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Contents

Publication 535 Important Changes for 1998 ............. 2


Cat. No. 15065Z
Department Important Changes for 1999 ............. 2
of the
Treasury Business 1. Deducting Business Expenses ..

2. Employees' Pay ...........................


2

6
Internal
Revenue
Service Expenses 3. Meals and Lodging Furnished to
Employees ................................... 9

4. Fringe Benefits ............................ 11

For use in preparing 5. Employee Benefit Programs ...... 19

1998 Returns
6. Retirement Plans .........................

7. Rent Expense ..............................


27

31

8. Interest ......................................... 33

9. Taxes ............................................ 39

10. Insurance ..................................... 41

11. Costs You Can Deduct or


Capitalize ...................................... 43

12. Amortization ................................ 47

13. Depletion ...................................... 54

14. Business Bad Debts ................... 58

15. Electric and Clean-Fuel Vehicles 60

16. Other Expenses ........................... 63

17. How To Get More Information ... 70

Index .................................................... 71

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.

Help with unresolved tax issues. Most


problems can be solved with one contact by
calling, writing, or visiting an IRS office. But
if you have tried unsuccessfully to resolve a
problem with the IRS, you should contact the
Taxpayer Advocate's Problem Resolution
Program (PRP). Someone at PRP will assign
you a personal advocate who is in the best
position to try to resolve your problem. The
Taxpayer Advocate can also offer you special
help if you have a significant hardship as a
result of a tax problem.
You should contact the Taxpayer Advo-
cate if:

• You have tried unsuccessfully to resolve


your problem with the IRS and have not
been contacted by the date promised, or
• You are on your second attempt to re-
solve a problem.
You may contact a Taxpayer Advocate by
calling a new assistance number, 1–877–
777–4778. Persons who have access to
TTY/TDD equipment can call 1–800–
829–4059 and ask for the Taxpayer Advo-
cate. If you prefer, you can write to the Tax-
payer Advocate at the office that last con- Participant's compensation. Beginning in Health insurance deduction for the self-
tacted you. 1998, a plan participant's compensation in- employed. For 1999, this deduction is in-
While Taxpayer Advocates cannot change cludes certain deferrals unless you elect not creased to 60% of the amount you paid for
the tax law or make a technical tax decision to include any amount contributed under a medical insurance for yourself and your fam-
they can clear up problems that resulted from salary reduction agreement (that is not in- ily. For more information, see chapter 10.
previous contacts and ensure that your case cluded in the gross income of the employee).
is given a complete and impartial review. The new rule, which takes into account Business use of your home. Beginning in
Taxpayer Advocates are working to put ser- amounts deferred in certain employee benefit 1999, you may be able to deduct expenses
vice first. For more information about PRP, plans, will increase the tax-deferred amount for your home office, even if it is not where
get Publication 1548, The Problem Resolution that you can contribute to a deferred contri- you perform your most important business
Program of the Internal Revenue Service. bution plan at the election of the employee. activities or spend most of your business
The deferrals include amounts contributed by time. For more information, see Publication
an employee under a: 553, Highlights of 1998 Tax Changes, or
Publication 587, Business Use of Your Home
• Qualified cash or deferred arrangement (Including Use by Day-Care Providers).
Important Changes (section 401(k) plan), or a
for 1998 • Salary reduction agreement to contribute
to a SIMPLE IRA plan or a SARSEP.
The following items highlight some changes
in the tax law for 1998. For more information, see chapter 6.

