The Home Office Deduction: Actual Expenses vs. the Simplified Method

If you run your business from your home or perform certain functions at home that are related to your business, you might be able to claim a home office deduction against your business income on your 2018 income tax return. Thanks to a tax law change back in 2013, there are now two methods for claiming this deduction: the actual expenses method and the simplified method.

Basics of the deduction

In general, you’ll qualify for a home office deduction if part of your home is used “regularly and exclusively” as your principal place of business.

If your home isn’t your principal place of business, you may still be able to deduct home office expenses if 1) you physically meet with patients, clients or customers on your premises, or 2) you use a storage area in your home (or a separate free-standing structure, such as a garage) exclusively and regularly for your business.

Actual expenses

Traditionally, taxpayers have deducted actual expenses when they claim a home office deduction. Deductible home office expenses may include:

  • Direct expenses, such as the cost of painting and carpeting a room used exclusively for business,
  • A proportionate share of indirect expenses, such as mortgage interest, property taxes, utilities, repairs and insurance, and
  • A depreciation allowance.

But keeping track of actual expenses can be time consuming.

The simplified method

Fortunately, there’s a simplified method that’s been available since 2013: You can deduct $5 for each square foot of home office space, up to a maximum total of $1,500.

For example, if you’ve converted a 300-square-foot bedroom to an office you use exclusively and regularly for business, you can write off $1,500 under the simplified method (300 square feet x $5). However, if your business is located in a 600-square-foot finished basement, the deduction will still be only $1,500 because of the cap on the deduction under this method.

As you can see, the cap can make the simplified method less beneficial for larger home office spaces. But even for spaces of 300 square feet or less, taxpayers may qualify for a bigger deduction using the actual expense method. So, tracking your actual expenses can be worth the extra hassle.

Flexibility in filing

When claiming the home office deduction, you’re not locked into a particular method. For instance, you might choose the actual expense method on your 2018 return, use the simplified method when you file your 2019 return next year and then switch back to the actual expense method thereafter. The choice is yours.

Unsure whether you qualify for the home office deduction? Or wondering whether you should deduct actual expenses or use the simplified method? Contact us. We can help you determine what’s right for your specific situation.

© 2019

Auditing Cashless Transactions

Like most businesses, you’ve probably experienced a significant increase in the number of customers who prefer to make cashless payments. And you may be wondering: How does the acceptance of these types of transactions affect the auditing of your financial statements?

Cashless transactions require the exchange of digital information to facilitate payments. Instead of focusing on the collection and recording of physical cash, your auditors will spend significant time analyzing your company’s electronic sales records. This requires four specific procedures.

1. Identifying accepted payment methods

Auditors will ask for a list of the types of payments your company accepts and the process maps for each payment vehicle. Examples of cashless payment methods include:

  • Credit and debit cards,
  • Mobile wallets (such as Venmo),
  • Digital currencies (such as Bitcoin),
  • Automated Clearing House (ACH) payments,
  • Wire transfers, and
  • Payments via intermediaries (such as PayPal).

Be prepared to provide documents detailing how the receipt of cashless payments works and how the funds end up in your company’s bank account.

2. Evaluating roles and responsibilities

Your auditors will request a list of employees involved in the receipt, recording, reporting and analysis of cashless transactions. They will also want to see how your company manages and monitors employee access to every technology platform connected to cashless payments.

Evaluating who handles each aspect of the cashless payment cycle helps auditors confirm whether you have the appropriate level of security and segregation of duties to prevent fraud and misstatement.

3. Testing the reconciliation process

Auditors will review prior sales reconciliations to test their accuracy and ensure appropriate recognition of revenue. This may be especially challenging as companies implement the new accounting rules on revenue recognition for long-term contracts. Auditors also will test accounting entries related to such accounts as inventory, deferred revenue and accounts receivable.

4. Analyzing trends

Cashless transactions create an electronic audit trail. So, there’s ample data for auditors to analyze. To uncover anomalies, auditors may, for example, analyze sales by payment vehicle, over different time periods and according to each employee’s sales activity.

If your company has experienced payment fraud, it’s important to share that information with your audit team. Also tell them about steps you took to remediate the problem and recover losses.

Preparing for a cashless future

Before we arrive to conduct fieldwork, let’s discuss the types of cashless payments you now accept — or plan to accept in the future. Depending on the number of cashless methods, we’ll amend our audit program to review them in detail.

© 2019

When Are LLC Members Subject to Self-Employment Tax?

Limited liability company (LLC) members commonly claim that their distributive shares of LLC income — after deducting compensation for services in the form of guaranteed payments — aren’t subject to self-employment (SE) tax. But the IRS has been cracking down on LLC members it claims have underreported SE income, with some success in court.

