If you’re claiming deductions for business meals or vehicle expenses, expect the IRS to closely review them. In some cases, taxpayers have incomplete documentation or try to create records months (or years) later. In doing so, they fail to meet the strict substantiation requirements set forth under tax law. Tax auditors are adept at rooting out inconsistencies, omissions and errors in taxpayers’ records, as illustrated by one recent U.S. Tax Court case. (T.C. Memo. 2024-82)

Facts of the case

The taxpayer operated a software installation, training and consulting business. She claimed substantial deductions for several tax years. The IRS disallowed many of the deductions and the U.S. Tax Court agreed. Here’s a rundown of some of the disallowed expenses and the reasons why they couldn’t be deducted:

Meals and entertainment. The business owner deducted nearly $9,000 for meal expenses in one tax year and testified the amount was for “working lunches” with the “person she worked for and the developer.” As documentation, she submitted bank statements. The court noted that “bank statements alone do not substantiate the ‘business purpose of the expense’ or the ‘business relationship’ between petitioner and the individuals with whom she dined.” It added: “The cost of eating lunch during the workday is not — without more — a deductible business expense.”

Supplies. The taxpayer deducted more than $17,000 for supplies purchased during two tax years. She testified that these included “desks, monitors, office equipment, paper, printers, [and] anything that was pertinent to the business itself.” To substantiate her reported expenses, the taxpayer submitted receipts from office supply stores. However, the receipts were dated later than the tax years in question, and they covered (among other things) purchases of soda dispensers and gift cards. The court noted that “some of these purchases appear personal” and all were made after she terminated her consulting business.

Home office expenses. Over two years, the taxpayer deducted $21,393 for the business use of a home office. But the court ruled that she “failed to prove that the ‘focal point’ of her software consulting business was her home.” At trial, she testified that she was required to be on site at a client’s office much of the time. In addition, she didn’t supply evidence to establish how much time she worked from home or what (if any) portion of her residence was used exclusively for business purposes.

Other expenses the court disallowed included attorney’s fees, utilities, hotel stays and vehicle expenses. In all cases, the taxpayer didn’t substantiate with adequate records or sufficient evidence that the expenses were related to her business.

Best practices

This case exemplifies why it’s critical to maintain meticulous records to support business expense deductions. Here’s a list of DOs and DON’Ts to help meet the strict IRS and tax law substantiation requirements for these items:

DO keep detailed, accurate records. For example, for each business meal, record the amount, date, place, business purpose, and the business relationship of any person you dine with. If you have employees whom you reimburse for meals, travel and vehicle expenses, make sure they’re complying with all the rules.

DON’T reconstruct expense logs at year end or wait until you receive a notice from the IRS. Take a moment to record the details in a log or diary or on a receipt at the time of an event or soon after. Require employees to submit weekly or monthly expense reports.

DO respect the fine line between personal and business expenses. Be careful about combining business and pleasure. Your business checking account and credit cards shouldn’t be used for personal expenses.

DON’T be surprised if the IRS asks you to prove your deductions. Vehicle, travel, meal and home office expenses are attention magnets. Be prepared for a challenge.

Stand up to scrutiny

With organization and our guidance, your tax records can stand up to IRS inspection. There may be other ways to substantiate your deductions. In addition, there may be a way to estimate certain deductions (called “the Cohan rule”), if your records are lost due to a fire, theft, flood or other disaster.

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Many businesses turn to independent contractors to help manage costs, especially during times of staffing shortages and inflation. If you’re among them, ensuring these workers are properly classified for federal tax purposes is crucial. Misclassifying employees as independent contractors can result in expensive consequences if the IRS steps in and reclassifies them. It could lead to audits, back taxes, penalties and even lawsuits.

Understanding worker classification

Tax law requirements for businesses differ for employees and independent contractors. And determining whether a worker is an employee or an independent contractor for federal income and employment tax purposes isn’t always straightforward. If a worker is classified as an employee, your business must:

• Withhold federal income and payroll taxes,
• Pay the employer’s share of FICA taxes,
• Pay federal unemployment (FUTA) tax,
• Potentially offer fringe benefits available to other employees, and
• Comply with additional state tax requirements.

In contrast, if a worker qualifies as an independent contractor, these obligations generally don’t apply. Instead, the business simply issues Form 1099-NEC at year end (for payments of $600 or more). Independent contractors are more likely to have more than one client, use their own tools, invoice customers and receive payment under contract terms, and have an opportunity to earn profits or suffer losses on jobs.

Defining an employee

What defines an “employee”? Unfortunately, there’s no single standard.

Generally, the IRS and courts look at the degree of control an organization has over a worker. If the business has the right to direct and control how the work is done, the individual is more likely to be an employee. Employees generally have tools and equipment provided to them and don’t incur unreimbursed business expenses.