Standard mileage rate. The standard mile- Matching contributions for self-employed 1.
age rate for the cost of operating your car, individuals. Beginning in 1998, matching
van, pickup, or panel truck in 1998 is 32.5
cents per mile for all business miles. You can
contributions to a 401(k) plan on behalf of a
self-employed individual will no longer be Deducting
use the standard mileage rate for a vehicle treated as elective contributions subject to the
you lease, as well as one you own. limit on elective deferrals. The matching con-
tributions for partners and other self-
Business
Vacation pay. An accrual method employer employed individuals will receive the same
treatment as the matching contributions of
Expenses
can generally deduct for a tax year vacation
pay and other deferred compensation that is other employees. For more information, see
paid to employees within 21/2 months after the chapter 6.
end of the tax year. For tax years ending after
July 22, 1998, for determining whether an Contributions to a SEP-IRA or a SIMPLE
IRA. A SEP-IRA or a SIMPLE IRA cannot
Introduction
amount is deferred compensation and when This chapter covers the general rules for de-
deferred compensation is paid, no amount is be designated as a Roth IRA. Contributions
to a SEP-IRA or a SIMPLE IRA will not affect ducting business expenses. Business ex-
considered “paid” to an employee until it is penses are the costs of carrying on a trade
actually received by the employee. the amount that an individual can contribute
to a Roth IRA. For information about Roth or business. These expenses are usually
IRAs, see Publication 590. deductible if the business is operated to make
Meals furnished on your business prem- a profit.
ises. For tax years beginning after 1997, the Health insurance deduction for the self-
50% limit on deductions for meals generally
does not apply to meals you furnish to em-
employed. The deduction for health insur- Topics
ance of self-employed individuals increases This chapter discusses:
ployees on your business premises if all of the to 45% for 1998. For more information, see
meals are excluded from the employees' chapter 10.
wages because you furnished them for your
• What can be deducted
convenience (for substantial business rea-
Certain partnerships must figure depletion
• How much can be deducted
sons other than to provide additional pay).
allowance. For partnership tax years begin- • When to deduct
Also, under a special rule enacted in 1998
ning after 1997, an electing large partnership, • Not-for-profit activities
for any tax year, you can treat all meals you
rather than each partner, generally must fig-
furnish to employees on your business
ure the depletion allowance for the partner-
premises as furnished for your convenience
ship's oil and gas property. For more infor-
if more than half (instead of substantially all) Useful Items
mation, see chapter 13.
of these employees are furnished the meals You may want to see:
for your convenience. See chapter 3.
Taxable income limit for certain percent-
age depletion. For tax years beginning after Publication
Qualified transportation fringe benefits in 1997 and before 2000, percentage depletion
place of pay. For tax years beginning after on the marginal production of oil or natural m 334 Tax Guide for Small Business
1997, you can exclude qualified transporta- gas is not limited to taxable income from the m 463 Travel, Entertainment, Gift and
tion fringe benefits from an employee's wages property figured without the depletion de-
even if you provide them in place of pay. See Car Expenses
duction. For more information, see chapter
chapter 4. 13. m 529 Miscellaneous Deductions
m 536 Net Operating Losses
Group health plan requirements. For plan Meal expense deduction for certain indi-
years beginning after 1997, you (or the plan, viduals. Beginning in 1998, if an employee m 538 Accounting Periods and Methods
if a multi-employer plan) may be subject to is subject to the Department of Transporta-
m 547 Casualties, Disasters, and Thefts
an excise tax if your plan does not meet cer- tion's hours of service limits, you may be able
tain new requirements. These requirements (Business and Nonbusiness)
to deduct 55% of the meal and beverage ex-
generally: penses you reimburse for their travel away m 551 Basis of Assets
from their tax home. For more information,
1) Obligate plans to pay for a minimum see chapter 16. m 587 Business Use of Your Home (In-
hospital stay for mothers and newborns cluding Use by Day-Care Provid-
if the plan otherwise provides benefits for ers)
hospital stays in connection with m 925 Passive Activity and At-Risk Rules
childbirth, and Important Changes m 936 Home Mortgage Interest De-
2) Prevent certain special limits from being
placed on mental health benefits. for 1999 duction
The following items highlight some changes m 946 How To Depreciate Property
For more information, see chapter 5. in the tax law for 1999.
Page 2 Chapter 1 Deducting Business Expenses
Form (and Instructions) • Cost of goods sold—chapter 6 of Publi- Business Assets
cation 334.
m Sch A (Form 1040) Itemized De- The cost of any asset you use in your busi-
ductions • Inventories—Publication 538. ness is a capital expense. There are many
• Uniform capitalization rules—section different kinds of business assets, such as
m 5213 Election To Postpone Determi- land, buildings, machinery, furniture, trucks,
nation as To Whether the 1.263A of the Income Tax Regulations.
patents, and franchise rights. You must capi-
Presumption Applies That an Ac- talize the full cost of the asset, including
tivity Is Engaged in for Profit Capital Expenses freight and installation charges.
See chapter 17 for information about get- If you produce certain property for use in
You must capitalize, rather than deduct, some
ting publications and forms. your trade or business, capitalize the pro-
costs. These costs are a part of your invest-
duction costs under the uniform capitalization
ment in your business and are called “capital
rules. See section 1.263A of the Income Tax
expenses.” There are, in general, three types
Regulations for information on those rules.
of costs you capitalize.
What Can 1) Going into business.
Improvements
Be Deducted? 2) Business assets. The costs of making improvements to a
To be deductible, a business expense must business asset are capital expenses, if the
3) Improvements.
be both ordinary and necessary. An ordinary improvements add to the value of the asset,
expense is one that is common and accepted appreciably lengthen the time you can use it,
in your trade or business. A necessary ex- Recovery. Although you generally cannot
take a current deduction for a capital ex- or adapt it to a different use. You can deduct
pense is one that is helpful and appropriate repairs that keep your property in a normal
for your trade or business. An expense does pense, you may be able to take deductions
for the amount you spend through a method efficient operating condition as a business
not have to be indispensable to be considered expense.
necessary. of depreciation, amortization, or depletion.
These methods allow you to deduct part of Improvements include new electric wiring,
It is important to separate business ex- a new roof, a new floor, new plumbing,
penses from: your cost each year over a number of years.
In this way you are able to “recover” your bricking up windows to strengthen a wall, and
capital expense. See Amortization (chapter lighting improvements.
1) The expenses used to figure the cost of
goods sold, 12) and Depletion (chapter 13) in this publi-
cation. For information on depreciation, see Restoration plan. Capitalize the cost of re-
2) Capital expenses, and Publication 946. conditioning, improving, or altering your
3) Personal expenses. property as part of a general restoration plan
Going Into Business to make it suitable for your business. This
If you have an expense that is partly applies even if some of the work would by
The costs of getting started in business, be- itself be classified as repairs.
TIP for business and partly personal, fore you actually begin business operations,
separate the personal part from the are capital expenses. These costs may in-
business part. clude expenses for advertising, travel, utili- Replacements. You cannot deduct the cost
ties, or employees' wages. of a replacement that stops deterioration and
adds to the life of your property. Capitalize
Cost of Goods Sold If you go into business. When you go into that cost and depreciate it.
If your business manufactures products or business, treat all costs you had to get it Treat amounts paid to replace parts of a
purchases them for resale, some of your ex- started as capital expenses. machine that only keep it in a normal operat-
penses are for the products you sell. You use Usually you recover costs for a particular ing condition like repairs. However, if your
these expenses to figure the cost of the goods asset through depreciation. Other start-up equipment has a major overhaul, capitalize
you sold during the year. You deduct these costs can be recovered through amortization. and depreciate the expense.
costs from your gross receipts to figure your If you do not choose to amortize these costs,
gross profit for the year. You must maintain you generally cannot recover them until you
inventories to be able to determine your cost sell or otherwise go out of business. Capital or Deductible Expenses
of goods sold. If you use an expense to figure See Going Into Business in chapter 12 for To help you distinguish between capital and
cost of goods sold, you cannot deduct it again more information on business start-up costs. deductible expenses, several different items
as a business expense. are discussed below.
The following are types of expenses that
If you do not go into business. If you are
go into figuring cost of goods sold.
an individual, and your attempt to go into Business motor vehicles. You usually
business is not successful, the expenses you capitalize the cost of a motor vehicle you buy
• The cost of products or raw materials in had in trying to establish yourself in business
your inventory, including the cost of hav- to use in your business. You can recover its
fall into two categories. cost through annual deductions for depreci-
ing them shipped to you.
ation.
• The cost of storing the products you sell. 1) The costs you had before making a de- There are dollar limits on the depreciation
cision to acquire or begin a specific you may claim each year on passenger au-
• Direct labor costs (including contributions business. These costs are personal and
to pension or annuity plans) for workers tomobiles used in your business. See Publi-
nondeductible. They include any costs cation 463.
who produce the products. incurred during a general search for, or Repairs you make to your business vehi-
• Depreciation on machinery used to preliminary investigation of, a business cle are deductible expenses. However,
produce the products. or investment possibility. amounts you pay to recondition and overhaul
• Factory overhead expenses. 2) The costs you had in your attempt to a business vehicle are capital expenses.
acquire or begin a specific business.
Under the uniform capitalization rules, you These costs are capital expenses and Roads and driveways. The costs of building
may have to include certain indirect costs of you can deduct them as a capital loss. a private road on your business property and
production and resale in your cost of goods
the cost of replacing a gravel driveway with
sold. Indirect costs include rent, interest, If you are a corporation, and your attempt
a concrete one are capital expenses you may
taxes, storage, purchasing, processing, re- to go into a new trade or business is not
be able to depreciate. The cost of maintain-
packaging, handling, and administrative successful, you may be able to deduct all
ing a private road on your business property
costs. This rule on indirect costs does not investigatory costs as a loss.
is a deductible expense.
apply to personal property you acquire for The costs of any assets acquired during
resale if your average annual gross receipts your unsuccessful attempt to go into business
(or those of your predecessor) for the pre- are a part of your basis in the assets. You Tools. Unless the uniform capitalization rules
ceding 3 tax years are not more than $10 cannot take a deduction for these costs. You apply, amounts spent for tools used in your
million. will recover the costs of these assets when business are deductible expenses if the tools
For more information, see the following. you dispose of them. have a life expectancy of less than one year.
Chapter 1 Deducting Business Expenses Page 3
Machinery parts. Unless the uniform cap- ments), gas and oil, tires, repairs, tune-ups, 1) The money and adjusted basis of prop-
italization rules apply, the cost of replacing insurance, and registration fees. Instead of erty you contribute to the activity, and
short-lived parts of a machine to keep it in figuring the business part of these actual ex-
good working condition and not to add to its penses, you may be able to use a standard 2) Amounts you borrow for use in the ac-
life is a deductible expense. mileage rate to figure your deduction. For tivity if:
1998, the standard mileage rate for a car that a) You are personally liable for repay-
Heating equipment. The cost of changing you own or lease is 32.5 cents for each ment, or
from one heating system to another is a cap- business mile.
ital expense and not a deductible expense. If you are self-employed, you can also b) You pledge property (other than
deduct the business part of interest on your property used in the activity) as se-
car loan, state and local personal property tax curity for the loan.
Personal Expenses on the car, parking fees, and tolls, whether
Generally, you cannot deduct personal, living or not you claim the standard mileage rate. For more information, see Publication 925.
or family expenses. However, if you have an You can use the nonbusiness part of the Passive activities. Generally, you are in
expense for something that is used partly for personal property tax to determine your de- a passive activity if you have a trade or busi-
business and partly for personal purposes, duction for taxes on Schedule A (Form 1040) ness activity in which you do not materially
divide the total cost between the business if you itemize your deductions. participate during the year, or a rental activity.
and personal parts. You can deduct as a For more information on car expenses and Deductions from passive activities generally
business expense only the business part. the rules for using the standard mileage rate, can only offset your income from passive ac-
For example, if you borrow money and see Publication 463. tivities. You cannot deduct any excess de-
use 70% of it for business and the other 30% ductions against your other income. In addi-
for a family vacation, generally you can de- tion, you can take passive activity credits only
duct as a business expense only 70% of the from tax on net passive income. Any excess
loss or credits are carried over to later years.
interest you pay on the loan. The remaining
30% is personal interest that is not deductible.
How Much For more information, see Publication 925.
Net operating loss. If your deductions
See chapter 8 for information on deducting
interest and the allocation rules.
Can Be Deducted? are more than your income for the year, you
You cannot deduct more for a business ex- may have a “net operating loss.” You can use
Business use of your home. If you use part pense than the amount you actually spend. a net operating loss to lower your taxes in
of your home in your business, you may be There is usually no other limit on how much other years. See Publication 536 for more in-
able to claim part of the expenses of main- you can deduct if the amount is reasonable. formation.
taining your home as a business expense. However, if your deductions are large enough
These expenses include mortgage interest, to produce a net business loss for the year,
insurance, utilities, repairs and depreciation. the amount of tax loss may be limited.
The business use of your home must meet When Can an
strict requirements before you can take any Recovery of amount deducted. If you re-
of these expenses as business deductions. cover part of an expense in the same tax year Expense Be
To qualify to claim expenses for the busi- for which you have claimed a deduction, re-
ness use of your home, you must meet the duce your expense deduction by the amount Deducted?
following tests. of the recovery. If you have a recovery in a When an expense can be deducted depends
later year, include the recovered amount in on your accounting method. An accounting
1) Your use must be: income. However, if part of the deduction for method is a set of rules used to determine
a) Exclusive (however, see the ex- the expense did not reduce your tax, you do when and how income and expenses are re-
ceptions below), not have to include all the recovery in income. ported. The two basic methods are the cash
Exclude an amount equal to the part that did method and an accrual method.
b) Regular, not reduce your tax. For more information on accounting
c) For your trade or business, AND For more information on recoveries and methods, see Publication 538.
the tax benefit rule, see Publication 525,
2) The business part of your home must be Taxable and Nontaxable Income. Cash method. Under the cash method of
one of the following:
accounting, you deduct business expenses in
a) Your principal place of business for Payments in kind. If you provide services the tax year you actually paid them, even if
your trade or business, or to pay a business expense, the amount you you incur them in an earlier year.
can deduct is the amount you spend to pro-
b) A place of business where you vide the services. It is not what you would
meet or deal with patients, clients, Accrual method. Under an accrual method
have paid in cash. of accounting, you generally deduct business
or customers in the normal course Similarly, if you pay a business expense
of your trade or business, or expenses when you become liable for them,
in goods or other property, you can deduct whether or not you pay them in the same
c) A separate structure (not attached only the amount the property costs you. If year. All events that set the amount of the
to your home) that you use in con- these costs are included in the cost of goods liability must have happened, and you must
nection with your trade or business. sold do not deduct them as a business ex- be able to figure the amount of the expense
pense. with reasonable accuracy.
You do not have to meet the exclusive use Economic performance rule. Under an
test if: Limits on losses. If your deductions for an accrual method, you generally cannot deduct
investment or business activity are more than or capitalize business expenses until eco-
1) You use part of your home for the stor- the income it brings in, you have a net loss. nomic performance occurs. If your expense
age of inventory or product samples, or There may be limits on how much, if any, of is for property or services provided to you, or
2) You use part of your home as a day-care the loss you can use to offset income from for your use of property, economic perform-
facility. other sources. ance occurs as the property or services are
Not-for-profit limits. If you do not carry provided, or as the property is used. If your
For more information, see Publication 587. on your business activity with the intention of expense is for property or services you pro-
making a profit, you cannot use a loss from vide to others, economic performance occurs
Business use of your car. If you use your it to offset other income. The kinds of de- as you provide the property or services.
car in your business, you can deduct car ex- ductions you can take for a not-for-profit ac-
penses. If you use your car for both business tivity and the amounts you can deduct are Example. Your tax year is the calendar
and personal purposes, you must divide your limited so that a deductible loss will not result. year. In December 1998, the Field Plumbing
expenses based on mileage. Only your ex- See Not-for-Profit Activities, later. Company did some repair work at your place
penses for the miles you drove the car for At-risk limits. Generally, a deductible of business and sent you a bill for $150. You
business are deductible as business ex- loss from a business or investment activity is paid it by check in January 1999. If you use
penses. limited to the investment you have “at risk” in an accrual method of accounting, deduct the
You can deduct actual car expenses, the activity. You are “at risk” in any activity $150 on your tax return for 1998 because all
which include depreciation (or lease pay- for: events that set the amount of liability and
Page 4 Chapter 1 Deducting Business Expenses
economic performance occurred in that year. 3) You depend on income from the activity Gross income ..................................... $3,200
If you use the cash method of accounting, you for your livelihood, Less expenses:
can deduct the expenses on your 1999 return. Real estate taxes ........................... $700
4) Your losses are due to circumstances Home mortgage interest ................ 900
beyond your control (or are normal in the Insurance ........................................ 400
Prepayment. You cannot deduct expenses start-up phase of your type of business), Utilities ............................................ 700
in advance, even if you pay them in advance. Maintenance ................................... 200
This rule applies to both the cash and accrual 5) You change your methods of operation Depreciation on an automobile ...... 600
methods. It applies to prepaid interest, pre- in an attempt to improve profitability, Depreciation on a machine ............ 200
paid insurance premiums, and any other ex-
6) You, or your advisors, have the knowl- Total expenses ............................... 3,700
pense paid far enough in advance to, in ef-
fect, create an asset with a useful life edge needed to carry on the activity as
Loss $500
extending substantially beyond the end of the a successful business,
current tax year. Ida must limit her deductions to $3,200,
7) You were successful in making a profit the gross income she earned from the activ-
in similar activities in the past, ity. The limit is reached in category (3), as
Example. In 1998, you sign a 10-year
lease and immediately pay your rent for the 8) The activity makes a profit in some follows:
first three years. Even though you paid the years, and how much profit it makes, and
rent for 1998, 1999, and 2000, you can de- Limit on deduction ........................... $3,200
duct only the rent for 1998 on your current tax 9) You can expect to make a future profit Category 1, Taxes and interest ...... $1,600
return. You can deduct on your 1999 and from the appreciation of the assets used Category 2, Insurance, utilities, and
2000 tax returns the rent for those years. in the activity. maintenance .................................... 1,300 2,900
Available for Category 3 ................. $300
Contested liabilities. Under the cash Limit on Deductions The $300 for depreciation is divided be-
method, you can deduct a contested liability tween the automobile and machine, as fol-
only in the year you pay the liability. Under and Losses lows:
an accrual method, you can deduct contested If your activity is not carried on for profit, take $600
3 $300 = $225 depreciation for the automobile
liabilities, such as taxes (except foreign or deductions only in the following order, only to $800
U.S. possession income, war profits, and ex- the extent stated in the three categories, and, $200
