and succession expenses, but are depreciable capital ex- taxes. Uniform capitalization rules. Uniform cap- penses. The part of the payments used to pay italization rules apply to certain taxpayers who the interest charges on the bonds is deduct- produce real or tangible personal property for ible as taxes. use in a trade or business or for sale to cus- Topics tomers. They also apply to taxpayers who This chapter discusses: acquire property for resale. Under these rules, Charges for services. Water bills, sewer- you may have to either include in inventory age, and other service charges assessed • When to deduct taxes costs or capitalize certain expenses related against your business property are not real • Real estate taxes to the property, such as taxes. For more in- estate taxes, but are deductible as business formation, see Publication 551. expenses. • Income taxes • Employment taxes Carrying charges. Carrying charges include Purchase or sale of real estate. If real es- • Other taxes taxes you pay to carry or develop real estate or to carry, transport, or install personal tate is sold during the year, the real estate property. You can choose to capitalize carry- taxes must be divided between the buyer and ing charges not subject to the uniform cap- the seller. Useful Items italization rules if they are otherwise deduct- The buyer and seller must divide the real You may want to see: ible. For more information, see chapter 11. estate taxes according to the number of days in the real property tax year (the period to Publication which the tax imposed relates) that each Refunds of taxes. If you receive a refund for owned the property. Treat the seller as pay- Ⅺ 15 Circular E, Employer's Tax Guide any taxes you deducted in an earlier year, ing the taxes up to but not including the date include the refund in income only to the extent of sale. Treat the buyer as paying the taxes Ⅺ 378 Fuel Tax Credits and Refunds the deduction reduced your tax in the earlier beginning with the date of sale. For this pur- year. For more information, see Recovery of Ⅺ 533 Self-Employment Tax pose, disregard the accrual or lien dates un- amount deducted in chapter 1. der local law. You can usually find this infor- Ⅺ 538 Accounting Periods and Methods mation on the settlement statement you You must include any interest you received at closing. Ⅺ 551 Basis of Assets TIP receive with state or local tax refunds If you (the seller) cannot deduct taxes until in income. they are paid because you use the cash Form (and Instructions) method of accounting and the buyer of your property is personally liable for the tax, you Ⅺ Sch A (1040) Itemized Deductions are considered to have paid your part of the Ⅺ Sch SE (Form 1040) Self-Employment tax at the time of the sale. This lets you de- Tax duct the part of the tax to the date of sale Real Estate Taxes even though you did not pay it. You must also Ⅺ 3115 Application for Change in Ac- Deductible real estate taxes are any state, include the amount of that tax in the selling counting Method local, or foreign taxes on real estate levied for price of the property. See chapter 17 for information about get- the general public welfare. The taxing au- If you (the seller) use an accrual method ting publications and forms. thority must base the taxes on the assessed and have not chosen to ratably accrue real value of the real estate and charge them estate taxes, you are considered to have ac- uniformly against all property under its juris- crued your part of the tax on the date you sell diction. Deductible real estate taxes generally the property. do not include taxes charged for local benefits When To and improvements that increase the value of Example. Al Green, a calendar year ac- Deduct Taxes the property. See Taxes for local benefits, crual method taxpayer, owns real estate in X later. County. He has not chosen to ratably accrue Generally, you can only deduct taxes in the If you use an accrual method of account- property taxes. November 30 of each year is year you pay them. This applies whether you ing, you generally cannot accrue real estate the assessment and lien date. He sold the use the cash method or an accrual method taxes until you pay them to the government property on June 30, 1999. Under his ac- of accounting. authority. You can, however, choose to counting method he would not be able to Under an accrual method, you can deduct ratably accrue the taxes during the year. See claim a deduction for the taxes because the a tax before you pay it if you meet the ex- Election to ratably accrue, later. sale occurred before November 30. He is ception for recurring items discussed under treated as having accrued his part of the tax, Economic Performance in Publication 538. Taxes for local benefits. Generally, you 180/ 365 (January 1–June 29), on June 30, and You can also choose to ratably accrue real cannot deduct taxes charged for local benefits he can deduct it for 1999. estate taxes as discussed later under Real and improvements that tend to increase the Estate Taxes. value of your property. These include as- sessments for streets, sidewalks, water Election to ratably accrue. If you use an Limit on accrual of taxes. A taxing juris- mains, sewer lines, and public parking facili- accrual method, you can choose to accrue diction can require the use of a date for ac- ties. You should increase the basis of your real estate tax that is related to a definite pe- cruing taxes that is earlier than the date it property by the amount of the assessment. riod ratably over that period. Page 32 Chapter 9 Taxes Example. John Smith is a calendar year Filing a tax return is not considered con- for certain purposes. For more information, taxpayer who uses an accrual method. His testing a liability. If you do not make an ob- see Publication 378. real estate taxes for the real property tax year, jective act of protest or show some affirmative July 1, 1999, to June 30, 2000, amount to evidence of denial of the liability, you can Occupational taxes. You can deduct as a $1,200. July 1 is the assessment and lien deduct any additional state or local income business expense an occupational tax date. taxes found to be due for a prior year in the charged at a flat rate by a locality for the If John chooses to ratably accrue the year for which they were originally imposed. privilege of working or conducting a business taxes, $600 will accrue in 1999 ($1,200 × You cannot deduct them in the year in which in the locality. 6/ 12 , July 1–December 31) and the balance the liability is finally determined. will accrue in 2000. Personal property tax. You can deduct any Foreign income taxes. Generally, you can tax imposed by a state or local government Separate elections. You can make an take either a deduction or a credit for income on personal property used in your trade or election for each separate trade or business taxes imposed on you by a foreign country business. and for nonbusiness activities if you account or a U.S. possession. However, an individual for them separately. Once you elect to ratably cannot take a deduction or credit for foreign Sales tax. Treat any sales tax you pay on a accrue real estate taxes, you must use that income taxes paid on income that is exempt service or on the purchase or use of property method unless you get permission from the from U.S. tax under the foreign earned in- as part of the cost of the service or property. IRS to change from that method. See Re- come exclusion or the foreign housing exclu- If the service or the cost or use of the property voking the election, later. sion. For information on these exclusions, see is a deductible business expense, you can Making the election. If you make your Publication 54, Tax Guide for U.S. Citizens deduct the tax as part of that service or cost. election for the first year in which you incur and Resident Aliens Abroad. If the property is merchandise bought for re- real estate taxes, attach a statement to your sale, the sales tax is part of the cost of the income tax return for that year. The statement merchandise. If the property is depreciable, should show all the following items. add the sales tax to the basis for depreciation. For more information on basis, see Publica- • The trades or businesses to which the Employment Taxes tion 551. election applies and the accounting If you have employees, you must withhold method or methods used. various taxes from your employees' pay. Most Do not deduct state and local sales • The period to which the taxes relate. employers must withhold their employees' ! taxes imposed on the buyer that you share of social security and Medicare taxes CAUTION must collect and pay over to the state • The computation of the real estate tax along with state and federal income taxes. or local government. Do not include these deduction for the first year of the election. You may also need to pay certain employ- taxes in gross receipts or sales. ment taxes from your own funds. These in- Generally, you must file your return by the clude your share of social security and Medi- Self-employment tax. You can deduct one- due date (including extensions). However, if care taxes as an employer along with half of your self-employment tax as a busi- you timely filed your return for the year with- unemployment taxes. ness expense in figuring your adjusted gross out making the election, you can still make the You should treat the taxes you withhold income. This deduction only affects your in- election by filing an amended return within 6 from your employees' pay as wages on your come tax. It does not affect your net earnings months of the due date of the return (exclud- tax return. You can deduct the employment from self-employment or your self-employ- ing extensions). Attach the election to the taxes you must pay from your own funds as ment tax. amended return and write “Filed pursuant to taxes. To deduct the tax, enter on Form 1040, section 301.9100–2” on the election state- line 27, the amount shown on the “Deduction ment. File the amended return at the same Example. You pay your employee for one-half of self-employment tax” line of address you filed the original return. $18,000 a year. However, after you withhold Schedule SE (Form 1040). If you make the election for a year after various taxes, your employee receives For more information on self-employment the first year in which you incur real estate $14,500. You also pay an additional $1,500 tax, see Publication 533. taxes, file Form 3115. Generally, you must file in employment taxes. You should deduct the this form during the tax year for which the full $18,000 as wages. You can deduct the election is to be effective. For more informa- $1,500 you pay from your own funds as taxes. tion, see the instructions for Form 3115. Revoking the election. To revoke an For more information on employment election to ratably accrue real estate taxes, taxes, see Publication 15. file Form 3115 during the tax year for which 10. the change is requested. Unemployment fund taxes. As an em- ployer, you may have to make payments to a state unemployment compensation fund or Insurance to a state disability benefit fund. Deduct these Income Taxes payments as taxes. This section discusses federal, state, local, and foreign income taxes. Important Change Federal income taxes. You cannot deduct Other Taxes federal income taxes. The following are other taxes you can deduct for 1999 if you incur them in the ordinary course of State and local income taxes. A corpo- your trade or business. Health insurance deduction for the self- ration or partnership can deduct state income employed. For 1999, this deduction in- taxes imposed on the corporation or partner- Excise taxes. You can deduct as a business creases to 60% of the amount you paid for ship as business expenses. An individual can expense all excise taxes that are ordinary and health insurance for yourself and your family. deduct state income taxes only as an item- necessary expenses of carrying on your trade After 2001, the deduction will increase again. ized deduction on Schedule A (Form 1040). or business. See Health Insurance Deduction for the Self- However, an individual can deduct a state Employed. tax on gross income (as distinguished from Franchise taxes. You can deduct corporate net income) directly attributable to a trade or franchise taxes as a business expense. business as a business expense. Accrual of contested income taxes. If Fuel taxes. Taxes on gasoline, diesel fuel, Introduction you use an accrual method, can deduct taxes and other motor fuels that you use in your You generally can deduct the ordinary and before you pay them, and contest a state or business are usually included as part of the necessary cost of insurance as a business local income tax liability, a special rule ap- cost of the fuel. Do not deduct these taxes expense if it is for your trade, business, or plies. Under this special rule, you must accrue as a separate item. profession. However, you may have to capi- and deduct any contested amount in the tax You may be entitled to a credit or refund talize certain insurance costs under the uni- year in which the liability is finally determined. for federal excise tax you paid on fuels used form capitalization rules. For more informa- Chapter 10 Insurance Page 33 tion, see Capitalizing Premiums, later. contributions as taxes if they are con- Use your age at the end of the tax year. sidered taxes under state law. Long-term care insurance contract. A long-term care insurance contract is any in- Topics 8) Overhead insurance. This insurance surance contract that only provides coverage This chapter discusses: pays you for business overhead ex- of qualified long-term care services. The penses you have during long periods of contract must meet all the following require- • Deductible premiums disability caused by your injury or sick- ments. • Nondeductible premiums ness. • Capitalizing premiums 9) Car and other vehicle insurance. This • It must be guaranteed renewable. insurance covers vehicles used in your • It must provide that refunds, other than • When to deduct premiums business for liability, damages, and other refunds on the death of the insured or losses. If you operate a vehicle partly for complete surrender or cancellation of the personal use, you can deduct only the contract, and dividends under the con- part of your insurance premiums that Useful Items tract may be used only to reduce future You may want to see: applies to the business use of the vehi- premiums or increase future benefits. cle. If you use the standard mileage rate Publication to figure your car expenses, you cannot • It must not provide for a cash surrender deduct any car insurance premiums. value or other money that can be paid, Ⅺ 525 Taxable and Nontaxable Income assigned, pledged as collateral for a loan, 10) Life insurance covering your officers and or borrowed. Ⅺ 538 Accounting Periods and Methods employees if you are not directly or indi- • It generally must not pay or reimburse Ⅺ rectly a beneficiary under the contract. 547 Casualties, Disasters, and Thefts expenses incurred for services or items 11) Use and occupancy and business inter- that would be reimbursed under Medi- Form (and Instructions) ruption insurance. This insurance pays care, except where Medicare is a sec- you for lost profits if your business is shut ondary payer or the contract makes per Ⅺ 1040 U.S. Individual Income Tax Return down due to a fire or other cause. diem or other periodic payments without See chapter 17 for information about get- regard to expenses. ting publications and forms. Health Insurance Qualified long-term care services. Deduction for the Qualified long-term care services are: Self-Employed • Necessary diagnostic, preventive, Deductible Premiums You can deduct 60% of the amount paid therapeutic, curing, treating, mitigating, You can generally deduct premiums you pay during 1999 for medical insurance and qual- and rehabilitative services, and ified long-term care insurance for yourself and for the following kinds of insurance related to • Maintenance or personal care services. your trade or business. your family if you are one of the following. The services must be required by a chron- 1) Fire, theft, flood, or similar insurance. • A self-employed individual. ically ill individual and prescribed by a li- 2) Credit insurance on losses from unpaid • A general partner (or a limited partner censed health care practitioner. debts. receiving guaranteed payments) in a Chronically ill individual. A chronically partnership. ill individual is a person who has been certi- 3) Group hospitalization and medical insur- • A shareholder owning more than 2% of fied as one of the following. ance for employees, including long-term the outstanding stock of an S corporation. care insurance. • An individual who, for at least 90 days, is a) If a partnership pays accident and You are allowed this deduction whether unable to perform at least two activities health insurance premiums for its you paid the premiums yourself or your part- of daily living without substantial assist- partners, it can deduct them as nership or S corporation paid them and you ance due to loss of functional capacity. guaranteed payments made to the included the premium amounts in your gross Activities of daily living are eating, partners. income. Take this deduction on line 28 of toileting, transferring, bathing, dressing, Form 1040. and continence. b) If an S corporation pays accident and health insurance premiums for Percentage increases after 2001. For tax • An individual who requires substantial its shareholder-employees, it can years beginning after 2001, the deductible supervision to be protected from threats deduct the premiums. percentage of your health insurance premi- to health and safety due to severe cog- nitive impairment. For more details, see Accident and ums gradually increases. The increases are shown in the following table. Health Plans in chapter 5. The certification must have been made by a 4) Liability insurance. Deductible licensed health care practitioner within the For Tax Years Beginning in: Percentage previous 12 months. 5) Malpractice insurance that covers your 1999 through 2001 ...... 60% Benefits received. For information on personal liability for professional 2002 ...... 70% excluding from gross income benefits you re- negligence resulting in injury or damage After 2002 ...... 100% ceive from a long-term care contract, see to patients or clients. Publication 525. 6) Workers' compensation insurance set by Long-term care insurance. If you pay the state law that covers any claims for premiums on a qualified long-term care in- Limits. You cannot deduct an amount more bodily injuries or job-related diseases surance contract for yourself, your spouse, than your net earnings from the trade or suffered by employees in your business, or your dependents, you can include those business in which the medical insurance plan regardless of fault. premiums when figuring your deduction. But or long-term care insurance plan is estab- you can include only the lesser of the follow- lished. If the business in which the insurance a) If a partnership pays workers' com- ing amounts. plan is established is an S corporation, you pensation premiums for its partners, cannot deduct more than your wages from the it can deduct these amounts as 1) The amount you pay. S corporation. guaranteed payments to the part- 2) The amount shown below. Other coverage. You cannot take the ners. deduction for any month if you were eligible a) Age 40 or less — $210 b) If an S corporation pays the work- to participate in any employer (including your spouse's) subsidized health plan at any time ers' compensation premiums for its b) Age 41 to 50 — $400 shareholder-employees, it can de- during that month. This rule is applied sepa- c) Age 51 to 60 — $800 duct these amounts. rately to plans that provide long-term care in- surance and plans that do not provide long- d) Age 61 to 70 — $2,120 7) Contributions to a state unemployment term care insurance. However, any medical insurance fund. You can deduct these e) Age 71 and above — $2,660 insurance payments not deductible on line 28 Page 34 Chapter 10 Insurance limit. Include your insurance payments under that plan on line 1 of the separate worksheet and your net profit (or wages) from that busi- Table 10-1. Self-Employed Health Insurance Deduction ness on line 4 (or line 11). Worksheet (Keep for your records.)

1a) Enter total payments made during the tax year for health insurance for yourself, your spouse, and your dependents. (Do not include payments for coverage for any month during which you were eligible Nondeductible to participate in a health plan subsidized by your or your spouse’s employer. Also, do not include payments for long-term care Premiums 1a) insurance.) You cannot deduct premiums on the following 1b) For long-term care insurance coverage, enter the lesser of: kinds of insurance. A) Total payments made, or 1) Self-insurance reserve funds. You B) $210—if age 40 or less cannot deduct amounts credited to a re- $400—if age 41 to 50 serve you set up for self-insurance. This $800—if age 51 to 60 applies even if you cannot get business $2,120—if age 61 to 70 insurance coverage for certain business $2,660—if age 71 or older risks. However, your actual losses may (Do not include payments for any month during which you were be deductible. See Publication 547. eligible to participate in a long-term care insurance plan 1b) 2) Loss of earnings. You cannot deduct subsidized by your or your spouse’s employer.) premiums for a policy that pays for your 1c) Add the total of lines 1a) and 1b) 1c) lost earnings due to sickness or disabil- 2) Percentage used to figure deduction for 1999 2) .60 ity. However, see the earlier discussion on overhead insurance, item (8), under 3) 3) Multiply the amount on line 1c) by the percentage on line 2 Deductible Premiums. 4) Enter your net profit and any other earned income* from the trade 3) Certain life insurance and annuities. or business under which the insurance plan is established. (If the For contracts issued before June 9, 4) business is an S corporation, skip to line 11.) 1997, you cannot deduct the premiums 5) Enter the total of all net profits from: line 31, Schedule C (Form on a life insurance policy covering your- 1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F self, an employee, or any person with a (Form 1040); or line 15a, Schedule K-1 (Form 1065); plus any financial interest in your business if you other income allocable to the profitable businesses. See the are directly or indirectly a beneficiary of instructions for Schedule SE (Form 1040). (Do not include any the policy. You are included among net losses shown on these schedules.) 5) possible beneficiaries of the policy if the policy owner is obligated to repay a loan 6) Divide line 4 by line 5 6) from you using the proceeds of the pol- 7) Multiply Form 1040, line 27, by the percentage on line 6 7) icy. A person has a financial interest in your business if the person is an owner 8) Subtract line 7 from line 4 8) or part owner of the business or has lent 9) Enter the amount, if any, from Form 1040, line 29, attributable to money to the business. the same trade or business in which the health insurance plan is For contracts issued after June 8, established 9) 1997, you generally cannot deduct the 10) Subtract line 9 from line 8 10) premiums on any life insurance policy, endowment contract, or annuity contract 11) Enter your wages from an S corporation in which you are a if you are directly or indirectly a benefi- more-than-2% shareholder and in which the health insurance plan ciary. The disallowance applies without is established 11) regard to whom the policy covers. 12) Enter the amount from Form 2555, line 43, attributable to the Partners. If, as a partner in a part- amount entered on line 4 or 11 above, or the amount from Form nership, you take out an insurance policy 2555-EZ, line 18, attributable to the amount entered on line 11 on your own life and name your partners as beneficiaries to induce them to retain above 12) their investments in the partnership, you 13) Subtract line 12 from line 10 or 11, whichever applies 13) are considered a beneficiary. You cannot 14) Compare the amounts on lines 3 and 13 above. Enter the deduct the insurance premiums. smaller of the two amounts here and on Form 1040, line 28. (Do 4) Insurance to secure a loan. If you take not include this amount when figuring a medical expense out a policy on your life or on the life of deduction on Schedule A (Form 1040).) 14) another person with a financial interest in your business to get or protect a *Earned income includes net earnings and gains from the sale, transfer, or licensing of property you business loan, you cannot deduct the created. It does not include capital gain income. premiums as a business expense. Nor can you deduct the premiums as interest of Form 1040 can be included as part of your ever, if any of the following apply, you must on business loans or as an expense of medical expenses on Schedule A (Form use the worksheet in this chapter. financing loans. In the event of death, 1040) if you itemize your deductions. the proceeds of the policy are not taxed Effect on self-employment tax. Do not • You have more than one source of in- as income even if they are used to liqui- subtract the health insurance deduction when come subject to self-employment tax. date the debt. figuring net earnings for your self-employment tax. • You file Form 2555 or Form 2555–EZ Effect on itemized deductions. Subtract (relating to foreign earned income). the amount of the health insurance deduction • You are using amounts paid for long-term from your medical insurance when figuring care insurance to figure the deduction. Capitalizing Premiums your medical expenses on Schedule A (Form Under the uniform capitalization rules, you 1040) if you itemize your deductions. If you have more than one health plan must capitalize the direct costs and part of the ! during the year and each plan is es- indirect costs for production or resale activ- How to figure the deduction. Generally, CAUTION tablished under a different business, ities. Include these costs in the basis of you can use the worksheet in the Form 1040 you must use separate worksheets (in this property you produce or acquire for resale instructions to figure your deduction. How- chapter) to figure each plan's net earnings rather than claiming them as a current de- Chapter 10 Insurance Page 35 duction. You recover the costs through de- and for the 9-month period in 2001, you can Useful Items preciation, amortization, or cost of goods sold deduct $450. You may want to see: when you use, sell, or otherwise dispose of If you use the cash method of accounting the property. and you pay the $1,200 premium in January Publication 2000, you cannot deduct any amount on your When the uniform capitalization rules ap- 1999 return. However, you can deduct $750 Ⅺ 544 Sales and Other Dispositions of ply. You must use the uniform capitalization (the $150 that applies to 1999 plus the $600 Assets rules if, in your trade or business or activity that applies to 2000) on your return for 2000. carried on for profit, you do any of the fol- Form (and Instructions) lowing. Dividends received. If you receive dividends from business insurance and you deducted Ⅺ 3468 Investment Credit • Produce real property or tangible per- the premiums in prior years, part of the divi- sonal property for use in the business or dends are income. For more information, see Ⅺ 8826 Disabled Access Credit Tax Benefit Rule in Publication 525. activity. See chapter 17 for information about get- • Produce real property or tangible per- ting publications and forms. sonal property for sale to customers. • Acquire property for resale. However, you generally do not have to use the uniform capitalization rules for personal property Carrying Charges acquired for resale if your average annual 11. Carrying charges include the taxes and inter- gross receipts are not more than est you pay to carry or develop real property $10,000,000 for the 3 prior tax years. or to carry, transport, or install personal Costs You property. Certain carrying charges must be Indirect costs include premiums for insur- capitalized under the uniform capitalization ance on your plant or facility, machinery, Can Deduct rules. (For more information on capitalization equipment, materials, property produced, or of interest, see chapter 8.) You can choose property acquired for resale. or Capitalize to capitalize carrying charges not subject to the uniform capitalization rules, but only if More information. For more information on they are otherwise deductible. the uniform capitalization rules, see Uniform You can choose to capitalize carrying Capitalization Rules in Publication 538 and charges separately for each project you have the regulations under Internal Revenue Code and for each type of carrying charge. For un- section 263A. Introduction improved and unproductive real property, This chapter discusses the two ways of your choice is good for only 1 year. You must treating certain costs—deduction or capital- decide whether to capitalize carrying charges ization. each year the property remains unimproved You generally deduct a cost (expense) by and unproductive. For other property, your When To subtracting it from your income in either the choice to capitalize carrying charges remains Deduct Premiums year you incur it or the year you pay it. in effect until construction, development, or If you capitalize a cost, you may be able installation is completed (or, for personal You can usually deduct insurance premiums to recover it over a period of years through property, the date you first use it, if later). in the tax year to which they apply. periodic deductions for amortization, de- pletion, or depreciation. When you capitalize How to make the choice. To make the Cash method. If you use the cash method a cost, you add it to the basis of property to choice to capitalize a carrying charge, write of accounting, you must generally deduct in- which it relates. a statement saying which charges you surance premiums in the tax year in which Except for exploration costs for mineral choose to capitalize. Attach it to your original you actually pay them, even if you incurred deposits, a partnership, corporation, estate, tax return for the year the choice is to be ef- them in an earlier year. or trust makes the choice to deduct or capi- fective. However, if you timely filed your re- talize the costs discussed in this chapter. turn for the year without making the choice, Accrual method. If you use an accrual Each individual partner, shareholder, or ben- you can still make the choice by filing an method of accounting, you cannot deduct in- eficiary chooses whether to deduct or capi- amended return within 6 months of the due surance premiums before the tax year in talize exploration costs. date of the return (excluding extensions). At- which you incur a liability for them, even if you You may be subject to the alternative tach the statement to the amended return and paid them in an earlier year. For more infor- ! minimum tax (AMT) if you deduct any write “Filed pursuant to section 301.9100–2” mation about accrual methods of accounting, CAUTION of these expenses other than carrying on the statement. File the amended return at see chapter 1. charges and the costs of removing architec- the same address you filed the original return. tural barriers. Cash or accrual method prepayments. For more information on alternative mini- You cannot deduct in one year the entire mum tax, see the instructions for Form 6251, premium for an insurance policy that covers Alternative Minimum Tax—Individuals or Research and more than one year. You can deduct only the Form 4626, Alternative Minimum part of the premium that applies to that year. Tax—Corporations. Experimental Costs For each later tax year, you can deduct the part that applies to that tax year. The costs of research and experimentation are generally capital expenses. However, you Example. You operate a business and Topics can choose to deduct these costs as current file your returns on a calendar-year basis. This chapter discusses: business expenses. You bought a fire insurance policy on your For information on amortizing these costs, building effective October 1, 1999, and paid • Carrying charges see Research and Experimental Costs in a premium of $1,200 for 2 years of coverage. chapter 12. • Research and experimental costs On your 1999 return, you can deduct only the part of the total premium that applies to the • Intangible drilling costs Research and experimental costs defined. 3 months of coverage in 1999. For 2000 and Research and experimental costs are rea- • Exploration costs 2001, you can deduct the part of the premium sonable costs you incur in your trade or that applies to each of those years. Since the • Development costs business for activities intended to provide in- total policy premium is $1,200 for 2 years, the formation to help eliminate uncertainty about • Circulation costs yearly rate is $600 and the monthly rate is the development or improvement of a prod- $50. For the 3-month period in 1999, you can • Costs of removing barriers to the disabled uct. Uncertainty exists if the information deduct $150; for 2000, you can deduct $600; and the elderly available to you does not establish how to Page 36 Chapter 11 Costs You Can Deduct or Capitalize located outside the United States. However, If you: Then: you can choose to include the costs in the adjusted basis of the well to figure depletion. Deduct research and experimental costs as Deduct all research and experimental costs If you do not make this choice, you can de- a current business expense, for the year of choice and all later years. duct the costs over the 10-year period begin- ning with the tax year in which you paid or Do not deduct research and experimental Amortize them over at least 60 months, incurred them. These rules do not apply to a costs as a current business expense, starting with the month you first receive an nonproductive well. economic benefit from the research. develop or improve a product or the appro- a well for the production of oil, gas, priate design of a product. Whether costs geothermal steam, or geothermal hot water. Exploration Costs qualify as research and experimental costs You can choose to deduct costs for items The costs of determining the existence, lo- depends on the nature of the activity to which only if the items have no salvage value. Items cation, extent, or quality of any mineral de- the costs relate. Neither the nature of the with no salvage value include wages, fuel, posit are ordinarily capital expenses if the product or improvement being developed nor repairs, hauling, and supplies related to drill- costs lead to the development of a mine. You the level of technological advancement mat- ing wells and preparing them for production. recover these costs through depletion as the ters when making this determination. The cost to you of any drilling or development mineral is removed from the ground. How- The costs of obtaining a patent, including work done by contractors under any form of ever, you can choose to deduct domestic ex- attorneys' fees in making and perfecting a contract is also an intangible drilling and de- ploration costs paid or incurred before the patent application, are research and exper- velopment cost. However, see Amounts paid development stage began (except those for imental costs. to a contractor that must be capitalized, next. oil, gas, and geothermal wells). Product. The term “product” includes any You can also choose to deduct the cost of the following. of drilling bore holes to determine the location How to make the choice. You choose to and delineation of offshore hydrocarbon de- deduct exploration costs by taking the de- • Formula posits if the shaft is capable of conducting duction on your income tax return or an • Invention hydrocarbons to the surface on completion. amended income tax return for the tax year It does not matter whether there is any intent you paid or incurred the costs. Your return • Patent to produce hydrocarbons. must adequately describe and identify each • Pilot model If you do not choose to deduct your in- property or mine, and clearly state how much tangible drilling and development costs cur- is being deducted for each one. The choice • Process rently, you can choose to deduct them over applies to the tax year you make this choice • Technique the 60-month period beginning with the month and all later tax years. they were paid or incurred. Partnerships. Each partner, not the • Similar property partnership, chooses whether to capitalize or Amounts paid to a contractor that must to deduct that partner's share of exploration It also includes products used by you in your be capitalized. Amounts paid to a contractor costs. trade or business or held for sale, lease, or must be capitalized if they are either of the license. following. Costs not included. Research and ex- Reduced corporate deductions for explo- perimental costs do not include expenses for ration costs. A corporation (other than an Amounts properly allocable to the cost any of the following. • S corporation) can deduct only 70% of its of depreciable property. domestic exploration costs. It must capitalize • Advertising or promotions. • Amounts paid only out of production or the remaining 30% and amortize them over the 60-month period starting with the month • Consumer surveys. proceeds from production if the amount is depletable income to the recipient. the exploration costs are paid or incurred. The • Efficiency surveys. 