All businesses can deduct ordinary and necessary business expenses from their tax return. But be careful — it’s not black and white.
ONE SIZE DOESN’T FIT ALL
Deductible business expenses aren’t uniform. An ordinary business expense for a dog walking business certainly wouldn’t be ordinary for a bakery.
Think of it like this. What expenses are unequivocally needed to run your business? A dog walker needs dog treats and leashes. But a bakery doesn’t.
BEWARE OF THE GRAY AREA
Several types of expenses tend to occupy the gray areas. These include business meals, automobile expenses, travel, and capital expenditures. Without clear-cut rules, don’t blur the lines between what’s deductible and what’s not. A lunch with a customer is a business expense. But lunch with your spouse or child likely isn’t. Travel to an industry conference is an ordinary expense. However, a trip to the Maldives, where you spend a few hours planning your company’s future, doesn’t count.
A business may be able to claim a federal income tax deduction for a theft loss. But does embezzlement count as theft? In most cases it does but you’ll have to substantiate the loss. A recent U.S. Tax Court decision illustrates how that’s sometimes difficult to do.
Basic rules for theft losses
The tax code allows a deduction for losses sustained during the taxable year and not compensated by insurance or other means. The term “theft” is broadly defined to include larceny, embezzlement and robbery. In general, a loss is regarded as arising from theft only if there’s a criminal element to the appropriation of a taxpayer’s property.
In order to claim a theft loss deduction, a taxpayer must prove:
The amount of the loss,
The date the loss was discovered, and
That a theft occurred under the law of the jurisdiction where the alleged loss occurred.
Facts of the recent court case
Years ago, the taxpayer cofounded an S corporation with another shareholder. At the time of the alleged embezzlement, the other original shareholder was no longer a shareholder, and she wasn’t supposed to be compensated by the business. However, according to court records, she continued to manage the S corporation’s books and records.
The taxpayer suffered an illness that prevented him from working for most of the year in question. During this time, the former shareholder paid herself $166,494. Later, the taxpayer filed a civil suit in a California court alleging that the woman had misappropriated funds from the business.
On an amended tax return, the corporation reported a $166,494 theft loss due to the embezzlement. The IRS denied the deduction. After looking at the embezzlement definition under California state law, the Tax Court agreed with the IRS.
The Tax Court stated that the taxpayer didn’t offer evidence that the former shareholder “acted with the intent to defraud,” and the taxpayer didn’t show that the corporation “experienced a theft meeting the elements of embezzlement under California law.”
The IRS and the court also denied the taxpayer’s alternate argument that the corporation should be allowed to claim a compensation deduction for the amount of money the former shareholder paid herself. The court stated that the taxpayer didn’t provide evidence that the woman was entitled to be paid compensation from the corporation and therefore, the corporation wasn’t entitled to a compensation deduction. (TC Memo 2021-66)
How to proceed if you’re victimized
If your business is victimized by theft, embezzlement or internal fraud, you may be able to claim a tax deduction for the loss. Keep in mind that a deductible loss can only be claimed for the year in which the loss is discovered, and that you must meet other tax-law requirements. Keep records to substantiate the claimed theft loss, including when you discovered the loss. If you receive an insurance payment or other reimbursement for the loss, that amount must be subtracted when computing the deductible loss for tax purposes. Contact us with any questions you may have about theft and casualty loss deductions.
What if you decide to, or are asked to, guarantee a loan to your corporation? Before agreeing to act as a guarantor, endorser or indemnitor of a debt obligation of your closely held corporation, be aware of the possible tax consequences. If your corporation defaults on the loan and you’re required to pay principal or interest under the guarantee agreement, you don’t want to be blindsided.
Business vs. nonbusiness
If you’re compelled to make good on the obligation, the payment of principal or interest in discharge of the obligation generally results in a bad debt deduction. This may be either a business or a nonbusiness bad debt deduction. If it’s a business bad debt, it’s deductible against ordinary income. A business bad debt can be either totally or partly worthless. If it’s a nonbusiness bad debt, it’s deductible as a short-term capital loss, which is subject to certain limitations on deductions of capital losses. A nonbusiness bad debt is deductible only if it’s totally worthless.