cess profits taxes), in the tax year you pay the if you are an individual, only if you itemize 3 $300 = $75 depreciation for the machine
$800
liability (or transfer money or other property them on Schedule A (Form 1040).
to satisfy the obligation), or in the tax year you
settle the contest. However, to take the de- The basis of each asset is reduced ac-
duction in the year of payment or transfer, you Category 1. Deductions you can take for cordingly.
must meet certain conditions. See Contested personal as well as for business activities are The $1,600 for category (1) is deductible
Liability in Publication 538 for more informa- allowed in full. For individuals, all nonbusi- in full on the appropriate lines for taxes and
tion. ness deductions, such as those for home interest on Schedule A (Form 1040). Ida adds
mortgage interest, taxes, and casualty losses, the remaining $1,600 (the total of categories
belong in this category. Deduct them on the (2) and (3)) to her other miscellaneous de-
Related persons. Under an accrual method appropriate lines of Schedule A (Form 1040).
of accounting, you generally deduct expenses ductions on Schedule A (Form 1040) that are
You can only deduct a nonbusiness casualty subject to the 2%-of-adjusted-gross-income
when you incur them, even if you have not loss to the extent it is more than $100 and
paid them. However, if you and the person limit.
all these losses exceed 10% of your adjusted
you owe are “related persons” and the person gross income. See Publication 547 for more
you owe uses the cash method of accounting, information on casualty losses. Partnerships and S corporations. If a
you must pay the expense before you can For the limits that apply to mortgage in- partnership or S corporation carries on a
deduct it. The deduction by an accrual terest, see Publication 936. not-for-profit activity, these limits apply at the
method payer is allowed when the corre- partnership or S corporation level. They are
sponding amount is includible in income by reflected in the individual shareholder's or
Category 2. Deductions that do not result in
the related cash method payee. See Related partner's distributive shares.
an adjustment to the basis of property are
Persons in Publication 538.
allowed next, but only to the extent your gross
income from the activity is more than the de-
More than one activity. If you have several
ductions you take (or could take) for it under
undertakings, each may be a separate activ-
the first category. Most business deductions,
ity, or several undertakings may be one ac-
Not-for-Profit such as those for advertising, insurance pre-
miums, interest, utilities, wages, etc., belong
tivity. The following are the most significant
facts and circumstances in making this de-
Activities in this category.
termination.
If you do not carry on your business or in-
vestment activity to make a profit, there is a Category 3. Business deductions that de-
crease the basis of property are allowed last, • The degree of organizational and eco-
limit on the deductions you can take. You nomic interrelationship of various under-
cannot use a loss from the activity to offset but only to the extent the gross income from
the activity is more than deductions you take takings.
other income. Activities you do as a hobby,
or mainly for sport or recreation, come under (or could take) for it under the first two cate- • The business purpose that is (or might
this limit. So does an investment activity in- gories. The deductions for depreciation, be) served by carrying on the various
tended only to produce tax losses for the in- amortization, and the part of a casualty loss undertakings separately or together in a
vestors. an individual could not deduct in category (1) business or investment setting.
The limit on not-for-profit losses applies to belong in this category. Where more than one
individuals, partnerships, estates, trusts, and asset is involved, divide depreciation and • The similarity of various undertakings.
S corporations. It does not apply to corpo- these other deductions proportionally among
rations other than S corporations. those assets. The IRS will generally accept your character-
In determining whether you are carrying ization of several undertakings as one activity,
Individuals must claim the amounts in or more than one activity, if supported by facts
on an activity for profit, all the facts are taken TIP categories (2) and (3) as miscella-
into account. No one factor alone is decisive. and circumstances.
neous deductions on Schedule A
Among the factors to consider are whether: (Form 1040). They are subject to the If you are carrying on two or more
2%-of-adjusted-gross-income limit. See Pub- TIP different activities, keep the de-
1) You carry on the activity in a business- lication 529 for information on this limit.
like manner, ductions and income from each one
separate. Figure separately whether each is
2) The time and effort you put into the ac- Example. Ida is engaged in a not-for- a not-for-profit activity. Then figure the limit
tivity indicate you intend to make it prof- profit activity. The income and expenses of on deductions and losses separately for each
itable, the activity are as follows: activity that is not for profit.
Chapter 1 Deducting Business Expenses Page 5
Presumption of Profit
An activity is presumed carried on for profit if
2. Deductibility of Pay
it produced a profit in at least 3 of the last 5
You generally can deduct as a business ex-
tax years including the current year. Activities
pense salaries, wages, and other forms of
that consist primarily of breeding, training,
showing, or racing horses are presumed car- Employees' Pay pay you make to employees for personal
services. However, you must reduce the de-
ried on for profit if they produced a profit in
duction by any current tax year employment
at least 2 of the last 7 tax years including the
credits. For more information about these
current year. You have a profit when the
credits, see Form 3800 and the related em-
gross income from an activity is more than the
ployment credit forms.
deductions for it.
If a taxpayer dies before the end of the
Important Change
5-year (or 7-year) period, the period ends on
the date of the taxpayer's death.
for 1998 Commissions. Generally, you can deduct a
commission you pay to a salesperson or an-
If your business or investment activity Vacation pay. An accrual method employer other person. However, you and the service
passes this 3- (or 2-) years-of-profit test, pre- can generally deduct for a tax year vacation provider must agree on the service to be
sume it is carried on for profit. This means it pay and other deferred compensation that is performed and the amount to be paid before
will not come under these limits. You can take paid to employees within 21/2 months after the that person performs the service.
all your business deductions from the activity, end of the tax year. For tax years ending after
even for the years that you have a loss. You July 22, 1998, for determining whether an
can rely on this presumption in every case, Employee-stockholder. A salary paid to an
amount is deferred compensation and when employee who is also a stockholder must
unless the IRS shows it is not valid. deferred compensation is paid, no amount is meet the same tests for deductibility as the
considered “paid” to an employee until it is salary of any other executive or employee.
actually received by the employee. See Tests for Deductibility, later.
Using the presumption later. If you are
starting an activity and do not have 3 years You cannot deduct a payment to an
(or 2 years) showing a profit, you may want employee-stockholder that is not for services
performed. The payment may be a distribu-
to take advantage of this presumption later,
after you have the 5 (or 7) years of experi-
Introduction tion of dividends on stock. This is most likely
ence allowed by the test. This chapter is about deducting salaries, to occur in a corporation with few sharehold-
You can choose to do this by filing Form wages, and other forms of pay you make to ers, practically all of whom draw salaries. A
5213. Filing this form postpones any deter- your employees. salary paid to an employee-stockholder that
mination that your activity is not carried on for You also may pay your employees indi- is more than the salary ordinarily paid for
profit until 5 (or 7) years have passed since rectly through employee benefit programs. similar services and that bears a close re-
you started the activity. For example, you can deduct group term life lationship to the employee's stock holdings
insurance premiums you pay or incur on a probably is not paid wholly for services per-
policy covering an employee if you are not the formed. This salary may include a distribution
Form 5213 must be filed within 3
direct or indirect beneficiary of the policy. You of earnings on the stock.
TIP years of the due date of your return
can deduct the cost of providing coverage of If the payment to an employee-
for the year in which you first carried
$50,000 or less for an employee as an em- stockholder of a closely held corporation is
on the activity; or, if earlier, within 60 days of
ployee benefit. You must include the cost of reasonable and for services performed, the
receiving written notice from the Internal
providing coverage over $50,000 in the em- payment will not be denied as a deduction
Revenue Service proposing to disallow de-
ployee's income, and you can deduct it as merely because the corporation has a poor
ductions attributable to the activity.
wages. For more information about employee history of paying dividends on its outstanding
benefit programs, see chapter 5. stock.
The rules discussed in this chapter can If your corporation uses an accrual
apply to sole proprietors, partnerships, cor- method of accounting and the salary is unpaid
porations, estates, trusts, and any other entity at the end of the tax year, see Unpaid Sala-
that carries on a trade or business and pays ries, later.
The benefit gained by making this choice an employee for services.
is that the IRS will not immediately question Relative. You can deduct the salary or
whether your activity is engaged in for profit. Topics wages paid to a relative who is an employee,
Accordingly, it will not restrict your de- This chapter discusses: including your minor child, if the payment
ductions. Rather, you will gain time to earn meets the four tests for deductibility, dis-
a profit in 3 (or 2) out of the first 5 (or 7) years • Deductibility of pay cussed later. However, also see Unpaid Sal-
you carry on the activity. If you show 3 (or aries, later.
2) years of profit at the end of this period, your • Kinds of payments
deductions are not limited under these rules.
If you do not have 3 years (or 2 years) of Payment to beneficiary of deceased em-
profit, the limit can be applied retroactively to Useful Items ployee. You can deduct a payment you
any year in the 5-year (or 7-year) period with You may want to see: make to an employee's beneficiary because
a loss. of the employee's death if the payment is
Filing Form 5213 automatically extends reasonable in relation to past services per-
Publication
the period of limitations on any year in the formed by the employee. The payment also
5-year (or 7-year) period to 2 years after the m 15 Circular E, Employer's Tax Guide must meet the other tests for deductibility,
due date of the return for the last year of the discussed later.
m 15–A Employer's Supplemental Tax
period. The period is extended only for de-
Guide
ductions of the activity and any related de- Uniform capitalization rules. Generally,
ductions that might be affected. m 521 Moving Expenses you must capitalize or include in inventory the
m 551 Basis of Assets wages and salaries you pay employees to
produce real or tangible personal property or
m 946 How To Depreciate Property to acquire property for resale. If the property
is inventory, add the wages to inventory.
Form (and Instructions) Capitalize the costs for any other property.
Personal property you acquire for resale
m W–2 Wage and Tax Statement is not subject to these rules if your average
annual gross receipts for the 3 preceding tax
m 3800 General Business Credit years are $10 million or less. You can deduct
See chapter 17 for information about get- these costs as a current business expense.
ting publications and forms. For more information, see Publication 551.
Page 6 Chapter 2 Employees' Pay
Construction of capital asset. You cannot • Your policy regarding pay for all of your • It is given for length of service or safety
deduct salaries and other wages incurred for employees. achievement.
constructing a capital asset. You must include
them in the basis of the asset and recover • The history of pay for each employee. • It is awarded as part of a meaningful
your cost through depreciation deductions. presentation.
Individual salaries. You must base the
See Publication 946 for information about test of whether a salary is reasonable on each • It is awarded under conditions and cir-
depreciation. individual's salary and the service performed, cumstances that do not create a signif-
not on the total salaries paid to all officers or icant likelihood of disguised pay.
all employees. For example, even if the total
Tests for Deductibility amount you pay to your officers is reason- Length-of-service award. An award will
To be deductible, salaries or wages you pay able, you cannot deduct an individual officer's not qualify as a length-of-service achievement
your employees must meet all the following entire salary if it is not reasonable based on award if either of the following applies.
tests. the items listed above.
• The employee receives the award during
his or her first 5 years of employment.
• Ordinary and necessary Test 3 — For services performed. You
• Reasonable
must be able to prove the payment was made • The employee received a length-of-
for services actually performed. service award (other than one of very
• For services performed small value) during that year or in any of
Test 4 — Paid or incurred. You must have the prior 4 years.
• Paid or incurred
actually made the payment or incurred the
expense in the tax year. Safety achievement award. An award
Test 1 — Ordinary and necessary. You If you use the cash method of accounting, will not qualify as a safety achievement award
must be able to show that the salary, wage, deduct the salary or wages paid to an em- if it is given to either of the following.
or other payment for services an employee ployee in the year you pay it to the employee.
performs for you is an ordinary and necessary If you use an accrual method of account- 1) A manager, administrator, clerical em-
expense. You also must be able to show that ing, deduct your expense for the salary or ployee, or other professional employee.
it is directly connected with your trade or wage when you establish your obligation to
business. For more information, see What 2) More than 10% of the employees during
make the payment, when you can determine the year, excluding those listed in (1).
Can Be Deducted? in chapter 1. the amount of the obligation with reasonable
That you pay your employee for a legiti- certainty, and when economic performance Qualified or nonqualified plan awards.
mate business purpose is not sufficient, by occurs. Economic performance generally oc- You must give a qualified plan award as part
itself, for you to deduct the amount as a curs as an employee performs the services of an established written plan that does not
business expense. You can deduct a pay- for you. The economic performance rule is discriminate in favor of highly compensated
ment for your employee's services only if the discussed in When Can an Expense Be De- employees as to eligibility or benefits. See
payment is ordinary and necessary in carrying ducted? in chapter 1. Your payment need not Exclusion of Certain Fringe Benefits in chap-
on your trade or business. be made in the year the obligation exists. You ter 4 for the definition of a highly compen-
Expenses (including salaries and other can defer it to a later date, but special rules sated employee.
payments for services) incurred to complete apply. See Unpaid Salaries, later. An award is not a qualified plan award if
a merger, recapitalization, consolidation, or the average cost of all the employee
other reorganization are not expenses of achievement awards given during the tax year
carrying on a business; they are capital ex- (that would be qualified plan awards except
penditures. You cannot deduct them as ordi-
nary and necessary business expenses.
Kinds of Payments for this limit) is more than $400. To figure this
Some of the ways you may provide pay to average cost, do not take into account awards
However, if you later abandon your plan to of very small value.
reorganize, etc., you can deduct the ex- your employees are discussed next.
Limits on deductible awards. Deduct-
penses for the plan in the tax year you ible nonqualified plan awards made to any
abandon it.
Bonuses and Awards one employee cannot be more than $400
You can deduct bonuses and awards to your during the tax year. The total deductible
Test 2 — Reasonable. Determine the rea- awards, including both qualified and non-
sonableness of pay by the facts. Generally, employees if they meet certain conditions.
qualified plan awards, made to any one em-
reasonable pay is the amount that like enter- ployee cannot be more than $1,600 during
prises ordinarily would pay for the services Bonuses. You can deduct a bonus paid to
the tax year.
under similar circumstances. an employee if you intended the bonus as
If the employee achievement awards are
You must be able to prove the pay is additional pay for services, not as a gift, and
not more than the limits, you can exclude
reasonable. Base this test on the circum- the services were actually performed. How-
them from the employee's income and you
stances that exist when you contract for the ever, for you to deduct the amount as wages,
can deduct them on the “Other deductions”
services, not those existing when the rea- the total bonuses, salaries, and other pay
line of your tax return or business schedule.
sonableness is questioned. If the pay is ex- must be reasonable for the services per-
If the award costs more than the amount
cessive, you can deduct only the part that is formed. Include the bonus in the employee's
you can deduct, include in the employee's
reasonable. income. You can pay a bonus in cash, prop-
income the larger of the following amounts.
Factors to consider. To determine if pay erty, or a combination of both.
is reasonable, consider the following items • The part of the cost of the award you
and any other pertinent facts. Gifts of nominal value. If, to promote em-
cannot deduct (up to the award's fair
ployee goodwill, you distribute turkeys, hams,
market value).
or other merchandise of nominal value to your
• The duties performed by the employee.
employees at holidays, the value of these • The amount by which the fair market
• The volume of business handled. items is not salary or wages. You can deduct value of the award is more than the
the cost of these items as a business expense amount you can deduct.
• The character and amount of responsi-
even though the employees do not include
bility. Do not include the remaining value of the
the items in income.
• The complexities of your business. If you distribute cash, gift certificates, or award in the employee's income.
similar items readily convertible to cash, the
• The amount of time required.
value of these items is additional wages or
• The general cost of living in the locality. salaries, regardless of the amount or value. Loans or Advances
You generally can deduct as wages a loan
• The ability and achievements of the indi-
Employee achievement awards. You can or advance you make to an employee that
vidual employee performing the service.
deduct the cost of an employee achievement you do not expect the employee to repay if it
• The pay compared with the amount of award, subject to certain limits. An employee is for personal services actually performed.
gross and net income of the business, achievement award is tangible personal The total must be reasonable when you add
as well as with distributions to share- property that meets all the following require- the loan or advance to the employee's other
holders, if the business is a corporation. ments. pay, and it must meet the tests for deduct-
Chapter 2 Employees' Pay Page 7
ibility, discussed earlier. However, if the em- amount is includible in that person's gross The Lomar Corporation pays Frank $600
ployee performs no services, treat the amount income. in January of the second year, and the bal-
you advanced to the employee as a loan, Related persons. For this special rule, ance that March. The corporation can deduct
which you cannot deduct. related persons include the following. the salary of $1,000 in the first year. Frank
and the Lomar Corporation are not related
Below-market interest rate loans. On cer- 1) Members of a family, but only the fol- persons at the end of Lomar's first tax year.
tain loans you make to an employee or lowing relatives.
stockholder, you are treated as having re-
a) Brothers and sisters (either whole- Guaranteed Annual Wage
ceived interest income and as having paid
or half-blood).
compensation or dividends equal to that in- If you guarantee to pay certain employees full
terest. See Below-Market Interest Rate b) Spouses. pay during the year (determined by the num-
Loans in chapter 8 for more information. ber of hours in the normal work year) under
c) Ancestors (parents, grandparents, terms of a collective bargaining agreement,
etc.). you can deduct the pay as wages. You must
Vacation Pay d) Lineal descendants (children, include the payments in the employees' in-
Vacation pay is an amount you pay or will pay grandchildren, etc.). come, and they are subject to FICA and
to an employee while the employee is on va- FUTA taxes and income tax withholding.
cation. It includes an amount you pay an 2) An individual and a corporation in which
employee even if the employee chooses not more than 50% of the value of the out-
to take a vacation. Vacation pay does not in- standing stock is owned directly or indi- Pay for
clude any amount for sick pay or holiday pay. rectly by or for that individual.
Sickness and Injury
Cash method. If you use the cash method Indirect ownership of stock. To decide You can deduct amounts you pay to your
of accounting, deduct vacation pay as wages if a person indirectly owns any of the out- employees for sickness and injury, including
when you pay it to an employee. standing stock of a corporation, use the fol- lump-sum amounts, as compensation. How-
lowing rules. ever, your deduction is limited to amounts not
Accrual method. If you use an accrual compensated by insurance or other means.
method of accounting, you can deduct vaca- 1) Stock owned directly or indirectly by or
tion pay earned by an employee as wages in for a corporation, partnership, estate, or
the year earned only if you pay it at one of the trust is considered owned proportion- Meals and Lodging
following times. ately by or for its shareholders, partners, You usually can deduct the cost of furnishing
or beneficiaries. meals and lodging to your employees if the
• By the close of your tax year. 2) Stock owned directly or indirectly by or expense is an ordinary and necessary busi-
for an individual's family is considered ness expense. Do not deduct the cost as
• If the amount is vested, within 21/2 months employees' pay, but as an expense of oper-
after the end of the tax year. owned by the individual. See Related
persons, earlier, for persons considered ating your business. For example, if you own
Deduct vacation pay in the year paid if you members of a family. a restaurant, include in the cost of goods sold