30% the corporation capitalizes cannot be added to its basis in the property for purposes • Management studies. How to make the choice. You choose to of figuring cost depletion. However, the deduct intangible drilling and development • Quality control testing. amount amortized is treated as additional costs currently by taking the deduction on depreciation and is subject to recapture as • Research in connection with literary, his- your income tax return for the first tax year ordinary income on a disposition of the prop- torical, or similar projects. you have eligible costs. No formal statement erty. See Section 1250 Property under De- is required. If you file Form 1040 (Schedule preciation Recapture in chapter 3 of Publica- • The acquisition of another's patent, C), enter these costs under “Other model, production, or process. tion 544. expenses.” These rules also apply to the deduction When and how to choose. Generally, you of development costs for corporations. See Energy credit for costs of geothermal Development Costs, later. can only make the choice to deduct these wells. If you capitalize the drilling and de- costs in the first year you incur research and velopment costs of geothermal wells that you Recapture of exploration expenses. When experimental costs. place in service during the tax year, you may You choose to deduct research and ex- your mine reaches the producing stage, you be able to claim a business energy credit. must recapture any exploration costs you perimental costs, rather than capitalize them, See Form 3468 for more information. by deducting them on your tax return for the chose to deduct. Use either of the following year in which you first have research and methods. experimental costs. Nonproductive well. If you capitalize your intangible drilling and development costs, you Method 1—Include the deducted costs in have another option if the well is nonproduc- gross income for the tax year the mine tive. You can deduct the intangible drilling reaches the producing stage. Your choice and development costs of the nonproductive must be clearly indicated on the return. Intangible well as an ordinary loss. You must indicate Increase your adjusted basis in the mine and clearly state your choice on your tax re- by the amount included in income. Gener- Drilling Costs turn for the year the well is completed. Once ally, you must choose this recapture The costs of developing oil, gas, or made, the choice for oil and gas wells is method by the due date (including exten- geothermal wells are ordinarily capital ex- binding for all later years. You can revoke sions) of your return. However, if you penses. You can usually recover them your choice for a geothermal well by filing an timely filed your return for the year without through depreciation or depletion. However, amended return that does not claim the loss. making the choice, you can still make the you can choose to deduct as current business choice by filing an amended return within expenses certain drilling and development Costs incurred outside the United States. 6 months of the due date of the return costs for wells in the United States in which You cannot deduct in one year all of the in- (excluding extensions). Make the choice you hold an operating or working interest. You tangible drilling and development costs paid on your amended return and write “Filed can deduct only costs for drilling or preparing or incurred for an oil, gas, or geothermal well pursuant to section 301.9100–2” on the Chapter 11 Costs You Can Deduct or Capitalize Page 37 form where you are including the income. Foreign development costs. The rules dis- You cannot deduct any costs that you paid File the amended return at the same ad- cussed earlier for foreign exploration costs or incurred to completely renovate or build a dress you filed the original return. apply to foreign development costs. new facility or public transportation vehicle, or to replace depreciable property in the Method 2—Do not claim any depletion de- normal course of business. duction for the tax year the mine reaches Reduced corporate deductions for devel- the producing stage and any later tax years opment costs. The rules discussed earlier until the amount of depletion you would for reduced corporate deductions for explo- Deduction limit. The most you can deduct have deducted equals the amount of de- ration costs also apply to corporate de- as a cost of removing barriers to the disabled ducted exploration costs. ductions for development costs. and the elderly for any tax year is $15,000. However, you can add any costs over this You also must recapture deducted explo- limit to the basis of the property and depreci- ration costs if you receive a bonus or royalty ate them. from mine property before it reaches the Circulation Costs producing stage. Do not claim any depletion A publisher can deduct as a business ex- Partners and partnerships. The $15,000 deduction for the tax year you receive the pense the costs of establishing, maintaining, limit applies to a partnership and also to each bonus or royalty and any later tax years, until or increasing the circulation of a newspaper, partner in the partnership. A partner can di- the amount of depletion you would have de- magazine, or other periodical. For example, vide the $15,000 limit in any manner among ducted equals the amount of your deducted a publisher can deduct the cost of hiring extra the partner's individually incurred costs and exploration costs. employees for a limited time to get new sub- the partner's distributive share of partnership If you dispose of the mine before your scriptions through telephone calls. Circulation costs. If the partner cannot deduct the entire deducted exploration costs have been fully costs are deductible even if they normally share of partnership costs, the partnership recaptured, recapture the balance by treating would be capitalized. can add any costs not deducted back to the all or part of your gain as ordinary income. This rule does not apply to the following basis of the improved property. costs that must be capitalized. A partnership must be able to show that Foreign exploration costs. If you pay or any amount added back to basis was not incur exploration costs for a mine or other • The purchase of land or depreciable deducted by the partner and that it was over natural deposit located outside the United property. a partner's $15,000 limit (as determined by States, you cannot deduct all of the costs in the partner). If the partnership cannot show • The acquisition of circulation through the the current year. You can choose to include this, it is presumed that the partner was able purchase of any part of the business of the costs (other than for an oil, gas, or to deduct the distributive shares of the part- another publisher of a newspaper, mag- geothermal well) in the adjusted basis of the nership's costs in full. mineral property to figure cost depletion. azine, or other periodical, including the purchase of another publishers circu- (Cost depletion is discussed in chapter 13.) Example. John Duke's distributive share lation list. If you do not make this choice, you must de- of ABC partnership's deductible expenses for duct the costs over the 10-year period begin- the removal of architectural barriers was ning with the tax year in which you pay or Other treatment of circulation costs. If a $20,000. John had $10,000 of similar ex- incur them. These rules also apply to foreign publisher does not want to currently deduct penses in his sole proprietorship. He chose development costs. circulation costs, the publisher can choose to deduct $5,000 of them. John allocated the one of the following ways to recover these remaining $10,000 of the $15,000 limit to his costs. share of ABC's expenses. John can capital- ize the excess $5,000 of his own expenses. • Capitalize all circulation costs that are Also, if ABC can show that John could not Development Costs properly chargeable to a capital account. You can deduct costs paid or incurred during deduct $10,000 of his share of the partner- the tax year for developing a mine or any • Amortize circulation costs over the 3-year ship's expenses because of how John applied other natural deposit (other than an oil or gas period beginning with the tax year they the limit, ABC can add $10,000 to the basis well) located in the United States. These were paid or incurred. of its property. costs must be paid or incurred after the dis- covery of ores or minerals in commercially How to make the choice. You choose to Qualification standards. You must meet the marketable quantities. Development costs in- capitalize circulation costs by attaching a following specific standards for improved ac- clude those incurred for you by a contractor. statement to your return for the first tax year cess for the disabled or the elderly to deduct Also, development costs include depreciation the choice applies. Your choice is binding for your costs as a current expense. on improvements used in the development the year it is made and for all later years, Grading. The ground must be graded to of ores or minerals. They do not include costs unless you get IRS approval to revoke it. the level of a normal entrance to make the of depreciable property. facility accessible to people with physical You can choose to treat development disabilities. costs as deferred expenses and deduct them Walks. ratably as the units of produced ores or min- Costs of erals related to the expenses are sold. This 1) A public walk must be at least 48 inches choice applies each tax year to expenses Removing Barriers wide and cannot slope more than 5%. paid or incurred in that year. Once made, the A fairly long walk of maximum or near choice is binding for the year and cannot be to the Disabled maximum steepness must have level revoked for any reason. areas at regular intervals. A walk or and the Elderly driveway must have a nonslip surface. How to make the choice. The choice to The cost of an improvement to a business deduct development costs ratably as the ores asset is normally a capital expense. However, 2) A walk must have a continuing common or minerals are sold must be made for each you can choose to deduct the costs of making surface and must not have steps or mine or other natural deposit by a clear indi- a facility or public transportation vehicle sudden changes in level. cation on your return or by a statement filed owned or leased by you for use in connection 3) Where a walk crosses another walk, a with the IRS office where you file your return. with your trade or business more accessible driveway, or a parking lot, they must Generally, you must make the choice by the to and usable by those who are disabled or blend to a common level. However, this due date of the return (including extensions). elderly. does not require the removal of curbs However, if you timely filed your return for the A facility is all or any part of buildings, that are a safety feature for those with year without making the choice, you can still structures, equipment, roads, walks, parking disabilities, especially blindness. make the choice by filing an amended return lots, or similar real or personal property. A within 6 months of the due date of the return public transportation vehicle is a vehicle, such 4) A sloping walk must have a level plat- (excluding extensions). Clearly indicate the as a bus or railroad car, that provides trans- form at the top and at the bottom. If a choice on your amended return and write portation service to the public (including ser- door swings out onto the platform at the “Filed pursuant to section 301.9100–2.” File vice for your customers, even if you are not top or bottom of the walk, the platform the amended return at the same address you in the business of providing transportation must be at least 5 feet deep and 5 feet filed the original return. services). wide. If a door does not swing onto the Page 38 Chapter 11 Costs You Can Deduct or Capitalize platform, the platform must be at least 3 Stairs. floor or floor-mounted urinals that are feet deep and 5 feet wide. The platform level with the main floor. must extend at least 1 foot past the 1) Stairsteps must have round nosing of opening side of any doorway. between 1 and 11/2 inch radius. 7) Towel racks, towel dispensers, and other dispensers and disposal units must not Parking lots. 2) Stairs must have a handrail 32 inches be mounted higher than 40 inches from high, measured from the tread at the the floor. 1) At least one parking space close to a face of the riser. Water fountains. facility must be set aside and marked for 3) Stairs must have at least one handrail use by persons with disabilities. that extends at least 18 inches past the 1) A water fountain and a cooler must have top step and the bottom step. But this 2) A parking space must be open on one up-front spouts and controls. side to allow room for a person in a does not mean that a handrail extension wheelchair or on braces or crutches to which is itself a hazard is required. 2) A water fountain and a cooler must be hand-operated or hand-and-foot- get in and out of a car onto a level sur- 4) Each step must not be more than 7 operated. face suitable for wheeling and walking. inches high. 3) A parking space marked for use by per- 3) A water fountain mounted on the side sons with disabilities, when placed be- Floors. of a floor-mounted cooler must not be tween two regular diagonal or head-on more than 30 inches above the floor. parking spaces, must be at least 12 feet 1) Floors must have a nonslip surface. wide. 4) A wall-mounted, hand-operated water 2) Floors on each story of a building must cooler must be mounted with the basin 4) A parking space must be located so that be on the same level or must be con- 36 inches from the floor. a person in a wheelchair or on braces nected by a ramp of the type discussed or crutches does not have to go behind previously. 5) A water fountain must not be fully re- parked cars. cessed and must not be set into an Toilet rooms. alcove unless the alcove is at least 36 Ramps. inches wide. 1) A toilet room must have enough space 1) A ramp must not rise more than 1 inch for persons in wheelchairs to move Public telephones. in each foot of length. around. 1) A public telephone must be placed so 2) A ramp must have at least one handrail 2) A toilet room must have at least one toi- let stall that: that the dial and the headset can be that is 32 inches high, measured from reached by a person in a wheelchair. the surface of the ramp. The handrail a) Is at least 36 inches wide, must be smooth and extend at least 1 2) A public telephone must be equipped for foot past the top and bottom of the ramp. b) Is at least 56 inches deep, a person who is hearing impaired and it However, this does mean that a handrail must be identified as such with in- c) Has a door, if any, that is at least extension which is itself a hazard is re- structions for its use. 32 inches wide and swings out, quired. 3) Coin slots of public telephones must not 3) A ramp must have a nonslip surface. d) Has handrails on each side that are 33 inches high and parallel to the be more than 48 inches from the floor. 4) A ramp must have a level platform at the floor, 11/ 2 inches in outside diam- Elevators. top and at the bottom. If a door swings eter, 11/ 2 inches away from the wall, out onto the platform, the platform must and fastened securely at the ends 1) An elevator must be accessible to, and be at least 5 feet deep and 5 feet wide. and center, and usable by, persons with disabilities and If a door does not swing onto the plat- the elderly on the levels they use to enter form, the platform must be at least 3 feet e) Has a toilet with a seat 19 to 20 inches from the finished floor. the building and all levels and areas deep and 5 feet wide. The platform must normally used. extend at least 1 foot past the opening 3) A toilet room must have, in addition to side of any doorway. or instead of the toilet stall described in 2) Cab size must measure at least 54 by 68 inches to allow for turning a wheel- 5) A ramp must have level platforms no (2), at least one toilet stall that: chair. farther than 30 feet apart and at any turn. a) Is at least 66 inches wide, 3) Door clear opening width must be at 6) A curb ramp with a nonslip surface must b) Is at least 60 inches deep, be provided at an intersection. The curb least 32 inches. ramp must not be less than 4 feet wide c) Has a door, if any, that is at least 4) All controls needed must be within 48 to and must not rise more than 1 inch in 32 inches wide and swings out, 54 inches from the cab floor. These each foot of length. The two surfaces d) Has a handrail on one side, 33 controls must be usable by a person with must blend smoothly. inches high and parallel to the floor, a visual impairment and must be iden- 1 1 tifiable by touch. Entrances. A building must have at least 1 / 2 inches in outside diameter, 1 / 2 inches away from the wall, and one main entrance a person in a wheelchair Controls. Switches and controls for light, can use. The entrance must be on a level fastened securely at the ends and center, and heat, ventilation, windows, draperies, fire accessible to an elevator. alarms, and all similar controls needed or Doors and doorways. e) Has a toilet with a seat 19 to 20 used often must be placed within the reach inches from the finished floor with of a person in a wheelchair. These switches 1) A door must have a clear opening of at a centerline 18 inches from the side and controls must not be higher than 48 least 32 inches and must be operable wall on which the handrail is lo- inches from the floor. by a single effort. cated. Identification. 2) The floor on the inside and outside of a 4) A toilet room must have sinks with nar- 1) Raised letters or numbers must be used doorway must be level for at least 5 feet row aprons. Drain pipes and hot water to identify rooms and offices. These from the door in the direction the door pipes under a sink must be covered or identification marks must be placed on swings and must extend at least 1 foot insulated. past the opening side of the doorway. the wall to the right or left of the door at 5) A mirror and a shelf above a sink must a height of 54 to 66 inches above the 3) There must not be any sharp slopes or not be higher than 40 inches above the finished floor. sudden changes in level at a doorway. floor, measured from the top of the shelf The threshold must be flush with the and the bottom of the mirror. 2) A door that might prove dangerous if floor. The door closer must be selected, used by a visually impaired person, such placed, and set so as not to impair the 6) A toilet room for men must have wall- as a door leading to a loading platform, use of the door by persons with disabili- mounted urinals with the opening of the boiler room, stage, or fire escape, must ties. basin 15 to 19 inches from the finished be identifiable by touch. Chapter 11 Costs You Can Deduct or Capitalize Page 39 Warning signals. 5) Handrails and stanchions must be pro- Other barrier removals. To be deduct- vided in the entrance to the bus so that ible, expenses of removing any barrier not 1) An audible warning signal must be ac- passengers who have a disability or are covered by the above standards must meet companied by a simultaneous visual elderly can grasp them from outside the all three of the following tests. signal for the benefit of those who are bus and use them while boarding and hearing impaired. paying the fare. This system must in- 1) The removed barrier must be a sub- 2) A visual warning signal must be accom- clude a rail across the front of the bus stantial barrier to access or use of a fa- panied by a simultaneous audible signal interior that passengers can lean against cility or public transportation vehicle by for the benefit of persons who are visu- while paying fares. Overhead handrails persons who have a disability or are el- ally impaired. must be continuous except for a gap at derly. the rear doorway. 2) The removed barrier must have been a Hazards. Hanging signs, ceiling lights, 6) Floors and steps must have nonslip sur- barrier for at least one major group of and similar objects and fixtures must be at persons who have a disability or are el- least 7 feet above the floor. faces. Step edges must have a band of bright contrasting color running the full derly (such as people who are blind, International accessibility symbol. The deaf, or wheelchair users). international accessibility symbol must be width of the step. displayed on routes to a wheelchair- 7) A stepwell next to the driver must have, 3) The barrier must be removed without accessible entrance to a facility, at the en- when the door is open, at least 2 foot- creating any new barrier that significantly trance itself, and at wheelchair-accessible candles of light measured on the step impairs access to or use of the facility entrances to public transportation vehicles. tread. Other stepwells must have, at all or vehicle by a major group of persons times, at least 2 foot-candles of light who have a disability or are elderly. measured on the step tread. How to make the choice. If you choose to 8) The doorways of the bus must have deduct your costs for removing barriers to the outside lighting that provides at least 1 disabled or the elderly, claim the deduction foot-candle of light on the street surface on your income tax return (partnership return for a distance of 3 feet from the bottom for partnerships) for the tax year the ex- step edge. This lighting must be below penses were paid or incurred. Identify the window level and must be shielded from deduction as a separate item. The choice the eyes of entering and exiting pas- applies to all the qualifying costs you have sengers. during the year, up to the $15,000 limit. If you 9) The fare box must be located as far for- make this choice, you must maintain ade- ward as practical and must not block quate records to support your deduction. traffic in the vestibule. For your choice to be valid, you generally must file your return by its due date, including Rapid and light rail vehicles. extensions. However, if you timely filed your return for the year without making the choice, 1) Passenger doorways on the vehicle you can still make the choice by filing an sides must have clear openings at least amended return within 6 months of the due 32 inches wide. date of the return (excluding extensions). Rail facilities. Clearly indicate the choice on your amended 2) Audible or visual warning signals must return and write “Filed pursuant to section 1) A rail facility must have a fare control be provided to alert passengers of clos- 301.9100–2.” File the amended return at the area with at least one entrance with a ing doors. same address you filed the original return. clear opening at least 36 inches wide. 3) Handrails and stanchions must permit Your choice is irrevocable after the due date, 2) A boarding platform edge bordering a safe boarding, moving around, sitting including extensions of your return. drop-off or other dangerous condition and standing assistance, and getting off must be marked with a strip of floor ma- by persons who have a disability or are Disabled access credit. If you make your terial different in color and texture from elderly. On a level-entry vehicle, business accessible to persons with disabili- the rest of the floor surface. The gap handrails, stanchions, and seats must ties and your business is an eligible small between the boarding platform and ve- be located to allow a wheelchair user to business, you may be able to take the disa- hicle doorway must be as small as pos- enter the vehicle and position the bled access credit. If you make this choice, sible. wheelchair in a location that does not you must reduce the amount you deduct or block the movement of other passen- capitalize by the amount of the credit. Buses. gers. On a vehicle with steps that must For more information, see Form 8826. 1) A bus must have a mechanism such as be used in boarding, handrails and a lift or ramp to enter the bus and stanchions must be provided in the en- enough clearance to let a wheelchair trance so that persons who have a dis- user reach a secure location. ability or are elderly can grasp them and use them from outside the vehicle while 2) The bus must have a wheelchair- boarding. securing device. However, this does not 12. mean that a wheelchair-securing device 4) Floors must have nonslip surfaces. Step that is itself a barrier or hazard is re- edges on a light rail vehicle must have quired. a band of bright contrasting color running Amortization the full width of the step. 3) The vertical distance from a curb or from street level to the first front doorstep 5) A stepwell next to the driver must have, must not be more than 8 inches. Each when the door is open, at least 2 foot- front doorstep after the first step up from candles of light measured on the step the curb or street level must also not be tread. Other stepwells must have, at all Introduction more than 8 inches high. The steps at times, at least 2 foot-candles of light Amortization is a method of recovering (de- the front and rear doors must be at least measured on the step tread. ducting) certain capital costs over a fixed pe- 12 inches deep. riod of time. It is similar to the straight line 6) Doorways on a light rail vehicle must method of depreciation. 4) The bus must have clear signs that indi- have outside lighting that provides at cate that seats in the front of the bus are least 1 foot-candle of light on the street priority seats for persons who have a surface for a distance of 3 feet from the Topics disability or are elderly. The signs must bottom step edge. This lighting must be This chapter discusses: encourage other passengers to make below window level and must be these seats available to those who have shielded from the eyes of entering and • Amortizing costs of section 197 intangi- priority. exiting passengers. bles Page 40 Chapter 12 Amortization • Amortizing costs of going into business cludes the terms and conditions of employ- ment, whether contractual or otherwise, and • Amortizing reforestation costs Section 197 any other value placed on employees or any • Amortizing costs of pollution control fa- of their attributes. cilities Intangibles For example, you must amortize the part • Amortizing costs of research and exper- You must amortize over 15 years the capital- of the purchase price of a trade or business imentation ized costs of “section 197 intangibles” you that is for the existence of a highly skilled acquired after August 10, 1993. Section 197 workforce. Also, you must amortize the cost • Amortizing bond premiums intangibles are defined later. You must of acquiring an existing employment contract • Amortizing the cost of getting a lease amortize these costs if you hold the section or relationship with employees or consultants 197 intangibles in connection with your trade as part of the acquisition of a trade or busi- or business or in an activity engaged in for the ness. Useful Items production of income. Your deduction each You may want to see: year is the part of the adjusted basis (for Business books and records, etc. This in- purposes of determining gain) of the intangi- cludes the cost of technical manuals, training ble amortized ratably over a 15-year period, Publication manuals or programs, data files, and ac- beginning with the month acquired. You are counting or inventory control systems. It also Ⅺ 544 Sales and Other Dispositions of not allowed any other depreciation or amorti- includes the cost of customer lists, sub- Assets zation deduction for a section 197 intangible. scription lists, insurance expirations, patient or client files, and lists of newspaper, maga- Ⅺ 550 Investment Income and Expenses Section 197 zine, radio, or television advertisers. Ⅺ 946 How To Depreciate Property Intangibles Defined Patents, copyrights, etc. This category in- The following assets are section 197 intangi- cludes package designs, computer software, Form (and Instructions) bles. and any interest in a film, sound recording, videotape, book, or other similar property, Ⅺ 3468 Investment Credit 1) Goodwill. except as discussed later under Assets That Ⅺ 4562 Depreciation and Amortization 2) Going concern value. Are Not Section 197 Intangibles. Ⅺ 6251 Alternative Minimum 3) Workforce in place, including its compo- Tax—Individuals sition and the terms and conditions Customer-based intangible. A customer- based intangible is the composition of market, See chapter 17 for information about get- (contractual or otherwise) of its employ- ment. market share, and any other value resulting ting publications and forms. from the future provision of goods or services 4) Business books and records, operating because of relationships with customers in systems, or any other information base, the ordinary course of business. You must including lists or other information con- amortize the part (if any) of the purchase price How To Deduct cerning current or prospective custom- of a trade or business that is for the following ers. intangibles. Amortization 5) A patent, copyright, formula, process, The purpose of this section is to explain how design, pattern, know-how, format, or • Customer base. you deduct amortization. similar item. • Circulation base. Form 4562. You choose to amortize your 6) A customer-based intangible. • Undeveloped market or market growth. costs by completing Part VI of Form 4562 in 7) A supplier-based intangible. Insurance in force. the year in which you make the choice. • For later years, do not report your de- 8) Any item similar to items (3) through (7). • Mortgage servicing contracts. duction for amortization on Form 4562 unless 9) A license, permit, or other right granted • Investment management contracts. you must file the form for another reason. by a governmental unit or agency (in- You must file Form 4562 in any of the fol- cluding renewals). • Any other relationship with customers lowing situations. that involves the future provision of goods 10) A covenant not to compete entered into or services. • You start claiming amortization this tax in connection with the acquisition of an interest in a trade or business. year. Accounts receivable or other similar rights • You claim depreciation on property 11) A franchise, trademark, or trade name to income for goods or services provided to placed in service this year. (including renewals). customers before the acquisition of that trade or business are not section 197 intangibles. • You claim a section 179 deduction. You cannot amortize any of the in- tangibles listed in items (1) through • You claim a deduction for any vehicle ! Supplier-based intangible. A supplier- CAUTION (8) that you created unless you cre- reported on a form other than Schedule based intangible is the value resulting from ated them in connection with the acquisition C (Form 1040) or Schedule C–EZ (Form the future acquisition of goods or services of assets constituting a trade or business or 1040). because of business relationships with sup- a substantial part of a trade or business. • You claim depreciation on any vehicle or pliers of goods or services that are used or sold by the business. other listed property (regardless of when Goodwill. Goodwill is the value of a trade or For example, you must amortize the part it was placed in service). business based on expected continued cus- of the purchase price of a trade or business You claim depreciation on a return for a tomer patronage due to its name, reputation, • that is based on the existence of any of the corporation (other than an S corporation). or any other factor. following. Other forms to use. If you do not have to Going concern value. Going concern value file Form 4562, claim amortization directly on is the additional value of a trade or business • A favorable relationship with distributors the “Other expenses” line of Schedule C that attaches to property because the prop- (such as favorable shelf or display space (Form 1040) or the “Other deductions” line of erty is an integral part of a going concern. It at a retail outlet). Form 1065 or Form 1120. includes value based on the ability of a busi- • A favorable credit rating. ness to continue to function and generate in- Bond premium amortization. You do not come even though there is a change in own- • A favorable supply contract. use Form 4562 to report bond premium ership. amortization. How you report this amorti- Government-granted license, permit, etc. zation depends on when you get the bond. Workforce in place, etc. This includes the Any license, permit, or other right granted by For information on how to report bond pre- composition of a workforce (for example, its a governmental unit or an agency or instru- mium amortization, see Publication 550. experience, education, or training). It also in- mentality of a governmental unit is a section Chapter 12 Amortization Page 41 197 intangible. For example, you must amor- c) An interest in a patent or copyright. 