In order to be treated as a business bad debt, the guarantee must be closely related to your trade or business. If the reason for guaranteeing the corporation loan is to protect your job, the guarantee is considered closely related to your trade or business as an employee. But employment must be the dominant motive. If your annual salary exceeds your investment in the corporation, this tends to show that the dominant motive for the guarantee was to protect your job. On the other hand, if your investment in the corporation substantially exceeds your annual salary, that’s evidence that the guarantee was primarily to protect your investment rather than your job.
Except in the case of job guarantees, it may be difficult to show the guarantee was closely related to your trade or business. You’d have to show that the guarantee was related to your business as a promoter, or that the guarantee was related to some other trade or business separately carried on by you.
If the reason for guaranteeing your corporation’s loan isn’t closely related to your trade or business and you’re required to pay off the loan, you can take a nonbusiness bad debt deduction if you show that your reason for the guarantee was to protect your investment, or you entered the guarantee transaction with a profit motive.
In addition to satisfying the above requirements, a business or nonbusiness bad debt is deductible only if:
You have a legal duty to make the guaranty payment, although there’s no requirement that a legal action be brought against you;
The guaranty agreement was entered into before the debt becomes worthless; and
You received reasonable consideration (not necessarily cash or property) for entering into the guaranty agreement.
Any payment you make on a loan you guaranteed is deductible as a bad debt in the year you make it, unless the agreement (or local law) provides for a right of subrogation against the corporation. If you have this right, or some other right to demand payment from the corporation, you can’t take a bad debt deduction until the rights become partly or totally worthless.
These are only a few of the possible tax consequences of guaranteeing a loan to your closely held corporation. Contact us to learn all the implications in your situation.
Not all business expenses are created equally. Only those that rise to the “ordinary and necessary” threshold become tax deductible.
IT’S OK TO BE ORDINARY
To qualify as an ordinary business expense, it must be normal, usual, or customary for the type of business. Some expenses that may only happen once in a business’s life cycle, like a lawsuit, have been deemed ordinary business expenses because businesses often face legal challenges.
DO YOU NEED IT?
Necessary business expenses are those deemed appropriate and helpful. Determining whether an expense is appropriate and helpful is generally a judgment call based upon the type of business and the industry in which the company operates.
A key factor in determining necessity is that the expense can’t be primarily personal. That means if you own a plumbing business and have a passion for racing dirt bikes, placing your company’s logo on the bike, the trailer or your race jersey likely won’t satisfy the appropriate-and-helpful criteria.
If your company is planning to merge with or buy another business, your attention is probably on conducting due diligence and negotiating deal terms. But you also should address the post-closing financial reporting requirements for the transaction. If not, it may lead to disappointing financial results, restatements and potential lawsuits after the dust settles.
Here’s guidance on how to correctly account for M&A transactions under U.S. Generally Accepted Accounting Principles (GAAP).
Identify assets and liabilities
A seller’s GAAP balance sheet may exclude certain intangible assets and contingencies, such as internally developed brands, patents, customer lists, environmental claims and pending lawsuits. Overlooking identifiable assets and liabilities often results in inaccurate reporting of goodwill from the sale.
Private companies can elect to combine noncompete agreements and customer-related intangibles with goodwill. If this alternative is used, it specifically excludes customer-related intangibles that can be licensed or sold separately from the business.
It’s also important to determine whether the deal terms include arrangements to compensate the seller or existing employees for future services. These payments, along with payments for pre-existing arrangements, aren’t part of a business combination. In addition, acquisition-related costs, such as finder’s fees or professional fees, shouldn’t be capitalized as part of the business combination. Instead, they’re generally accounted for separately and expensed as incurred.
Determine the price
When the buyer pays the seller in cash, the purchase price (also called the “fair value of consideration transferred”) is obvious. But other types of consideration muddy the waters. Consideration exchanged may include stock, stock options, replacement awards and contingent payments.