pay it later than this. the cost of food your employees eat. If you
For tax years ending after July 22, 1998, 3) An individual owning any stock in a cor- operate a cafeteria for your employees, de-
vacation pay is not considered “paid” until it poration (other than because of rule (2) duct the costs of operating it on your return
is actually received by the employee. above) is considered to own the stock as business expenses. Similarly, if you rent
owned directly or indirectly by or for the or buy a house for an employee, you deduct
individual's partner. the cost of insurance, utilities, rent, and/or
Unpaid Salaries depreciation in each of those categories on
4) Stock considered owned by a person your return.
If you have a definite, fixed, and unconditional because of rule (1) is treated, for apply- You may have to include the value of
agreement to pay an employee a certain sal- ing rules (1), (2), or (3), as actually meals or lodging in an employee's income.
ary for the year, but you defer paying part of owned by that person. But stock con- For meals, this depends on whether you fur-
it until the next tax year, figure your deduction sidered owned by an individual because nished them on your premises for your con-
for the salary using the following rules. of rules (2) or (3) is not treated as owned venience. For lodging, it also depends on
by that individual for applying either rule whether you required it as a condition of em-
• If you use an accrual method of ac- (2) or (3) again to consider another the ployment. See chapter 3 for more information.
counting, you can deduct the entire salary owner of that stock.
in the first year if economic performance
occurs (the employee performed the ser- Example 1. Tom Green runs a retail store
vices in that year). as a sole proprietor. He uses the calendar
Payment of
• If you use the cash method of accounting, year as his tax year and an accrual method Employee Expenses
of accounting. Tom's brother Bob works for There generally are two different ways you
you can deduct each year only the
him, and he pays Bob $1,000 a month. Bob can deduct the amount you pay or reimburse
amount actually paid that year.
uses the calendar year as his tax year and the employees for business expenses they incur
If you made no definite prior arrangement, cash method of accounting. At the end of the for you for items such as travel and enter-
no fixed obligation exists to make the later year, Tom accrues Bob's December salary. tainment.
payments and you can deduct in the first year Because of a temporary cash shortage,
only the amount paid in that year. This rule is Tom pays Bob $600 in January of the next • You deduct the payment under an ac-
the same for the cash method and for any year and the $400 balance in April. Tom countable plan in the category of the
accrual method of accounting. cannot deduct the $1,000 until the year in expense paid. For example, if you pay
which he pays it, the year Bob must include an employee for travel expenses incurred
the amount in his income. on your behalf, deduct this payment as
Special rule for accrual method payer. If
you use an accrual method of accounting, you a travel expense on your return. See the
Example 2. The Lomar Corporation uses
cannot deduct salaries, wages, and other ex- instructions for the form you file for infor-
the calendar year as its tax year and an ac-
penses owed to a related person (defined mation on which lines to use.
crual method of accounting. Frank Wilson, an
next) until the tax year that both the following officer of the corporation, also uses the cal- • Include the payment under a nonac-
have occurred. endar year and the cash method of account- countable plan in the compensation you
ing. At the end of the calendar year, Frank pay your employees and deduct it as
• You make the payment. owns 50% of the outstanding stock of the wages on your return.
• The amount is includible in the income corporation. In March of the next year, he
of the person paid. buys additional shares that bring his holdings See Travel, Meals, and Entertainment in
to 51%. At the end of the first year, the cor- chapter 16 for more information about reim-
This rule applies even if you and that person poration accrues salary of $1,000 payable to bursing employees and an explanation of ac-
cease to be related persons before the Frank. countable and nonaccountable plans.
Page 8 Chapter 2 Employees' Pay
part on the kind of property interest you include in your employees' wages.
Education Expenses transfer. The amount you can deduct de-
If you pay or reimburse education expenses pends on the amount included in the recipi-
for an employee enrolled in a course not re- ent's income. You must report the amount on
Topics
quired for the job or not otherwise related to This chapter discusses:
a timely filed Form W–2 or Form 1099–MISC
the job, deduct the payment as wages. You (even if the recipient is a corporation) to take
must include the payment in the employee's • Deduction for meals and lodging
the deduction. However, You do not have to
income, and it is subject to FICA and FUTA report if the transfer: • Exclusion from employee wages
taxes and income tax withholding. However,
if the payment is part of a qualified educa- • Is exempt from reporting because the
tional assistance program, these rules may payment is less than the $600 reporting
not apply. See chapter 5.
Useful Items
requirement for Form 1099–MISC, or You may want to see:
If you pay or reimburse education ex-
penses for an employee enrolled in a job- • Meets any other reporting exception that
related course, you can deduct the payment applies to a recipient other than a corpo- Publication
as a noncompensatory business expense. ration.
m 15 Circular E, Employer's Tax Guide
Since this expense would be deductible if
paid by the employee, it is called a working See chapter 17 for information about get-
condition fringe benefit. Do not include a ting publications and forms.
working condition fringe benefit in an em-
ployee's income. Working condition fringe
benefits are discussed in more detail in
chapter 4.
3. Deduction for
Moving Expenses Meals and Lodging
Deduct as a qualified fringe benefit qualified Meals and You can usually deduct the cost of furnishing
meals and lodging to your employees. How-
moving expense reimbursements. Qualified
moving expense reimbursements are those
for expenses the employee could deduct if
Lodging ever, you can generally deduct only 50% of
your costs of furnishing meals. For more in-
he or she paid or incurred them.
Deduct as wages any reimbursement that
Furnished to formation, see Deduction limit on meals, later.
Deduct the cost on your business income
tax return in whatever category the expense
is not for a qualified moving expense re-
imbursement (that is, an expense the em- Employees falls. For example, if you operate a restaurant,
deduct the cost of the meals you furnish to
ployee cannot deduct).
your employees as part of the cost of goods
sold. If you operate a nursing home, motel,
Form W–2. You must show any reimburse- or rental property, deduct the costs of fur-
ment paid directly to an employee for moving nishing lodging to an employee as expenses
expenses on the employee's Form W–2. Important Change for utilities, linen service, salaries, depreci-
However, report any amount considered a ation, etc.
qualified fringe benefit in box 13, not as for 1998
wages in box 1. If you must include the value of the
Meals furnished on your business prem- ! meals and lodging in your employees'
CAUTION wages, do not deduct as wages the
More information. For more information ises. For tax years beginning after 1997, the
about moving expenses, see Publication 521. 50% limit on deductions for meals generally amount you claimed elsewhere on your re-
For information about excluding fringe bene- does not apply to meals you furnish to em- turn.
fits, see chapter 4. ployees on your business premises if all of the
meals are excluded from the employees' Deduction limit on meals. You can gener-
wages because you furnished them for your ally deduct only 50% of the costs of furnishing
Capital Assets convenience (for substantial business rea- meals to your employees. However, you can
If you transfer a capital asset or an asset used sons other than to provide additional pay). deduct the full costs of the following meals.
in your business to one of your employees See Deduction limit on meals under De-
as payment for services, you can deduct it duction for Meals and Lodging. • Meals that qualify as a de minimis fringe
as wages. The amount you can deduct is its Also, under a special rule enacted in 1998 benefit as discussed in chapter 4. For tax
fair market value on the date of the transfer for any tax year, you can treat all meals you years beginning after 1997, this generally
minus any amount the employee paid for the furnish to employees on your business includes meals you furnish to employees
property. You treat the deductible amount as premises as furnished for your convenience on your business premises if more than
received in exchange for the asset, and you if more than half (instead of substantially all) half of these employees are furnished the
must recognize any gain or loss realized on of these employees are furnished the meals meals for your convenience.
the transfer. Your gain or loss is the difference for your convenience. See Test 2—For Your • Meals whose value you include in an
between the fair market value of the asset Convenience under Exclusion From Em- employee's wages. For more information,
and its adjusted basis on the date of transfer. ployee Wages. see Exclusion From Employee Wages,
later.
Payment in • Meals you furnish to your employees at
Restricted Property Introduction the work site when you operate a res-
taurant or catering service.
Restricted property is property subject to a This chapter discusses the deduction for
condition that significantly affects its value. meals and lodging you furnish to your em-
• Meals you furnish to your employees as
part of the expense of providing recre-
If you transfer property, including stock in ployees. It also describes the tests you must
ational or social activities, such as a
your company, as payment for services and meet to exclude the value of meals and
company picnic.
the property is considered substantially lodging from your employees' wages.
vested in the recipient, you generally have a For information on the requirements that • Meals you must furnish to crew members
deductible ordinary and necessary business all business expenses must meet, see chap- of a commercial vessel under a federal
expense. ter 1. If you include the value of the meals and law. This includes crew members of
“Substantially vested” means the property lodging in an employee's wages, that value, commercial vessels operating on the
is not subject to a substantial risk of forfeiture. when added to all other compensation you Great Lakes, the Saint Lawrence
The recipient is not likely to have to give up pay to that employee, must meet all the tests Seaway, or any U.S. inland waterway if
his or her rights in the property in the future. described under Tests for Deductibility in meals would be required under federal
The amount and the year in which you can chapter 2. See chapter 4 for rules you must law had the vessel been operated at sea.
deduct the payment will vary, depending in use to value any meals or lodging you must This does not include meals you furnish
Chapter 3 Meals and Lodging Furnished to Employees Page 9
on vessels primarily providing luxury wa- Substantial nonpay reasons. The following If you charge your employees a flat
ter transportation. meals are furnished for a substantial nonpay amount for meals whether or not they eat the
• Meals you furnish on an oil or gas plat- business reason. meals, but you have to include the value of
form or drilling rig located offshore or in the meals in your employees' wages, include
• Meals you furnish during working hours the value of the meals whether it is more or
Alaska. This includes meals you furnish
so your employee will be available for less than the amount you charged. If no evi-
at a support camp that is near and inte-
emergency calls during the meal period. dence indicates otherwise, the value of the
gral to an oil or gas drilling rig located in
However, you must be able to show that meals is the amount you charged for them.
Alaska.
these emergency calls have occurred or
can reasonably be expected to occur.
• Meals you furnish during working hours Test 3—Lodging Required
because the nature of your business re- As a Condition of
Exclusion From stricts your employee to a short meal
period (such as 30 or 45 minutes), and Employment
Employee Wages the employee cannot be expected to eat This means that you require your employees
Generally, you must include in an employee's elsewhere in such a short time. For ex- to accept the lodging because they need to
wages the value of meals and lodging you ample, meals can qualify if the peak live on your business premises to be able to
furnish to the employee or anyone else in workload occurs during the normal lunch properly perform their duties. Examples in-
connection with the employee's services. Use hour. But if the reason for the short meal clude employees who must be available at
the general valuation rule, discussed in period is to allow the employee to leave all times and employees who could not per-
chapter 4, to determine the amount to include earlier in the day, the meal will not qualify. form their required duties without being fur-
in the employee's wages. However, if you • Meals you furnish during work hours be- nished the lodging.
provide meals at an employer-operated eat- cause your employee could not otherwise It does not matter whether you must fur-
ing facility, you may be able to use the eat proper meals within a reasonable nish the lodging as pay under the terms of
employer-operated eating facility rule to value period of time. For example, meals can an employment contract or a law fixing the
the meals. For more information, see chapter qualify if there are insufficient eating fa- terms of employment.
4. cilities near the place of employment. You may furnish the lodging to your em-
You can exclude from an employee's ployees with or without a charge. If you
• Meals you furnish to a restaurant or other charge a flat amount for lodging whether or
wages the value of meals you furnish to the
food service employee for each meal not the employee accepts it, do not include
employee if the meals qualify as a de minimis
period in which the employee works, if the flat charge in the employee's wages.
fringe benefit. (See chapter 4.) Also, you can
you furnish the meals during, immediately Whether the value of the lodging is wages
exclude from an employee's wages the value
before, or immediately after work hours. depends on whether you meet Tests 1, 2, and
of meals and lodging you, or a third party on
For example, if a waitress works through 3. If you do not meet all of these tests, you
your behalf, furnish to the employee or the
the breakfast and lunch periods, you can must include the value of the lodging in your
employee's spouse or dependents if you meet
exclude from her wages the value of the employees' wages whether it is more or less
all the following tests.
breakfast and lunch you furnish in your than the amount you charged for it. If no evi-
• Test 1. You furnish the meals or lodging restaurant for each day she works. dence indicates otherwise, the value of the
on your business premises. • Meals you furnish immediately after lodging is the amount you charged for it.
• Test 2. You furnish the meals or lodging working hours that you would have fur-
for your convenience. nished during working hours for a sub-
stantial nonpay business reason but that, Employment Taxes
• Test 3. In the case of lodging (but not because of the work duties, were not The value of meals and lodging you properly
meals), your employee must accept the eaten during working hours. exclude from an employee's wages is not
lodging on your business premises as a subject to social security, Medicare, and fed-
condition of his or her employment. • All meals you furnish to employees on
your business premises if more than half eral unemployment taxes, or income tax
However, if an employee can choose to of these employees are furnished meals withholding.
receive additional pay instead of meals or for a substantial nonpay business reason.
lodging, you must include the value of the
meals or lodging in the employee's wages. Meals you furnish to promote goodwill, Examples
The examples at the end of this chapter will boost morale, or attract prospective em- These examples will help you determine
help you apply these tests. ployees. These meals are considered fur- whether to include in your employees' wages
nished in your business for pay reasons. They the value of meals or lodging you furnish to
are not furnished for your convenience unless them.
Test 1—On Your Business you also have a substantial nonpay business
Premises reason for furnishing the meals. Example 1 (Meals). You operate a res-
This generally means the place of employ- taurant business. You furnish your employee,
Meals furnished on nonworkdays or with Carol, who is a waitress working 7 a.m. to 4
ment. For example, meals and lodging you lodging. The value of meals you furnish on
furnish to a household employee in your pri- p.m., two meals during each workday. You
any nonworkday is normally not furnished for encourage but do not require Carol to have
vate home are furnished on your business your convenience. However, if your employ-
premises. Similarly, meals you furnish to her breakfast on the business premises be-
ees must occupy lodging on your business fore starting work. She must have her lunch
cowhands while herding cattle on land you premises as a condition of employment, as
lease or own are furnished on your business on the premises. Since Carol is a food service
discussed later under Test 3—Lodging Re- employee and works during the normal
premises. quired As a Condition of Employment, do not breakfast and lunch periods, do not include
treat the value of any meal you furnish on the the value of her breakfast and lunch in her
Test 2—For Your business premises as wages. wages.
Convenience Meals with a charge. The fact that you Example 2 (Meals on nonworkdays).
Whether you furnish meals or lodging for your charge for the meals and that the employee The facts are the same as in Example 1, ex-
convenience as an employer depends on all may accept or decline the meals, is not taken cept that you also allow Carol to have meals
the facts and circumstances. You furnish the into account in determining whether meals on your business premises without charge on
meals or lodging to your employee for your are furnished for your convenience. her days off. You must include the value of
convenience if you do this for a substantial If you furnish meals for which you charge these meals in her wages.
business reason other than to provide the the employees a flat amount whether or not
employee with additional pay. This is true they eat the meals, do not include the flat Example 3 (Meals). Frank is a bank teller
even if a law or an employment contract pro- amount you charge in your employees' who works from 9 a.m. to 5 p.m. The bank
vides that they are furnished as pay. A written wages. You have to include the actual value furnishes his lunch without charge in a cafe-
statement that the meals or lodging are for of the meals in your employees' wages if Test teria the bank maintains on its premises. The
your convenience is not sufficient. 1 and Test 2 are not met. bank furnishes these meals to Frank to limit
Page 10 Chapter 3 Meals and Lodging Furnished to Employees
his lunch period to 30 minutes, since the The recipient does not have to be your
bank's peak workload occurs during the employee. For example, the recipient may be
normal lunch period. If Frank got his lunch Introduction a partner, director, or independent contractor.
elsewhere, it would take him much longer This chapter gives general information on In this chapter, the term “employee” includes
than 30 minutes, and the bank strictly en- fringe benefits and fringe benefit valuation any recipient of a fringe benefit unless stated
forces the time limit. The bank does not in- rules. However, it does not cover all the ex- otherwise.
clude the value of these meals in Frank's ceptions to these rules, or the rules that apply
wages. to the use of an aircraft. For more information, Including benefits in pay. Unless the law
see section 1.61–21 of the Income Tax Reg- says otherwise, you must include fringe ben-
Example 4 (Meals). A hospital maintains ulations. efits in an employee's wages. The benefits
a cafeteria on its premises where all of its 230 are subject to income and employment taxes.
employees may get meals at no charge dur- You and the employee will generally use
ing their working hours. The hospital furnishes
Topics
This chapter discusses: the general valuation rule, discussed later, to
meals to have 120 employees available for figure the amount of a fringe benefit to include
emergencies. Each of these employees is at • General information in the employee's income. However, you and
times called upon to perform services during the employee can use special rules to value
the meal period. Although the hospital does • The general valuation rule certain fringe benefits. For more information,
not require these employees to remain on the • Special valuation rules see Special Valuation Rules, later.
premises, they rarely leave the hospital during
their meal period. Since the hospital furnishes • Exclusion of certain fringe benefits from Nonemployee compensation. If the
meals to its employees to have more than half employee income TIP recipient of a taxable fringe benefit is
of them available for emergency calls during not your employee, the benefit is not
meal periods, the hospital does not include subject to employment taxes. However, you
the value of these meals in the wages of any Useful Items may have to report it on Form 1099–MISC,
of its employees. You may want to see: Miscellaneous Income, and you may have to
withhold income tax under the backup with-
Example 5 (Lodging). A hospital gives Publication holding rules. See the Instructions for Forms
Joan, an employee of the hospital, the choice 1099, 1098, 5498, and W–2G for more infor-
of living at the hospital free of charge or living m 15 Circular E, Employer's Tax Guide mation.
elsewhere and receiving a cash allowance in
addition to her regular salary. If Joan chooses m 521 Moving Expenses
to live at the hospital, the hospital must in- See chapter 17 for information about get-
clude the value of the lodging in her wages ting publications and forms.
because she is not required to live at the Deducting the cost. Even though you
hospital to properly perform the duties of her include an amount for noncash fringe benefits
employment. in an employee's wages, you cannot deduct
that amount as wages. But you may be able
General Information to take an expense or depreciation deduction
A fringe benefit is a form of pay provided to for your costs to provide the benefit. For ex-
any person for the performance of services ample, if a noncash fringe benefit you provide
by that person. For the rules discussed in this to an employee is the use of property you
chapter, treat a person who agrees not to lease, you must include the amount (value)
perform services (such as under a covenant of the benefit in the employee's wages, but
you cannot deduct that amount as wages.
4. not to compete) as performing services.
Examples of fringe benefits you may pro- However, you may be able to deduct the rent
vide include the following items. as a business expense.