1) You acquired the goodwill, going con- tize the capitalized costs of acquiring (includ- cern value, or other intangible after Au- d) A right under a contract (or a right ing issuing or renewing) a liquor license, a gust 10, 1993, and granted by a governmental agency) taxicab medallion or license, or a television if the right: 2) Any of the following conditions apply. or radio broadcasting license. i) Has a fixed life of less than 15 a) You or a related person (defined Covenant not to compete. A covenant not years, or later) held or used the intangible at any time from July 25, 1991, to compete (or similar arrangement) entered ii) Is of a fixed amount that, ex- through August 10, 1993. into in connection with the acquisition of an cept for the section 197 intan- interest in a trade or business or substantial gible provisions, would be re- b) You acquired the intangible from a portion of a trade or business, is a section 197 coverable under a method person who held the intangible at intangible. An interest in a trade or business similar to the unit-of-production any time from July 25, 1991, includes an interest in a partnership or stock method of cost recovery. through August 10, 1993, and as in a corporation engaged in a trade or busi- 6) An interest under either of the following. part of the transaction, the user ness. does not change. If you pay or incur an amount under a a) An existing lease or sublease of covenant not to compete (or similar arrange- tangible property, or c) You grant the right to use the in- ment) after the year in which you entered into tangible to a person (or a person the covenant (or similar arrangement), you b) A debt that was in existence when related to that person) who held or must amortize that amount over the months the interest was acquired. used the intangible at any time from July 25, 1991, through August 10, remaining in the 15-year amortization period. 7) A professional sports franchise and any 1993. You cannot amortize amounts paid under item acquired in connection with the a covenant not to compete (or similar ar- franchise. rangement) that represent additional consid- Exception. The anti-churning rules do not eration for the purchase of stock in a corpo- 8) A right to service residential mortgages apply to an intangible acquired from a dece- ration. You must add the amounts to the unless the right is acquired in the acqui- dent if the property's basis is stepped up to basis of the acquired stock. sition of a trade or business or a sub- fair market value. stantial part of a trade or business. Franchise, trademark, or trade name. A 9) Certain transaction costs under a corpo- Related person. For purposes of the anti- franchise, trademark, or trade name is a rate organization or reorganization in churning rules, the following are related per- section 197 intangible. You can deduct which any part of a gain or loss is not sons. amounts paid or incurred on the transfer, recognized. sale, or other disposition of a franchise, • Members of a family, including only trademark, or trade name if all of the following Computer software. Section 197 intangibles brothers, sisters, half-brothers, half- apply to the amounts. do not include computer software that is: sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descend- • They are contingent on the productivity, 1) Readily available for purchase by the ants (children, grandchildren, etc.). use, or disposition of the franchise, general public, • An individual and a corporation when the trademark, or trade name. 2) Subject to a nonexclusive license, and individual owns, directly or indirectly, • They are part of a series of payments more than 20% in value of the corpo- payable at least annually throughout the 3) Not substantially changed. ration's outstanding stock. term of the transfer agreement. Software that is not acquired in the acquisition • Two corporations that are members of • They are part of a series of payments that of a substantial part of a business is not a the same controlled group as defined in are substantially equal in amount or pay- section 197 intangible. section 1563(a) of the Internal Revenue able under a fixed formula. If you are allowed to depreciate any com- Code, except that “more than 20%” is puter software that is not a section 197 in- substituted for “at least 80%” in that defi- You must amortize any other amount, tangible, use the straight line method with a nition and the determination is made whether fixed or contingent that you paid or useful life of 36 months. For more information without regard to subsection (a)(4) and incurred because of the transfer of a fran- on depreciation of computer software, see (e)(3)(C) of section 1563. chise, trademark, or trade name. Publication 946. • A trust fiduciary and a corporation when Computer software defined. Computer the trust or grantor of the trust owns, di- software includes all programs designed to rectly or indirectly, more than 20% in Assets That Are Not cause a computer to perform a desired func- value of the corporation's outstanding Section 197 Intangibles tion. It also includes any database or similar stock. item that is in the public domain and is inci- The following assets are not section 197 in- dental to the operation of qualifying software. • A grantor and fiduciary, and the fiduciary tangibles. and beneficiary, of any trust. 1) Any interest in a corporation, partner- Costs associated with nonsection 197 in- • Fiduciaries of two different trusts, and the ship, trust or estate. tangibles. Amounts you take into account in fiduciary and beneficiary of two different determining the cost of nonsection 197 prop- trusts, if the same person is the grantor 2) Any interest under an existing futures erty are not considered section 197 intangi- of both trusts. contract, foreign currency contract, bles. These amounts are added to the basis notional principal contract, or similar fi- of the property. For example, none of the • A tax-exempt educational or charitable nancial contract. costs of acquiring real property held for the organization and a person who directly production of rental income are considered or indirectly controls the organization, or 3) Any interest in land. goodwill, going concern value, or any other a member of that person's family. 4) Most computer software (see Computer section 197 intangible. • A corporation and a partnership if the software defined, later). same persons own more than 20% in value of the outstanding stock of the 5) Any of the following not acquired in Anti-Churning Rules corporation and more than 20% of the connection with the acquisition of a trade Anti-churning rules prevent you from con- capital or profits interest in the partner- or business or a substantial part of a verting section 197 intangibles that do not ship. trade or business. qualify for amortization into property that • Two S corporations if the same persons a) An interest in a film, sound record- would qualify for amortization. You cannot use 15-year amortization for own more than 20% in value of the out- ing, videotape, book, or similar standing stock of each corporation. property. goodwill, going concern value, or any other intangible for which you cannot claim a de- • Two corporations, one of which is an S b) A right to receive tangible property preciation deduction and for which an corporation, if the same persons own or services under a contract or amortization deduction is only allowable un- more than 20% in value of the outstand- granted by a governmental agency. der section 197 if: ing stock of each corporation. Page 42 Chapter 12 Amortization • Two partnerships if the same persons 2) To avoid any of the anti-churning rules. a permissible method of accounting for own, directly or indirectly, more than 20% amortization. Revenue Procedure 97–27, of the capital or the profits interests in which is in Cumulative Bulletin 1997–1, gives both partnerships. Incorrect Amount of general instructions for getting approval. Cu- Amortization Deducted mulative Bulletins are available at many li- • A person and a partnership when the braries and IRS offices. You do not need IRS person owns, directly or indirectly, more If you did not deduct the correct amount of approval to correct any mathematical or than 20% of the capital or profits interests amortization for a section 197 intangible in posting error. See Amended Return, earlier. in the partnership. any year, you may be able to make a cor- rection for that year by filing an amended re- Automatic approval. You may be able to Treat these persons as related to you if turn. See Amended Return, later. If you are obtain automatic approval from the IRS to the relationship exists immediately before or not allowed to make the correction on an change your method of accounting if you immediately after you acquire the intangible. amended return, you can change your ac- meet all the following conditions. Ownership of stock or partnership in- counting method to claim the correct amount terest. In determining whether an individual of amortization. See Changing Your Ac- • The property is amortizable under section owns, directly or indirectly, any of the out- counting Method, later. 197 of the Internal Revenue Code. standing stock of a corporation or an interest in a partnership, the following rules apply. Basis adjustment. If you could deduct • It is property for which, under your pres- Rule 1. Stock or a partnership interest amortization but you did not take the de- ent accounting method, you deducted owned directly or indirectly by or for a corpo- duction, you must reduce the basis of the less than or more than the amount of ration, partnership, estate, or trust is consid- section 197 intangible by the amount of amortization allowable in at least the 2 ered owned proportionately by or for its amortization you were entitled to deduct. If years immediately preceding the year of shareholders, partners, or beneficiaries. you deduct more amortization than you change. (However, for a partnership interest owned should, you must decrease your basis by the • You owned the property at the beginning by or for a C corporation, this applies only to correct amount of amortization plus any of the of the year of change. shareholders who own, directly or indirectly, excess for which you received a tax benefit. 5% or more in value of the stock of the cor- File Form 3115 to request a change to a poration.) Amended Return permissible method of accounting for amorti- Rule 2. An individual is considered as zation. Revenue Procedure 98–60 and sec- owning the stock owned directly or indirectly If you did not deduct the correct amount of tion 2.01 of its Appendix, which is in Internal by or for his or her family. Family includes amortization, you can file an amended return Revenue Bulletin No. 1998–51, has in- only brothers and sisters, half-brothers and to make any of the following corrections. structions for getting automatic approval and half-sisters, spouse, ancestors, and lineal lists exceptions to the automatic approval descendants. • To correct a mathematical error made in procedures. Rule 3. An individual owning (other than any year. Exceptions. You generally cannot use by applying rule 2) any stock in a corporation • To correct a posting error made in any the automatic approval procedure under any is considered to own the stock owned directly year. of the following situations. or indirectly by or for his or her partner. Rule 4. For purposes of applying rule 1, • To correct the amount of amortization for • You (your federal income tax return) are 2, or 3, treat stock or a partnership interest section 197 intangibles for which you under examination. constructively owned by a person under rule have not adopted a method of account- • You are before a federal court or an ap- 1 as actually owned by that person. Do not ing. See Changing Your Accounting peals office for any income tax issue and treat stock or a partnership interest construc- Method, later. the method of accounting to be changed tively owned by an individual under rule 2 or If you did not deduct the correct amount of is an issue under consideration by the 3 as owned by the individual for reapplying amortization for the section 197 intangible on federal court or appeals office. rule 2 or 3 to make another person the con- two or more consecutively filed tax returns, • You changed the same method of ac- structive owner of the stock or partnership you have adopted a method of accounting for interest. counting (with or without obtaining IRS that property. If you have adopted a method approval) during the last 5 years (includ- of accounting, you cannot change the method ing the year of change). Exception. An exception to the anti-churning by filing amended returns. rules applies if you acquire an intangible from If an amended return is allowed, you must • You filed a Form 3115 to change the a person related to you by more than 20%, file it by the later of the following dates. same method of accounting during the but not more than 50%, under both of the last 5 years (including the year of following conditions. • 3 years from the date you filed your ori- change), but did not make the change ginal return for the year in which you did because the Form 3115 was withdrawn, • The seller recognizes gain on the dispo- not deduct the correct amount. not perfected, denied, or not granted. sition of the intangible. • 2 years from the time you paid your tax Also, see the exceptions listed in section • The seller pays income tax on the gain for that year. 2.01(2)(b) of the Appendix of Revenue Pro- at the highest tax rate. cedure 98–60. A return filed early is considered filed on the If this exception applies, the anti-churning due date. rules apply only to the amount of your ad- Disposition of justed basis in the intangible that is more than Changing Your the gain recognized by the seller. Section 197 Intangibles Accounting Method A section 197 intangible is treated as depre- Note. If the income tax on the gain (fig- If you did not deduct the correct amount of ciable property used in your trade or busi- ured without regard to this rule) is less than amortization for the section 197 intangible on ness. If you dispose of property held for more the tax on the gain at the highest rate, the any two or more consecutively filed tax re- than 1 year, any gain on the disposition, up seller reports the difference as additional tax turns, you have adopted a method of ac- to the amount of allowable amortization, is under this exception on Form 1040, line 40 counting for that property. You can claim the ordinary income (section 1245 gain). Any re- (or the appropriate line of other income tax correct amount of amortization only by maining gain, or loss, is a section 1231 gain returns). On the dotted line next to line 40, the changing your method of accounting for or loss. If you held the property 1 year or less, seller should write “197.” amortization. By changing your method of any gain or loss on its disposition is an ordi- accounting, you will be able to take into ac- nary gain or loss. For more information on Anti-abuse rule. You cannot amortize any count any unclaimed or excess amortization ordinary or capital gain or loss on business section 197 intangible acquired in a trans- from years before the year of change. property, see chapter 3 in Publication 544. action in which either of the following was one of the principal purposes. Approval required. You must get IRS ap- Nondeductible loss. If you acquire more proval to change your method of accounting. than one section 197 intangible in a trans- 1) To avoid the requirement that the intan- File Form 3115, Application for Change in action (or series of related transactions) and gible be acquired after August 10, 1993. Accounting Method, to request a change to later dispose of one of them or if one of them Chapter 12 Amortization Page 43 becomes worthless, you cannot deduct any you can only deduct these deferred start-up loss on the intangible. Instead, increase the Business Start-Up Costs costs to the extent they qualify as a loss from adjusted basis of each remaining amortizable Start-up costs are costs for creating an active a business. section 197 intangible by the part of the non- trade or business or investigating the creation deductible loss. Figure the increase by multi- or acquisition of an active trade or business. plying the nondeductible loss on the disposi- Start-up costs include any amounts paid or Costs of Organizing tion of the intangible by the following fraction. incurred in connection with any activity en- gaged in for profit and for the production of a Corporation income before the trade or business begins The costs of organizing a corporation are the • The numerator is the adjusted basis of in anticipation of the activity becoming an direct costs of creating the corporation. the remaining intangible on the date of active trade or business. the disposition. A start-up cost is amortizable if it meets Qualifying costs. You can amortize an or- both of the following tests. ganizational cost only if it meets all of the • The denominator is the total adjusted following tests. basis of all remaining amortizable section 1) It is a cost you could deduct if you paid 197 intangibles on the date of the dispo- or incurred it to operate an existing ac- • It is for the creation of the corporation. sition. tive trade or business (in the same field). • It is chargeable to a capital account. 2) It is a cost you pay or incur before the • You could amortize the cost over the life Covenant not to compete. A covenant not day your active trade or business begins. of the corporation if the corporation had to compete, or similar arrangement, is not a fixed life. Start-up costs can include costs for the considered disposed of or worthless before following items. you dispose of your entire interest in the trade You must have incurred the cost before the end of the first tax year in which the corpo- or business for which you entered into the • A survey of potential markets. covenant. ration was in business. A corporation using • An analysis of available facilities, labor, the cash method of accounting can amortize supplies, etc. organizational costs incurred within the first tax year, even if it does not pay them in that Nonrecognition transfers. If you dispose • Advertisements for the opening of the year. of one section 197 intangible and acquire business. another in a nonrecognition transfer, treat the The following are examples of organiza- part of the adjusted basis of the acquired in- • Salaries and wages for employees who tional costs. tangible that is not more than the adjusted are being trained, and their instructors. • Costs of temporary directors. basis of the transferred intangible as if it were • Travel and other necessary costs for se- the transferred section 197 intangible. You curing prospective distributors, suppliers, • The cost of organizational meetings. continue to amortize this part of the adjusted or customers. • State incorporation fees. basis over the remaining amortization period • Salaries and fees for executives and of the transferred section 197 intangible. • Accounting services for setting up the consultants, or for other professional Nonrecognition transfers include transfers to corporation. services. a corporation, partnership contributions and • The cost of legal services (such as draft- distributions, like-kind exchanges, and invol- Start-up costs do not include deductible ing the charter, bylaws, terms of the ori- untary conversions. interest, taxes, or research and experimental ginal stock certificates, and minutes of costs. See Research and Experimental organizational meetings). Example. You own a section 197 intan- Costs, later. gible you have amortized for 4 full years. It Costs you cannot amortize. The following has a remaining unamortized basis of Purchasing an active trade or business. costs are not organizational costs. You must $30,000. You exchange the asset plus Amortizable start-up costs for purchasing an capitalize these costs. $10,000 for a like-kind section 197 intangible. active trade or business include only costs The nonrecognition provisions of like-kind incurred in the course of a general search for • Costs for issuing and selling stock or se- exchanges apply. You amortize $30,000 of or preliminary investigation of the business. curities, such as commissions, profes- the basis of the acquired section 197 intangi- Costs you incur in the attempt to purchase a sional fees, and printing costs. ble over the 11 years remaining in the original specific business are capital expenses and • Costs associated with the transfer of as- 15-year amortization period for the trans- you cannot amortize them. sets to the corporation. ferred asset and the other $10,000 of ad- Investigative costs. Investigative costs justed basis over 15 years. are the costs that help you decide whether to purchase a business and which business to Costs of Organizing purchase. a Partnership Example. In June, you hired an ac- Partnership organizational costs are the direct counting firm to assist you in the potential costs of creating a partnership. purchase of XYZ. They researched XYZ's in- Going Into Business dustry and analyzed the financial projections Qualifying costs. You can amortize an or- of XYZ. In September, you hired a law firm to ganizational cost only if it meets all of the When you go into business, treat all costs you prepare and submit a letter of intent to XYZ. following tests. incur to get your business started as capital The letter stated that a binding commitment expenses. Capital expenses are part of your would result only after a purchase agreement • It is for the creation of the partnership and basis in the business. Generally, you recover was signed. The law firm and accounting firm not for starting or operating the partner- costs for particular assets through depreci- continued to provide services including a re- ship trade or business. ation deductions. However, you generally view of XYZ's books and records and the • It is chargeable to a capital account. cannot recover other costs until you sell the preparation of a purchase agreement. In Oc- business or otherwise go out of business. See tober, you signed a purchase agreement with • You could amortize the cost over the life Capital Expenses in chapter 1 for a dis- XYZ. of the partnership if the partnership had cussion of how to treat these costs if you do The costs to investigate the business be- a fixed life. not go into business. fore submitting the letter of intent to XYZ are You can choose to amortize certain costs amortizable investigative costs. The costs for Organizational costs include the following for setting up your business. The cost must services after that time relate to the attempt fees. qualify as one of the following. to purchase the business and must be capi- talized. • Legal fees for services incident to the organization of the partnership, such as • A business start-up cost. Disposition of business. If you completely negotiation and preparation of the part- nership agreement. • An organizational cost for a corporation. dispose of your business before the end of the amortization period, you can deduct any • Accounting fees for services incident to • An organizational cost for a partnership. remaining deferred start-up costs. However, the organization of the partnership. Page 44 Chapter 12 Amortization • Filing fees. • A description of the business to which the start-up costs relate. Reforestation Costs Costs you cannot amortize. You cannot • A description of each start-up cost in- amortize costs connected with any of the fol- curred. You can choose to amortize part of your lowing activities. qualified timber property reforestation costs. • The month your active business began These are the direct costs of planting or (or the month you acquired the business). seeding for forestation or reforestation. • Acquiring assets for the partnership or Qualifying costs. Qualifying costs in- transferring assets to the partnership. • The number of months in your amorti- zation period (not less than 60). clude only those costs you must capitalize • Admitting or removing partners, other and include in the adjusted basis of the property. They include costs for the following than at the time the partnership is first Filing the statement early. You can items. organized. choose to amortize your start-up costs by fil- ing the statement with a return for any tax • Making a contract concerning the opera- • Site preparation. tion of the partnership trade or business year before the year your active business (including a contract between a partner begins. If you file the statement early, the • Seeds or seedlings. and the partnership). choice becomes effective in the month of the tax year your active business begins. • Labor. • Syndication fees. Revised statement. You can file a re- • Tools. vised statement to include any start-up costs not included in your original statement. How- • Depreciation on equipment used in Syndication fees are costs for issuing and planting and seeding. marketing interests in the partnership (such ever, you cannot include on the revised statement any cost that you previously treated as commissions, professional fees, and Costs you can deduct currently are not quali- printing costs). You must capitalize syndi- on your return as a cost other than a start-up cost. You can file the revised statement with fying costs. cation fees. You cannot depreciate or amor- If the government reimburses you for re- tize them. a return filed after the return on which you choose to amortize your start-up costs. forestation costs under a cost-sharing pro- gram, you can amortize these costs only if you include the reimbursement in your in- How To Amortize Organizational costs. If you choose to come. amortize your organizational costs, complete You deduct start-up and organizational costs Part VI of From 4562 and prepare a separate in equal amounts over a period of 60 months Qualified timber property. Qualified timber statement that contains the following infor- or more. You can choose a period for start-up property can be a woodlot or other site that mation. costs that is different from the period you you own or lease. The property qualifies only choose for organizational costs, as long as if it meets all of the following requirements. both are 60 months or more. Once you • A description of each cost. choose an amortization period, you cannot • The amount of each cost. 1) It is located in the United States. change it. 2) It is held for the growing and cutting of To figure your deduction, divide your total • The date each cost was incurred. timber you will either use in, or sell for start-up or organizational costs by the months • The month your active business began use in, the commercial production of in the amortization period. The result is the (or the month you acquired the business). timber products. amount you can deduct each month. • The number of months in your amorti- 3) It consists of at least one acre planted A partnership using the cash method zation period (not less than 60). with tree seedlings in the manner ! of accounting cannot deduct a cost it normally used in forestation or refor- CAUTION has not paid by the end of the tax A cash basis partnership must also indicate estation. year. However, any cost the partnership the amount paid before the end of the year could have deducted as an organizational for each cost. Qualified timber property does not include cost in an earlier tax year can be deducted in property on which you have planted shelter the tax year of payment. You do not need to separately list any belts or ornamental trees, such as Christmas TIP partnership organizational cost that is trees. less than $10. Instead, you can list the When to begin amortization. The amorti- total amount of these costs, provided you list zation period starts with the month you begin the dates the first and last costs were in- Annual limit. Each year, you can choose to business operations. curred. If you use the cash method of ac- amortize up to $10,000 of qualified costs you counting, you must also list the total amount pay or incur during the tax year. If you are of these costs that were paid by the end of the married and file a separate return, the annual How To Make the Choice tax year. limit is $5,000. You cannot carry over or carry To choose to amortize start-up or organiza- back qualifying costs over the annual limit. tional costs, you must attach Form 4562 and The annual limit applies to costs you pay or Amended return. After a partnership incur during a tax year on all of your qualified an accompanying statement (explained later) makes the choice to amortize organizational to your return for the first tax year you are in timber property. costs, it can file an amended return to include If you pay or incur more than $10,000 in business. If you have both start-up and or- additional organizational costs. ganizational costs, attach a separate state- costs for more than one piece of timber ment to your return for each type of costs. property, you can divide the annual limit Generally, you must file the return by the due Corporations and partnerships. If your among any of the properties in any manner date (including any extensions). However, if business is organized as a corporation or you wish. you timely filed your return for the year with- partnership, only your corporation or partner- For example, if you incurred $10,000 of out making the choice, you can still make the ship can choose to amortize its start-up or qualifying costs on each of four qualified tim- choice by filing an amended return within 6 organizational costs. A shareholder or partner ber properties last year, you can divide months of the due date of the return (exclud- cannot make this choice. You, as shareholder $2,500 to each property, $5,000 to two prop- ing extensions). Attach Form 4562 and the or partner, cannot amortize any costs you erties, the entire $10,000 to any one property, statement to the amended return and write incur in setting up your corporation or part- or you can divide the $10,000 among some “Filed pursuant to section 301.9100–2” on nership. The corporation or partnership can or all of the properties in any other manner. Form 4562. File the amended return at the amortize these costs. Partnerships and S corporations. The same address you filed the original return. $10,000 annual limit applies to a partnership You, as an individual, can choose to or an S corporation and to each partner or TIP amortize costs you incur to investigate shareholder. A partnership or S corporation Start-up costs. If you choose to amortize an interest in an existing partnership. makes the choice to amortize its qualified your start-up costs, complete Part VI of Form These costs qualify as business start-up costs costs and allocates the costs (limited to 4562 and prepare a separate statement that if you succeed in acquiring an interest in the $10,000) among the partners or sharehold- contains the following information. partnership. ers. Chapter 12 Amortization Page 45 A partner or shareholder is also subject to Attach a separate statement for each prop- cost recovery. You must then reduce the the annual limit of $10,000 ($5,000, if married erty for which you amortize reforestation amortizable basis of the facility. and filing a separate return) regardless of the costs. Generally, you must make the choice New identifiable treatment facility. A source of the costs. For example, if you are on a timely filed return (including extensions) new identifiable treatment facility is tangible a partner in two or more partnerships that for the tax year in which you incurred the depreciable property that is identifiable as a choose to amortize qualified costs, your total costs. However, if you timely filed your return treatment facility. This does not include a share of partnership amortizable basis cannot for the year without making the choice, you building and its structural components unless be more than $10,000 on a joint return can still make the choice by filing an amended the building is exclusively a treatment facility. ($5,000 if married and filing a separate re- return within 6 months of the due date of the turn). Amortizable basis is the part of the return (excluding extensions). Attach Form Basis reduction for corporations. A cor- basis of qualified property that is from refor- 4562 and the statement to the amended re- poration must reduce the amortizable basis estation costs. turn and write “Filed pursuant to section of a pollution control facility by 20% before Estates. Estates can choose to amortize 301.9100–2” on Form 4562. File the amended figuring the amortization deduction. up to $10,000 of qualified reforestation costs return at the same address you filed the ori- paid or incurred in each tax year. Any amor- ginal return. tizable basis acquired by an estate is divided More information. For more information on the amortization of pollution control facilities, between the estate and the income benefi- Where to report. If you file Schedule C or ciary based on the income of the estate see section 169 of the Internal Revenue Code F (Form 1040) for the activity in which you and the related regulations. allocable to each. The amortizable basis dis- incurred reforestation costs, include your tributed from an estate to a beneficiary is amortization deduction on the line for “Other taken into account in determining the benefi- Expenses.” If you do not file Schedule C or ciary's annual limit. F, include your amortization deduction in the Life tenant and remainderman. If one total on line 32 of Form 1040. Enter the Research and person holds the property for life with the re- amount and “RFST” (for reforestation) on the mainder going to another person, the life dotted line next to line 32. Experimental Costs tenant is entitled to the full amortization (up You can amortize your research and exper- to the annual limit) for reforestation costs Revocation.You must get IRS ap- imental costs, deduct them as current busi- made by the life tenant. Any remainder inter- proval to revoke your choice to ness expenses, or write them off over a est in the property is ignored for amortization amortize reforestation costs. Your 10-year period. If you choose to amortize purposes. application to revoke the choice must include these costs, deduct them in equal amounts your name, address, the years for which your over 60 months or more. The amortization Amortization period. You can amortize choice was in effect, and your reason for re- period begins the month you first receive an qualified reforestation costs over a period of voking it. You, or your duly authorized repre- economic benefit from the research. For a 84 months. The 84-month period starts on the sentative, must sign the application and file it definition of “research and experimental first day of the first month of the second half at least 90 days before the due date (without costs” and information on deducting them as of the tax year you incur the costs (July 1st extensions) for filing your income tax return current business expenses, see chapter 11. for a calendar year taxpayer). You can claim for the first tax year for which your choice is amortization deductions for no more than 6 to end. months of the first and last (eighth) tax years Send the application to: Optional write-off method. Rather than of the period. amortize these costs or deduct them as a Commissioner of Internal Revenue current expense, you have the option of de- Example. Last year (a full 12-month tax Washington, DC 20224 ducting (writing off) research and exper- year), John Jones incurred qualified refor- imental costs ratably over a 10-year period estation costs of $8,400. His monthly de- beginning with the tax year in which you in- duction ($100) is figured by dividing $8,400 curred the costs. by 84 months. Since it was the first year of the For more information on the optional 84-month period, he can deduct only $600 write-off method, see Internal Revenue Code ($100 × 6 months). section 59(e).