For example, it can be challenging to assign fair value to contingent consideration, such as earnouts payable only if the acquired entity achieves predetermined financial benchmarks. Contingent consideration may be reported as a liability or equity (if the buyer will be required to pay more if it achieves the benchmark) or as an asset (if the buyer will be reimbursed for consideration already paid). Contingent consideration that’s reported as an asset or liability may need to be remeasured each period if new facts are obtained during the measurement period or for events that occur after the acquisition date.
Allocate fair value
Next, you’ll need to split up the purchase price among the assets acquired and liabilities assumed. This requires you to estimate the fair value of each item. Any leftover amount is assigned to goodwill. Essentially, goodwill is the premium the buyer is willing to pay above the fair value of the net assets acquired for expected synergies and growth opportunities related to the business combination.
In rare instances, a buyer negotiates a “bargain” purchase. Here, the fair value of the net assets exceeds the purchase price. Rather than book negative goodwill, the buyer reports a gain on the purchase.
Make accounting a forethought, not an afterthought
M&A transactions and the accompanying financial reporting requirements are uncharted territory for many buyers. Don’t wait until after a deal closes to figure out how to report it. We can help you understand the accounting rules and the fair value of the acquired assets and liabilities before closing.
During the pandemic, cash has been tight for many small businesses, which may make it hard to attract and retain skilled workers. In lieu of providing cash bonuses or annual raises, some companies may decide to give valued employees a share of their future profits. While corporations generally issue stock options, limited liability companies (LLCs) use a relatively new form of equity compensation called “profits interests” to incentivize workers. Here’s a summary of the accounting rules that are used to account for these transactions.
Types of awards
Under U.S. Generally Accepted Accounting Principles (GAAP), profits interest awards may be classified as:
Bonus arrangements, or
Classification is determined by the specific terms and features of the profits interest. In most cases, the fair value of the award must be recorded as an expense on the income statement. Profits interest can also result in the recognition of a liability on the balance sheet and require footnote disclosures.
Under GAAP, fair value is the price an entity would receive to sell an asset — or pay to transfer a liability — in a transaction that’s orderly, takes place between market participants and occurs at the acquisition date. If quoted market prices and other observable inputs aren’t available, unobservable inputs are used to estimate fair value.
One of the upsides to issuing profits interest awards is their flexibility. There’s no standard definition of a profits interest; the term “profits” can refer to whatever is agreed to by the LLC and the recipient of the award. In addition, profits interest units may be subject to various terms and conditions, such as:
Specific performance thresholds, and
An LLC may offer multiple types of profits interests, allowing it to customize awards for various purposes. The varieties of terms and conditions that can be incorporated into a profits interest requires the use of customized valuation techniques.
Need for improvement
Many private companies struggle with how to report profits interests. In recent years, the Financial Accounting Standards Board (FASB) has discussed ways to simplify the rules, including scaling back the disclosure requirements and providing a practical expedient to measure grant-date fair value of these awards. No changes have been made yet, however.
For more information
Accounting complexity has caused some private companies to shy away from profits interest arrangements. But they can be an effective tool for attracting and retaining workers under the right circumstances. Contact us for help reporting these transactions under existing GAAP or for an update on the latest developments from the FASB.
Breakeven analysis can be useful when investing in new equipment, launching a new product or analyzing the effects of a cost reduction plan. During the COVID-19 pandemic, however, many struggling companies are using it to evaluate how much longer they can afford to keep their doors open.
Fixed vs. variable costs
Breakeven can be explained in a few different ways using information from your company’s income statement. It’s the point at which total sales are equal to total expenses. More specifically, it’s where net income is equal to zero and sales are equal to variable costs plus fixed costs.
To calculate your breakeven point, you need to understand a few terms:
Fixed expenses. These are the expenses that remain relatively unchanged with changes in your business volume. Examples include rent, property taxes, salaries and insurance.
Variable/semi-fixed expenses. Your sales volume determines the ebb and flow of these expenses. If you had no sales revenue, you’d have no variable expenses and your semifixed expenses would be lower. Examples are shipping costs, materials, supplies and independent contractor fees.