Fringe Benefits • The use of a car. When fringe benefits are treated as paid.
• Flights on airplanes. You may choose to treat certain taxable
noncash fringe benefits (other than benefits
• Discounts on property or services. you provide as nonemployee compensation)
• Memberships in country clubs or other as paid by the pay period, or by the quarter,
or on any other basis you choose as long as
Important Changes social clubs.
you treat the benefits as paid at least as often
• Tickets to entertainment or sporting
for 1998 events.
as once a year. However, this choice does
not apply to fringe benefits that involve the
transfer of personal property normally held for
Meals furnished to employees. For tax Provider of fringe benefit. You are the investment or the transfer of real property.
years beginning after 1997, if the value of provider of a fringe benefit if it is provided for Treat these benefits, and taxable cash fringe
meals you provide at your eating facility for services performed for you. You may be the benefits, as paid when they are made avail-
employees can be excluded from wages be- provider of the benefit even if it was provided able to the employee.
cause you furnish them for your convenience, by another person. For example, you are the You do not have to make a formal choice
you may be able to treat the meals as a de provider of a fringe benefit your client or cus- of payment dates or notify the IRS of the
minimis fringe benefit. See De Minimis (Mini- tomer provides to your employee for services dates you choose. You do not have to use the
mal) Fringe. the employee performs for you. same time period for all employees. You may
Nonemployer provider. You do not have change methods as often as you like, as long
to be the employer of the recipient to be the as you treat all benefits provided in a calendar
Qualified transportation fringe benefits in provider of a fringe benefit. For example, you year as paid by December 31 of that year.
place of pay. For tax years beginning after may provide fringe benefits to an independent However, you may be able to use the special
1997, you can exclude qualified transporta- contractor as a client or customer of the con- accounting period rule, discussed later, for
tion fringe benefits from an employee's wages tractor. fringe benefits you actually provide during
even if you provide them in place of pay. See
November and December.
Qualified Transportation Fringe.
Recipient of benefit. Your employee or Multiple dates for one benefit. You can
some other person who performs services for treat a taxable noncash fringe benefit as paid
Vehicle cents-per-mile rule. The standard you is the recipient of a fringe benefit provided on one or more dates in the same calendar
mileage rate you can use under the vehicle for those services. Your employee may be the year even if the employee receives the entire
cents-per-mile rule to value the personal use recipient of the benefit even if it is provided benefit at one time. For example, if you pro-
of a car, van, pickup, or panel truck you pro- to someone who did not perform services for vide your employee with a fringe benefit on
vide to an employee in 1998 is 32.5 cents per you. For example, your employee is the re- March 31 that you value at $1,000, you can
mile for all personal miles. See Vehicle cipient of a fringe benefit you provide to a treat the $1,000 as though it had been pro-
Cents-Per-Mile Rule. member of the employee's family. vided equally over 4 quarters and paid on
Chapter 4 Fringe Benefits Page 11
March 31, June 30, September 30, and De- ited amount of the cost, however, include the ployee, the employee can use that spe-
cember 31. fair market value of the fringe benefit that is cial rule. If you do not use one of the
due to any excess cost. special rules, the employee can use a
Accounting period. You generally have the special rule only if you do not treat the
option to report taxable noncash fringe bene- Fair market value (FMV). In general, you value of the benefit as wages for report-
fits (other than benefits provided as nonem- determine the FMV of a fringe benefit on the ing purposes by the due date of the re-
ployee compensation) by using either of the basis of all the facts and circumstances. The turn (including extensions) and one of
following rules. FMV of a fringe benefit is the amount the the conditions just listed in items 2
employee would have to pay a third party in through 4 is met. In any case, the em-
1) The general rule: value the benefit for a an arm's-length transaction to buy or lease ployee can always use the general val-
full calendar year (January 1 - December the particular fringe benefit. uation rule discussed earlier.
31). Neither the amount the employee consid-
2) If you and the employee properly use a
ers to be the value of the fringe benefit nor the
2) The special accounting period rule (dis- special rule, the employee must include
cost you incur to provide the benefit deter-
cussed next). in gross income the value you determine
mines its FMV.
under the rule, minus any amount he or
Special accounting period rule. Instead she paid you and any amount excluded
Employer-provided vehicles. In general, by law from gross income. If you also
of reporting fringe benefits on a calendar year
the value of an employer-provided vehicle is properly determine the amount of the
basis, you may choose to use a special ac-
the amount the employee would have to pay employee's working condition fringe
counting period rule. However, this choice
a third party to lease the same or a similar benefit (explained later under Exclusion
does not apply to fringe benefits that involve
vehicle on the same or comparable terms in of Certain Fringe Benefits), the em-
the transfer of personal property normally
the same geographic area where the em- ployee must include in gross income the
held for investment or the transfer of real
ployee uses the vehicle. A comparable lease net value you determined, minus any
property.
term would be the amount of time the vehicle amount he or she paid you. You and the
Under the special accounting period rule,
is available for the employee's use, such as employee can use the special rule to
you can treat the value of benefits you actu-
a 1-year period. determine the amount the employee
ally provide in the last 2 months of the cal-
Do not determine the value by multiplying owes you.
endar year (or any shorter period) as though
a cents-per-mile rate times the number of
you paid them in the next year. To do this,
miles driven unless the employee can prove 3) If you provide vehicles to more than one
add the value of these benefits to the value
the vehicle could have been leased on a employee, you do not have to use the
of benefits you provide in the first 10 months
cents-per-mile basis. (However, see Vehicle same special rule for each employee. If
of the next year.
Cents-Per-Mile Rule, later.) you provide a vehicle for use by more
Benefits you actually provide. Only the
than one employee (for example, an
benefits you actually provide during the last
employer-sponsored van pool), you can
2 months of a calendar year can be deferred
use any special rule. However, you must
until the next year. For example, if you treat
a fringe benefit as provided equally over the Special use that rule for all employees who share
use of the vehicle.
year, as discussed earlier under When fringe
benefits are treated as paid, you can defer Valuation Rules 4) You can use the formulas in the special
only the benefit you actually provide during You may be able to use special valuation rules only with those rules. When you
the last 2 months. rules instead of the general valuation rule to properly apply a special rule to a fringe
Use of special rule is optional. You can value certain fringe benefits, including the use benefit, the IRS will accept your value for
use the special accounting period rule for of any vehicle or eating facility you provide. that fringe benefit. However, if you do
some fringe benefits and not for others. The The special valuation rules include the fol- not properly apply a special rule, or if you
period of use need not be the same for each lowing rules. use a special rule but are not entitled to
fringe benefit. However, if you use the rule for do so, the IRS will use the general valu-
a particular benefit, use it for all employees • Automobile lease rule. ation rule to value the fringe benefit.
who receive that benefit.
If you use the special accounting period • Vehicle cents-per-mile rule.
More information. For more information on
rule, your employee must use it for the same • Commuting rule. the special valuation rules, including those
period for all purposes. However, your em- (such as the rules for aircraft) not discussed
ployee can use it only if you use it.
• Unsafe conditions commuting rule.
in this chapter, see section 1.61–21(c)–(k) of
• Employer-operated eating facility rule. the Income Tax Regulations.
More information. For more information on
withholding from and reporting of taxable Conditions for use. When reporting fringe
noncash fringe benefits, see Publication 15. benefits, you can choose to use any of the Automobile Lease Rule
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.
General the benefit. If you provide an employee with
an automobile for less than an entire calendar
1) You treat the value of the benefit as
Valuation Rule wages for reporting purposes by the due
year, the value of the benefit is either a pro-
rated annual lease value or the daily lease
You generally must include in an employee's date of the return (including extensions) value (discussed later). Include the lease
wages the amount by which the fair market for the tax year you provide the benefit. value in the employee's wages unless it is
value of a fringe benefit is more than the sum 2) The employee includes the value of the excluded from gross income by law.
of the following amounts. benefit in income by the due date of the For this rule, automobile means any
return for the year the employee receives four-wheeled vehicle manufactured primarily
1) Any amount the employee paid for the for use on public streets, roads, and high-
the benefit.
benefit. ways.
3) The employee is not a control employee
2) Any amount the law excludes from in- as defined later under Commuting Rule.
come. Benefits excluded for business use. If the
4) You demonstrate a good faith effort to employee uses the automobile for business,
However, you and the employee may use treat the benefit correctly for reporting he or she may qualify to exclude part of the
special rules to value certain fringe benefits. purposes. lease value as a working condition fringe
(See Special Valuation Rules, later.) benefit. You can reduce the amount of the
If the law excludes a fringe benefit cost Using the special rules. All of the following lease value by the working condition fringe
from gross income, do not include in the em- rules apply when you use the special rules. and include the net amount in the employee's
ployee's wages the difference between the wages, or you can choose to include the en-
fair market value and the excludable cost of 1) If you use one of the special rules to tire lease value. See Vehicle-allocation rules
that fringe benefit. If the law excludes a lim- value a benefit you provide to the em- under Working Condition Fringe, later.
Page 12 Chapter 4 Fringe Benefits
Annual Lease Value equipment in the FMV if the employee to automobile lease rule on the first
whom the automobile is available uses the day for which you do not use the
Generally, you figure the annual lease value
specialized equipment in a trade or business commuting rule.
of an automobile as follows:
other than yours.
b) If you adopt the vehicle cents-per-
1) Determine the FMV of the automobile Neither the amount the employee consid-
mile rule when you first make the
(discussed later) on the first date the ers to be the value of the fringe benefit nor
automobile available to any em-
automobile is available to any employee your cost for either buying or leasing the au-
ployee for personal use, you can
for personal use. tomobile determines its FMV. However, see
change to the automobile lease rule
Safe-harbor value, next.
2) Using the following Annual Lease Value on the first day on which the auto-
Safe-harbor value. You may be able to
Table, read down column 1 until you mobile no longer qualifies for that
use a safe-harbor value as the FMV. For an
come to the dollar range within which the rule.
automobile you bought at arm's length, the
FMV of the automobile falls. Then read safe-harbor value is your cost, including tax, 2) You must use the rule for all later years
across to column 2 to find the annual title, and other purchase expenses. You can- in which you make the automobile avail-
lease value. not have been the manufacturer of the vehi- able to any employee, except that for
cle. any year during which use of the auto-
Annual Lease Value Table For an automobile you lease, the safe- mobile qualifies, you can use the com-
(1) (2) harbor value is: muting rule.
Annual
Automobile Lease 1) The manufacturer's invoice price (in- 3) You must continue to use the rule if you
Fair Market Value Value cluding options) plus 4%, provide a replacement automobile to the
$0 to 999 ..................................................... $600 employee and your primary reason for
2) The manufacturer's suggested retail the replacement is to reduce federal
1,000 to 1,999 ............................................. 850
2,000 to 2,999 ............................................. 1,100 price less 8% (including sales tax, title, taxes.
3,000 to 3,999 ............................................. 1,350 and other expenses of purchase), or
4,000 to 4,999 ............................................. 1,600 4) The employee can use the automobile
3) The retail value of the automobile re- lease rule only if the employee uses the
5,000 to 5,999 ............................................. 1,850
6,000 to 6,999 ............................................. 2,100 ported by a nationally recognized pricing rule beginning with the first day on which
7,000 to 7,999 ............................................. 2,350 source, if that retail value is reasonable the automobile is made available to the
8,000 to 8,999 ............................................. 2,600 for that automobile. employee for personal use (and the em-
9,000 to 9,999 ............................................. 2,850 ployer does not use the commuting rule.
10,000 to 10,999 ......................................... 3,100 Items included in annual lease value table.
11,000 to 11,999 ......................................... 3,350 Each annual lease value in the table includes
12,000 to 12,999 ......................................... 3,600 4-year lease term. The annual lease values
13,000 to 13,999 ......................................... 3,850
the FMV of maintenance and insurance ser- in the table are based on a 4-year lease term.
14,000 to 14,999 ......................................... 4,100 vices for the automobile. Do not reduce this These values will generally stay the same for
15,000 to 15,999 ......................................... 4,350 value by the FMV of any of these services the period that begins with the first date you
16,000 to 16,999 ......................................... 4,600 that you did not provide. For example, do not use this special rule for the automobile and
17,000 to 17,999 ......................................... 4,850 reduce the annual lease value by the FMV ends on December 31 of the 4th full calendar
18,000 to 18,999 ......................................... 5,100 of a maintenance service contract or insur-
19,000 to 19,999 ......................................... 5,350
year following that date.
ance you did not provide. (You can take into Figure the annual lease value for each
20,000 to 20,999 ......................................... 5,600
21,000 to 21,999 ......................................... 5,850
account the services actually provided for the later 4-year period by determining the FMV
22,000 to 22,999 ......................................... 6,100 automobile by using the general valuation of the automobile on January 1 of the first
23,000 to 23,999 ......................................... 6,350 rule, discussed earlier.) year of the later 4-year period and selecting
24,000 to 24,999 ......................................... 6,600 Items not included. The annual lease the amount in column 2 of the table that cor-
25,000 to 25,999 ......................................... 6,850 value does not include the FMV of fuel you responds to the appropriate dollar range in
26,000 to 27,999 ......................................... 7,250 provide to an employee for personal use, re-
28,000 to 29,999 ......................................... 7,750
column 1.
gardless of whether you provide it, reimburse Using the special accounting period
30,000 to 31,999 ......................................... 8,250
32,000 to 33,999 ......................................... 8,750
its cost, or have it charged to you. You must rule. If you use the special accounting period
34,000 to 35,999 ......................................... 9,250 include the value of the fuel separately in the rule, discussed earlier, you can figure the
36,000 to 37,999 ......................................... 9,750 employee's wages. You can value fuel you annual lease value for each later 4-year pe-
38,000 to 39,999 ......................................... 10,250 provided at FMV or at 5.5 cents per mile for riod at the beginning of the special accounting
40,000 to 41,999 ......................................... 10,750 all miles driven by the employee. However, period that starts immediately before the
42,000 to 43,999 ......................................... 11,250 you cannot value at 5.5 cents per mile fuel