Some businesses that misclassify workers may qualify for relief under Section 530 of the tax code, but only if specific conditions are met. The requirements include treating all similar workers consistently and filing all related tax documents accordingly. Keep in mind, this relief doesn’t apply to all types of workers.

Why you should proceed cautiously with Form SS-8

Businesses can file Form SS-8 to request an IRS determination on a worker’s status. However, this move can backfire. The IRS often leans toward classifying workers as employees, and submitting this form may draw attention to broader classification issues — potentially triggering an employment tax audit.

In many cases, it’s wiser to consult with us to help ensure your contractor relationships are properly structured from the outset, minimizing risk and ensuring compliance. For example, you can use written contracts that clearly define the nature of the relationships. You can maintain documentation that supports the classifications, apply consistent treatment to similar workers and take other steps.

When a worker files Form SS-8

Workers themselves can also submit Form SS-8 if they believe they’re misclassified — often in pursuit of employee benefits or to reduce self-employment tax. If this happens, the IRS will contact the business, provide a blank Form SS-8 and request it be completed. The IRS will then evaluate the situation and issue a classification decision.

Help avoid costly mistakes

Worker classification is a nuanced area of tax law. If you have questions or need guidance, reach out to us. We can help you accurately classify your workforce to avoid costly missteps.

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Are you starting a business with partners and deciding on the right entity? An S corporation might be the best choice for your new venture.

One benefit of an S corporation

One major advantage of an S corporation over a partnership is that shareholders aren’t personally liable for corporate debts. To ensure this protection, it’s crucial to:

• Adequately finance the corporation,
• Maintain the corporation as a separate entity, and
• Follow state-required formalities (for example, by filing articles of incorporation, adopting bylaws, electing a board of directors and holding organizational meetings).

Handling losses

If you anticipate early losses, an S corporation is more favorable than a C corporation from a tax perspective. Shareholders in a C corporation generally don’t benefit from such losses. However, as an S corporation shareholder, you can deduct your share of losses on your personal tax return, up to your basis in the stock and any loans you made to the entity. Losses exceeding your basis can be carried forward and deducted in the future when there’s sufficient basis.

Profits and taxes

Once the S corporation starts earning profits, the income is taxed directly to you, whether or not it’s distributed. It will be reported on your individual tax return and combined with income from other sources. Your share of the S corporation’s income isn’t subject to self-employment tax, but your wages will be subject to Social Security taxes. If the income qualifies as qualified business income (QBI), you can take the 20% pass-through deduction, subject to various limitations.

Note: The QBI deduction is set to expire after 2025 unless extended by Congress. However, the deduction will likely be extended and maybe even made permanent under the Tax Cuts and Jobs Act extension being negotiated in Congress.

Fringe benefits

If you plan to offer fringe benefits like health and life insurance, be aware that the costs for a more than 2% shareholder are deductible by the entity but taxable to the recipient.

Protecting S status

Be cautious about transferring stock to ineligible shareholders (for example, another corporation, a partnership or a nonresident alien), as this could terminate the S election, making the corporation a taxable entity. To avoid this risk, have each shareholder sign an agreement not to make transfers that would jeopardize the S election. Also, be aware that an S corporation can’t have more than 100 shareholders.

Final steps

Before making your final decision on the entity type, consult with us. We can answer your questions and help you launch your new venture successfully.

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When selling business assets, understanding the tax implications is crucial. One area to focus on is Section 1231 of the Internal Revenue Code, which governs the treatment of gains and losses from the sale or exchange of certain business property.

Business gain and loss tax basics

The federal income tax character of gains and losses from selling business assets can fall into three categories:

• Capital gains and losses. These result from selling capital assets which are generally defined as property other than 1) inventory and property primarily held for sale to customers, 2) business receivables, 3) real and depreciable business property including rental real estate, and 4) certain intangible assets such as copyrights, musical works and art works created by the taxpayer. Operating businesses typically don’t own capital assets, but they might from time to time.
• Sec. 1231 gains and losses. These result from selling Sec. 1231 assets which generally include 1) business real property (including land) that’s held for more than one year, 2) other depreciable business property that’s held for more than one year, 3) intangible assets that are amortizable and held for more than one year, and 4) certain livestock, timber, coal, domestic iron ore and unharvested crops.
• Ordinary gains and losses. These result from selling all assets other than capital assets and Sec. 1231 assets. Other assets include 1) inventory, 2) receivables, and 3) real and depreciable business assets that would be Sec. 1231 assets if held for over one year. Ordinary gains can also result from various recapture provisions, the most common of which is depreciation recapture.

