Hot Button Tax Topics for 2009

by Logan Gray

There is significant responsibility placed on business taxpayers to comply with the numerous regulations and requirements as set forth by the Internal Revenue Service and state taxing agencies. In an effort to both inform and educate our business taxpayers, we are writing to discuss some of the key compliance and recordkeeping issues for the upcoming tax filing season. We strongly encourage you to take the time to read and understand the topics presented in advance of the December 31, 2009 year end and determine if these issues may be applicable to your business.

1. Employee vs. Independent Contractor

For federal tax purposes, there is an important distinction made between an employee and independent contractor. Generally speaking, when determining whether a worker is an employee or independent contractor, the IRS will consider ALL evidence as to the degree of control and degree of independence of the worker. Recent IRS guidance, however, has divided evidence to the degree of control and independence into three main categories: behavioral control, financial control, and relationship of the parties. Below is a brief definition and example of each category of control:

Behavioral Control - Facts that show whether the business has the right to direct or control how the worker does the work. For example, if you receive extensive instructions on how work is to be done, this suggests that you may be an employee.
Financial Control - Facts that show whether the business has a right to control the business aspects of the worker's job. For example, if you can realize a profit or incur a loss, this suggests that you may be an independent contractor.
Relationship of the Parties - Facts that show how the business and the worker perceive their relationship. For example, if you receive benefits, such as insurance, pension, or paid leave, this suggests that you may be an employee.

No single fact provides the answer to whether a worker is an employee or independent contractor. It is important to understand the business and the relationship of the parties when determining worker classification as improper classification can have significant tax consequences to both the worker and the business.

2. Business Use of Automobiles

Expenses for gasoline, oil, tires, repairs, insurance, depreciation, parking fees and tolls, licenses, and garage rent incurred for automobiles used in a trade or business are deductible. However, the deduction is allowed only for that portion of the expenses that are attributable to business. The Internal Revenue Service requires that all taxpayers be prepared to substantiate automobile expense deductions with adequate records of sufficient evidence, to account for the following:

The amount of each expenditure on the vehicle, including lease payments, repairs and maintenance, gas, and other expenditures
The total mileage on the vehicle each year and the breakdown of the business, personal, and commuting miles
The date of each expenditure and the business purpose for each use of the vehicle

In recent tax years the area of automobile expense deduction and their substantiation have received increased attention and scrutiny from the Internal Revenue Service. As a general rule, taxpayers must keep a written log of all automobile expenditures including all the information listed above. In addition to a written record, taxpayers should also keep receipts for any expense of $75 or more.

3. Business Use of Cell Phones

Cell phones that are supplied by an employer and used for business are treated in a similar way to automobiles used for business. The nature of these assets lends them to personal use and therefore subjects the assets to "listed property" rules. Generally, these listed property rules require taxpayers to adequately substantiate the extent of an asset's business use. Expenses related to cell phones may only be deducted for income tax purposes if the expenses can be substantiated by adequate records, or by sufficient evidence corroborating the expenses including all of the following:

the amount of the expense
the time and place of the expense
the business purpose of the expense
the business relationship to the persons involved in the in the expense

In addition, employees must document their personal use of the cell phone, and the employer must include such use in the employee's income on Form W-2.

4. Medical Insurance Premiums of S Corporation Shareholders

The health and accident insurance premiums paid on behalf of a 2% S corporation shareholder-employees are deductible by the S corporations as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder- employee's Form W-2. This additional compensation is not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. It should however, be included in Box 1 (Wages) of the Form W-2, Wages and Tax Statement, issued to the shareholder, but is not included in Boxes 3 or 5 of Form W-2. For New Jersey and Delaware residents this amount should also be included in Box 16 (State Wages). Pennsylvania residents should not include shareholder health insurance premiums in Box 16 (State Wages).

A 2% shareholder-employee is eligible for a deduction against adjusted gross income for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation. For a medical care plan to be considered "established by the S corporation" it can be in the name of the S corporation or in the name of the 2% shareholder. In addition, medical care plans in the name of the 2% shareholder must either be paid by the S corporation directly or reimbursed if paid by the 2% shareholder. In either instance the premium payment or the reimbursement should be added as wages on the 2% shareholder's Form W-2.

5. Travel and Entertainment

Travel expenses are defined as the ordinary and necessary expenses of traveling away from home for your business, profession, or job. An ordinary expense is one that is common in your trade or business. A necessary expense is one that is helpful and appropriate for your business. The types of expenses you can deduct depend upon facts and circumstances. Some common examples would be airline tickets, hotel fares, vehicle rentals, and meals. When you travel away from home on business, you should keep a written record of all travel expenses incurred. A written record of travel expenses should include the amount, date, place or description, and business purpose for each expense.

Entertainment expenses may be deductible only if they are both ordinary and necessary and meet one of the following tests:

Directly-related test - to meet this test you must show that the main purpose was the active conduct of business, that you did engage in business during the entertainment, and you had more than general expectation of some business benefit at a future time.
Associated test - to meet this test you must show that the entertainment is associated with your trade or business, and that the entertainment is directly before or after a substantial business discussion.

In general, you can only deduct 50% of your business-related entertainment expenses. This 50% limit applies to employees or their employers, and self-employed persons (including independent contractors) or their clients, depending on whether the expenses are reimbursed.

All taxpayers have the responsibility to understand and comply with the requirements as set forth by the Internal Revenue Service and state taxing agencies. It should be noted that the topics discussed in this letter and the requirements set fourth by the federal and state taxing agencies have already been in place. We believe that it is important to review these issues regularly as any excessive or improper application of the topics discussed could substantially increase your risk of audit by taxing authorities or significantly impact your tax liability. As your accountants and tax preparers we are providing this information for you as it is important that you understand the growing support and documentation requirements of the Internal Revenue Service and state taxing agencies. If you do not understand or you need further clarification on any of the issues discussed in this letter, please contact your Baratz & Associates representative.