44,000 to 45,999 ......................................... 11,750
January 1 date described in the previous
you provide for miles driven outside the paragraph.
46,000 to 47,999 ......................................... 12,250
48,000 to 49,999 ......................................... 12,750
United States (including its possessions and For example, assume that you use the
50,000 to 51,999 ......................................... 13,250 territories), Canada, and Mexico. special accounting period rule and that be-
52,000 to 53,999 ......................................... 13,750 If you reimburse an employee for the cost ginning on November 1, 1997, the special
54,000 to 55,999 ......................................... 14,250 of fuel, or have it charged to you, you gener- accounting period is November 1 to October
56,000 to 57,999 ......................................... 14,750 ally value the fuel at the amount you reim- 31. You elect to use the automobile lease
58,000 to 59,999 ......................................... 15,250 burse, or the amount charged to you if it was valuation rule as of January 1, 1998. You can
For vehicles with an FMV of more than bought at arm's length. refigure the annual lease value on November
$59,999, the annual lease value equals: (0.25 If you have 20 or more automobiles, see 1, 2001, rather than on January 1, 2002.
× the FMV of the automobile) + $500. section 1.61–21(d)(3)(ii)(D) of the Income Tax
Regulations. Transferring an automobile from one em-
Fair market value. The FMV of the auto- If you provide any service other than ployee to another. Unless the primary pur-
mobile is the amount a person would pay to maintenance and insurance for an automo- pose of the transfer is to reduce federal taxes,
buy it from a third party, in an arm's length bile, you must add the FMV of that service to you can refigure the annual lease value
transaction, in the area in which the vehicle the annual lease value of the automobile in based on the FMV of the automobile on Jan-
is bought or leased. That amount includes all determining the value of the benefit. uary 1 of the calendar year of transfer.
purchase expenses, such as sales tax and However, if you use the special account-
title fees. Consistency rules. If you adopt the auto- ing period rule, you can refigure the annual
If you have 20 or more automobiles, see mobile lease rule for an automobile, the fol- lease value (based on the FMV of the auto-
section 1.61–21(d)(5)(v) of the Income Tax lowing rules apply. mobile) at the beginning of the special ac-
Regulations. If you and the employee own or counting period in which the transfer occurs.
1) You must adopt it by the first day you
lease the automobile together, see section If you do not refigure the annual lease value,
make the automobile available to any
1.61–21(d)(2)(ii) of the Income Tax Regu- the employee cannot refigure it.
employee for personal use. However,
lations.
the following exceptions apply.
You do not have to include the FMV of a Prorated annual lease value. If you provide
telephone or any specialized equipment a) If you adopt the commuting rule an automobile to an employee for continuous
added to, or carried in, the automobile if the when you first make the automobile periods of 30 or more days but less than an
equipment is necessary for your business. available to any employee for per- entire calendar year, you can prorate the an-
However, include the value of specialized sonal use, you can change to the nual lease value. Figure the prorated annual
Chapter 4 Fringe Benefits Page 13
lease value by multiplying the annual lease Personal use is any use of the vehicle Consistency rules. If you adopt the cents-
value by a fraction, using the number of days other than use in your trade or business. per-mile rule for an automobile, the following
of availability as the numerator and 365 as the For the vehicle cents-per-mile rule, a ve- rules apply.
denominator. hicle is any motorized wheeled vehicle, in-
If you provide an automobile continuously cluding an automobile, manufactured prima- 1) You must adopt it by the first day you
for at least 30 days, but the period covers 2 rily for use on public streets, roads, and make the automobile available to any
calendar years (2 special accounting periods highways. employee for personal use. However, if
if you are using the special accounting period you adopt the commuting rule when you
rule, discussed earlier), you can use the pro- Regular use in your business. Determine first make the automobile available to
rated annual lease value or the daily lease whether a vehicle is regularly used in your any employee for personal use, you can
value. trade or business on the basis of all the facts change to the cents-per-mile rule on the
If you have 20 or more automobiles, see and circumstances. A vehicle is regularly first day for which you do not use the
section 1.61–21(d)(6) of the Income Tax used in your trade or business if it meets one commuting rule.
Regulations. of the following safe-harbor conditions. 2) You must use the rule for all later years
If an automobile is unavailable to the em- in which you make the automobile avail-
ployee because of his or her personal rea- 1) At least 50% of the vehicle's total annual able to any employee and the automo-
sons (for example, if the employee is on va- mileage is for your trade or business. bile qualifies, except that for any year
cation), you cannot take into account the during which use of the automobile
periods of unavailability when you use a pro- 2) You sponsor a commuting pool that
generally uses the vehicle each workday qualifies for the commuting rule, you can
rated annual lease value. use the commuting rule. However, if the
to drive at least 3 employees to and from
You cannot use a prorated annual work. vehicle does not qualify for the cents-
! lease value if the reduction of federal
CAUTION tax is the main reason the automobile Infrequent business use of the vehicle,
per-mile rule during a later year, you can
adopt for that year and thereafter any
is unavailable. such as for occasional trips to the airport or other special rule for which the vehicle
between your multiple business premises, is then qualifies.
Daily lease value. If you provide an auto- not regular use of the vehicle in your trade 3) You must continue to use the rule if you
mobile for continuous periods of one or more or business. provide a replacement automobile to the
but less than 30 days, use the daily lease employee and your primary reason for
value to figure its value. Figure the daily lease Mileage rule. If you provide an employee the replacement is to reduce federal
value by multiplying the annual lease value with a vehicle you do not expect the employee taxes.
by a fraction, using four times the number of to use regularly in your trade or business but
days of availability as the numerator and 365 that meets the mileage rule, you can use the 4) The employee can use the vehicle
as the denominator. cents-per-mile method to value the benefit. A cents-per-mile rule only if the employee
However, you can apply a prorated annual vehicle meets the mileage rule for a calendar uses the rule beginning with the first day
lease value for a period of continuous avail- year if: on which the automobile is made avail-
ability of less than 30 days by treating the able to the employee for personal use
automobile as if it had been available for 30 1) It is actually driven at least 10,000 miles (and the employer does not use the
days. Use a prorated annual lease value if it in that year, and commuting rule).
would result in a lower valuation than applying
2) It is used during the year primarily by
the daily lease value to the shorter period of
availability.
employees. Commuting Rule
Under this rule, the value of the commuting
Consider the vehicle used primarily by use of a vehicle you provide is $1.50 per
Vehicle Cents-Per-Mile Rule employees if they use it consistently for one-way commute (that is, from home to work
commuting. For example, if only one em- or from work to home) for each employee who
Under this rule, you determine the value of a ployee uses a vehicle during the year and that
vehicle you provide to an employee for per- commutes in the vehicle.
employee drives the vehicle at least 10,000 The term vehicle means any motorized
sonal use by multiplying the standard mileage miles in that calendar year, the vehicle meets
rate by the total miles the employee drives the wheeled vehicle, including an automobile,
the mileage rule even if all miles driven by the manufactured primarily for use on public
vehicle for personal purposes. For 1998, this employee are personal. Do not treat use of
rate is 32.5 cents per mile. streets, roads, and highways.
the vehicle by an individual (other than the You can use this special rule to figure
You can use the vehicle cents-per-mile employee) whose use would be taxed to the
rule if you provide an employee with a vehicle commuting value if you and the employee
employee as use by the employee. If you meet all the following requirements.
that: own or lease the vehicle only part of the year,
reduce the 10,000 mile requirement propor- 1) You own or lease the vehicle and pro-
1) You reasonably expect will be regularly
tionately. vide it to one or more employees for use
used in your trade or business through-
out the calendar year (or for a shorter in your trade or business.
period during which you own or lease it), Items included in cents-per-mile rate. The
cents-per-mile rate includes the FMV of 2) For bona fide noncompensatory busi-
or ness reasons, you require the employee
maintenance and insurance for the vehicle.
2) Meets the mileage rule requirements Do not reduce the rate by the FMV of any to commute in the vehicle.
discussed later. service included in the rate that you did not 3) You establish a written policy under
provide. (You can take into account the ser- which you do not allow the employee to
When you cannot use the cents- vices actually provided for the vehicle by us- use the vehicle for personal purposes,
! per-mile rule. You cannot use the
CAUTION vehicle cents-per-mile rule for an au-
ing the general valuation rule, discussed ear- other than for commuting or de minimis
lier.) personal use (such as a stop for a per-
tomobile first made available to an employee For miles driven in the United States, its sonal errand on the way between a
for personal use in 1998 if the FMV of the territories and possessions, Canada, and business delivery and the employee's
automobile is more than $15,600. If you and Mexico, the cents-per-mile rate includes the home).
the employee own or lease the automobile FMV of fuel you provide. If you do not provide
together, see section 1.61–21(e)(1)(iii) of the fuel, you can reduce the rate by no more than 4) The employee does not use the vehicle
Income Tax Regulations. 5.5 cents. for personal purposes, other than com-
For special rules that apply to fuel you muting and de minimis personal use.
provide for miles driven outside the United 5) If this vehicle is an automobile, the em-
States, Canada, and Mexico, see section ployee who must use it for commuting is
Apply the standard mileage rate only to 1.61–21(e)(3)(ii)(B) of the Income Tax Regu- not a control employee (defined later).
personal miles. Disregard business miles. lations.
For example, if the employee drives 20,000 The FMV of any other service you provide Personal use of a vehicle is all use that is not
personal miles and 35,000 business miles in for a vehicle is not included in the cents-per- for your trade or business.
1998, the personal use value of the vehicle mile rate. Use the general valuation rule to An employer-provided vehicle generally
is $6,500 (20,000 × 0.325). value these services. used each workday to carry at least three
Page 14 Chapter 4 Fringe Benefits
employees to and from work in an employer- 3) The employee does not use the trans- 1) The individual meal subsidy method.
sponsored commuting pool meets require- portation for personal purposes other
ments (1) and (2) above. than commuting because of unsafe 2) The allocated total meal subsidy
conditions. method.
Chauffeur-driven vehicle. If the ve-
! hicle is a chauffeur-driven vehicle, you
CAUTION cannot use the commuting valuation
4) The employee is a qualified employee. Employer-operated eating facility. An
employer-operated eating facility for employ-
rule for any passenger. However, you can This special valuation rule applies on a ees is a facility that meets all the following
use it to value the commuting use of the trip-by-trip basis. If you and the employee fail conditions.
chauffeur. to meet the requirements for any trip, use the
FMV of the transportation to determine the 1) You own or lease the facility.
amount to include in the employee's wages.
2) You operate the facility. You are consid-
Transportation. This rule applies to trans- ered to operate the eating facility if you
Control employees. A control employee of have a contract with another to operate
a nongovernment employer is any em- portation of a qualified employee to or from
work by any motorized wheeled vehicle (in- it.
ployee who:
cluding an automobile) manufactured for use 3) The facility is on or near your business
1) Is a board- or shareholder-appointed, on public streets, roads, and highways. You premises.
confirmed, or elected officer of the em- or the employee must buy the transportation
from a party that is not related to you. If the 4) You provide meals (food, drinks, and
ployer and whose pay for 1998 is
employee buys it, you must reimburse the related services) at the facility during, or
$70,000 or more,
employee for its cost (for example, cabfare) immediately before or after, the employ-
2) Is a director of the employer, under a bona fide reimbursement arrange- ee's workday.
3) Receives pay for 1998 of $145,000 or ment.
more from the employer, or Total meal value. The total meal value is
Unsafe conditions. Unsafe conditions exist 150% of the direct operating costs of the
4) Owns a 1% or more equity, capital, or if, under the facts and circumstances, a rea- eating facility. This total meal value is con-
profits interest in the employer. sonable person would consider it unsafe for sidered the value of all meals provided at that
the employee to walk or use public transpor- facility for employees during the calendar
Any individual who owns (or is considered year.
tation at the time of day the employee must
to own under section 318(a) of the Internal Direct operating costs. The direct op-
commute. One factor indicating whether it is
Revenue Code or principles similar to section erating costs of an eating facility are the costs
unsafe is the history of crime in the ge-
318(a) for entities other than corporations) 1% of food and drinks and the cost of labor for
ographic area surrounding the employee's
or more of the FMV of an entity (the “owned employees performing services relating to the
workplace or home at the time of day the
entity”) is considered a 1% owner of all other facility primarily on the eating facility prem-
employee commutes.
entities grouped with the owned entity under ises. For example, the labor costs for cooks,
the rules of section 414(b), (c), (m), or (o). waiters, and waitresses are included in direct
An employee who is an officer or director of Qualified employee. A qualified employee
is one who: operating costs. If an employee performs the
an employer is considered an officer or di- services both on and off premises, include
rector of all entities treated as a single em- 1) Performs services during the current only the labor costs for the services per-
ployer under section 414(b), (c), (m), or (o). year, formed on premises.
Instead of using the above definition, you
can choose to treat as control employees all 2) Is paid on an hourly basis, Do not include in direct operating
of your highly compensated employees. For
3) Is not claimed under section 213(a)(1) ! costs the labor cost for a manager of
CAUTION an eating facility who does not pri-
the definition of a highly compensated em-
of the Fair Labor Standards Act of 1938 marily perform services on the eating facility
ployee, see Highly compensated employee
(as amended) to be exempt from the premises.
under Exclusion of Certain Fringe Benefits,
minimum wage and maximum hour pro-
later.
visions,
A control employee of a government Individual meal subsidy method. Under
employer is any: 4) Is within a classification for which you this method, the value of meals provided to
actually pay, or specify in writing you will a particular employee during a calendar year
1) Elected official, or pay, overtime pay equal to or exceeding is the total of the individual meal subsidies
2) Employee whose pay is at least as much one and one-half times the regular rate you provide to that employee during that year.
as that paid to a federal government provided in section 207 of the 1938 Act, Figure the individual meal subsidy by multi-
employee at Executive Level V. For and plying the price charged for a particular meal
1998, this amount is $110,700. by a fraction, using the total meal value as the
5) Does not receive pay of more than numerator and the gross receipts of the eat-
$70,000 from you in 1998. ing facility for the calendar year as the de-
For the commuting rule, the term “gov-
ernment” includes any federal, state, or local nominator. Then subtract the amount paid
However, the employee will not be con-
governmental unit and any of their agencies by the employee for the meal.
sidered a qualified employee if you do not
or instrumentalities. comply with the recordkeeping requirements Meal charge required. You can use
concerning the employee's wages, hours, and
other conditions and practices of employment
! the individual meal subsidy method
Unsafe Conditions under section 211(c) of the 1938 Act and the
CAUTION only if there is a charge for each meal