The basic formula for calculating the breakeven point is:
Breakeven can be computed on various levels. For example, you can estimate it for your company overall or by product line or division, as long as you have requisite sales and cost data broken down.
To illustrate how this formula works, let’s suppose ABC Company generates $24 million in revenue, has fixed costs of $2 million and variable costs of $21.6 million. Here’s how those numbers fit into the breakeven formula:
Annual breakeven = $2 million / [1 – ($21.6 million / $24 million)] = $20 million
Monthly breakeven = $20 million / 12 = $1,666,667
As long as expenses stay within budget, the breakeven point will be reliable. In the example, variable expenses must remain at 90% of revenue and fixed expenses must stay at $2 million. If either of these variables changes, the breakeven point will change.
Lowering your breakeven
During the COVID-19 pandemic, distressed companies may have taken measures to reduce their breakeven points. One solution is to convert as many fixed costs into variable costs as possible. Another solution involves cost cutting measures, such as carrying less inventory and furloughing workers. You also might consider refinancing debt to take advantage of today’s low interest rates and renegotiating key contracts with lessors, insurance providers and suppliers. Contact us to help you work through the calculations and find a balance between variable and fixed costs that suits your company’s current needs.
This year, the optional standard mileage rate used to calculate the deductible costs of operating an automobile for business decreased by one-and-one-half cents, to 56 cents per mile. As a result, you might claim a lower deduction for vehicle-related expenses for 2021 than you could for 2020 or 2019. This is the second year in a row that the cents-per-mile rate has decreased.
Deducting actual expenses vs. cents-per-mile
In general, businesses can deduct the actual expenses attributable to business use of vehicles. This includes gas, oil, tires, insurance, repairs, licenses and vehicle registration fees. In addition, you can claim a depreciation allowance for the vehicle. However, in many cases, certain limits apply to depreciation write-offs on vehicles that don’t apply to other types of business assets.
The cents-per-mile rate is useful if you don’t want to keep track of actual vehicle-related expenses. With this method, you don’t have to account for all your actual expenses. However, you still must record certain information, such as the mileage for each business trip, the date and the destination.
Using the cents-per-mile rate is also popular with businesses that reimburse employees for business use of their personal vehicles. These reimbursements can help attract and retain employees who drive their personal vehicles extensively for business purposes. Why? Under current law, employees can no longer deduct unreimbursed employee business expenses, such as business mileage, on their own income tax returns.
If you do use the cents-per-mile rate, be aware that you must comply with various rules. If you don’t comply, the reimbursements could be considered taxable wages to the employees.
The 2021 rate
Beginning on January 1, 2021, the standard mileage rate for the business use of a car (van, pickup or panel truck) is 56 cents per mile. It was 57.5 cents for 2020 and 58 cents for 2019.
The business cents-per-mile rate is adjusted annually. It’s based on an annual study commissioned by the IRS about the fixed and variable costs of operating a vehicle, such as gas, maintenance, repair and depreciation. The rate partly reflects the current price of gas, which is down from a year ago. According to AAA Gas Prices, the average nationwide price of a gallon of unleaded regular gas was $2.42 recently, compared with $2.49 a year ago. Occasionally, if there’s a substantial change in average gas prices, the IRS will change the cents-per-mile rate midyear.
When this method can’t be used
There are some situations when you can’t use the cents-per-mile rate. In some cases, it partly depends on how you’ve claimed deductions for the same vehicle in the past. In other cases, it depends on if the vehicle is new to your business this year or whether you want to take advantage of certain first-year depreciation tax breaks on it.
As you can see, there are many factors to consider in deciding whether to use the mileage rate to deduct vehicle expenses. We can help if you have questions about tracking and claiming such expenses in 2021 — or claiming them on your 2020 income tax return.
Here are some of the key tax-related deadlines affecting businesses and other employers during the first quarter of 2021. Keep in mind that this list isn’t all-inclusive, so there may be additional deadlines that apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements.
Pay the final installment of 2020 estimated tax.
Farmers and fishermen: Pay estimated tax for 2020.