Maximum annual amortization. The maxi- Costs you can amortize. You can amortize mum annual amortization deduction for costs costs chargeable to a capital account if both incurred in any taxable year is $1,428.57 Pollution of the following apply. ($10,000 ÷ 7). The maximum deduction in the Control Facilities first and last tax year of the 84-month • You paid or incurred the costs in your amortization period is one half of $1,428.57 You can choose to amortize over 60 months trade or business. or $714.29. the cost of a certified pollution control facility. • You are not deducting the costs currently. Recapture. If you dispose of qualified timber Certified pollution control facility. A certi- property within 10 years after the tax year you fied pollution control facility is a new identifi- How to make the choice. To choose to create an amortizable basis in the property, able treatment facility used, in connection with amortize research and experimental costs, report any gain as ordinary income up to the a plant or other property in operation before enter your deduction in Part VI of Form 4562 amount of the amortization you took. 1976, to reduce or control water or atmo- and attach it to your income tax return. Gen- spheric pollution or contamination. The facility erally, you must file the return by the due date (including extensions). However, if you timely Investment credit. Reforestation costs eli- must do so by removing, changing, disposing, storing, or preventing the creation or emission filed your return for the year without making gible to be amortized qualify for the invest- the choice, you can still make the choice by ment credit, whether or not they are amor- of pollutants, contaminants, wastes, or heat. The facility must be certified by state and filing an amended return within 6 months of tized. See the instructions for Form 3468 for the due date of the return (excluding exten- information on the investment credit. federal certifying authorities. The facility must not significantly increase sions). Attach Form 4562 to the amended the output or capacity, extend the useful life, return and write “Filed pursuant to section How to make the choice. To choose to or reduce the total operating costs of the plant 301.9100–2” on Form 4562. File the amended amortize qualified reforestation costs, enter or other property. Also, it must not signif- return at the same address you filed the ori- your deduction in Part VI of Form 4562 and icantly change the nature of the manufactur- ginal return. Your choice is binding for the attach a statement that contains the following ing or production process or facility. year it is made and for all later years unless information. The federal certifying authority will not you get IRS approval to change to a different certify your property to the extent it appears method. • A description of the costs and the dates you will recover (over the property's useful you incurred them. life) all or part of its cost from the profit based More information. For more information on • A description of the type of timber being on its operation (such as through sales of re- amortizing research and development costs, grown and the purpose for which it is covered wastes). The federal certifying au- see section 174 of the Internal Revenue Code grown. thority will describe the nature of the potential and the related regulations. Page 46 Chapter 12 Amortization amortization purposes includes all renewal options (and any other period for which the Bond Premium lessee and lessor reasonably expect the Who Can Bond premium is the amount by which your lease to be renewed) if less than 75% of the basis in a bond right after you get it is more cost of getting the lease is attributable to the Claim Depletion than the total of all amounts payable on the term of the lease remaining on the acquisition If you have an economic interest in mineral bond after you get it (other than payments of date. The term of the lease remaining on the property or standing timber, you can take a qualified stated interest). acquisition date does not include any period deduction for depletion. More than one per- The term “bond,” as used in this dis- for which the lease may later be renewed, son can have an economic interest in the cussion, means any interest-bearing bond, extended, or continued under an option same mineral deposit or timber. debenture, note, or certificate or other evi- exercisable by the lessee. You have an economic interest if both dence of debt issued by a corporation or a Enter your deduction in Part VI of Form of the following apply. government or political subdivision of a gov- 4562 if you must file that form, or on the ap- ernment. The term does not include any ob- propriate line of your tax return. • You have acquired by investment a legal ligation listed below. interest in mineral deposits or standing timber. • Your stock in trade. • You have the right to income from the • Property that would properly be included extraction of the mineral or cutting of the in your inventory if on hand at the close timber, to which you must look for a re- of the tax year. 13. turn of your capital investment. • Property held by you primarily for sale to A contractual relationship you have that al- customers in the ordinary course of your Depletion lows you an economic or monetary advantage trade or business. from products of the mineral deposit or standing timber is not, in itself, an economic Tax-exempt bonds. If the bond yields tax- interest. A production payment carved out of, exempt interest, you must amortize the pre- or retained on the sale of, mineral property is mium. You cannot deduct the amortizable not an economic interest. premium in figuring your taxable income. Important Reminders However, each year you must reduce your basis in the bond by the amortization for the Temporary suspension of taxable income year. limit for certain percentage depletion. For tax years beginning after 1997 and before Mineral Property 2000, percentage depletion on the marginal The term “mineral property” means each Taxable bonds. You can choose to amortize production of oil or natural gas is not limited the premium on taxable bonds. This gener- separate interest you own in each mineral to taxable income from the property figured deposit in each separate tract or parcel of ally means that each year, over the life of the without the depletion deduction. For more in- bond, you use part of the premium to reduce land. You can treat mineral properties sepa- formation on marginal production, see section rately or as a group. See section 614 of the the amount of interest includible in your in- 613A(c) of the Internal Revenue Code. come. If you make this choice, you must re- Internal Revenue Code for rules on how to duce your basis in the bond by the amorti- treat separate properties. zation for the year. The premium on the bond Alternative minimum tax. Individuals, cor- Mineral property includes oil and gas is part of your basis in the bond. porations, estates, and trusts who claim de- wells, mines, and other natural deposits (in- Inflation-indexed instruments. An pletion deductions may be liable for alterna- cluding geothermal deposits). inflation-indexed debt instrument is generally tive minimum tax. There are two ways of figuring depletion a debt instrument on which the payments are For more information on alternative mini- on mineral property. adjusted for inflation and deflation (such as mum tax, see the following sources. Treasury Inflation-Indexed Securities). De- • Cost depletion. termine the premium on an inflation-indexed If you are: See: • Percentage depletion. debt instrument as of the date you acquire the An individual The instructions for Form instrument by assuming that there will be no 6251, Alternative Minimum Generally, you must use the method that inflation or deflation over the remaining term Tax—Individuals. gives you the larger deduction. However, un- of the instrument. Allocate the premium over A corporation Form 4626, Alternative Mini- less you are a small producer or royalty the remaining term of the instrument by mum Tax—Corporations. owner, you generally cannot use percentage making the same assumption. Reduce the An estate or trust Form 1041, U.S. Income Tax depletion for oil and gas wells. See Oil and instrument's interest income for the tax year Return for Estates and Trusts, Gas Wells, later. by the premium allocable to the tax year. Use and its instructions. any excess premium allocable to the tax year to offset the original issue discount on the in- Cost Depletion strument for the year. To figure cost depletion you must first deter- mine the following. Basis adjustment. If you are required to Introduction amortize bond premium, or choose to do so, Depletion is the using up of natural resources • The property's basis for depletion. you must decrease the basis of the bond by by mining, quarrying, drilling, or felling. The the amortizable bond premium. The result is depletion deduction allows an owner or oper- • The total recoverable units in the proper- the adjusted basis you use to figure gain or ator to account for the reduction of a product's ty's natural deposit. loss on the sale or redemption of the bond. reserves. • The number of units sold during the tax There are two ways of figuring depletion: year. More information. For more information on cost depletion and percentage depletion. For mineral property, you generally must use the how to figure and report bond premium, see Basis for depletion. To figure the property's Publication 550. method that gives you the larger deduction; for standing timber, you must use cost de- basis for depletion, subtract all of the follow- pletion. ing from the property's adjusted basis. 1) The amounts recoverable through: Topics Cost of This chapter discusses: a) Depreciation deductions, Getting a Lease b) Deferred expenses (including de- • Who can claim depletion ferred exploration and development If you get a lease for business property, you Mineral property costs), and recover the cost by amortizing it over the term • of the lease. The term of the lease for • Timber c) Deductions other than depletion. Chapter 13 Depletion Page 47 2) The residual value of land and improve- • The part of any bonus you paid for a crude oil and you and the related person re- ments at the end of operations. lease on the property that is allocable to fined more than 50,000 barrels on any day the product sold (or that otherwise gives during the tax year. 3) The cost or value of land acquired for rise to gross income) for the tax year. Related person. You and another person purposes other than mineral production. are related persons if either of you holds a A bonus payment includes a bonus for either significant ownership interest in the other Adjusted basis. The adjusted basis of a mineral lease or an oil and gas lease. person or if a third person holds a significant your property is your original cost or other Use the following fraction to figure the part ownership interest in both of you. basis, plus certain additions and improve- of the bonus you must subtract. For example, a corporation, partnership, ments, and minus certain deductions such as estate, or trust and anyone who holds a sig- depletion allowed or allowable and casualty Number of units sold in the tax year × Bonus nificant ownership interest in it are related losses. Your adjusted basis can never be less Recoverable units from the property Payments persons. A partnership and a trust are related than zero. See Publication 551, Basis of As- persons if one person holds a significant sets, for more information on adjusted basis. Taxable income limit. The percentage de- ownership interest in each of them. pletion deduction cannot be more than 50% For purposes of the related person rules, Total recoverable units. The total recover- (100% for oil and gas property) of your taxa- significant ownership interest means direct able units is the sum of the following two ble income from the property figured without or indirect ownership of 5% or more of any items. the depletion deduction. one of the following interests.

1) The number of units of mineral remaining For tax years beginning after 1997 • The value of the outstanding stock of a at the end of the year (including units ! and before 2000, percentage de- corporation. recovered but not sold). CAUTION pletion on the marginal production of oil or natural gas is not limited to taxable in- • The interest in the profits or capital of a 2) The number of units sold during the tax partnership. year (determined under your method of come from the property figured without the accounting, as explained next). depletion deduction. • The beneficial interests in an estate or trust. You must estimate or determine recover- When figuring your taxable income from able units (tons, pounds, ounces, barrels, the property for purposes of the taxable in- Any interest owned by or for a corporation, thousands of cubic feet, or other measure) come limit consider the following rules. partnership, trust, or estate is considered to of mineral products using the current industry be owned directly both by itself and propor- method and using the most accurate and re- • Do not deduct any net operating loss tionately by its shareholders, partners, or liable information you can obtain. deduction from the gross income from the beneficiaries. property. Retailers who cannot claim percentage Number of units sold. The number of units • Corporations do not deduct charitable depletion. You cannot claim percentage sold during the tax year is one of the follow- contributions from the gross income from depletion if both of the following apply. ing. the property. 1) You sell oil or natural gas or their by- • The units sold for which you receive • If, during the year, you dispose of an item of section 1245 property that was used products directly or through a related payment during your tax year (regardless person in any of the following situations. of the year of sale), if you use the cash in connection with mineral property, re- method of accounting. duce any allowable deduction for mining a) Through a retail outlet operated by expenses by the part of any gain you you or a related person. • The units sold based on your inventories, must report as ordinary income that is if you use the accrual method of ac- allocable to the mineral property. See b) To any person who is required un- counting. section 1.613–5(b)(1) of the regulations der an agreement with you or a re- for information on how to determine the lated person to use a trademark, The number of units sold during the tax amount of ordinary gain allocable to the trade name, or service mark or year does not include any on which depletion property. name owned by you or a related deductions were allowed or allowable in ear- person in marketing or distributing lier years. oil, natural gas, or their by-products. Oil and Gas Wells c) To any person given authority under Figuring the cost depletion deduction. Generally, only small producers and royalty an agreement with you or a related Once you have figured your property's basis owners can claim percentage depletion for person to occupy any retail outlet for depletion, the total recoverable units, and any oil or gas well. However, if you are not owned, leased, or controlled by you the number of units sold during the tax year, a small producer or royalty owner, you may or a related person. you can figure your cost depletion deduction be able to claim percentage depletion for the by taking the following steps. following items. 2) The combined gross receipts from sales (not counting resales) of oil, natural gas, • Natural gas sold under a fixed contract. or their by-products of all retail outlets Step Action Result taken into account in (1) are more than 1 Divide your property's Rate per unit. • Natural gas from geopressured brine. $5 million for the tax year. basis for depletion by total recoverable units. For information on the depletion deduction for For the purpose of determining if this rule 2 Multiply the rate per Cost depletion these items, see Natural Gas Wells, later. applies, do not count the following. unit by units sold deduction. during the tax year. Small Producers • Bulk sales of oil or natural gas to com- mercial or industrial users. If you are a small producer, you figure per- centage depletion using a rate of 15% of the • Bulk sales of aviation fuels to the De- Percentage Depletion gross income from the property based on partment of Defense. To figure percentage depletion, you multiply your average daily production of domestic • Sales of oil or natural gas or their by- a certain percentage, specified for each min- crude oil or domestic natural gas up to your products outside the United States if eral, by your gross income from the property depletable oil or natural gas quantity. How- none of your domestic production or that during the tax year. ever, certain refiners and retailers, as ex- of a related person is exported during the plained next, cannot claim percentage de- tax year or the prior tax year. Gross income. When figuring your percent- pletion. For information on figuring the age depletion, subtract from your gross in- deduction, see Figuring percentage depletion Sales through a related person. You come from the property the following later. are considered to be selling through a related amounts. person if any sale by the related person Refiners who cannot claim percentage produces gross income from which you may • Any rents or royalties you pay or incur for depletion. You cannot claim percentage benefit because of your direct or indirect the property. depletion if you or a related person refine ownership interest in the person. Page 48 Chapter 13 Depletion You are not considered to be selling come he received) by $200,000 (the gross 3) Figure depletion for all oil or natural gas through a related person who is a retailer if revenue from the property). Paul determined produced from the property using a per- all of the following apply. his share of the oil production to be 1,100 centage depletion rate of 15%. barrels (10,000 barrels × 11%). 4) Multiply the result figured in (3) by a • You do not have a significant ownership fraction, the numerator of which is the interest in the retailer. Depletable oil or natural gas quantity. result figured in (2) and the denominator • You sell your production to persons who Generally, your depletable oil quantity is of which is the result figured in (1). This are not related to either you or the 1,000 barrels and your depletable natural gas is your depletion allowance for that retailer. quantity is 6,000 cubic feet multiplied by the property for the year. number of barrels of your depletable oil • The retailer does not buy oil or natural quantity that you choose to apply. If you claim Taxable income limit. If you are a small gas from your customers or persons re- depletion on both oil and natural gas, you producer of oil and gas, your deduction for lated to your customers. must reduce your depletable oil quantity by percentage depletion is limited to the smaller the number of barrels you use to figure your • There are no arrangements for the of the following. retailer to acquire oil or natural gas you depletable natural gas quantity. If you are in- produced for resale or made available for volved in marginal production, see section • Your taxable income from the property purchase by the retailer. 613A(c) of the Internal Revenue Code to fig- figured without the deduction for de- ure your depletable oil or natural gas quantity. pletion. • Neither you nor the retailer knows of or You must allocate the depletable oil or gas controls the final disposition of the oil or quantity among the following in proportion to • 65% of your taxable income from all natural gas you sold or the original source each entity's or family member's production sources, figured without the depletion al- of the petroleum products the retailer ac- of domestic oil or gas for the year. lowance, any net operating loss quired for resale. carryback, and any capital loss • Corporations, trusts, and estates if 50% carryback. Transfers. You cannot claim percentage or more of the beneficial interest is owned depletion if you received your interest in a by the same or related persons (consid- You can carry over to the following year any proven oil or gas property by transfer after ering only persons that own at least 5% amount you cannot deduct because of the 1974 and before October 12, 1990. For a of the beneficial interest). 65% (of taxable income) limit. Add it to your definition of the term “transfer,” see section depletion allowance (before applying any You and your spouse and minor children. 1.613A–7(n) of the regulations. • limits) for the following year. Temporary suspension of taxable in- For purposes of this allocation, a related per- Figuring percentage depletion. Generally, come limit for marginal production. For tax son is anyone mentioned under Related per- years beginning after 1997 and before 2000, as a small producer you figure your percent- son in chapter 15 except that item (1) in that age depletion by computing your average percentage depletion on the marginal pro- discussion includes only an individual, his or duction of oil or natural gas is not limited to daily production of domestic oil or gas and her spouse, and minor children. comparing it to your depletable oil or gas taxable income from the property figured Members of the same controlled group of without the depletion deduction. For informa- quantity. If your average daily production corporations are treated as one taxpayer does not exceed your depletable oil or gas tion on marginal production, see section when figuring the depletable oil or natural gas 613A(c)(6) of the Internal Revenue Code. quantity, you figure your percentage depletion quantity. They share the depletable quantity, by multiplying the gross income from the oil and one member's share of the group's or gas property by 15%. If your average daily depletable quantity will reduce the other Partnerships and S Corporations production of domestic oil or gas exceeds members' share of the group's depletable Generally, each partner or shareholder, and your depletable oil or gas quantity, you must quantity. Under this rule, a controlled group not the partnership or S corporation, figures make an allocation as explained later under of corporations is defined in section 1563(a), the depletion allowance separately. (How- Average daily production exceeds depletable except that “more than 50%” is substituted for ever, see Electing large partnerships must quantities. “at least 80%” in that definition. figure depletion allowance, later.) Each part- In addition, there is a limit on the per- ner or shareholder must decide whether to centage depletion deduction. See Taxable Gross income from oil and gas property. use cost or percentage depletion. If a partner income limit, later. For purposes of percentage depletion, gross or shareholder uses percentage depletion, he income from oil and gas property is the or she must apply the 65% of taxable income Average daily production. Figure your av- amount you receive from the sale of the oil limit to his or her taxable income from all erage daily production by dividing your total or gas in the immediate vicinity of the well. If sources. domestic production for the tax year by the you do not sell the oil or gas on the property, number of days in your tax year. but manufacture or convert it into a refined Partner's or shareholder's adjusted basis. Part interest. If you have a part interest product before sale or transport it before sale, The partnership or S corporation must allo- in the production from a property, figure your the gross income from the property is the cate to each partner his or her share of the share of the production by multiplying total representative market or field price (RMFP) adjusted basis of each oil or gas property held production from the property by your per- of the oil or gas, before conversion or trans- by the partnership or S corporation. The centage of interest in the revenues from the portation. partnership or S corporation makes the allo- property. If you sold gas after you removed it from cation as of the date it acquires the oil or gas You have a part interest in property, for the premises for a price that is lower than the property. example, if you have a net profits interest. To RMFP, determine gross income from the The partner's share of the adjusted basis figure the share of production for your net property for percentage depletion purposes of the oil or gas property generally is figured profits interest, you must determine your per- without regard to the RMFP. according to that partner's interest in part- centage participation (as measured by the net Gross income from the property does not nership capital. However, in some cases, it is profits) in the gross revenue from the prop- include lease bonuses, advance royalties, or figured according to the partner's interest in erty. To figure this percentage, you divide the other amounts payable without regard to partnership income. income you receive for your net profits inter- production from the property. The partnership or S corporation adjusts est by the gross revenue from the property. the partner's or shareholder's share of the Average daily production exceeds adjusted basis of the oil and gas property for Example. John Oak owns oil property in any capital expenditures made for the prop- which Paul Elm owns a 20% net profits inter- depletable quantities. If your average daily production for the year is more than your erty and for any change in partnership or S est. During the year, the property produced corporation interests. 10,000 barrels of oil, which John sold for depletable oil or natural gas quantity, figure $200,000. John had expenses of $90,000 at- your allowance for depletion for each do- Each partner or shareholder must tributable to the property. The property gen- mestic oil or natural gas property as follows. separately keep records of his or her erated a net profit of $110,000. Paul received RECORDS share of the adjusted basis in each × 1) Figure your average daily production of income of $22,000 ($110,000 .20) for his oil or natural gas for the year. oil and gas property of the partnership or S net profits interest. corporation. The partner or shareholder must Paul determined his percentage partici- 2) Figure your depletable oil or natural gas reduce his or her adjusted basis by the de- pation to be 11% by dividing $22,000 (the in- quantity for the year. pletion he or she takes on the property each Chapter 13 Depletion Page 49 year. The partner or shareholder must use Natural gas from geopressured brine. tax the mine operator must pay to finance that reduced adjusted basis to figure cost Qualified natural gas from geopressured brine black lung benefits. depletion or his or her gain or loss if the is eligible for a percentage depletion rate of Extraction. Extracting ores or minerals partnership or S corporation disposes of the 10%. Qualified natural gas from geopres- from the ground includes extraction by mine property. sured brine is natural gas produced from a owners or operators of ores or minerals from well you began to drill after September 1978 the waste or residue of prior mining. This Reporting the deduction. Deduct oil and and before 1984 determined in accordance does not apply to extraction from waste or gas depletion for a partnership or S corpo- with section 503 of the Natural Gas Policy Act residue of prior mining by the purchaser of the ration interest on Schedule E (Form 1040). of 1978 to be produced from geopressured waste or residue or the purchaser of the rights The instructions for Schedule E explain where brine. to extract ores or minerals from the waste or to report your income and deductions and residue. whether you need to file either of the following Treatment processes. The processes forms. Mines and that are included as mining depend on the ore Geothermal Deposits or mineral mined. To qualify as mining, the • Form 6198, At-Risk Limitations. treatment processes must be applied by the Certain mines, wells, and other natural de- mine owner or operator. For a listing of • Form 8582, Passive Activity Loss Limita- posits, including geothermal deposits, qualify treatment processes considered as mining, tions. for percentage depletion. see section 613(c)(4) of the Internal Revenue Code and the related regulations. Electing large partnerships must figure Mines and other natural deposits. The Transportation of more than 50 miles. depletion allowance. For partnership tax percentage of your gross income from a na- If the IRS finds that the ore or mineral must years beginning after 1997, an electing large tural deposit that you can deduct as depletion be transported more than 50 miles to plants partnership, rather than each partner, gener- depends on the type of deposit. or mills to be treated because of physical and ally must figure the depletion allowance. The The following is a list of the depletion other requirements, the additional transporta- partnership figures the depletion allowance percentages for the more common minerals. tion that is authorized is included in the com- without taking into account the limits on the DEPOSITS PERCENT putation of gross income from mining. amount of production and taxable income. Also, the adjusted basis of a partner's interest Sulphur, uranium, and, if from deposits If you wish to include transportation in the partnership is not affected by the de- in the United States, asbestos, lead ore, of more than 50 miles in the compu- pletion allowance. zinc ore, nickel ore, and mica ...... 22 tation of gross income from mining, An electing large partnership is one that Gold, silver, copper, iron ore, and certain file an application in duplicate with the IRS. meets both the following requirements. oil shale, if from deposits in the United Include on the application the facts concern- States ...... 15 ing the physical and other requirements which • The partnership had 100 or more part- Borax, granite, limestone, marble, prevented the construction and operation of ners in the preceding year. mollusk shells, potash, slate, soapstone, the plant within 50 miles of the point of ex- and carbon dioxide produced from a well 14 traction. Send this application to: • The partnership chooses to be an elect- ing large partnership. Coal, lignite, and sodium chloride ...... 10 Internal Revenue Service Clay and shale used or sold for use in Washington, DC 20224 Disqualified partners. An electing large making sewer pipe or bricks or used or Attention: Assistant Chief Counsel, partnership does not figure the depletion al- sold for use as sintered or burned light- 1 Passthroughs and Special Industries lowance of its disqualified partners. The dis- weight aggregates ...... 