and the price charged each employee is the


Commuting Rule related regulations. same for any given meal.
Under this rule, the value of the commuting
use of transportation you provide each em-
ployee solely because of unsafe conditions Employer-Operated Eating
is $1.50 per one-way commute (that is, from Facility Rule Allocated total meal subsidy method. Un-
home to work or from work to home). You can use this rule to determine the value der this method, you figure the value of meals
You can use this special rule to figure of taxable meals you provide at an provided to a particular employee by allocat-
commuting value if you and the employee employer-operated eating facility for employ- ing the total meal subsidy among the em-
meet all the following requirements. ees. For situations where you do not have to ployees in any manner reasonable under the
include the value of meals in an employee's circumstances. It is presumed reasonable for
1) The employee would ordinarily walk or
wages, see chapter 3 and the discussion un- you to allocate the total meal subsidy on a
use public transportation for commuting.
der De Minimis (Minimal) Fringe, later. per-employee basis if you can show that you
2) You establish a written policy under Under this rule, you first figure the total provided each employee with approximately
which you do not allow the employee to meal value of meals provided at the facility. the same number of meals at the facility.
use the transportation for personal pur- Then you use that value to figure the value Total meal subsidy. This is the total
poses other than commuting because for each employee under either of the follow- meal value (explained earlier) minus the
of unsafe conditions. ing two methods. gross receipts of the facility.
Chapter 4 Fringe Benefits Page 15
Dependent child. For this fringe benefit,
No-Additional-Cost Service “dependent child” means any son, stepson,
Exclusion of Certain If you provide an employee with the same daughter, or stepdaughter who is a depend-
service you offer to customers in the ordinary ent of the employee, or both of whose parents
Fringe Benefits course of the line of business in which the have died and who has not reached age 25.
employee performs substantial services, this Treat a child of divorced parents as a de-
Special rules allow you to exclude certain service may be a no-additional-cost service.
fringe benefits you provide to an employee pendent of both parents.
Do not include the value of the service in the
from the employee's wages. You can exclude employee's wages if you do not incur any
under these rules all of the following fringe substantial additional costs to provide the Qualified Employee
benefits. service to the employee. (But see the pre-
ceding discussion, Nondiscrimination rules, if
Discount
• A no-additional-cost service. the employee is highly compensated.) To Do not include in an employee's wages the
determine additional costs include lost reve- value of a qualified employee discount. A
• A qualified employee discount. nue, but do not reduce the costs you incur qualified employee discount is a price re-
by any amount the employee paid for this duction you give an employee on certain
• A working condition fringe. service. property or services you offer to customers in
Generally, no-additional cost services are the ordinary course of the line of business in
• A de minimis (minimal) fringe. which the employee performs substantial
excess capacity services, such as airline, bus,
• A qualified transportation fringe. or train tickets; hotel rooms; or telephone services. For the rules on line of business,
services provided free or at a reduced price see No-Additional-Cost Services, earlier. If
• A qualified moving expense reimburse- to employees working in those lines of busi- the employee is highly compensated, see
ment. ness. Nondiscrimination rules, the first discussion
Generally, an employer's line of business in this section.
• An on-premises athletic facility. However, a discount on real property
is determined by the Enterprise Standard In-
dustrial Classification Manual (ESIC Manual) (such as a building or land) or on personal
These are not the only employee benefits prepared by the Statistical Policy Division of property of a kind commonly held for invest-
you can exclude from the employee's wages. the U.S. Office of Management and Budget. ment (such as stocks or bonds) is not a
You can also exclude certain benefits you For more information, see section 1.132–4 of qualified employee discount. The exclusion
provide through employee benefit programs. the Income Tax Regulations. does not apply where there is a reciprocal
For more information, see chapter 5. agreement under which another employer
Generally, the above exclusions do not provides the discount. A qualified employee
apply if the tax treatment of the fringe benefit Reciprocal agreements. Employees can discount also does not include any amount
is provided by another tax rule. For example, exclude the value of a no-additional-cost ser- that is more than the following amount.
an exclusion does not apply to employer- vice provided by an unrelated employer if all
provided dependent care assistance or tuition the following tests apply. 1) For a discount on property, your gross
reductions, the tax treatments of which are profit percentage times the price you
covered by other rules. However, if another 1) The service is the same type of service charge customers for the property.
tax rule excludes a benefit from wages and generally provided to customers in both
the line of business in which the em- 2) For a discount on services, 20% of the
the exclusion is a limited amount of the ben- price you charge customers for the ser-
efit's cost, an exclusion under the fringe ben- ployee works and the line of business in
which the service is provided. vice.
efit rules may apply to the rest of the cost.
2) You and the employer providing the Determine your gross profit percentage
service have a written reciprocal agree- based on all property you offer to customers
Nondiscrimination rules. You cannot ex- ment under which a group of employees (including employee customers) in the ordi-
clude a no-additional-cost service, a qualified of each employer, all of whom perform nary course of your line of business and your
employee discount, or a meal provided at an substantial services in the same line of experience during the tax year immediately
employer-operated eating facility for employ- business, may receive no-additional-cost before the tax year in which the discount is
ees from the wages of a highly compensated services from the other employer. available. To figure your gross profit percent-
employee unless the benefit is available on age, subtract the total cost of the property
the same terms to: 3) Neither you nor the other employer in- from the total sales price of the property and
curs any substantial additional cost (in- divide the result by the total sales price of the
1) All employees, or cluding lost revenue) either in providing property.
the service or because of the written The term “employee” includes the same
2) A group of employees defined under a agreement. individuals listed earlier under No-Additional-
reasonable classification you set up that Cost Service. For special rules concerning
does not favor highly compensated em- Employee. For this fringe benefit, employees of a leased section of a depart-
ployees. “employee” includes any: ment store, see section 1.132–3(d) of the In-
come Tax Regulations.
Meals provided at an employer-operated eat- 1) Individual currently employed by you,
ing facility are discussed under De Minimis 2) Individual who stopped working for you Working Condition Fringe
(Minimal) Fringe. as an employee because of retirement You can exclude from an employee's wages
If any benefit is discriminatory, include the or disability, (as a working condition fringe benefit) the
total value of the benefit, not only the value
value of property or services you provide if the
of the discriminatory part, in the wages of your 3) Surviving spouse of an individual who employee could deduct them as a trade or
highly compensated employees. died while working for you as an em- business or depreciation expense if he or she
Highly compensated employee. A ployee or who stopped working for you paid for them.
highly compensated employee for 1998 is an as an employee because of retirement For this fringe benefit, “employee” in-
employee who: or disability, or cludes any:
4) Partner who performs services for a
1) Was a 5% owner at any time during the 1) Individual currently employed by you,
partnership.
year or the preceding year, or 2) Partner who performs services for a
Treat services you provide to the spouse partnership,
2) Received more than $80,000 in pay for or dependent child of an employee as pro-
the preceding year. vided to the employee. 3) Director of your company, and
Treat any use of air transportation by the 4) Independent contractor who performs
When you apply requirement (2), you may parent of an employee as use by the em- services for you.
choose to include only employees who were ployee. This rule does not apply to use by the
also in the top 20% of employees when parent of a person considered an employee However, do not exclude from the com-
ranked by pay for the preceding year. because of item (3) above. pensation you pay to an independent con-
Page 16 Chapter 4 Fringe Benefits
tractor who performs services for you the section 1.132–5(o) of the Income Tax Regu- law enforcement officer includes an arson in-
value of parking or the use of consumer lations. vestigator if the investigator meets these re-
goods that you provide in a product testing quirements.
program. Also, do not exclude from the com- Qualified Nonpersonal Use
pensation you pay to a director the value of Trucks and vans. A pickup truck or van is
the use of consumer goods you provide in a Vehicles not a qualified nonpersonal use vehicle un-
product testing program. All of an employee's use of a qualified non- less specially modified so it is not likely to be
personal use vehicle qualifies as a working used more than minimally for personal pur-
Vehicle-allocation rules. Generally, for an condition fringe. You can exclude the value poses. The following are guidelines that a
employer-provided vehicle, the amount you of that use from the employee's wages. A pickup truck or van can meet to be a qualified
can exclude as a working condition fringe is qualified nonpersonal use vehicle is any ve- nonpersonal use vehicle. Even if these
the amount that would be allowable as a hicle the employee is not likely to use more guidelines are not met, the vehicle may still
deductible business expense if paid by the than minimally for personal purposes be- qualify, based upon the facts. In that case,
employee. That is, if the employee uses the cause of its design. Qualified nonpersonal contact the IRS for further guidance.
car for business, as well as for personal use, use vehicles include all of the following vehi- Pickup truck. A pickup truck with a
the value of the working condition fringe is the cles. loaded gross vehicle weight not over 14,000
portion determined to be for business use of pounds qualifies if clearly marked with per-
the vehicle. See Business use of your car in 1) Clearly marked police and fire vehicles.
manently affixed decals, special painting, or
chapter 1. Also, see the special rules for cer- 2) Unmarked vehicles used by law other advertising associated with your trade,
tain demonstrator cars and qualified nonper- enforcement officers (explained later) if business, or function. It must be either:
sonal use vehicles, discussed later. the use is officially authorized.
However, instead of excluding the value 1) Equipped with at least one of the fol-
of the working condition fringe related to the 3) An ambulance or hearse used for its lowing:
deductible car expense, you may include the specific purpose.
entire annual lease value in an employee re- a) Hydraulic lift gate,
4) Any vehicle designed to carry cargo with
cipient's wages. The employee can then claim a loaded gross vehicle weight over b) Permanent tanks or drums,
any deductible business car expense as an 14,000 pounds.
itemized deduction on his or her personal in- c) Permanent side boards or panels
come tax return. 5) Delivery trucks with seating for the driver that materially raise the level of the
The total inclusion option is only allowed only, or driver plus a folding jump seat. sides of the truck bed, or
if you use the automobile lease rule (dis- 6) A passenger bus with a capacity of at d) Other heavy equipment (such as
cussed under Special Valuation Rules, ear- least 20 passengers used for its specific an electric generator, welder, boom,
lier) to value the fringe benefit for a vehicle purpose. or crane used to tow automobiles
you furnish to the employee. and other vehicles), or
7) School buses.
Educational assistance. If you pay the cost 8) Tractors and other special purpose farm 2) Used primarily to transport a particular
of an employee's education, you may be able vehicles. type of load (other than over the public
to exclude the cost from the employee's highways) in a construction, manufac-
wages under the tax rules that apply to em- turing, processing, farming, mining, drill-
Clearly marked police or fire vehicles. A
ployer-provided educational assistance pro- ing, timbering, or other similar operation
police or fire vehicle is a vehicle, owned or
grams. Costs you cannot exclude under those for which it was specially designed or
leased by a governmental unit (or any of its
rules may be excluded only if they qualify as significantly modified.
agencies or instrumentalities), that a police
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- Van. A van with a loaded gross vehicle
must use for commuting. The governmental weight not over 14,000 pounds qualifies if
cation must be a job-related deductible ex- unit must prohibit any personal use (other
pense by the employee. For more information clearly marked with permanently affixed
than commuting) of the vehicle outside the decals, special painting, or other advertising
on educational assistance programs, see limit of the police officer's arrest powers or the
chapter 5. For more information on deductible associated with your trade, business, or
fire fighter's obligation to respond to an function. It must have a seat for the driver
education expenses, see Publication 508, emergency. A police or fire vehicle is clearly
Educational Expenses. only or the driver and one other person, and
marked if, through a painted symbol or words, either:
it is easy to see the vehicle is a police or fire
Outplacement services. You can exclude vehicle. A marking on a license plate is not a
from an employee recipient's wages the value 1) Permanent shelving that fills most of the
clear marking for this purpose. cargo area, or
of outplacement services provided to the
employee on the basis of need if you get a Unmarked law enforcement vehicles. The 2) The cargo area is open and the van al-
substantial business benefit from the services governmental agency or department that ways carries merchandise, material, or
distinct from the benefit you get from the owns or leases the vehicle and employs the equipment used in your trade, business,
payment of additional wages. Substantial officer must authorize any personal use of an or function.
business benefits include promoting a posi- unmarked law enforcement vehicle. The per-
tive business image, maintaining employee sonal use must be necessary to help enforce
morale, and avoiding wrongful termination Items Not Excludable
the law, such as being able to report directly
suits. from home to a stakeout site or to an emer- The following are some items you cannot ex-
You cannot exclude the value of services gency. Use for vacation or recreation trips clude from an employee's wages as working
that do not qualify as a working condition cannot qualify as an authorized use. condition fringe benefits.
fringe because the employee can choose to Law enforcement officer. A law
receive cash or taxable benefits in place of 1) A service or property offered through a
enforcement officer is a full-time employee of
the services. If you maintain a severance flexible spending account. A flexible
a governmental unit that is responsible for
plan and permit employees to get outplace- spending account is an agreement that
preventing or investigating crimes involving
ment services with reduced severance pay, gives employees over a time period a
injury to persons or property (including
include in the employee's wages the differ- certain amount of unspecified noncash
catching or detaining persons for these
ence between the unreduced severance and benefits with a predetermined cash
crimes). The law must allow the employee to
the reduced severance payments. value.
take all of the following actions.
2) Any item for which the employee does
Demonstrator cars. All of the use of a 1) Carry firearms. not have the necessary substantiation to
demonstrator car by your full-time auto deduct as a trade, business, or depreci-
salesperson generally qualifies as a working 2) Execute search warrants.
ation expense.
condition fringe if the use is primarily to facil- 3) Make arrests (other than citizen's ar-
itate the services the salesperson provided for rests). 3) Expenses the employee can deduct un-
you and there are substantial restrictions on der sections of the Internal Revenue
personal use. For more information and the The employee must regularly carry Code other than for trade or business
definition of “full-time auto salesperson,” see firearms except when working undercover. A expenses or depreciation.
Chapter 4 Fringe Benefits Page 17
4) A physical examination program, Qualified parking. Qualified parking is
whether mandatory to some or all em-
Qualified Transportation parking you provide to your employees on or
ployees. Fringe near your business premises. It also includes
You can exclude qualified transportation parking on or near the location from which
5) A cash payment you made to the em- your employees commute to work using mass
ployee unless you require the employee fringe benefits from the wages of employees,
up to certain limits. The following benefits, transit, commuter highway vehicles, or
to do all of the following: carpools. It does not include parking at or
which you can provide in any combination at
a) Use the money for expenses for a the same time to an employee, are qualified near your employee's home.
specific or prearranged activity that transportation fringe benefits.
are deductible as trade, business, Exclusion Limits
or depreciation expenses, 1) A ride in a commuter highway vehicle if For 1998, you may exclude from the wages
the ride is between the employee's home of each employee up to:
b) Verify that he or she used the
and work place.
money for these expenses, and
1) $65 per month for combined commuter
c) Return any unused money to you. 2) A transit pass. highway vehicle transportation and
3) Qualified parking. transit passes, and
2) $175 per month for qualified parking.
De Minimis (Minimal) Fringe Amounts you give to an employee for
An employee's wages do not include the these expenses under a bona fide re- Excess benefits taxable. If, for any month,
value of a de minimis fringe benefit. This imbursement arrangement are also the fair market value of a benefit is more than
benefit is any property or service you provide excludable. Cash reimbursements for transit its limit, include in the employee's wages only
to an employee that has so little value (taking passes qualify only if a voucher or a similar the amount over the limit, minus any amount
into account how frequently you provide sim- item that the employee can exchange only for paid for the benefit by or for the employee.
ilar benefits to your employees) that ac- a transit pass is not readily available for direct
counting for it would be unreasonable or ad- distribution by you to your employee. Example 1. Each month, you provide a
ministratively impracticable. Cash, no matter transit pass valued at $70 to your employee,
how little, is never excludable as a de minimis Tom Travis. He does not pay you for any part
Employee. You can provide qualified trans- of the pass. Because the value of the transit
fringe, except for occasional meal money or
portation fringe benefits only to employees. pass exceeds the limit, for each month you
transportation fare as discussed next.
The definition of employee includes com- provide this pass you must include $5 in his
Examples of de minimis fringes include:
mon-law employees and other statutory em- wages for income and employment tax pur-
ployees, such as officers of corporations. poses.
• Occasional typing of personal letters by Self-employed individuals, including partners,
a company secretary, 2-percent shareholders in S corporations, Example 2. Each month, you provide
• Occasional personal use of a company sole proprietors, and other independent con- qualified parking valued at $180 to Travis
copying machine, if you sufficiently con- tractors are not employees for purposes of Ramon. He does not pay you for any part of
trol its use, this fringe benefit. the parking. Because the value of the parking
• Occasional parties or picnics for employ- exceeds the limit, for each month you provide
ees and their guests, Benefit provided in place of pay. For tax this parking you must include $5 in his wages
years beginning after 1997, you can exclude for income and employment tax purposes.
• Occasional meals, meal money, or local qualified transportation fringe benefits from
transportation fare, not based on hours Example 3. You provide qualified parking
an employee's wages even if you provide with a fair market value of $200 per month to
worked, provided to an employee be- them in place of pay.
cause the employee is working overtime your employees, but you charge the employ-
and, for meals and meal money, provided ees $25 per month. The value of the parking
to enable the employee to work overtime, Relation to other fringe benefits. You exceeds the limit by $25. You reduce that
cannot exclude a qualified transportation excess benefit by the amount your employees
• Holiday gifts, other than cash, with a low fringe benefit under the de minimis or working paid ($25). Do not include any amount in your
FMV, condition fringe benefit rules. However, if you employees' wages.
• Occasional tickets for entertainment provide a local transportation benefit other
events, than by transit pass or commuter highway Taxable Benefits – Withholding
vehicle, or to a person other than an em-
• Coffee, doughnuts, or soft drinks fur- ployee as defined earlier, you may be able to and Reporting
nished to employees, and exclude all or part of the benefit under other Treat taxable transportation fringe benefits as
• Group-term life insurance payable on the fringe benefit rules (de minimis, working con- wages subject to employment taxes. When
death of an employee's spouse or de- dition, etc.). and how you withhold on and report the value
pendent if the face amount is not more of qualified transportation fringe benefits that
than $2,000. you must include in an employee's wages
Commuter highway vehicle. A commuter
depends on whether the benefits are noncash
highway vehicle is any highway vehicle that
benefits or cash reimbursements.
Employer-operated eating facility. The seats at least 6 adults (not including the
value of meals you provide to employees at driver). In addition, you must reasonably ex-
Noncash benefits. For information on when
an eating facility operated by you is a de pect that at least 80% of the vehicle mileage
and how to withhold on and report taxable
minimis fringe benefit only if the annual reve- will be for transporting employees between
noncash fringe benefits, see Including bene-
nue from the facility equals or exceeds the their homes and work place, with your em-
fits in pay and When fringe benefits are
direct operating costs of the facility. For the ployees occupying at least one-half of the
treated as paid under General Information at
nondiscrimination requirements, see Nondis- vehicle's seats (not including the driver's).
the beginning of this chapter.
crimination rules, the first discussion in this
section, Exclusion of Certain Fringe Benefits. Transit pass. A transit pass is any pass, Cash reimbursements. For employment tax
For more information, including definitions of token, farecard, voucher, or similar item enti- purposes, treat taxable cash reimbursements
an employer-operated eating facility and di- tling a person, free of charge or at a reduced as paid when they are made available to the
rect operating costs, see Employer-Operated rate, to ride: employee. You must deposit and report
Eating Facility Rule, the last discussion in the amounts withheld along with your FUTA tax
preceding section, Special Valuation Rules. • Mass transit, or and your part of the social security and Med-
Meals furnished for your convenience. icare taxes.
For tax years beginning after 1997, if the • In a vehicle that seats at least 6 adults
value of the meals furnished at your eating (not including the driver), if a person in
facility for employees can be excluded from the business of transporting persons for More Information
the employees' wages under the rules ex- pay or hire operates it. For more information on qualified transporta-
plained in chapter 3, your revenue from the tion fringe benefits, including van pools, and
meals is considered to equal the facility's di- Mass transit may be publicly- or privately- how to determine the value of parking, see
rect operating costs for them. operated and includes bus, rail, or ferry. Notice 94–3, 1994–1 C.B. 327.
Page 18 Chapter 4 Fringe Benefits
Qualified Moving Expense Useful Items
You may want to see:
Reimbursements
You can exclude from an employee recipi-
5. Publication
ent's wages any qualified moving expense
reimbursement. This is any amount you give
the employee, directly or indirectly (including
Employee m 15 Circular E, Employer's Tax Guide
m 15–A Employer's Supplemental Tax
services furnished in kind), as a payment for,
or a reimbursement of, expenses that would Benefit Guide
be deductible as moving expenses if your m 503
employee paid or incurred them. You should Programs Child and Dependent Care Ex-
penses
make the reimbursements under rules similar
to those described in chapter 16 for re- m 525 Taxable and Nontaxable Income
imbursements of expenses for travel, meals, m 968 Tax Benefits for Adoption
and entertainment under accountable plans.
m 969 Medical Savings Accounts
Deductible moving expenses. Deductible
Important Change (MSAs)
moving expenses include only the reasonable
expenses of:
for 1998 Form (and Instructions)