February 1 (The usual deadline of January 31 is a Sunday)
File 2020 Forms W-2, “Wage and Tax Statement,” with the Social Security Administration and provide copies to your employees.
Provide copies of 2020 Forms 1099-MISC, “Miscellaneous Information,” and 1099-NEC, “Nonemployee Compensation” to recipients of income from your business where required.
File 2020 Forms 1099-NEC reporting nonemployee compensation payments in Box 1 with the IRS.
File Form 940, “Employer’s Annual Federal Unemployment (FUTA) Tax Return,” for 2020. If your undeposited tax is $500 or less, you can either pay it with your return or deposit it. If it’s more than $500, you must deposit it. However, if you deposited the tax for the year in full and on time, you have until February 10 to file the return.
File Form 941, “Employer’s Quarterly Federal Tax Return,” to report Medicare, Social Security and income taxes withheld in the fourth quarter of 2020. If your tax liability is less than $2,500, you can pay it in full with a timely filed return. If you deposited the tax for the quarter in full and on time, you have until February 10 to file the return. (Employers that have an estimated annual employment tax liability of $1,000 or less may be eligible to file Form 944, “Employer’s Annual Federal Tax Return.”)
File Form 945, “Annual Return of Withheld Federal Income Tax,” for 2020 to report income tax withheld on all nonpayroll items, including backup withholding and withholding on accounts such as pensions, annuities and IRAs. If your tax liability is less than $2,500, you can pay it in full with a timely filed return. If you deposited the tax for the year in full and on time, you have until February 10 to file the return.
March 1 (The usual deadline of February 28 is a Sunday)
File 2020 Forms 1099-MISC with the IRS if: 1) they’re not required to be filed earlier and 2) you’re filing paper copies. (Otherwise, the filing deadline is March 31.)
If a calendar-year partnership or S corporation, file or extend your 2020 tax return and pay any tax due. If the return isn’t extended, this is also the last day to make 2020 contributions to pension and profit-sharing plans.
Unfortunately, many businesses have experienced problems with collections during the COVID-19 pandemic. Accounts receivable are a major item on most companies’ balance sheets. Slow-paying — or even nonpaying — customers or clients adversely affect cash flow. Proactive measures can help identify collections issues early and remedy them before they spiral out of control.
Recognize the warning signs
To stay on top of collections, be aware of the following red flags:
Anonymous clients. Some prospective customers don’t seem to exist anywhere other than, say, a vague email address. This is a sign to move cautiously. It’s not too much to expect that even start-up businesses have some sort of online presence, a physical address, and a working email address and phone number.
Empty assurances. One warning sign is clients who ask that work on their product or service start immediately, but without providing assurances that payment will be forthcoming. In some industries, it might be common practice for suppliers to provide goods or services, and follow up with invoices later. When that’s not the case, however, consider the lack of credible assurances to be a warning sign. That’s especially true if a prospective customer is vague on the budget for a project.
Future earnings as payment. Customers who promise some portion of future earnings as payment may be legitimate. But, before you begin work, nail down the terms and decide if the potential reward compensates for the risk.
Perpetual nitpicking. A client who regularly finds fault with minor details of a project may keep it from ever getting off the ground. While clients have a right to expect the level of quality promised at the outset of a project, those who seem to continually search for reasons to criticize products or services may be using their purported dissatisfaction to avoid paying for their purchase.
Take precautionary measures
If you’re skeptical you’ll be able to collect from a customer, it’s wise to ask for a retainer or deposit up front before starting a project. You can also request progress payments while the project is in process. Additional steps that can help expedite collections include:
Following up with a firm, but tactful, email when an invoice is overdue.
Moving to a phone call if follow-up emails aren’t generating a response.
Trying to contact the customer’s accounts payable staff or business manager, if previous follow-up efforts aren’t working.
If you have clients that continue to withhold payment after these steps, it may be time to take legal action. When it’s necessary to pursue missing payments, persistence pays off.
Delinquent payments and write-offs can damage your company’s operations and profitability. Contact us if your business is experiencing collections issues. We can help you sort out your options.