SE tax background

Self-employment income is subject to a 12.4% Social Security tax (up to the wage base) and a 2.9% Medicare tax. Generally, if you’re a member of a partnership — including an LLC taxed as a partnership — that conducts a trade or business, you’re considered self-employed.

General partners pay SE tax on all their business income from the partnership, whether it’s distributed or not. Limited partners, however, are subject to SE tax only on any guaranteed payments for services they provide to the partnership. The rationale is that limited partners, who have no management authority, are more akin to passive investors.

(Note, however, that “service partners” in service partnerships, such as law firms, medical practices, and architecture and engineering firms, generally may not claim limited partner status regardless of their level of participation.)

LLC uncertainty

Over the years, many LLC members have taken the position that they’re equivalent to limited partners and, therefore, exempt from SE tax (except on guaranteed payments for services). But there’s a big difference between limited partners and LLC members. Both enjoy limited personal liability, but, unlike limited partners, LLC members can actively participate in management without jeopardizing their liability protection.

Arguably, LLC members who are active in management or perform substantial services related to the LLC’s business are subject to SE tax, while those who more closely resemble passive investors should be treated like limited partners. The IRS issued proposed regulations to that effect in 1997, but hasn’t finalized them — although it follows them as a matter of internal policy.

Some LLC members have argued that the IRS’s failure to finalize the regulations supports the claim that their distributive shares aren’t subject to SE tax. But the IRS routinely rejects this argument and has successfully litigated its position. The courts generally have imposed SE tax on LLC members unless, like traditional limited partners, they lack management authority and don’t provide significant services to the business.

Review your situation

The law in this area remains uncertain, particularly with regard to capital-intensive businesses. But given the IRS’s aggressiveness in collecting SE taxes from LLCs, LLC members should assess whether the IRS might claim that they’ve underpaid SE taxes.

Those who wish to avoid or reduce these taxes in the future may have some options, including converting to an S corporation or limited partnership, or restructuring their ownership interests. When evaluating these strategies, there are issues to consider beyond taxes. Contact us to discuss your specific situation.

© 2019

Public Companies to Disclose Stock Hedging Policies and Practices

Does your company have policies in place regarding the use of hedging transactions by company insiders? Final Securities and Exchange Commission (SEC) guidance will soon require public companies to disclose whether their officers, employees and directors are allowed to offset a decrease in the market value of the company’s stock. Here’s what you should know to provide up-to-date disclosures.

Hedging concerns

Starting in the 1980s and 1990s, many companies adopted stock-compensation programs to help align the financial interests of executives and other company insiders with those of public shareholders. However, in the years leading up to the 2008 financial crisis, the growing prevalence of hedging instruments made many investors suspect those common interests had eroded.

Critics said a short-sale hedge could protect an executive, employee or director who receives stock incentives against a subsequent drop in the stock price. Similarly, selling a stock future increases the value of the insider’s position as the stock price drops.

Disclosure requirements

SEC Release No. 33-10593, Disclosure of Hedging by Employees, Officers, and Directors, was issued on December 20, 2018. Mandated by Section 955 of the Dodd-Frank Act, the rule amends Item 402 of Regulation S-K under the Securities Act of 1933.

The new rule doesn’t direct companies to establish policies regarding hedging. Rather, it requires a company to describe any policies it has adopted regarding the ability of its employees (including officers) or directors to purchase financial instruments that hedge or offset any decrease in the market value of equity securities granted as compensation, or held directly or indirectly by the employee or director. The new disclosure is required in a proxy statement or information statement relating to an election of directors.

The rule requires companies to disclose fully their hedging policies and practices for securities of:

  • The company,
  • Any parent company,
  • Any subsidiary of the company, or
  • Any subsidiary of the company parent.

Alternatively, companies can choose to provide a summary of hedging practices that includes a description of any categories of hedging transactions that are specifically permitted or disallowed. If a company doesn’t have any such policies, it needs to disclose that fact or state that hedging is generally permitted.

Effective date

The new disclosure rule goes into effect for fiscal years beginning on or after July 1, 2019. However, companies that qualify as smaller reporting companies (SRCs) or emerging growth companies (EGCs) will get an extra year to comply.

An SRC has a public float of less than $250 million. EGC is a class of company established in 2012 that’s eligible for lighter disclosure and reporting requirements for the first five years after going public. Listed closed-end funds and foreign private issuers (FPIs) won’t be subject to the new disclosure requirements.

Contact us to help your public company comply with the new SEC rule. We can draft comprehensive disclosures and, if necessary, help you implement effective hedging policies.