7 / 2 qualified partners must figure it themselves, Clay used or sold for use in making as explained earlier. drainage and roofing tile, flower pots, Disposal of coal or iron ore. You cannot All of the following are disqualified part- and kindred products, and gravel, sand, take a depletion deduction on coal (including ners. and stone (other than stone used or sold for use by a mine owner or operator as lignite) or iron ore mined in the United States dimension or ornamental stone) ...... 5 that you disposed of after holding it for more • Refiners who cannot claim percentage than 1 year if you retained an economic in- depletion (discussed under Small Pro- You can find a complete list of deposits terest in it. Treat any gain on the disposition ducers, earlier). and their percentage depletion rates in sec- as a capital gain. tion 613(b) of the Internal Revenue Code. Disposal to related person. This rule • Retailers who cannot claim percentage Corporate deduction for iron ore and depletion (discussed under Small Pro- does not apply if you dispose of the coal or coal. The percentage depletion deduction of iron ore to one of the following persons. ducers, earlier). a corporation for iron ore and coal (including • Any partner whose average daily pro- lignite) is reduced by 20% of: • A related person (as listed in chapter 15). duction of domestic crude oil and natural gas is more than 500 barrels during the • The percentage depletion deduction for • A person owned or controlled by the tax year in which the partnership tax year the tax year (figured without regard to this same interests that own or control you. ends. Average daily production is dis- reduction), minus cussed earlier. • The adjusted basis of the property at the Geothermal deposits. Geothermal deposits close of the tax year (figured without the located in the United States or its pos- depletion deduction for the tax year). sessions qualify for a percentage depletion Natural Gas Wells rate of 15%. A geothermal deposit is a You can use percentage depletion for natural Gross income from mining. For property geothermal reservoir of natural heat stored in gas sold under a fixed contract or produced other than a geothermal deposit or an oil or rocks or in a watery liquid or vapor. For per- from geopressured brine. gas well, gross income from the property centage depletion purposes, a geothermal means the gross income from mining. Mining deposit is not considered a gas well. Natural gas sold under a fixed contract. includes all of the following. Figure gross income from a geothermal Natural gas sold under a fixed contract quali- steam well in the same way as for oil and gas fies for a percentage depletion rate of 22%. • Extracting ores or minerals from the wells. See Gross income from oil and gas Natural gas sold under a fixed contract is ground. property, earlier, under Oil and Gas Wells. domestic natural gas sold by the producer under a contract provided that the price can- • Applying certain treatment processes. not be adjusted to reflect any increase in the • Transporting ores or minerals (generally, Lessor's Gross Income seller's tax liability because of the repeal of not more than 50 miles) from the point A lessor's gross income from the property that percentage depletion for gas. The contract of extraction to the plants or mills in which qualifies for percentage depletion usually is must have been in effect from February 1, the treatment processes are applied. the total of the royalties received from the 1975, until the date of sale of the gas. Price lease. However, for purposes of oil, gas, or increases after February 1, 1975, are pre- Excise tax. Gross income from mining geothermal property, gross income does not sumed to take the increase in tax liability into includes the separately stated excise tax re- include lease bonuses, advanced royalties, account unless demonstrated otherwise by ceived by a mine operator from the sale of or other amounts payable without regard to clear and convincing evidence. coal to compensate the operator for excise production from the property. Page 50 Chapter 13 Depletion Bonuses and advanced royalties. Bonuses Depletion unit. You figure your depletion received upon the grant of rights and ad- unit each year by taking the following steps. vanced royalties are payments a lessee 14. makes to a lessor for the lease or for min- 1) Determine your cost or adjusted basis erals, gas, or oil to be extracted from leased of the timber on hand at the beginning property. Both types of payments are made of the year. before production. If you are the lessor, your Business income from bonuses and advanced royalties 2) Add to the amount determined in (1) the is subject to an allowance for depletion. cost of any units acquired during the Bad Debts Figuring cost or percentage depletion year and any additions to capital. on bonuses and advanced royalties. To figure cost depletion on a bonus, multiply your 3) Figure the number of units to take into adjusted basis in the property by a fraction, account by adding the number of units the numerator of which is the bonus and the acquired during the year to the number Introduction denominator of which is the total bonus and of units on hand in the account at the royalties expected to be received. To figure beginning of the year and then adding If someone owes you money you cannot col- cost depletion on advanced royalties, use the (or subtracting) any correction to the es- lect you have a bad debt. There are two kinds computation explained earlier under Cost timate of the number of units remaining of bad debts—business bad debts and non- Depletion, treating the units for which the ad- in the account. business bad debts. vanced royalty is received as the units sold. Generally, a business bad debt is one that To figure percentage depletion (for other 4) Divide the result of (2) by the result of comes from operating your trade or business. than gas, oil, or geothermal property), any (3). This is your depletion unit. You can deduct business bad debts as an bonus or advanced royalty payments are part expense on your business tax return. of your gross income from the property. All other bad debts are nonbusiness bad Example. You bought a timber tract for Terminating the lease. If you receive a debts and deductible as short-term capital $160,000 and the land was worth as much bonus on a lease that expires, terminates, or losses on Schedule D (Form 1040). For more as the timber. Your basis for the timber is is abandoned before you derive any income information on nonbusiness bad debts, see $80,000. Based on an estimated one million from the extraction of mineral or cutting of Publication 550, Investment Income and Ex- board feet (1,000 MBF) of standing timber, timber, include in income the depletion de- penses. you figure your depletion unit to be $80 per duction you took. Also increase your adjusted MBF ($80,000 divided by 1,000). If you cut basis in the property to restore the depletion 500 MBF of timber, your depletion allowance Topics deduction you previously subtracted. would be $40,000 (500 MBF multiplied by This chapter discusses: For advanced royalties, include in income $80). the depletion claimed on minerals for which • Definition of business bad debts the advanced royalties were paid if the min- erals were not produced before lease termi- When to claim depletion. Claim your de- • How to treat business bad debts nation. Increase your adjusted basis in the pletion allowance as a deduction in the year • Where to deduct business bad debts property by the amount you include in in- of sale or other disposition of the products cut come. from the timber, unless you choose to treat the cutting of timber as a sale or exchange. Include allowable depletion for timber pro- Useful Items Delay rentals. These are payments for de- ducts not sold during the tax year the timber You may want to see: ferring development of the property. Since is cut as a cost item in the closing inventory delay rentals are ordinary rent, they are ordi- of timber products for the year. The inventory Publication nary income that is not subject to depletion. is your basis for determining gain or loss in Ⅺ These rentals can be avoided by either the tax year that you sell the timber products. 525 Taxable and Nontaxable Income abandoning the lease, beginning develop- Ⅺ ment operations, or obtaining production. 536 Net Operating Losses Example. Assume the same facts as in Ⅺ the previous example except that you sold 544 Sales and Other Dispositions of only half of the timber products in the cutting Assets year. You would deduct $20,000 of the Ⅺ 550 Investment Income and Expenses $40,000 depletion that year. You would add Timber the remaining $20,000 depletion to your Ⅺ 556 Examination of Returns, Appeal closing inventory of timber products. Rights, and Claims for Refund The term “timber property” means your eco- nomic interest in standing timber in each tract See chapter 17 for information about get- ting publications and forms. or block representing a separate timber ac- Choosing to treat the cutting of timber as count. a sale or exchange. You can choose, under You can figure timber depletion only by certain circumstances, to treat the cutting of the cost method. Percentage depletion does timber held for more than 1 year as a sale or not apply to timber. Base your depletion on exchange. You must make the choice on your Defined your cost or other basis in the timber. Your income tax return for the tax year it applies. A business bad debt is a loss from the cost does not include the cost of land. If you make this choice, subtract the adjusted worthlessness of a debt that was either of the Depletion takes place when you cut basis for depletion from the fair market value following. standing timber. You can figure your depletion of the timber on the first day of the tax year deduction when the quantity of cut timber is in which you cut it to figure the gain or loss first accurately measured in the process of to report on the cutting. You generally report • Created or acquired in your trade or exploitation. the gain as long-term capital gain. The fair business. market value then becomes your basis for • Closely related to your trade or business figuring your ordinary gain or loss on the sale when it became partly or totally Figuring cost depletion. To figure your cost or other disposition of the products cut from worthless. depletion allowance, you multiply the number the timber. For more information, see Timber of timber units cut by your depletion unit. in chapter 2 of Publication 544, Sales and The bad debts of a corporation are always Timber units. When you acquire timber Other Dispositions of Assets.. business bad debts. property, you must make an estimate of the A debt is closely related to your trade or quantity of marketable timber that exists on business if your primary motive for incurring the property. You measure the timber using Form T. Attach Form T, Forest Activities the debt is a business reason. board feet, log scale, cords, or other units. If Schedules, to your income tax return if you you later determine that you have more or are claiming a deduction for timber depletion Example. John Smith, an advertising less units of timber, you must adjust the ori- or choosing to treat the cutting of timber as agent, made loans to certain clients to keep ginal estimate. a sale or exchange. their business. His main reason for making Chapter 14 Business Bad Debts Page 51 these loans was to help his business. One of erwise, a loss from these debts is a nonbusi- take a business bad debt deduction, since his these clients later went bankrupt and could ness bad debt. guarantee was made in the course of his not repay him. Since John's business was the Debt acquired from a decedent. The trade or business for a good faith business main reason for making the loan, the debt character of a loss from debt of a business purpose. He was motivated by the desire to was a business debt and he can take a busi- acquired from a decedent is determined in the retain one of his better clients and keep a ness bad debt deduction. same way as a debt sold by a business. If you sales outlet. are in a trade or business, a loss from the When debt is worthless. You do not have debts is a business bad debt if the debts were Deductible in the year paid. You can to wait until a debt is due to determine closely related to your trade or business when deduct a payment you make on a loan you whether it is worthless. A debt becomes they became worthless. Otherwise, a loss guaranteed in the year of payment unless you worthless when there is no longer any chance from these debts is a nonbusiness bad debt. have rights against the borrower. that the amount owed will be paid. Liquidation. If you liquidate your busi- Rights against a borrower. When you It is not necessary to go to court if you can ness and some of your accounts receivable make payment on a loan you guaranteed, you show that a judgement from the court would become worthless, they are business bad may have the right to take the place of the be uncollectible. You must only show that you debts. lender. The debt is then owed to you. If you have taken reasonable steps to collect the have this right, or some other right to demand debt. Bankruptcy of your debtor is generally Debts of political parties. If a political party payment from the borrower, you cannot take good evidence of the worthlessness of at (or other organization that accepts contribu- a bad debt deduction until these rights be- least a part of an unsecured and unpreferred tions or spends money to influence elections) come partly or totally worthless. debt. owes you money and the debt becomes worthless, you cannot take a bad debt de- Bankruptcy claim. You can deduct as a bad Debts from sales or services. Business duction unless you use an accrual method of debt only the difference between the amount bad debts are mainly the result of credit sales accounting and meet all the following tests. owed to you by a bankrupt entity and the to customers. They can also be the result of amount you received from the distribution of loans to suppliers, clients, employees, or dis- 1) The debt was from the sale of goods or its assets. tributors. Goods and services customers have services in the ordinary course of your not paid for are shown in your books as either trade or business. Sale of mortgaged property. If mortgaged or pledged property is sold for less than the accounts receivable or notes receivable. If 2) More than 30% of all your receivables you are unable to collect any part of these debt, the unpaid, uncollectible balance of the accrued in the year of the sale were from debt after the sale is a bad debt. If the debt accounts or notes receivable, the uncollect- sales made to political parties. ible part is a business bad debt. Accounts or represents capital or an amount you previ- notes receivable valued at fair market value 3) You made substantial continuing efforts ously included in income, you can deduct it at the time of the transaction are deductible to collect on the debt. as a bad debt in the year it becomes totally only at that fair market value, even though the worthless or in the year you charged it off as value may be less than face value. Loan or capital contribution. You cannot partially worthless. You can take a bad debt deduction for take a bad debt deduction for a loan you these accounts and notes receivable only if made to a corporation if, based on the facts Recovery of bad debt. If you deduct a bad the amount owed you was included in your and circumstances, the loan is actually a debt and later recover (collect) all or part of gross income for the year the deduction is contribution to capital. it, you may have to include all or part of the claimed or for a prior year. This applies to recovery in gross income. The amount you amounts owed you from all sources of taxable Debts of an insolvent partner. If your include is limited to the amount you actually income, such as sales, services, rents, and business partnership breaks up and one of deducted. However, you can exclude the interest. your former partners is insolvent and cannot amount deducted that did not reduce your tax. If you qualify under certain rules, you can pay any of the partnership's debts, you may Report the recovery as “Other income” on the use the nonaccrual-experience method of have to pay more than your share of the appropriate business form or schedule. accounting discussed later. Under this partnership's debts. If you pay any part of the Example. In 1998, the Willow Corporation method, you do not have to accrue income insolvent partner's share of the debts, you can had gross income of $158,000, a bad debt that, based on your experience, you expect take a bad debt deduction. deduction of $3,500, and other allowable de- to be uncollectible. ductions of $49,437. The corporation reported Accrual method taxpayers. Accrual Business loan guarantee. If you guarantee on the accrual method of accounting and method taxpayers normally report income as a debt that becomes worthless, the debt can used the specific charge-off method for bad they earn it. They can take a bad debt de- qualify as a business bad debt if all the fol- debts. The entire bad debt deduction reduced duction for an uncollectible receivable if they lowing requirements are met. the tax on the 1998 corporate return. In 1999, have included the uncollectible amount in in- the corporation recovers part of the $3,500 come. • You made the guarantee in the course deducted in 1998. It must include the part Cash method taxpayers. Cash method of your trade or business. recovered in income for 1999 as “Other in- taxpayers normally report income when they come” on its corporate return. receive payment. They cannot take a bad • You have a legal duty to pay the debt. debt deduction for amounts owed to them that • You made the guarantee before the debt Net operating loss (NOL) carryover. If they have not received and cannot collect became worthless. You meet this re- a bad debt deduction increases an NOL car- because they never included those amounts quirement if you reasonably expected ryover that has not expired before the begin- in income. that you would not have to pay the debt ning of the tax year in which the recovery without full reimbursement from the takes place, you treat the deduction as having Debts from a former business. If you sell issuer. reduced your tax. A bad debt deduction that your business but keep its accounts receiv- • You receive reasonable consideration for contributes to a net operating loss helps lower able, these debts are business debts since making the guarantee. You meet this taxes in the year to which you carry the net they arose in your trade or business. If an requirement if you made the guarantee operating loss. account becomes worthless, the loss is a in accord with normal business practice See Publication 536 for more information business bad debt. These accounts would or for a good faith business purpose. about net operating losses. also be business debts if sold to the new More information. See Recoveries in owner of the business. Consider any guarantee you make to Publication 525 for more information on re- If you sell your business to one person protect or improve your job as closely related covered amounts. and sell your accounts receivable to someone to your trade or business as an employee. else, the character of the debts as business Property received for debt. If you receive or nonbusiness is based on the activities of Example. Bob Zayne owns the Zayne property in partial settlement of a debt, reduce the new holder of these debts. A loss from the Dress Company. He guaranteed payment of the debt by the fair market value of the prop- debts is a business bad debt to the new a $20,000 note for Elegant Fashions, a dress erty received. You can deduct the remaining holder if that person acquired the debts in his outlet. Elegant Fashions is one of Zayne's debt as a bad debt in the year you determine or her trade or business or if the debts were largest clients. Elegant Fashions later filed for it is worthless. closely related to the new holder's trade or bankruptcy and defaulted on the loan. Mr. If you later sell the property, any gain on business when they became worthless. Oth- Zayne made full payment to the bank. He can the sale is due to the appreciation of the Page 52 Chapter 14 Business Bad Debts property after it was used to partially settle the • 3 years from the date you filed your ori- al-experience method from a different ac- debt. You must include any gain from the sale ginal return. counting method. in gross income. The gain is not a recovery For more information on the separate of a bad debt. For information on the sale of • 2 years from the date you paid the tax. receivable system, see section 1.448–2T of an asset, see Publication 544. However, see Publication 556 for information the regulations. For more information on the on suspending the time period for filing a periodic system, see Notice 88–51 in Cumu- claim when you are physically or mentally lative Bulletin 1988–1. unable to handle your financial affairs. How To Treat Use one of the following forms to file a claim for a credit or refund. There are two ways to treat business bad debts. Where To Deduct If you are an: File: Use the following guide to find where to de- • The specific charge-off method. Individual Form 1040X duct your business bad debts. • The nonaccrual-experience method. Corporation Form 1120X S corporation Form 1120S (check box F(4)) If you are a: Then deduct your bad debt on: Generally, you must use the specific charge- Partnership Form 1065 (check box G(4)) off method. However, you can use the non- Sole Proprietor Line 9 of Schedule C accrual-experience method if you meet the For more information about filing a claim, see (Form 1040) requirements discussed later. Publication 556. or Line 2 of Schedule C–EZ (Form 1040) Specific Charge-Off Method Nonaccrual-Experience Farmer Line 34 of Schedule F (Form 1040) If you use the specific charge-off method, you Method can deduct specific business bad debts that Corporation Line 15 or Form 1120 If you use an accrual method of accounting or become either partly or totally worthless dur- and qualify under the rules explained in this Line 15 of Form 1120–A ing the tax year. section, you can use the nonaccrual- or experience method of accounting for bad Line 10 of Form 1120S Partly worthless debts. You can deduct debts. Under this method, you do not accrue Partnership Line 12 of Form 1065 specific bad debts that are partly uncollect- income that you expect to be uncollectible. ible. Your deduction is limited to the amount If you determine, based on your experi- you charge-off on your books during the tax ence, that certain amounts (accounts receiv- year. You do not have to charge-off and de- able) are uncollectible, do not include them in duct your partly worthless debts annually. You your gross income for the tax year. can delay the charge-off until a later year. You cannot, however, deduct any part of a debt Amounts must be for performing services. after the year it becomes totally worthless. You can use the nonaccrual-experience 15. Deduction disallowed. You can gener- method only for amounts earned by perform- ally take a partial bad debt deduction only in ing services that you would otherwise include the year you make the charge-off on your in income. You cannot use this method for Electric and books. If the Internal Revenue Service (IRS) amounts owed to you from activities such as does not allow your deduction and the debt lending money, selling goods, or acquiring Clean-Fuel becomes partly worthless in a later tax year, receivables or other rights to receive pay- you can deduct the amount you charge-off in ments. Vehicles that year plus the amount charged off in the earlier year. The charge-off in the earlier year, Interest or penalty charged. Generally, you unless reversed on your books, fulfills the cannot use the nonaccrual-experience charge-off requirement for the later year. method for amounts due on which you charge interest or a late payment penalty. However, Introduction Totally worthless debts. Deduct a totally do not treat a discount offered for early pay- You are allowed a limited deduction for the worthless debt only in the tax year it becomes ment as the charging of interest or a penalty cost of clean-fuel vehicle property and clean- totally worthless. Do not include any amount if both of the following apply. fuel vehicle refueling property you place in deducted in an earlier tax year when the debt service during the tax year. Also, you are al- was only partly worthless. • You otherwise accrue the full amount due lowed a tax credit of 10% of the cost of any You do not have to make an actual as gross income at the time you provide qualified electric vehicle you place in service charge-off on your books to claim a bad debt the services. during the tax year. deduction for a totally worthless debt. How- • You treat the discount allowed for early ever, you may want to do so. If you do not payment as an adjustment to gross in- You can take the electric vehicle and the IRS later rules the debt is only partly come in the year of payment. TIP credit or the deduction for clean-fuel worthless, you will not be allowed a deduction vehicle property regardless of for the debt in that tax year. A deduction of How to apply this method. You can apply whether you use the vehicle in a trade or a partly worthless bad debt is limited to the business. However, you can take a deduction amount actually charged-off. the nonaccrual-experience method under ei- ther of the following systems. for clean-fuel vehicle refueling property only if you use the property in your trade or busi- Filing a claim for refund. If you did not de- • Separate receivable system. ness. duct a bad debt on your original return for the year it became worthless, you can file a claim • Periodic system. for a credit or refund. If the bad debt was totally worthless, you must file the claim by Under the separate receivable system, apply Topics the later of the following dates. the nonaccrual-experience method separately This chapter discusses: to each account receivable. Under the peri- • 7 years from the date your original return odic system, apply the nonaccrual-experience • The deduction for clean-fuel vehicle was due (not including extensions). method to total qualified accounts receivable property at the end of your tax year. • 2 years from the date you paid the tax. Treat each system as a separate method • The deduction for clean-fuel vehicle re- of accounting. You generally cannot change fueling property from one system to the other without IRS • Recapture of the deductions If the claim is for a partially worthless bad approval. • The electric vehicle credit debt, you must file the claim by the later of the Generally, you also need IRS approval to following dates. change to either system under the nonaccru- • Recapture of the credit Chapter 15 Electric and Clean-Fuel Vehicles Page 53 Useful Items to be propelled by a clean-burning fuel. Deduction for Clean-Fuel You may want to see: The only part of a vehicle's basis that qualifies for the deduction is the part at- Vehicle Refueling Property tributable to: Publication For your property to qualify for this deduction: a) A clean-fuel engine that can use a 1) It must be depreciable property, and Ⅺ 463 Travel, Entertainment, Gift, and clean-burning fuel, Car Expenses 2) Its original use must begin with you. b) The property used to store or de- Ⅺ 544 Sales and Other Dispositions of liver the fuel to the engine, or However, see Nonqualifying property, Assets earlier. c) The property used to exhaust gases Ⅺ 946 How To Depreciate Property from the combustion of the fuel. Clean-fuel vehicle refueling property. Clean-fuel vehicle refueling property is any Form (and Instructions) 2) Any property installed on a motor vehicle (including installation costs) to enable it property (other than a building or its structural components) used to do either of the follow- Ⅺ 8834 Qualified Electric Vehicle Credit to be propelled by a clean-burning fuel if: ing. See chapter 17 for information about get- ting publications and forms. a) The property is an engine (or mod- 1) Store or dispense a clean-burning fuel ification of an engine) that can use into the fuel tank of a motor vehicle pro- a clean-burning fuel, or pelled by the fuel, but only if the storage or dispensing is at the point where the b) The property is used to store or fuel is delivered into the tank. Deductions for deliver that fuel to the engine or to exhaust gases from the combustion 2) Recharge motor vehicles propelled by Clean-Fuel Vehicle of that fuel. electricity, but only if the property is lo- cated at the point where the vehicles are recharged. and Refueling For vehicles that may be propelled by both Property a clean-burning fuel and any other fuel, your For the definition of a motor vehicle, see deduction is generally the additional cost of Deduction for Clean-Fuel Vehicle Property, You are allowed a limited deduction for the permitting the use of the clean-burning fuel. earlier. cost of clean-fuel vehicle property. You are Recharging property. This property in- also allowed a limited deduction for the cost Clean-fuel vehicle property does not cludes any equipment used to provide elec- of clean-fuel vehicle refueling property. These include an electric vehicle that quali- ! tricity to the battery of a motor vehicle pro- deductions are allowed only in the tax year CAUTION fies for the electric vehicle credit dis- pelled by electricity. It includes low-voltage you place the property in service. cussed later. recharging equipment, high-voltage (quick) You cannot claim these deductions for the charging equipment, and ancillary connection part of a property's cost that you claim as a Motor vehicle defined. A motor vehicle is equipment such as inductive charging equip- section 179 deduction. any vehicle that has four or more wheels and ment. It does not include property used to is manufactured primarily for use on public generate electricity, such as solar panels or Nonqualifying property. You cannot claim streets, roads, and highways. It does not in- windmills, and does not include the battery these deductions for property used in the fol- clude a vehicle operated exclusively on a rail used in the vehicle. lowing ways. or rails. Deduction limit. The maximum deduction 1) Predominantly outside the United States. Qualified property. For your property to you can claim for clean-fuel vehicle refueling 2) Predominantly to furnish lodging or in qualify for the deduction: property placed in service at one location is connection with the furnishing of lodging. $100,000. To figure your maximum deduction 1) It must be acquired for your own use and for any tax year, subtract from $100,000 the 3) By certain tax-exempt organizations. not for resale, total you (or any related person or prede- cessor) claimed for clean-fuel vehicle refuel- 4) By governmental units or foreign per- 2) Its original use must begin with you, and ing property placed in service at that location sons or entities. for all earlier years. 