Favorable tax treatment

Gains and losses from selling Sec. 1231 assets receive favorable federal income tax treatment.

Net Sec. 1231 gains. If a taxpayer’s Sec. 1231 gains for the year exceed the Sec. 1231 losses for that year, all the gains and losses are treated as long-term capital gains and losses — assuming the nonrecaptured Sec. 1231 loss rule explained later doesn’t apply.

An individual taxpayer’s net Sec. 1231 gain — including gains passed through from a partnership, LLC, or S corporation — qualifies for the lower long-term capital gain tax rates.

Net Sec. 1231 losses. If a taxpayer’s Sec. 1231 losses for the year exceed the Sec. 1231 gains for that year, all the gains and losses are treated as ordinary gains and losses. That means the net Sec. 1231 loss for the year is fully deductible as an ordinary loss, which is the optimal tax outcome.

Unfavorable nonrecaptured Sec. 1231 loss rule

Now for a warning: Taxpayers must watch out for the nonrecaptured Sec. 1231 loss rule. This provision is intended to prevent taxpayers from manipulating the timing of Sec. 1231 gains and losses in order to receive favorable ordinary loss treatment for a net Sec. 1231 loss, followed by receiving favorable long-term capital gain treatment for a net Sec. 1231 gain recognized in a later year.

The nonrecaptured Sec. 1231 loss for the current tax year equals the total net Sec. 1231 losses that were deducted in the preceding five tax years, reduced by any amounts that have already been recaptured. A nonrecaptured Sec. 1231 loss is recaptured by treating an equal amount of current-year net Sec. 1231 gain as higher-taxed ordinary gain rather than lower-taxed long-term capital gain.

For losses passed through to an individual taxpayer from a partnership, LLC, or S corporation, the nonrecaptured Sec. 1231 loss rule is enforced at the owner level rather than at the entity level.

Tax-smart timing considerations

Because the unfavorable nonrecaptured Sec. 1231 loss rule cannot affect years before the year when a net Sec. 1231 gain is recognized, the tax-smart strategy is to try to recognize net Sec. 1231 gains in years before the years when net Sec. 1231 losses are recognized.

Conclusion

Achieving the best tax treatment for Sec. 1231 gains and losses can be a challenge. We can help you plan the timing of gains and losses for optimal tax results.

© 2025

New beneficial ownership information (BOI) reporting requirements that many small businesses were required to comply with by January 1, 2025, have been suspended nationwide under a new court ruling. However, businesses can still voluntarily submit BOI reports, according to the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN).

How we got here

Under the Corporate Transparency Act (CTA), the BOI reporting requirements went into effect on January 1, 2024. The requirements are intended to help prevent criminals from using businesses for illicit activities, such as money laundering and fraud. The CTA requires many small businesses to provide information about their “beneficial owners” (the individuals who ultimately own or control the businesses) to FinCEN. Failure to submit a BOI report by the applicable deadline may result in civil or criminal penalties or both.

Under the CTA, the exact deadline for BOI compliance depends on the entity’s date of formation. Reporting companies created or registered before January 1, 2024, have one year to comply by filing initial reports, which means their deadline would be January 1, 2025. Those created or registered on or after January 1, 2024, but before January 1, 2025, have 90 days to file their initial reports upon receipt of their creation or registration documents. Entities created or registered on or after January 1, 2025, would have 30 days upon receipt of their creation or registration documents to file initial reports.

New court ruling

On December 3, 2024, the U.S. District Court for the Eastern District of Texas issued an order granting a nationwide preliminary injunction that:

1. Enjoins the CTA, including enforcement of the statute and regulations implementing its BOI reporting requirements, and,
2. Stays all deadlines to comply with the CTA’s reporting requirements.

The U.S. Department of Justice, on behalf of the Treasury Department, filed an appeal in the case on December 5, 2024.

FinCEN states on its website that it “continues to believe … that the CTA is constitutional,” but while the litigation is ongoing, it will comply with the order as long as it remains in effect.

“Therefore,” it adds, “reporting companies are not currently required to file their beneficial ownership information with FinCEN and will not be subject to liability if they fail to do so while the preliminary injunction remains in effect.”

This is the latest litigation related to the CTA. In two earlier cases, U.S. District Courts upheld the BOI reporting requirements. In another case, the CTA was ruled unconstitutional, but only the named plaintiffs and their members were allowed to ignore the BOI requirements while an appeal is pending. More than 30 million other businesses still needed to meet the January 1, 2025, deadline — until now.

The future is unclear

Be aware that the ruling is preliminary, so it could be overturned or modified by future court decisions or legislation. FinCEN stated that businesses can continue to submit BOI reports voluntarily. Contact us if you have questions about how to proceed.

© 2024