© 2019

Fundamental Tax Truths for C-Corporations

The flat 21% federal income tax rate for C corporations under the Tax Cuts and Jobs Act (TCJA) has been great news for these entities and their owners. But some fundamental tax truths for C corporations largely remain the same:

C corporations are subject to double taxation.

Double taxation occurs when corporate income is taxed once at the corporate level and again at the shareholder level as dividends are paid out. The cost of double taxation, however, is now generally less because of the 21% corporate rate.

And double taxation isn’t a problem when a C corporation needs to retain all its earnings to finance growth and capital investments. Because all the earnings stay “inside” the corporation, no dividends are paid to shareholders, and, therefore, there’s no double taxation.

Double taxation also isn’t an issue when a C corporation’s taxable income levels are low. This can often be achieved by paying reasonable salaries and bonuses to shareholder-employees and providing them with tax-favored fringe benefits (deductible by the corporation and tax-free to the recipient shareholder-employees).

C corporation status isn’t generally advisable for ventures with appreciating assets or certain depreciable assets.

If assets such as real estate are eventually sold for substantial gains, it may be impossible to extract the profits from the corporation without being subject to double taxation. In contrast, if appreciating assets are held by a pass-through entity (such as an S corporation, partnership or limited liability company treated as a partnership for tax purposes), gains on such sales will be taxed only once, at the owner level.

But assets held by a C corporation don’t necessarily have to appreciate in value for double taxation to occur. Depreciation lowers the tax basis of the property, so a taxable gain results whenever the sale price exceeds the depreciated basis. In effect, appreciation can be caused by depreciation when depreciable assets hold their value.

To avoid this double-taxation issue, you might consider using a pass-through entity to lease to your C corporation appreciating assets or depreciable assets that will hold their value.

C corporation status isn’t generally advisable for ventures that will incur ongoing tax losses.

When a venture is set up as a C corporation, losses aren’t passed through to the owners (the shareholders) like they would be in a pass-through entity. Instead, they create corporate net operating losses (NOLs) that can be carried over to future tax years and then used to offset any corporate taxable income.

This was already a potential downside of C corporations, because it can take many years for a start-up to be profitable. Now, under the TCJA, NOLs that arise in tax years beginning after 2017 can’t offset more than 80% of taxable income in the NOL carryover year. So it may take even longer to fully absorb tax losses.

Do you have questions about C corporation tax issues post-TCJA? Contact us.

© 2019

Private Companies: Have You Implemented the New Revenue Recognition Standard?

Private companies that follow U.S. Generally Accepted Accounting Principles (GAAP) must comply with the landmark new revenue recognition standard in 2019. Many private company CFOs and controllers report that they still have significant work to do to meet the demands of the sweeping rules. If you haven’t started the implementation process, it’s time to get the ball rolling.

Lessons from public company peers

Affected private companies must start following Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Accounting Standards Codification Topic 606), the first time they issue financial statements in 2019. For private companies with a fiscal year end or issuing quarterly statements under U.S. GAAP, that could be within the next few months. Other private companies have until the end of the year or even early 2020. No matter what, it’s crunch time.

Public companies, which had to begin following the standard in 2018, reported that, even if the new accounting didn’t radically change the number they reported in the top line of their income statements, it changed the method by which they had to calculate it. They had to comb through contracts and offer paper trails to back up their estimates to auditors. Public companies largely reported that the standard was more work than they anticipated. Private companies can expect the same challenges.

An overview

The revenue recognition standard erases reams of industry-specific revenue guidance in U.S. GAAP and attempts to come up with the following five-step revenue recognition model for most businesses worldwide:

1. Identify the contracts with a customer.2. Identify the performance obligations in the contract.3. Determine the transaction price.4. Allocate the transaction price to the performance obligations.5. Recognize revenue as the entity satisfies a performance obligation.
In many cases, the revenue a company reports under the new guidance won’t differ much from what it reported under old rules. But the timing of when a company can record revenues may be affected, particularly for long-term, multi-part arrangements. Companies also must assess:

  • The extent by which payments could vary due to such terms as bonuses, discounts, rebates and refunds,
  • The extent that collected payments from customers is “probable” and won’t result in a significant reversal in the future, and
  • The time value of money to determine the transaction price.

The result is a process that offers fewer bright-line rules and more judgment calls compared to old U.S. GAAP.

We can help

Our accounting experts can help you avoid a “fire drill” right before your implementation deadline and employ best practices learned from public companies that made the switch in 2018. Contact us for help getting your revenue reporting systems, processes and policies up to speed.

© 2019