3) Either— Clean-burning fuels. The following are If the deduction limit applies, you must clean-burning fuels. a) The motor vehicle of which it is a ! specify on your tax return the property part must satisfy any federal or CAUTION (and portions of the property's cost) 1) Natural gas. state emissions standards that ap- that you are using as a basis for the de- ply to each fuel by which the vehicle duction. 2) Liquefied natural gas. is designed to be propelled, or Related persons. For this purpose, re- 3) Liquefied petroleum gas. b) It must satisfy any federal and state lated persons include the following persons. emissions certification, testing, and 4) Hydrogen. warranty requirements that apply. 1) An individual and his or her brothers and 5) Electricity. sisters, half-brothers, half-sisters, However, see Nonqualifying property, spouse, ancestors, and lineal descend- 6) Any other fuel that is at least 85% alco- earlier. ants. hol (any kind) or ether. 2) An individual and a corporation when the Deduction limit. The maximum deduction individual owns, directly or indirectly, Deduction for Clean-Fuel you can claim for qualified clean-fuel vehicle more than 50% in value of the out- property with respect to any motor vehicle is: Vehicle Property standing stock of the corporation. The deduction for this property may be 1) $50,000 for a truck or van with a gross 3) Two corporations that are members of claimed regardless of whether the property is vehicle weight rating over 26,000 pounds the same controlled group as defined in used in a trade or business. or for a bus with a seating capacity of section 267(f) of the Internal Revenue at least 20 adults (excluding the driver), Code. Clean-fuel vehicle property. Clean-fuel ve- 2) $5,000 for a truck or van with a gross 4) A grantor and a fiduciary of any trust. hicle property is either of the following kinds vehicle weight rating over 10,000 pounds 5) Fiduciaries of two separate trusts if the of property. but not more than 26,000 pounds, or same person is a grantor of both trusts. 1) A motor vehicle produced by an original 3) $2,000 for a vehicle not included in (1) 6) A fiduciary and a beneficiary of the same equipment manufacturer and designed or (2). trust. Page 54 Chapter 15 Electric and Clean-Fuel Vehicles 7) A fiduciary and a beneficiary of two clean-fuel vehicle property is used partly for • 662/ 3 % if the recapture date is within the separate trusts if the same person is a nonbusiness purposes, claim the nonbusi- second full year after the date the vehicle grantor of both trusts. ness part of the deduction as explained ear- was placed in service. lier under Nonbusiness use of clean-fuel ve- 8) A fiduciary of a trust and a corporation 1 3 hicle property by individuals. • 33 / % if the recapture date is within the when the trust or a grantor of the trust third full year after the date the vehicle owns, directly or indirectly, more than was placed in service. Partnerships. Partnerships claim the de- 50% in value of the outstanding stock duction for the business use of clean-fuel ve- of the corporation. Recapture date. The recapture date is hicle and clean-fuel vehicle refueling property generally the date of the event that causes 9) A person and a tax-exempt educational on line 20 of Form 1065. the recapture. However, the recapture date or charitable organization that is con- for an event described in item (3), earlier, is trolled directly or indirectly by that person S corporations. S corporations claim the the first day of the recapture year in which the or by members of the family of that per- deduction for the business use of clean-fuel event occurs. son. vehicle and clean-fuel vehicle refueling prop- erty on line 19 of Form 1120S. 10) A corporation and a partnership if the How to report. How you report the recapture same persons own more than 50% in amount for clean-fuel vehicle property as in- value of the outstanding stock of the Other corporations. Corporations claim the come depends on how you claimed the de- corporation and more than 50% of the deduction for the business use of clean-fuel duction for that property. capital or profits interest in the partner- vehicle and clean-fuel vehicle refueling prop- Nonbusiness use by individuals. In- ship. erty on line 26 of Form 1120 (line 22 of Form clude the amount on line 21 of Form 1040. 1120–A). Business use by employees. Include 11) Two S corporations or an S corporation the amount on line 21 of Form 1040. and a regular corporation if the same Business use by sole proprietors. In- persons own more than 50% in value of Recapture of clude the amount on the Other income line the outstanding stock of each corpo- the Deductions of either Schedule C (Form 1040) or Sched- ration. If the property ceases to qualify, you may ule F (Form 1040). 12) A partnership and a person owning, di- have to recapture the deduction. You recap- Partnerships and corporations (includ- rectly or indirectly, more than 50% of the ture the deduction by including it, or a part of ing S corporations). Include the amount on capital or profits interest in the partner- it, in your income. the Other income line of the form you file. ship. 13) Two partnerships if the same persons Clean-Fuel Vehicle Property Clean-Fuel Vehicle own, directly or indirectly, more than You must recapture the deduction for clean- Refueling Property 50% of the capital or profits interest in fuel vehicle property if the property ceases to You must recapture the deduction for clean- both partnerships. qualify within 3 years after the date you fuel vehicle refueling property if the property ceases to qualify at any time before the end 14) An executor of an estate and a benefi- placed it in service. The property will cease of its depreciation recovery period. The ciary of the estate, except in the case to qualify if it: property will cease to qualify if it: of a sale or exchange in satisfaction of 1) Is modified so that it can no longer be a pecuniary bequest. propelled by a clean-burning fuel, 1) Ceases to be a clean-fuel vehicle refu- eling property (for example, by being To determine whether an individual di- 2) Ceases to be a qualified clean-fuel ve- converted to store and dispense gaso- rectly or indirectly owns any of the outstand- hicle property (for example, by failing to line), ing stock of a corporation, see Ownership of meet emissions standards), or stock, under Related Persons, in Publication 2) Is no longer used 50% or more in your 3) Is used— 538. trade or business, or a) Predominantly outside the United 3) Is used— States, How To Claim a) Predominantly outside the United b) Predominantly to furnish lodging or States, the Deductions in connection with the furnishing of How you claim the deductions for clean-fuel lodging, b) Predominantly to furnish lodging or vehicles and refueling property depends on in connection with the furnishing of c) By certain tax-exempt organiza- the use of the property and the kind of income lodging, tax return you file. tions, or c) By certain tax-exempt organiza- d) By governmental units or foreign tions, or Nonbusiness use of clean-fuel vehicle persons or entities. property by individuals. Individuals can d) By governmental units or foreign claim the deduction for the nonbusiness use Sales or other dispositions. If you sell or persons or entities. of clean-fuel vehicle property by including the otherwise dispose of the vehicle within 3 deduction in the total on line 32 of Form 1040. years after the date you placed it in service Sales or other dispositions. If you sell or Also, enter the amount of your deduction and and know or have reason to know that it will otherwise dispose of the property before the “Clean-Fuel” on the dotted line next to line 32. be used in a manner described above, you end of its recovery period and know or have If you use the vehicle partly for business, see are subject to the recapture rules. In other reason to know that it will be used in a man- the next two discussions. sales or dispositions (including a disposition ner described above, you are subject to the by reason of an accident or other casualty), recapture rules. In other sales or dispositions, Business use by employees. Employees the recapture rules do not apply. the recapture rules do not apply. who use clean-fuel vehicle property for busi- If the vehicle was subject to depreciation, The deduction (minus any recapture ness, or partly for business and partly for the deduction (minus any recapture) is con- amount) is considered depreciation when fig- nonbusiness purposes, should include the sidered depreciation when figuring the part uring the part of the gain that is ordinary in- entire deduction in the total on line 32 of Form of the gain that is ordinary income. See Pub- come upon its disposition. See Publication 1040. Also, enter the amount of your de- lication 544 for more information on disposi- 544 for more information on dispositions of duction and “Clean-Fuel” on the dotted line tions of depreciable property. depreciable property. next to line 32. Recapture amount. Figure your recapture Recapture amount. Figure your recapture Business use by sole proprietors. Individ- amount by multiplying the deduction by a re- amount by multiplying the deduction you uals who operate a business as a sole pro- capture percentage. The percentages are as claimed by the following fraction. prietor must claim their deduction for the follows. business use of clean-fuel vehicles and Total recovery period for _ Recovery years before clean-fuel vehicle refueling property on the • 100% if the recapture date is within the the property the recapture year Other expenses line of either Schedule C first full year after the date the vehicle (Form 1040) or Schedule F (Form 1040). If was placed in service. Total recovery period for the property Chapter 15 Electric and Clean-Fuel Vehicles Page 55 Recapture date. The recapture date is c) By certain tax-exempt organiza- c) By certain tax-exempt organiza- generally the date of the event that causes tions, or tions, or the recapture. However, the recapture date d) By governmental units or foreign for an event described in item (2) or (3), ear- d) By governmental units or foreign persons or entities. lier, is the first day of the recapture year in persons or entities. which the event occurs. Sales or other dispositions. If you sell or dispose of the vehicle within 3 years after the How to report. How you report the recapture Amount of the Credit date you place it in service and know or have amount for clean-fuel vehicle refueling prop- The credit is generally 10% of the cost of reason to know that it will be used in a man- erty depends on how you claimed the de- each qualified electric vehicle you place in ner described above, you are subject to the duction for that property. service during the year. If your vehicle is a recapture rules. In other sales or dispositions, Business use by sole proprietors. In- depreciable business asset, you must reduce the recapture rules do not apply. clude the amount on the Other income line the cost of the vehicle by any section 179 If the vehicle was subject to depreciation, of either Schedule C (Form 1040) or Sched- deduction before figuring the 10% credit. If the credit (minus any recapture amount) is ule F (Form 1040). you need information on the section 179 de- considered depreciation when figuring the Partnerships and corporations (includ- duction, see Publication 946. part of the gain that is ordinary income. See ing S corporations). Include the amount on Publication 544 for more information on dis- the Other income line of the form you file. Credit limits. The credit is limited to $4,000 for each vehicle. The total credit is limited to positions of depreciable property. the excess of your regular tax liability, re- Basis Adjustments duced by certain credits, over your tentative Recapture amount. Figure your recapture You must reduce the basis of your clean-fuel minimum tax. To figure the amount of credit amount by multiplying the credit by a recap- vehicle or clean-fuel vehicle refueling property you can take, complete Form 8834 and attach ture percentage. The percentages are as fol- by the amount of the deduction claimed. If, in it to your tax return. lows. a later year, you must recapture part or all of • 100% if the recapture date is within the the deduction, increase the basis of the first full year after the date the vehicle property by the amount recaptured. If the How To was placed in service. property is depreciable property, you can re- Claim the Credit cover this additional basis over the property's • 662/ 3 % if the recapture date is within the remaining recovery period beginning with the You must complete and attach Form 8834 to second full year after the date the vehicle tax year of recapture. your tax return to claim the electric vehicle was placed in service. credit. Enter your credit on your tax return as If you were using the percentage ta- discussed next. • 331/ 3 % if the recapture date is within the bles to figure your depreciation on the third full year after the date the vehicle ! was placed in service. CAUTION property, you will not be able to con- Individuals. Individuals claim the credit by tinue to do so. See Publication 946 for infor- entering the amount from line 19 of Form Recapture date. The recapture date is mation on figuring your depreciation without 8834 on line 47 of Form 1040. Check box generally the date of the event that causes the tables. “d” and specify Form 8834. the recapture. However, the recapture date for an event described in item (2), earlier, is Partnerships. Partnerships enter the the first day of the recapture year in which the amount from line 19 of Form 8834 on line 13 event occurs. of Schedule K (Form 1065). The partnership Electric Vehicle Credit then allocates the credit to the partners on How to report. How you report the recapture You can choose to claim a tax credit for a line 13 of Schedule K–1 (Form 1065). See the amount of the electric vehicle credit depends qualified electric vehicle you place in service instructions for Form 1065. on how the credit was claimed. during the year. You can make this choice Individuals. Include the amount on line regardless of whether the property is used in S corporations. S corporations enter the 56 of Form 1040. Write “QEVCR” on the dot- a trade or business. amount from line 19 of Form 8834 on line 13 ted line next to line 56. of Schedule K (Form 1120S). The S corpo- Partnerships. Include on line 25 of ration then allocates the credit to the share- Schedule K–1 (Form 1065) the information a Qualified Electric Vehicle holders on line 13 of Schedule K–1 (Form partner needs to figure the recapture of the A vehicle is a qualified electric vehicle if it 1120S). See the instructions for Form 1120S. credit. meets all of the following requirements. S corporations. Include on line 23 of Other corporations. Corporations other Schedule K–1 (Form 1120S) the information 1) It has at least four wheels and is manu- than S corporations claim the credit by en- a shareholder needs to figure the recapture factured primarily for use on public tering the amount from line 19 of Form 8834 of the credit. streets, roads, and highways. in the total for line 4c of Schedule J (Form Other corporations. Include the amount 2) It is powered primarily by an electric 1120) and checking the Form 8834 box to the on line 8 of Schedule J (Form 1120), or line motor drawing current from rechargeable left of the entry. See the instructions for Form 5 of Part I (Form 1120–A). Write “QEV re- batteries, fuel cells, or other portable 1120. capture” on the dotted line next to that entry sources of electrical current. space. 3) You were the first person to use it. Recapture of the Credit Basis Adjustments 4) You acquired it for your own use and not The electric vehicle credit is subject to re- for resale. capture if, within 3 years after the date you If you claim a tax credit for a qualified electric place the vehicle in service, it ceases to vehicle you place in service during the year, Generally, an electric vehicle is not qual- qualify for the electric vehicle credit. You re- you must reduce your basis in that vehicle by ified if it: capture the credit by adding it, or a part of it, the lesser of: to your income tax. 1) $4,000, or 1) Has ever been used as a nonelectric The vehicle ceases to qualify if it: vehicle, 2) 10% of the cost of the vehicle. 2) Is operated exclusively on a rail or rails, 1) Is modified so that it is no longer prima- or rily powered by electricity, or This basis reduction rule applies even if the credit allowed is less than that amount. 3) Is used— 2) Is used— If you must recapture part or all of the credit, increase the basis of your vehicle by a) Predominantly outside the United a) Predominantly outside the United the amount recaptured. If the qualified electric States, States, vehicle is depreciable property, you can re- b) Predominantly to furnish lodging or b) Predominantly to furnish lodging or cover the additional basis over the vehicle's in connection with the furnishing of in connection with the furnishing of remaining recovery period beginning with the lodging, lodging, tax year of recapture. Page 56 Chapter 15 Electric and Clean-Fuel Vehicles If you were using the percentage ta- Useful Items Accountable Plans bles to figure your depreciation on the ! You may want to see: To be an accountable plan, your reimburse- CAUTION vehicle, you will not be able to con- ment or allowance arrangement must require tinue to do so. See Publication 946 for infor- Publication mation on figuring your depreciation without your employees to meet all of the following the tables. rules. Ⅺ 463 Travel, Entertainment, Gift, and Car Expenses 1) They must have paid or incurred deductible expenses while performing Ⅺ 529 Miscellaneous Deductions services as your employees. Ⅺ 542 Corporations 2) They must adequately account to you for Ⅺ 946 How To Depreciate Property these expenses within a reasonable pe- riod of time. 16. Ⅺ 1542 Per Diem Rates 3) They must return any excess re- Form (and Instructions) imbursement or allowance within a rea- Other Expenses sonable period of time. Ⅺ Sch A (Form 1040) Itemized Deductions An arrangement under which you advance money to employees is treated as meeting (3) Ⅺ 1099–MISC Miscellaneous Income above only if the following requirements are also met. Important Change Ⅺ 6069 Return of Excise Tax on Excess Contributions to Black Lung Ben- for 1999 efit Trust Under Section 4953 and • The advance is reasonably calculated not Computation of Section 192 De- to exceed the amount of anticipated ex- duction penses. Standard mileage rate. The standard mile- age rate for the cost of operating your car, See chapter 17 for information about get- • You make the advance within a reason- van, pickup, or panel truck in 1999 is 321/2 ting forms and publications. able period of time. cents a mile for all business miles driven be- fore April 1. The rate is 31 cents a mile for Reasonable period of time. A rea- business miles driven after March 31. See TIP sonable period of time depends on chapter 5. the facts and circumstances. Gener- Travel, Meals, ally, you can consider the period reasonable if your employees adequately account for the and Entertainment expenses within 60 days after they pay or Important Changes To be deductible, expenses incurred for incur them and if they return any excess re- travel, meals, and entertainment must be or- imbursement within 120 days after they pay for 2000 dinary and necessary expenses of carrying or incur the expense. Also, the period is con- on your trade or business. Generally, you also sidered reasonable if you give your employ- must show that entertainment expenses (in- ees a periodic statement (at least quarterly) Meal expense deduction subject to “hours cluding meals) are directly related to, or as- that asks them to either return or adequately of service” limits. For 2000, this deduction sociated with, the conduct of your trade or account for outstanding amounts and they do increases to 60% of the reimbursed meals business. so within 120 days of the statement. An ad- your employees consume while they are The following discussion explains how you vance made to an employee within 30 days subject to the Department of Transportation's deduct any reimbursements or allowances of the time he or she has an expense is con- “hours of service” limits. For more information, you make for these expenses incurred by sidered made within a reasonable period. see Meal expenses when subject to “hours your employees. If you are self-employed and of service” limits, later. incur these expenses yourself, see Publica- tion 463 for information on how you can de- Standard mileage rate. The standard mile- duct them. age rate for the cost of operating your car, van, pickup, or panel truck in 2000 is 32.5 If any expenses reimbursed under this cents per mile for each business mile. Reimbursements arrangement are not substantiated, or are an excess reimbursement that is not returned How you deduct a reimbursement or allow- within a reasonable period of time by an em- ance arrangement (including per diem allow- ployee, you cannot treat these expenses as ances, discussed later) for travel, meals, and reimbursed under an accountable plan. In- Introduction entertainment expenses incurred by your stead, treat the reimbursed expenses as paid This chapter covers some expenses you as employees depends on whether you have an under a nonaccountable plan, discussed a business owner may have that are not ex- accountable plan or a nonaccountable plan. later. plained in earlier chapters of this publication. A reimbursement or allowance arrange- ment is a system by which you pay advances, reimbursements, and charges for your em- How to deduct. You can take a deduction Topics ployees' business expenses and they sub- for travel, meals, and entertainment if you This chapter discusses: stantiate their expenses to you so you can reimburse your employees for these ex- substantiate your deduction of the advance, penses under an accountable plan. The • Travel, meals, and entertainment reimbursement, or charge. If you make a amount you deduct for meals and enter- single payment to your employees and it in- tainment, however, may be subject to a 50% • Bribes and kickbacks cludes both wages and an expense re- limit, discussed later. If you are a sole pro- • Charitable contributions imbursement, you must specify the amount prietor, deduct the reimbursement on line 24 of the reimbursement. of Schedule C (Form 1040). If you file a cor- • Education expenses If you reimburse these expenses under poration income tax return, include the re- • Franchises, trademarks, and trade an accountable plan, deduct them as travel, imbursement in the amount claimed on the names meal, and entertainment expenses. If you “Other deductions” line of Form 1120 or Form reimburse these expenses under a nonac- 1120–A. If you file any other income tax re- • Lobbying expenses countable plan, you must report the re- turn, such as a partnership or S corporation imbursements as wages on Form W–2 and return, deduct the reimbursement on the ap- • Penalties and fines deduct them as wages. See Table 16–1, Re- propriate line of the return as provided in the • Repayments (claim of right) porting Reimbursements. instructions for that return. Chapter 16 Other Expenses Page 57 Table 16-1. Reporting Reimbursements High-low method. This is a simplified method of computing the federal per diem If the type of reimbursement (or other rate for lodging and meal expenses for trav- eling within the continental United States. It expense allowance) arrangement is eliminates the need to keep a current list of under: Then the employer reports on Form W-2: the per diem rate in effect for each city in the continental United States. An accountable plan with: Under the high-low method, the per diem amount for travel during 1999 is $185 for Actual expense reimbursement: No amount. certain locations. All other areas have a per Adequate accounting made and excess diem amount of $115. The areas eligible for returned the $185 per diem amount under the high-low method are listed in Publication 1542. Actual expense reimbursement: The excess amount as wages in box 1. Adequate accounting and return of excess Reporting per diem and car allowances. both required but excess not returned The following paragraphs explain how to re- port per diem and car allowances. The man- Per diem or mileage allowance up to the No amount. ner in which you report them depends on how federal rate: the amount of the allowance compares to the Adequate accounting and excess returned federal rate. Allowance LESS than or EQUAL to the Per diem or mileage allowance up to the The excess amount as wages in box 1. The federal rate. If your allowance for the em- federal rate: amount up to the federal rate is reported ployee is less than or equal to the appropriate Adequate accounting and return of excess only in box 13—it is not reported in box 1. federal rate, that allowance is not part of the both required but excess not returned employee's pay. Deduct the allowance as travel expenses (including meals that may be Per diem or mileage allowance exceeds the The excess amount as wages in box 1. The subject to the 50% limit, discussed later). See federal rate: amount up to the federal rate is reported How to deduct under Accountable Plans, Adequate accounting up to the federal rate only in box 13—it is not reported in box 1. earlier. only and excess not returned Allowance MORE than the federal rate. If your employee's allowance is more than the A nonaccountable plan with: appropriate federal rate, you must report the allowance as two separate items. Either adequate accounting or return of The entire amount as wages in box 1. You include the allowance amount up to the federal rate in box 13 (code L) of the excess, or both, not required by plan employee's Form W–2. Deduct it as travel expenses (as explained above). This part of No reimbursement plan The entire amount as wages in box 1. the allowance is treated as reimbursed under an accountable plan. You include the allowance amount that is Per Diem and Car Allowances can read Revenue Procedure 98–63 at many public libraries. more than the federal rate in box 1 (and in You may reimburse your employees under boxes 3 and 5 if they apply) of the employee's an accountable plan based on travel days, Form W–2. Deduct it as wages subject to in- miles, or some other fixed allowance. In Per diem allowance. If your employee ac- come tax withholding, social security, Medi- these cases, your employee is considered to tually substantiates to you the other elements care, and federal unemployment taxes. This have accounted to you for the amount of the (discussed earlier) of the expenses reim- part of the allowance is treated as reimbursed expense that does not exceed the rates es- bursed using the per diem allowance, how under a nonaccountable plan as explained tablished by the federal government. Your you report and deduct the allowance depends later under Nonaccountable Plans. employee must actually substantiate to you on whether the allowance is for lodging and the other elements of the expense, such as meal expenses or for meal expenses only and Meals and Entertainment time, place, and business purpose. whether the allowance is more than the fed- eral rate. The federal rate can be figured Under an accountable plan, you can generally using any one of the following methods. deduct only 50% of any otherwise deductible Car allowance. Your employee is consid- business-related meal and entertainment ex- ered to have accounted to you for car ex- 1) The regular federal per diem rate. penses that you reimburse your employees. penses that do not exceed the standard The deduction limit applies even if you reim- mileage rate. For 1999, the standard mileage 2) The standard meal allowance. burse them for 100% of the expenses. rate is 32.5 cents for all business miles in- curred for the period January 1 to March 31. 3) The high-low method. Application of the 50% limit. The 50% de- For the period April 1 to December 31, 1999, duction limit applies to reimbursements you the standard rate is 31 cents per mile for each Regular federal per diem rate. The make to your employees for expenses they business mile. The standard mileage rate is regular federal per diem rate is the highest incur while traveling away from home on considered to be the federal rate. If the car amount that the federal government will pay business and for entertaining business cus- allowance you pay is equal to or less than the to its employees for lodging, meal, and inci- tomers at your place of business, a restau- standard mileage rate, see Allowance LESS dental expenses (or meal and incidental ex- rant, or other location. It applies to attending than or EQUAL to the federal rate, later. If the penses only) while they are traveling away a business convention or reception, business car allowance you pay is more than the from home in a particular area. The rates are meeting, or business luncheon at a club. The standard mileage rate, see Allowance MORE different for different locations. Publication deduction limit may also apply to meals you than the federal rate, later. 1542 lists the rates in the continental U.S. furnish on your premises to your employees You can choose to reimburse your em- The federal rates for meal and incidental (discussed in chapter 3). ployees using a fixed and variable rate expenses are the same as those rates dis- Related expenses. Taxes and tips relat- (FAVR) allowance. This is an allowance that cussed under Standard Meal Allowance in ing to a meal or entertainment activity that you includes a combination of payments covering chapter 1 in Publication 463. reimburse to your employee under an ac- fixed and variable costs, such as a cents- Standard meal allowance. For an al- countable plan are included in the amount per-mile rate to cover your employees' vari- lowance for meal expenses only, the federal that is subject to the 50% limit. Reimburse- able operating costs (such as gas, oil, etc.) rate is the standard meal allowance (see ments you make for expenses, such as cover plus a flat amount to cover your employees' chapter 1 in Publication 463). You may pay charges for admission to a nightclub, rent fixed costs (such as depreciation, insurance, an allowance for meal expenses only if, for paid for a room to hold a dinner or cocktail etc.). For information on using a FAVR al- example, you reimburse actual lodging ex- party, or the amount you pay for parking at a lowance, see Revenue Procedure 98–63 in penses or do not reimburse lodging expenses sports arena, are all subject to the 50% limit. Internal Revenue Bulletin No. 1998–52. You because there are none. However, the cost of transportation to and Page 58 Chapter 16 Other Expenses from a business meal or entertainment activity providing the food and beverages. These ex- some minor social activities, but the main that is otherwise allowable is not subject to penses are subject to the 50% limit unless purpose of the meeting must be your com- the 50% limit. they qualify as de minimis fringe benefits, pany's business. These expenses are subject discussed in chapter 4, or unless they are to the 50% limit. How to apply the 50% limit. If you provide compensation to your employees and you your employees with a per diem allowance treat them as provided under a nonaccount- Trade association meetings. You can de- (discussed earlier) only for meal and inci- able plan, as discussed later. duct expenses directly related to and neces- dental expenses, the amount treated as an sary for attending business meetings or con- expense for food and beverages is the lesser Employee activities. You can deduct the ventions of certain exempt organizations. of the following. expense of providing recreational, social, or These organizations include business similar activities (including the use of a facil- leagues, chambers of commerce, real estate • The per diem allowance. ity) for your employees. The benefit must be boards, and trade and professional associ- • The federal meal and incidental expense primarily for your employees who are not ations. These expenses are subject to the rate (M & IE). highly compensated employees. The defi- 50% limit. nition of a highly compensated employee is If you provide your employee with a per the same as the one given in chapter 4 under Sale of meals or entertainment. You can diem allowance that covers lodging, meals, Exclusion of Certain Fringe Benefits, with the deduct the cost of providing meals, enter- and incidental expenses, you must treat an following exceptions. tainment, goods and services, or use of facil- amount equal to the federal M & IE rate for ities that you sell to the public. For example, the area of travel as an expense for food and • An employee owning less than a 10% if you run a nightclub, your expense for the beverages. If you use the high-low method, interest in your business is not consid- entertainment you furnish to your customers, the federal M & IE rate is treated as $42 for ered a shareholder or other owner. such as a floor show, is a business expense. a high-cost locality and $34 for any other lo- • An employee is treated as owning any These expenses are not subject to the 50% cality. If the per diem allowance you provide interest owned by a family member. limit. for a full day of travel is less than the federal Family members include brothers, sis- per diem rate for the area of travel, you can ters, a spouse, ancestors, and lineal de- Advertising to promote goodwill. You can treat 40% of the per diem allowance as the scendants. deduct the cost of providing meals, enter- amount for food and beverages. tainment, or recreational facilities to the gen- These expenses are not subject to the eral public as a means of advertising or pro- Drilling rigs. The 50% limit does not apply 50% limit. For example, the expenses for moting goodwill in the community. For to the food or beverages an employer pro- food, beverages, and entertainment for a example, the expense of sponsoring a tele- vides on an oil or gas platform or drilling rig company-wide picnic are not subject to the vision or radio show is deductible. You can located offshore or in Alaska. This exception 50% limit. also deduct the expense of distributing free also applies to food and beverages provided food and beverages to the general public. by an employer at a support camp that is near Nonaccountable Plans These expenses are not subject to the 50% and integral to an oil or gas drilling rig located limit. in Alaska. A nonaccountable plan is an arrangement that does not meet the requirements for an accountable plan. All amounts paid, or treated Charitable sports event. The 50% limit Meal expenses when subject to “hours of does not apply to the expenses covered by service” limits. You can deduct 55% of the as paid, under a nonaccountable plan are reported as wages on Form W–2. The pay- a package deal that includes a ticket to a reimbursed meals your employees consume charitable sports event if the event meets while away from their tax home on business ments are subject to income tax withholding, social security, Medicare, and federal unem- certain conditions. See Entertainment tickets during or incident to any period subject to the in chapter 2 of Publication 463 for a list of the Department of Transportation's hours of ser- ployment taxes. You can deduct the re- imbursement as compensation or wages only conditions a charitable sports event must vice limits. The percentage increases to 60% meet. for 2000. to the extent it meets the deductibility tests for Individuals subject to the Department of employees' pay in chapter 2. Deduct the al- Transportation's hours of service limits in- lowable amount as compensation or wages clude the following. on the appropriate line of your income tax return, as provided in its instructions. Miscellaneous • Certain air transportation workers (such as pilots, crew, dispatchers, mechanics, Other Reimbursed Expenses Expenses and control tower operators) who are You may provide meals and entertainment In addition to travel, meal, and entertainment under Federal Aviation Administration expenses to individuals who are not your expenses, there are other expenses you can regulations. employees. These expenses may or may not deduct. This section briefly covers some of • Interstate truck operators and bus drivers be subject to the 50% limit, depending on the these expenses (listed in alphabetical order). who are under Department of Transpor- circumstances. tation regulations. Advertising expenses. You generally can • Certain railroad employees (such as en- Nonemployee. If you provide a person who deduct reasonable advertising expenses if gineers, conductors, train crews, dis- is not your employee with meals, goods, ser- they relate to your business activities. Gen- patchers, and control operations person- vices, or the use of a facility and the item you erally, you cannot deduct the cost of adver- nel) who are under Federal Railroad provide is considered entertainment, you can tising to influence legislation. See Lobbying Administration regulations. deduct the expense only to the extent it is expenses, later. included in the gross income of the recipient You can usually deduct as a business • Certain merchant mariners who are under as compensation for services or as a prize expense the cost of institutional or “good Coast Guard regulations. or award. If you are required to include these will” advertising to keep your name before the expenses on an information return (Form public if it relates to business you reasonably De minimis (minimal) fringe benefit. The 1099–MISC), you cannot claim a deduction expect to gain in the future. For example, the 50% limit does not apply to an expense for for them unless you file the necessary infor- cost of advertising that encourages people to food or beverage that is excluded from the mation return. For more information about contribute to the Red Cross, to buy U.S. gross income of an employee because it is a when to file Form 1099–MISC, see the sepa- Saving Bonds, or to participate in similar de minimis fringe benefit. See chapter 4 for rate Instructions for Forms 1099, 1098, 5498, causes is usually deductible. additional information on de minimis fringe and W–2G. These expenses are not subject Foreign expenses. You cannot deduct benefits. to the 50% limit. the costs of advertising on foreign radio and television (including cable) where the adver- Company cafeteria or executive dining Director, stockholder, or employee tising is primarily for a market in the United room. You can deduct the cost of food and meetings. You can deduct entertainment States. However, this rule only applies to ad- beverages you provide primarily to your em- expenses directly related to business vertising expenses in countries that deny a ployees on your business premises. This in- meetings of your employees, partners, stock- deduction for advertising on a United States cludes the cost of maintaining the facilities for holders, agents, or directors. You can provide broadcast primarily for that country's market. Chapter 16 Other Expenses Page 59 Anticipated liabilities. Anticipated liabilities captains and chief officers of vessels it re- tory's basis is zero and you cannot claim a or reserves for anticipated liabilities are not pairs. It considers kickbacks necessary to get charitable contribution deduction. Treat the deductible. For example, assume you sold business. The owners of the ships do not inventory's cost as you would ordinarily treat 1-year TV service contracts this year totaling know of these payments. it under your method of accounting. For ex- $50,000. From experience, you know you will In the state where the corporation oper- ample, include the purchase price of inventory have expenses of about $15,000 in the com- ates, it is unlawful to attempt to influence the bought and donated in the same year in the ing year for these contracts. You cannot de- actions of any employee, private agent, or cost of goods sold for that year. duct any of the $15,000 this year by charging fiduciary in relation to the principal's or em- A corporation (other that an S corporation) expenses to a reserve or liability account. You ployer's affairs by giving or offering anything can deduct its basis in the property plus 1/2 can deduct your expenses only when you of value without the knowledge and consent of the gain that would have been realized if actually pay or accrue them, depending on of the principal or employer. The state gen- the property had been sold at its fair market your accounting method. erally enforces the law. The kickbacks paid value on the date of contributions. But the by the Yard Corporation are not deductible. deduction cannot be more than twice the Black lung benefit trust contributions. If property's basis. For more information on the you, as a coal mine operator, make a contri- Medicare or Medicaid. Kickbacks, charitable contribution of property by a cor- bution to a qualified black lung benefit trust, bribes, and rebates paid in Medicare or poration, see section 170(e)(3) of the Internal you may be able to deduct your contribution. Medicaid programs are not deductible. Revenue Code. To deduct it, you must make your contribution Form 1099–MISC. If you pay kickbacks during the tax year or pay it to the trust by the during your tax year, whether or not they are Example 1. You own an auto repair shop due date for filing your federal income tax deductible on your return, include them when and in 1999 you donated auto parts to your return (including extensions). You must make figuring if you must file an information return, local school for its auto repair class. The fair the contribution in cash or in property the trust Form 1099–MISC. For more information market value of the parts at the time of the is permitted to hold. about when to file Form 1099–MISC, see the contribution was $600 and you had included Figure your allowable deduction for con- separate Instructions for Forms 1099, 1098, $400 for the parts in your opening inventory tributions to a black lung benefit trust on 5498, and W–2G. for 1999. Your charitable contribution is $400. Schedule A of Form 6069. You reduce your opening inventory by the Car and truck expenses. You can deduct $400 for the donated property. the cost of operating a car, truck, or other Bribes and kickbacks. You cannot deduct vehicle in your business. These costs include Example 2. Assume the same facts as bribes, kickbacks, or similar payments if they gas, oil, repairs, license tags, insurance, and Example 1, except you purchased the auto are either of the following. depreciation. Only the expenses for business parts in 1999 for $400 (not part of the opening 1) Payments directly or indirectly to an offi- use are deductible. Traveling between your inventory). The $400 is included as part of the cial or employee of any government or home and your place of business is usually cost of goods sold for 1999 but not in figuring an agency or instrumentality of any gov- not business use. the basis of the property. Your charitable ernment in violation of the law. If the Under certain conditions, you can use the contribution is $0. government is a foreign government, the standard mileage rate instead of deducting payments are not deductible if they are the actual expenses for your vehicle. The Club dues and membership fees. Gener- unlawful under the Foreign Corrupt standard mileage rate is given at the begin- ally, you cannot deduct amounts you pay or Practices Act of 1977. ning of this chapter. For more information on incur for membership in any club organized how to figure your deduction, see Publication for business, pleasure, recreation, or any 2) Payments directly or indirectly to a per- 463. other social purpose. This includes country son in violation of any federal or state clubs, athletic clubs, luncheon clubs, sporting law (but only if that state law is generally Charitable contributions. Cash payments clubs, airline clubs, and hotel clubs. enforced) that provides for a criminal to charitable, religious, educational, scientific, Exception. Unless a main purpose is to penalty or for the loss of a license or or similar organizations may be deductible as conduct entertainment activities for members privilege to engage in a trade or busi- business expenses if the payments are not or their guests or to provide members or their ness. charitable contributions or gifts. If the pay- guests with access to entertainment facilities, ments are charitable contributions or gifts, the following organizations will not be treated Meaning of “generally enforced.” A you cannot deduct them as business ex- as clubs organized for business, pleasure, state law is considered generally enforced penses. However, corporations (other than S recreation, or other social purpose. unless it is never enforced or enforced only corporations) can deduct charitable contribu- for infamous persons or persons whose vio- tions on their income tax returns. See Chari- • Boards of trade. lations are extraordinarily flagrant. For exam- table Contributions in Publication 542 for ple, a state law is generally enforced unless more information. Sole proprietors, partners • Business leagues. proper reporting of a violation of the law re- in a partnership, or shareholders in an S cor- • Chambers of commerce. sults in enforcement only under unusual cir- poration may be able to deduct charitable cumstances. contributions made by their business on • Civic or public service organizations. Kickbacks. A kickback includes a pay- Schedule A (Form 1040). ment for referring a client, patient, or cus- • Professional organizations such as bar tomer. The common kickback situation occurs Example. You paid $15 to a local church associations and medical associations. when money or property is given to someone for a half-page ad in a program for a concert • Real estate boards. as payment for influencing a third party to it is sponsoring. The purpose of the ad was purchase from, use the services of, or other- to encourage readers to buy your products. • Trade associations. wise deal with the person who pays the Since your payment is not a contribution, you kickback. In many cases, the person whose cannot deduct it as such. However, you can Damages recovered. Special rules apply to business is being sought or enjoyed by the deduct it as an advertising expense. compensation you receive for damages sus- person who pays the kickback does not know tained as a result of patent infringement, of the payment. Inventory. If you contribute inventory breach of contract or fiduciary duty, or anti- (property that you sell in the course of your trust violations. You must include this com- Example 1. Mr. Green, an insurance business), the amount you can claim as a pensation in your income. However, you may broker, pays part of the insurance commis- contribution deduction is the smaller of its fair be able to take a special deduction. The sions he earns to car dealers who refer in- market value on the day you contributed it or deduction applies only to amounts recovered surance customers to him. The car dealers its basis. The basis of donated inventory is for actual injury, not any additional amount. are not licensed to sell insurance. Mr. Green any cost incurred for the inventory in an ear- The deduction is the smaller of the following. cannot deduct these payments if they are in lier year that you would otherwise include in your opening inventory for the year of the violation of any federal or state law as ex- • The amount you received or accrued for contribution. You must remove the amount plained previously in (2) under Bribes and damages in the tax year reduced by the of your contribution deduction from your kickbacks. amount you paid or incurred in the year opening inventory. It is not part of the cost of to recover that amount. Example 2. The Yard Corporation is in goods sold. the business of repairing ships. It returns If the cost of donated inventory is not in- • Your losses from the injury you have not 10% of the repair bills as kickbacks to the cluded in your opening inventory, the inven- deducted. Page 60 Chapter 16 Other Expenses Demolition expenses or losses. You can- Example 3. Peter Green, an architect in • A period of more than 10 years, regard- not deduct any amount paid or incurred to New York, decided to take a special 2-week less of the period of the agreement. demolish a structure or any loss for the un- course in Los Angeles on the latest building depreciated basis of a demolished structure. techniques. While there, he spent an extra 8 The above business deductions do Add these amounts to the basis of the land weeks on personal activities. The time he ! not apply to transfers after October where the demolished structure was located. spent on personal activities indicates his main CAUTION 2, 1989, and before August 11, 1993, reason for going to Los Angeles was to take if the principal sum is over $100,000. Depreciation. If property you buy to use in a vacation. He can deduct his education ex- your business has a useful life substantially penses and meals and lodging for the 2 Charge any payment not deductible be- beyond the year it is placed in service, you weeks he attended the course. He cannot cause of these rules to a capital account. generally cannot deduct the entire cost as a deduct his round trip transportation expense However, you can deduct the payments business expense in the year you buy it. You to Los Angeles or any of the expenses for the charged to a capital account over the life of must spread the cost over more than one tax 8 weeks spent on personal activities. the asset if you can determine the useful life year and deduct part of it each year. This of the asset. Otherwise, you can amortize the method of deducting the cost of business Environmental cleanup costs. You can payment over a 25-year period beginning with property is called depreciation. deduct certain costs to clean up land and to the tax year the transfer occurs. However, you may be able to elect to de- treat groundwater that you contaminated with Contracts entered into before October duct a limited amount of the cost of certain hazardous waste from your business oper- 3, 1989. For contracts to buy a franchise, depreciable property in the year you place it ations. You can deduct the costs you incur to trademark, or trade name entered into before in service in your business. This deduction is restore your land and groundwater to the October 3, 1989, you can deduct payments known as the “section 179 deduction.” same physical condition that existed prior to contingent on productivity, use, or disposition. For information on depreciation and the contamination. You cannot deduct costs for The rules discussed earlier for annual and section 179 deduction, see Publication 946. the construction of groundwater treatment fa- substantially equal payments do not apply. cilities. You must capitalize those costs and Disposition of franchise, trademark, or you can recover them through depreciation. trade name. If you transfer, sell, or otherwise Donations to business organizations. You dispose of a franchise, trademark, or trade can deduct donations to business organiza- Franchise, trademark, trade name. If you name at a gain, you must recapture as ordi- tions as business expenses if all the following buy a franchise, trademark, or trade name, nary income the payments you deducted as: conditions are met. you can deduct the amount you pay or incur for the transfer as a business expense only • A lump-sum or serial payment of a prin- • The donation relates directly to your trade if the payments are part of a series of pay- cipal amount not treated as a sale or ex- or business. ments that are: change of an asset, • You reasonably expect a financial return • An amortized payment deducted over 25 in line with your donation. 1) Contingent on productivity, use, or dis- position of the item, years, or • The donation is not a nondeductible lob- • The amortization claimed on section 197 2) Payable at least annually for the entire bying expense as discussed later under intangibles. Lobbying expenses. term of the transfer agreement, and 3) Substantially equal in amount (or pay- For more information about dispositions For example, a donation you make to a able under a fixed formula). of franchises, trademarks, and trade names, committee organized by the Chamber of see chapter 2 in Publication 544. Commerce to bring a national convention to When determining the term of the transfer your city may be deductible. agreement, include all renewal options and Interview expense allowances. Re- any other period for which you and the imbursements you make to job candidates for Education expenses. You can deduct the transferor reasonably expect the agreement transportation or other expenses related to ordinary and necessary expenses you pay for to be renewed. interviews for possible employment are not the education and training of your employees. A franchise includes an agreement that wages. They are not subject to social security For more information, see Education Ex- gives one of the parties to the agreement the and Medicare taxes (FICA), federal unem- penses in chapter 2. right to distribute, sell, or provide goods, ser- ployment taxes (FUTA), or the withholding of You can also deduct your own education vices, or facilities within a specified area. income tax. You can deduct the reimburse- expenses (including certain related travel) Property acquired after August 10, ments as a business expense. However, ex- that are related to your trade or business. You 1993 (or after July 25, 1991, if elected). Any penses for food, beverages, and enter- must be able to show the education maintains amounts you pay or incur for the transfer that tainment are subject to the 50% limit or improves skills required in your trade or are not described in (1) through (3) under discussed earlier under Meals and Enter- business, or it is required by law or regu- Franchise, trademark, trade name, above tainment. lations for keeping your pay, status, or job. must be charged to a capital account. These You cannot deduct education expenses are “section 197 intangibles” and are amor- Legal and professional fees. Legal and you incur to meet the minimum requirements tized over 15 years. See chapter 12 for more professional fees, such as fees charged by of your present trade or business, or those information on amortization. accountants, that are ordinary and necessary that qualify you for a new trade or business. You can also elect to apply this same expenses directly related to operating your This is true even if the education maintains treatment to any franchise, trademark, or business are deductible as business ex- or improves skills presently required in your trade name acquired after July 25, 1991. This penses. However, you usually cannot deduct business. election is binding and cannot be revoked legal fees you pay to acquire business assets. without consent from the IRS. Add them to the basis of the property. Example 1. Dr. Carter, who is a psychi- Property acquired before August 11, If the fees include payments for work of a atrist, begins a program of study at an ac- 1993. For a transfer not treated as a sale or personal nature (such as making a will), you credited psychoanalytic institute to qualify as exchange of a capital asset, you can deduct take a business deduction only for the part a psychoanalyst. She can deduct the cost of a lump-sum payment of an agreed upon of the fee related to your business. The per- the program because the study maintains or principal amount ratably over the shorter of sonal portion of legal fees for producing or improves skills required in her profession and the following. collecting taxable income, doing or keeping does not qualify her for a new one. your job, or for tax advice may be deductible • 10 years. on Schedule A (Form 1040) if you itemize Example 2. Herb Jones owns a repair • The period of the transfer agreement. deductions. See Publication 529. shop for electronic equipment. The bulk of Tax preparation fees. You can deduct the business is television repairs, but occa- For a transfer not treated as a sale or ex- as a trade or business expense the cost of sionally he fixes tape decks and disc players. change of a capital asset, you can deduct, in preparing that part of your tax return relating To keep up with the latest technical changes, the year made, a payment that is one of a to your business as a sole proprietor. The he takes a special course to learn how to re- series of approximately equal payments pay- remaining cost is deductible on Schedule A pair disc players. Since the course maintains able over either of the following. (Form 1040) if you itemize deductions. and improves skills required in his trade, he You can also take a business deduction can deduct its cost. • The period of the transfer agreement. for the amount you pay or incur in resolving Chapter 16 Other Expenses Page 61 asserted tax deficiencies for your business c) Is an immediate deputy of an indi- example, deduct as a utilities expense the as a sole proprietor. vidual listed in items (a) or (b) cost of telephone calls made under this ser- above. vice and deduct as rental expense the cost Licenses and regulatory fees. Licenses of renting machinery and equipment for this and regulatory fees for your trade or business Exceptions to denial of deduction. The service. paid each year to state or local governments general denial of the deduction does not ap- generally are deductible. Some licenses and ply to the following. Penalties and fines. Penalties you pay for fees may have to be amortized. See chapter late performance or nonperformance of a • Expenses of appearing before, or com- 12 for more information. contract are generally deductible. For in- municating with, any local council or stance, if you contracted to construct a build- similar governing body concerning its ing by a certain date and had to pay an Lobbying expenses. Generally, you cannot legislation (local legislation) if the legis- amount for each day the building was not deduct lobbying expenses. Lobbying ex- lation is of direct interest to you or to you finished after that date, you can deduct the penses include amounts paid or incurred for and an organization of which you are a amounts paid or incurred. any of the following activities. member. An Indian tribal government is On the other hand, you cannot deduct treated as a local council or similar gov- penalties or fines you pay to any government • Influencing legislation. erning body. agency or instrumentality because of a vio- • Participating in or intervening in any poli- • Any in-house expenses for influencing lation of any law. These fines or penalties in- tical campaign for, or against, any candi- legislation and communicating directly clude the following amounts. date for public office. with a covered executive branch official • Attempting to influence the general pub- if those expenses for the tax year do not • Paid because of a conviction for a crime lic, or segments of the public, about exceed $2,000 (excluding overhead ex- or after a plea of guilty or no contest in elections, legislative matters, or referen- penses). a criminal proceeding. dums. • Expenses incurred by taxpayers engaged • Paid as a penalty imposed by federal, • Communicating directly with covered in the trade or business of lobbying state, or local law in a civil action, in- executive branch officials (defined later) (professional lobbyists) on behalf of cluding certain additions to tax and addi- in any attempt to influence the official another person (but does apply to pay- tional amounts and assessable penalties actions or positions of those officials. ments by the other person to the lobbyist imposed by the Internal Revenue Code. for lobbying activities). • Researching, preparing, planning, or co- • Paid in settlement of actual or possible ordinating any of the preceding activities. Impairment-related expenses. If you are liability for a fine or penalty, whether civil disabled, you can deduct expenses neces- or criminal. Your expenses for influencing legislation sary for you to be able to work (impairment- • Forfeited as collateral posted for a pro- and communicating directly with a covered related expenses) as a business expense, ceeding that could result in a fine or executive branch official include a portion of rather than as a medical expense. penalty. your labor costs and general and administra- You are disabled if you have either of the tive costs of your business. For information following. Examples of nondeductible penalties and on making this allocation, see section fines include the following. 1.162–28 of the income tax regulations. • A physical or mental disability (for exam- You cannot take a charitable deduction ple, blindness or deafness) that func- • Fines for violating city housing codes. or business expense for amounts paid to an tionally limits your being employed. organization described in section 170(c) of • Fines paid by truckers for violating state the Internal Revenue Code if both of the fol- • A physical or mental impairment that maximum highway weight laws and air lowing apply. substantially limits one or more of your quality laws. major life activities. • Civil penalties for violating federal laws • The organization conducts lobbying ac- You can deduct the expense as a busi- regarding mining safety standards and tivities on matters of direct financial in- discharges into navigable waters. terest to your business. ness expense if all the following apply. • A principal purpose of your contribution • Your work clearly requires the expense A fine or penalty does not include any of is to avoid the rules discussed earlier that for you to satisfactorily perform the work. the following. prohibit a business deduction for lobbying • The goods or services purchased are expenses. • Legal fees and related expenses to de- clearly not needed or used, other than fend yourself in a prosecution or civil incidentally, in your personal activities. If a tax-exempt organization, other than a action for a violation of the law imposing section 501(c)(3) organization, provides you • Their treatment is not specifically pro- the fine or civil penalty. with a notice on the portion of dues that are vided for under other tax law provisions. • Court costs or stenographic and printing allocable to nondeductible lobbying and poli- charges. tical expenses, you cannot deduct that portion Example. You are blind. You must use of the dues. a reader to do your work, both at and away • Compensatory damages paid to a gov- Covered executive branch official. For from your place of work. The reader's ser- ernment. purposes of this discussion, a covered exec- vices are only for your work. You can deduct utive branch official includes the following. your expenses for the reader as a business Nonconformance penalty. You can de- expense. duct a nonconformance penalty assessed by 1) The President. the Environmental Protection Agency for fail- Moving machinery. Generally, the cost of ing to meet certain emission standards. 2) The Vice President. moving your machinery from one city to an- 3) Any officer or employee of the White other is a deductible expense. So is the cost Political contributions. You cannot deduct House Office of the Executive Office of of moving machinery from one plant to an- contributions or gifts to political parties or the President and the two most senior other, or from one part of your plant to an- candidates as business expenses. In addi- level officers of each of the other agen- other. You can deduct the cost of installing tion, you cannot deduct expenses you pay or cies in the Executive Office. the machinery in the new location. However, incur to take part in any political campaign of you must capitalize the costs of installing or a candidate for public office. 4) Any individual who: moving newly purchased machinery. Indirect political contributions. You a) Is serving in a position in Level I of also cannot deduct indirect political contribu- the Executive Schedule under sec- Outplacement services. You can deduct the tions and costs of taking part in political ac- tion 5312 of title 5, United States costs of outplacement services you provide tivities as business expenses. Examples of Code, to your employees to help them find new nondeductible expenses include the following. employment (such as career counseling, b) Has been designated by the Presi- resumé assistance, skills assessment, etc.). • Advertising in a convention program of a dent as having Cabinet-level status, The costs of outplacement services may political party, or in any other publication or cover more than one deduction category. For if any of the proceeds from the publication Page 62 Chapter 16 Other Expenses are for, or intended for, the use of a poli- 2) Refigure your tax from the earlier year Subscriptions. You can deduct as a busi- tical party or candidate. without including in income the amount ness expense subscriptions to professional, you repaid in 1999. technical, and trade journals that deal with • Admission to a dinner or program (in- your business field. cluding, but not limited to, galas, dances, 3) Subtract the tax in (2) from the tax shown film presentations, parties, and sporting on your return for the earlier year. This Supplies and materials. Unless you have events) if any of the proceeds from the is the credit. function are for, or intended for, the use deducted the cost in any earlier year, you generally can deduct the cost of materials and of a political party or candidate. 4) Subtract the answer in (3) from the tax supplies actually consumed and used during for 1999 figured without the deduction • Admission to an inaugural ball, gala, pa- the tax year. (step 1). rade, concert, or similar event if identified If you keep incidental materials and sup- with a political party or candidate. plies on hand, you can deduct the cost of the If the amount from method 1 is less tax, incidental materials and supplies you bought Repairs. The cost of repairing or improving deduct the amount repaid on the same form during the tax year if all of the following re- property used in your trade or business is ei- or schedule on which you previously reported quirements are met. ther a deductible or capital expense. You can it. For example, if you reported it as self- deduct repairs that keep your property in a employment income, deduct it as a business • You do not keep a record of when they normal efficient operating condition, but that deduction on Schedule C or Schedule C–EZ are used. do not add to the value or usefulness of (Form 1040). If you reported it as wages, de- • You do not take an inventory of the property or appreciably lengthen its life. If the duct it as an itemized deduction on line 27 of amount on hand at the beginning and end repairs add to the value or usefulness of your Schedule A (Form 1040). of the tax year. property or significantly increase its life you If using method 2 results in less tax, claim must capitalize them. Although you cannot the credit on line 63 of Form 1040, and write • This method does not distort your in- deduct capital expenses as current expenses, “I.R.C. 1341” next to line 63. come. you can usually deduct them over a period of time as depreciation. Example. For 1998 you filed a return and You can also deduct the cost of books, reported your income on the cash method. In professional instruments, equipment, etc., if The cost of repairs includes the costs 1999 you repaid $5,000 included in your 1998 you normally use them up within a year. TIP of labor, supplies, and certain other gross income under a claim of right. Your fil- However, if the usefulness of these items items. You cannot deduct the value ing status in 1999 and 1998 is single. Your extends substantially beyond the year they of your own labor. income and tax for both years are as follows: are placed in service, you generally must re- cover their costs through depreciation. See Examples of repairs include the following. 1998 1998 Depreciation, earlier. With Income Without Income • Patching and repairing floors. Taxable Utilities. Your business expenses for heat, Income $15,000 $10,000 • Repainting the inside and outside of a lights, power, and telephone service are Tax building. deductible. However, any part due to personal Liability $ 2,254 $ 1,504 use is not deductible. • Repairing roofs and gutters. 1999 1999 Telephone. If you have an office in your • Mending leaks. Without Deduction With Deduction home, even though you are in business, you Taxable cannot deduct the cost of basic local tele- You cannot deduct the cost of repairs that Income $49,950 $44,950 phone service (including any taxes) for the you added to the cost of goods sold as a Tax first telephone line you have in your home. separate business expense. Liability $10,646 $ 9,246 Your tax under method (1) is $9,246. Your tax Repayments (claim of right). If you had to under method (2) is $9,896, figured as fol- repay an amount that you included in your lows: income in an earlier year because at that time you thought you had an unrestricted right to Tax previously determined for 1998 ...... $ 2,254 it, you can deduct the amount repaid from Less: Tax as refigured ...... − 1,504 17. your income in the year in which you repay Decrease in 1998 tax $ 750 it. Regular tax liability for 1999 ...... $10,646 Type of deduction. The type of de- Less: Decrease in 1998 tax ...... − 750 How To duction you are allowed in the year of repay- Refigured tax for 1999 $ 9,896 ment depends on the type of income you in- Because you pay less tax under method (1), Get More cluded in the earlier year. For instance, if you you should take a deduction for the repay- repay an amount that you previously reported ment in 1999. Information as a capital gain, deduct the repayment as a capital loss. Repayment does not apply. This dis- You can order free publications and forms, Repayment—$3,000 or less. If the cussion does not apply to the following. ask tax questions, and get more information amount you repaid was $3,000 or less, de- from the IRS in several ways. By selecting the duct it from your income in the year you re- • Deductions for bad debts. method that is best for you, you will have paid it. If you reported it as wages, unem- quick and easy access to tax help. ployment compensation, or other • Deductions from sales to customers, nonbusiness ordinary income, enter it on line such as returns and allowances, and Free tax services. To find out what services 22 of Schedule A (Form 1040). If you re- similar items. are available, get Publication 910, Guide to ported it as a capital gain, deduct it on Free Tax Services. It contains a list of free tax Schedule D (Form 1040). • Deductions for legal and other expenses of contesting the repayment. publications and an index of tax topics. It also Repayment—over $3,000. If the amount describes other free tax information services, you repaid was more than $3,000, you can including tax education and assistance pro- take a deduction for the amount repaid Year payment deducted. If you use the grams and a list of TeleTax topics. (Method 1) or you can take a credit against cash method, you can take the deduction for your tax (Method 2). Figure your tax under the tax year in which you actually make the Personal computer. With your per- both methods and use the method that results repayment. If you use any other accounting sonal computer and modem, you can in less tax. method, you can deduct the repayment only access the IRS on the Internet at Method 1. Figure your tax for 1999 for the tax year in which it is a proper de- www.irs.gov. While visiting our web site, you claiming a deduction for the repaid amount. duction under your accounting method. For can select: Method 2. Follow these steps. example, if you use an accrual method, you are entitled to the deduction in the tax year in • Frequently Asked Tax Questions (located 1) Figure your tax for 1999 without de- which the obligation for the repayment ac- under Taxpayer Help & Ed) to find an- ducting the repaid amount. crues. swers to questions you may have. Chapter 17 How To Get More Information Page 63 • Forms & Pubs to download forms and give accurate, courteous, and professional CD-ROM. You can order IRS Publi- publications or search for forms and answers, we evaluate the quality of our tele- cation 1796, Federal Tax Products on publications by topic or keyword. phone services in several ways. CD-ROM, and obtain: • Fill-in Forms (located under Forms & • A second IRS representative sometimes Pubs) to enter information while the form • Current tax forms, instructions, and pub- monitors live telephone calls. That person lications. is displayed and then print the completed only evaluates the IRS assistor and does form. not keep a record of any taxpayer's name • Prior-year tax forms, instructions, and • Tax Info For You to view Internal Reve- or tax identification number. publications. nue Bulletins published in the last few • We sometimes record telephone calls to • Popular tax forms which may be filled in years. evaluate IRS assistors objectively. We electronically, printed out for submission, • Tax Regs in English to search regulations hold these recordings no longer than one and saved for recordkeeping. and the Internal Revenue Code (under week and use them only to measure the • Internal Revenue Bulletins. United States Code (USC)). quality of assistance. • Digital Dispatch and IRS Local News Net • We value our customers' opinions. The CD-ROM can be purchased from (both located under Tax Info For Busi- Throughout this year, we will be survey- National Technical Information Service (NTIS) ness) to receive our electronic newslet- ing our customers for their opinions on by calling 1–877–233–6767 or on the Internet ters on hot tax issues and news. our service. at www.irs.gov/cdorders. The first release is available in mid-December and the final • Small Business Corner (located under release is available in late January. Tax Info For Business) to get information IRS Publication 3207, Small Business on starting and operating a small busi- Walk-in. You can walk in to many Resource Guide, is an interactive CD-ROM ness. post offices, libraries, and IRS offices that contains information important to small You can also reach us with your computer to pick up certain forms, instructions, businesses. It is available in mid-February. using File Transfer Protocol at ftp.irs.gov. and publications. Also, some libraries and IRS You can get one free copy by calling offices have: 1–800–829–3676. • An extensive collection of products avail- TaxFax Service. Using the phone able to print from a CD-ROM or photo- attached to your fax machine, you can copy from reproducible proofs. receive forms and instructions by • The Internal Revenue Code, regulations, Help with unresolved tax problems. If you calling 703–368–9694. Follow the directions Internal Revenue Bulletins, and Cumula- have attempted to deal with an IRS problem from the prompts. When you order forms, tive Bulletins available for research pur- unsuccessfully, you should contact your Tax- enter the catalog number for the form you poses. payer Advocate. need. The items you request will be faxed to The Taxpayer Advocate represents your you. interests and concerns within the IRS by protecting your rights and resolving problems that have not been fixed through normal channels. While Taxpayer Advocates cannot Phone. Many services are available Mail. You can send your order for change the tax law or make a technical tax by phone. forms, instructions, and publications decision, they can clear up problems that re- to the Distribution Center nearest to sulted from previous contacts and ensure that you and receive a response within 10 work- your case is given a complete and impartial • Ordering forms, instructions, and publi- days after your request is received. Find the review. cations. Call 1–800–829–3676 to order address that applies to your part of the To contact your Taxpayer Advocate: current and prior year forms, instructions, country. and publications. • Call the Taxpayer Advocate's toll-free • Asking tax questions. Call the IRS with • Western part of U.S.: number: 1–877–777–4778. your tax questions at 1–800–829–1040. Western Area Distribution Center Rancho Cordova, CA 95743–0001 • Call the IRS toll-free number: • TTY/TDD equipment. 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Page 64 Chapter 17 How To Get More Information Index

Credit, electric vehicle ...... 56 Valuation rules ...... 10 Long-term care insurance ...... 34 A Fuel taxes ...... 33 Losses: Accident plans ...... 17 At-risk limits ...... 4 Accountable plan ...... 57 Limits ...... 4 Achievement awards ...... 6 D Net operating ...... 4 Day care (dependent care pro- Adoption assistance programs .. 18 G Not-for-profit rules ...... 4 gram) ...... 18 Gas wells ...... 50 Advertising ...... 59 Passive activities ...... 4 Amortization: De minimis fringe benefit ...... 14 Geothermal wells ...... 37, 50 Anti-abuse rule ...... 43 De minimis OID ...... 29 Gifts, nominal value ...... 6 Anti-churning rules ...... 42 Debt-financed: Going into business ...... 2, 44 Bond premium ...... 47 Acquisition ...... 28 Goodwill ...... 41 M Corporate organization costs 44 Distributions ...... 28 Group health plan ...... 17 Machinery parts ...... 3 Dispositions of section 197 in- Definitions: Group-term life insurance ...... 19 Materials and supplies ...... 63 tangibles ...... 43 Achievement award ...... 6 Meals and entertainment ...... 58 Experimental costs ...... 46 Business bad debt ...... 51 Meals and lodging ...... 7 Going into business costs .... 44 Clean-burning fuel ...... 54 Medical expenses, business or Clean-fuel vehicle property .. 54 H personal ...... 62 How to amortize ...... 45 Health insurance, deduction for Clean-fuel vehicle refueling Medical reimbursement plans ... 17 How to deduct ...... 41 self-employed ...... 34 property ...... 54 Medical savings accounts ...... 18 Incorrect amount deducted .. 43 Health plans ...... 17 Employee ...... 14, 15, 16, 19 Mining: Partnership organization Heating equipment ...... 3 Fringe benefit ...... 9 Depletion ...... 50 costs ...... 44 Help (See More information) Necessary expense ...... 2 Development costs ...... 38 Pollution control facilities ...... 46 Highly compensated em- Ordinary expense ...... 2 Exploration costs ...... 37 Reforestation costs ...... 45 ployee ...... 14, 18 Qualified electric vehicle ...... 56 Money purchase pension plan .. 23 Related person ...... 42 Hobby losses, not for profit ...... 4 Section 197 intangibles ...... 41 More information ...... 63 Research costs ...... 46 Home, business use ...... 3 Section 197 intangibles Demonstrator cars ...... 16 Mortgages: defined ...... 41 Dependent care assistance ...... 18 Cost of acquiring ...... 29 Start-up costs ...... 44 Depletion: Interest ...... 29 Anticipated liabilities ...... 60 Mineral property ...... 47 I Moving expenses: Assessments, local ...... 32 Oil and gas wells ...... 48 Improvements: Machinery ...... 62 Assistance (See More information) Percentage table ...... 50 By lessee ...... 26 Reimbursements ...... 15 At-risk limits ...... 4 Timber ...... 51 For disabled and elderly ...... 38 Athletic facilities, on premise ..... 14 Who can claim ...... 47 To business assets ...... 3 Attorney fees ...... 61 Depreciation ...... 61 Income taxes ...... 33 N Awards: Development costs, miners ...... 38 Incorrect amount of amortization Natural gas ...... 50 Employee achievement ...... 6 Disabled: deducted ...... 43 Necessary expense ...... 2 Length-of-service ...... 6 Dependent care program ..... 18 Individual retirement arrange- Net operating loss ...... 4 Safety ...... 6 Improvements for ...... 38 ments (IRAs) ...... 24 No-additional-cost service ...... 14 Drilling and development costs . 37 Insurance: Nonaccountable plan ...... 59 Driveways ...... 3 Accident and health plans .... 17 Nonqualifying intangibles ...... 42 Dues, membership ...... 60 Capitalizing premiums ...... 35 Not-for-profit activities ...... 4 B Deductible premiums ...... 34 Bad debts ...... 51 Group-term life ...... 19 Black lung payments ...... 60 Nondeductible premiums ..... 35 E Self-employed individuals .... 34 O Bond premium ...... 47 Economic interest ...... 47 Intangible drilling costs ...... 37 Office in home ...... 3 Bonuses: Economic performance ...... 4 Intangibles, amortization ...... 41 Oil and gas wells: Employee ...... 6 Education expenses ...... 6, 61 Interest: Depletion ...... 48 Royalties ...... 51 Educational assistance Allocation of ...... 27 Drilling costs ...... 37 Bribes ...... 60 programs ...... 19 Below-market ...... 30 Partnerships ...... 49 Business meal expenses ...... 59 Elderly, improvements for ...... 38 Business expense for ...... 26 S corporations ...... 49 Business use of your car ...... 60 Electric vehicle credit ...... 56 Capitalized ...... 29, 30 Ordinary expense ...... 2 Business: Employee benefit programs: Carrying charge ...... 36 Organization costs: Assets ...... 3 Accident and health plans .... 17 Deductible ...... 28 Corporate ...... 44 Bad debts ...... 51 Adoption assistance ...... 18 Forgone ...... 31 Partnership ...... 44 Books and records ...... 41 Cafeteria plans ...... 18 Life insurance policies ...... 30 Outplacement services ...... 16, 62 Use of car ...... 3 Deduction for ...... 7 Not deductible ...... 29 Use of home ...... 3 Dependent care assistance . 18 Refunds of ...... 30 Educational assistance ...... 19 When to deduct ...... 30 Group-term life insurance .... 19 P Interview expenses ...... 61 Employee discount, qualified .... 15 Parking, qualified ...... 15 IRAs ...... 24 C Employees' pay ...... 5 Passive activities ...... 4 Cafeteria plans ...... 18 Employment taxes ...... 33 Payments in kind ...... 4 Campaign contribution ...... 62 Entertainment tickets ...... 59 Penalties: Capital expenses ...... 2, 3 Environmental cleanup costs .... 61 Deductible ...... 62 Capitalization of interest ...... 30 K Excise taxes ...... 33 Keogh plan (See Qualified plan) Nondeductible ...... 62 Car and truck expenses ...... 3, 60 Experimentation costs ...... 36, 46 Key employee ...... 18, 20 Prepayment ...... 29 Carrying charges ...... 36 Exploration costs ...... 37 Key person ...... 30 Percentage depletion ...... 48 Charitable: Kickbacks ...... 60 Personal expenses ...... 3 Contributions ...... 60 Personal property tax ...... 33 Sports event ...... 59 Points ...... 29 Child care (dependent care pro- F Political contributions ...... 62 gram) ...... 18 Fees: L Pollution control facilities ...... 46 Circulation costs, newspapers and Commitment ...... 30 Leases: Prepaid expenses: periodicals ...... 38 Legal and professional ...... 61 Cost of getting ...... 26, 47 General rule ...... 4 Clean-fuel property ...... 54 Loan origination ...... 29 Improvements by lessee ...... 26 Insurance ...... 36 Cleanup costs, environmental ... 61 Regulatory ...... 62 Leveraged ...... 25 Interest ...... 30 Club dues ...... 60 Tax return preparation ...... 61 Mineral ...... 51 Rent ...... 25 Commitment fees ...... 30 Fines ...... 62 Oil and gas ...... 51 Prepayment penalty ...... 29 Computer software ...... 42 Forgone interest ...... 31 Sales distinguished ...... 25 Profit-sharing plans ...... 23 Constant-yield method ...... 29 Form: Taxes on ...... 25 Publications (See More information) Contested liabilities ...... 4 5305–SEP ...... 21 Legal and professional fees ...... 61 Contributions: Franchise ...... 42, 61 Licenses ...... 41, 62 Charitable ...... 60 Franchise taxes ...... 33 Loans: Political ...... 62 Free tax services ...... 63 Below-market interest rate ... 30 Q Copyrights ...... 41 Fringe benefit: Discounted ...... 30 Qualified plan ...... 23 Cost depletion ...... 47 Deduction for ...... 7 Origination fees ...... 29 Cost of getting lease ...... 26, 47 Definitions ...... 9 To employees ...... 7 Cost of goods sold ...... 2 Exclusions ...... 13 Lobbying expenses ...... 62 R Covenant not to compete ...... 42 Nondiscrimination rules ...... 14 Lodging and meals ...... 7 Real estate taxes ...... 32 Page 65 Recapture: Retirement plans: Special valuation rules for certain Timber ...... 45, 51 Clean-fuel deductions ...... 55 Defined benefit ...... 23 fringe benefits ...... 10 Tools ...... 3 Electric vehicle credit ...... 56 Defined contribution ...... 23 Standard mileage rate ...... 58 Trademark, trade name ...... 42, 61 Exploration expenses ...... 37 IRAs ...... 24 Standby charges ...... 30 Transit pass ...... 15 Timber property ...... 46 Money purchase ...... 23 Start-up costs ...... 44 Transportation fringe benefit ..... 15 Recovery of amount deducted .... 3 Profit-sharing ...... 23 Stock bonus plan ...... 23 Travel ...... 57 Reforestation costs ...... 45 Qualified ...... 23 Subscriptions ...... 60 TTY/TDD information ...... 63 Regulatory fees ...... 62 Salary reduction ...... 21 Supplies and materials ...... 63 Reimbursements: SEP ...... 21 Accountable plan ...... 57 SIMPLE ...... 22 U Mileage ...... 58 Stock bonus ...... 23 Unemployment fund taxes ...... 33 Moving expense ...... 15 Roads ...... 3 T Unpaid expenses, related per- Nonaccountable plan ...... 59 Tax help (See More information) sons ...... 4, 30 Per diem ...... 58 Tax preparation fees ...... 61 Utilities ...... 63 Qualifying requirements ...... 57 Tax problems, unresolved ...... 64 Related persons: S Taxes: Anti-churning rules ...... 42 Salaries and wages ...... 5 Carrying charge ...... 36 Clean-fuel vehicle deduction 54 V Sales taxes ...... 33 Employment ...... 33 Vacation pay ...... 8 Coal or iron ore ...... 50 Self insurance: Excise ...... 33 Key employee ...... 18 Valuation rules for fringe Medical reimbursement plans 17 Franchise ...... 33 benefits ...... 10 Payments to ...... 4, 30 Self-employed health insurance Fuel ...... 33 Refiners ...... 48 deduction ...... 34 Income ...... 33 Unreasonable rent ...... 24 Self-employment tax ...... 33 Leased property ...... 25 Rent expense, capitalizing ...... 26 Self-insurance: Personal property ...... 33 W Repairs ...... 63 Reserve for ...... 35 Real estate ...... 32 Wages and salaries ...... 5 Repayments (claim of right) ...... 63 SEP plans ...... 21 Sales ...... 33 Welfare benefit funds ...... 7 Replacements ...... 3 Service, no additional cost ...... 14 Unemployment fund ...... 33 Working condition fringe benefit 16 Research costs ...... 36, 46 Sick pay ...... 8 Taxpayer Advocate ...... 64 Ⅵ SIMPLE plans ...... 22 Telephone ...... 63

Page 66 See How To Get More Information for a variety of ways to get publications, Tax Publications for Business Taxpayers including by computer, phone, and mail.

General Guides 463 Travel, Entertainment, Gift, and Car 597 Information on the United States- Expenses Canada Income Tax Treaty 1 Your Rights as a Taxpayer 505 Tax Withholding and Estimated Tax 598 Tax on Unrelated Business Income 17 Your Federal Income Tax (For 510 Excise Taxes for 2000 of Exempt Organizations Individuals) 515 Withholding of Tax on Nonresident 686 Certification for Reduced Tax Rates 225 Farmer’s Tax Guide Aliens and Foreign Corporations in Tax Treaty Countries 334 Tax Guide for Small Business 517 Social Security and Other 901 U.S. Tax Treaties 509 Tax Calendars for 2000 Information for Members of the 908 Bankruptcy Tax Guide 553 Highlights of 1999 Tax Changes Clergy and Religious Workers 911 Direct Sellers 595 Tax Highlights for Commercial 527 Residential Rental Property 925 Passive Activity and At-Risk Rules Fishermen 533 Self-Employment Tax 946 How To Depreciate Property 910 Guide to Free Tax Services 534 Depreciating Property Placed in 947 Practice Before the IRS and Power Service Before 1987 of Attorney Employer’s Guides 535 Business Expenses 954 Tax Incentives for Empowerment 536 Net Operating Losses Zones and Other Distressed 15 Circular E, Employer’s Tax Guide 537 Installment Sales Communities 15-A Employer’s Supplemental Tax Guide 538 Accounting Periods and Methods 1544 Reporting Cash Payments of Over 51 Circular A, Agricultural Employer’s 541 Partnerships $10,000 Tax Guide 542 Corporations 1546 The Taxpayer Advocate Service of 80 Federal Tax Guide For Employers in 544 Sales and Other Dispositions of the IRS the U.S. Virgin Islands, Guam, Assets American Samoa, and the Spanish Language Publications Commonwealth of the Northern 551 Basis of Assets Mariana Islands (Circular SS) 556 Examination of Returns, Appeal Rights, and Claims for Refund 1SP Derechos del Contribuyente 179 Circular PR Guía Contributiva 579SP Cómo Preparar la Declaración de Federal Para Patronos 560 Retirement Plans for Small Business (SEP, SIMPLE, and Keogh Plans) Impuesto Federal Puertorriqueños 594SP Comprendiendo el Proceso de Cobro 926 Household Employer’s Tax Guide 561 Determining the Value of Donated Property 850 English-Spanish Glossary of Words 583 and Phrases Used in Publications Specialized Publications Starting a Business and Keeping Records Issued by the Internal Revenue Service 378 Fuel Tax Credits and Refunds 587 Business Use of Your Home (Including Use by Day-Care 1544SP Informe de Pagos en Efectivo en Providers) Exceso de $10,000 (Recibidos en una Ocupación o Negocio) 594 Understanding the Collection Process

Commonly Used Tax Forms See How To Get More Information for a variety of ways to get forms, including by computer, fax, phone, and mail. Items with an asterisk are available by fax. For these orders only, use the catalog numbers when ordering.

Catalog Catalog Form Number and Title Number Form Number and Title Number W-2 Wage and Tax Statement 10134 1120S U.S. Income Tax Return for an S Corporation 11510 W-4 Employee’s Withholding Allowance Certificate* 10220 Sch D Capital Gains and Losses and Built-In Gains 11516 940 Employer’s Annual Federal Unemployment 11234 Sch K-1 Shareholder’s Share of Income, Credits, 11520 (FUTA) Tax Return* Deductions, etc. 940EZ Employer’s Annual Federal Unemployment 10983 2106 Employee Business Expenses* 11700 (FUTA) Tax Return* 2106-EZ Unreimbursed Employee Business 20604 941 Employer’s Quarterly Federal Tax Return 17001 Expenses* 1040 U.S. Individual Income Tax Return* 11320 2210 Underpayment of Estimated Tax by 11744 Sch A & B Itemized Deductions & Interest and 11330 Individuals, Estates, and Trusts* Ordinary Dividends* 2441 Child and Dependent Care Expenses* 11862 Sch C Profit or Loss From Business* 11334 2848 Power of Attorney and Declaration of 11980 Representative* Sch C-EZ Net Profit From Business* 14374 3800 Sch D Capital Gains and Losses* 11338 General Business Credit 12392 3903 Sch D-1 Continuation Sheet for Schedule D 10424 Moving Expenses* 12490 4562 Sch E Supplemental Income and Loss* 11344 Depreciation and Amortization* 12906 4797 Sch F Profit or Loss From Farming* 11346 Sales of Business Property* 13086 4868 Sch H Household Employment Taxes* 12187 Application for Automatic Extension of Time To 13141 File U.S. Individual Income Tax Return* Sch J Farm Income Averaging* 25513 5329 Additional Taxes Attributable to IRAs, Other 13329 Sch R Credit for the Elderly or the Disabled* 11359 Qualified Retirement Plans, Annuities, Modified Sch SE Self-Employment Tax* 11358 Endowment Contracts, and MSAs* 1040-ES Estimated Tax for Individuals* 11340 6252 Installment Sale Income* 13601 1040X Amended U.S. Individual Income Tax Return* 11360 8283 Noncash Charitable Contributions* 62299 1065 U.S. Partnership Return of Income 11390 8300 Report of Cash Payments Over $10,000 62133 Sch D Capital Gains and Losses 11393 Received in a Trade or Business* Sch K-1 Partner’s Share of Income, 11394 8582 Passive Activity Loss Limitations* 63704 Credits, Deductions, etc. 8606 Nondeductible IRAs* 63966 1120 U.S. Corporation Income Tax Return 11450 8822 Change of Address* 12081 1120-A U.S. Corporation Short-Form 11456 8829 Expenses for Business Use of Your Home* 13232 Income Tax Return

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