Group health plan requirements. For plan m W–2 Wage and Tax Statement
1) Moving household goods and personal
effects from the former home to the new years beginning after 1997, you (or the plan, m 5500 Annual Return/Report of Em-
home, and if a multi-employer plan) may be subject to ployee Benefit Plan (With 100 or
an excise tax if your plan does not meet cer- more participants)
2) Traveling (including lodging) from the tain new requirements. These requirements
former home to the new home. generally: m 5500–C/R Annual Return/Report of Em-
ployee Benefit Plan (With fewer
Deductible moving expenses do not 1) Obligate plans to pay for a minimum than 100 participants)
!
CAUTION
include any expenses for meals. hospital stay for mothers and newborns
if the plan otherwise provides benefits for
See chapter 17 for information about get-
ting publications and forms.
hospital stays in connection with
childbirth, and
For more information on deductible mov- 2) Prevent certain special limits from being
ing expenses, see Publication 521. placed on mental health benefits. Accident and Health
Nonqualified reimbursements. Include any For more information on this excise tax, see Plans
reimbursements for moving expenses that are Other Requirements, under Accident and This section provides basic tax information
not qualified moving expense reimburse- Health Plans, later. about accident and health plans.
ments in the employee's wages. This includes
any payment for, or reimbursement of, ex- Deducting the cost. You can generally de-
penses the employee deducted in a prior duct the cost of accident or health plan cov-
year.
Introduction erage you provide to your employees on the
“employee benefit programs” line of your
Where to report reimbursements. Report This chapter discusses some fringe benefits business income tax return.
any qualified moving expense reimburse- (defined in chapter 4) you can provide to your
ments you pay directly to an employee in employees as part of an employee benefit Accident or health plan. This is an ar-
1998 in box 13 of the employee's 1998 Form program. rangement that provides benefits for your
W–2. Qualified moving expense reimburse- You can generally deduct the cost of pro- employees, their spouses, and their depen-
ments you pay to a third party on behalf of the viding the benefits discussed in this chapter dents in the event of personal injuries or
employee and services that you furnish in on the “employee benefit programs” line of sickness. The benefits can be paid directly
kind to an employee are no longer reported your business income tax return. However, by you, through insurance, or through a trust
on Form W–2. Use code “P” to identify the you must be able to show that your cost for or fund that provides benefits directly or
reimbursements that are reported in box 13. each employee represents current pay and through insurance.
Include any nonqualified moving expense that the total of this cost plus your other pay Accident and health benefits include the
reimbursements with your employee's wages to the employee was reasonable as dis- following items.
in box 1. cussed in chapter 2.
You can generally exclude a limited • Contributions to the cost of accident or
amount of the cost of benefits you provide to health insurance covering your em-
an employee through certain employee ben- ployee.
On-Premises Athletic efit programs from the employee's wages as
Facilities you withhold, pay, and report employment • Contributions to a separate trust or fund
taxes. This chapter explains how to figure the that provides accident or health benefits
You can exclude from an employee's wages to your employees directly or through in-
amount you can exclude from your employ-
the value of an on-premises gym or other surance.
ee's wages.
athletic facility you provide and operate if
substantially all use during the calendar year • Contributions to your employee's medical
is by employees, their spouses, and their de- savings account.
Topics
pendent children. This chapter discusses: • Payments or reimbursements of medical
For this purpose, the term “employee” in- expenses.
cludes the same individuals included as em-
ployees for no-additional-cost services (de- • Accident and health plans • Payments for specific injuries or illnesses
scribed earlier). (such as the loss of the use of an arm
• Adoption assistance
The exclusion does not apply if you make or leg).
access to the facility available to the general • Cafeteria plans • Payments that replace or supplement
public through the sale of memberships, the • Dependent care assistance wages during an absence from work due
rental of the facility, or a similar arrangement. to illness or injury.
The exclusion also does not apply to any • Educational assistance
athletic facility that is for residential use. For • Group-term life insurance Special rules apply to accident or health
example, a resort with athletic facilities would plans that include coverage under a group
not qualify. • Welfare benefit funds health plan or contributions to an employee's
Chapter 5 Employee Benefit Programs Page 19
medical savings account. These rules are Continuation-of-Coverage 3) Divorce or legal separation of the cov-
explained later. ered employee from his or her spouse.
Your employee generally can exclude ac-
Requirement
cident or health plan benefits you provide Generally, you (or the plan, if a multi- 4) Entitlement to Medicare benefits for the
from his or her gross income. However, this employer plan) may be subject to an excise covered employee.
exclusion does not apply to payments based tax if your plan does not meet the
continuation-of-coverage requirement. 5) A dependent child ceasing to be a de-
on the length of absence from work. pendent, which ends the child's cover-
age under the plan.
Excise tax. The excise tax generally is $100
Exclusion from wages. You generally can per day during the noncompliance period 6) A bankruptcy proceeding (which began
exclude benefits you provide to your em- for each beneficiary. For beneficiaries in the after June 30, 1986) under title 11 of the
ployee under an accident or health plan from same family, the maximum tax is $200 per U. S. Code of the employer of a retired
his or her wages as you withhold, pay, and day. covered employee.
report employment taxes. However, you can- The noncompliance period begins on
not exclude payments you make under a the first day your plan does not meet this re- If any of these events occur, the plan must
self-insured plan as a continuation of your quirement and ends on the earlier of: provide an election period of at least 60 days
employee's wages during his or her absence
to qualified beneficiaries to choose to con-
from work (sick pay). Treat these payments 1) The first day your plan meets this re- tinue coverage under the plan.
as wages. quirement and the past failures have In general, this coverage must be identi-
Self-insured plans that favor highly been corrected, or cal to that received by beneficiaries who have
compensated individuals. If your plan is a
2) 6 months after the last day in the period not experienced any of these events.
self-insured plan and it favors highly com-
for which your plan could have been re- Qualified beneficiaries. A covered em-
pensated individuals, you must include all or
quired to meet this requirement (see ployee's spouse and dependent children, if
part of the amounts you pay to these individ-
Period of coverage, later). covered under the plan, are qualified benefi-
uals in their wages. Generally, a plan is not
ciaries. A child who is born to or placed for
considered to favor highly compensated indi-
Exceptions. The tax does not apply: adoption with the covered employee during
viduals as to eligibility to participate solely
the period of continuation coverage is also a
because some employees enroll in a health
1) For any period during which: qualified beneficiary. The covered employee
maintenance organization (HMO) as an al-
is a qualified beneficiary if the event is a ter-
ternative to the self-insured plan, if your con- a) You did not know that your plan mination or reduction of hours or a bankruptcy
tributions to the HMO are at least as much failed to meet this requirement, and proceeding.
as those you would have made to your plan.
Period of coverage. Coverage generally
A self-insured plan is a group health plan b) By exercising reasonable diligence
must extend for at least 36 months from the
that reimburses your employees for medical you would not have known that your
day the event occurs. If there is a termination
expenses not covered by an accident or plan failed to meet this requirement,
or reduction of hours, the coverage period
health insurance policy. The plan can be for or
must be at least 18 months (29 months in
the employees, their spouses, or their de-
2) If: certain cases of disability).
pendents.
In the case of a bankruptcy proceeding,
A highly compensated individual (for this a) Your plan failed to meet this re- coverage must extend until the death of the
purpose) is: quirement due to reasonable cause covered employee or qualified beneficiary or,
(not willful neglect), and for the surviving spouse or dependent chil-
1) One of the five highest paid officers, dren of the employee, 36 months after the
b) The plan's failure is corrected within
a 30-day period beginning when death of the employee.
2) A shareholder who owns (directly or in-
you knew, or would have known if Certain situations may shorten the period
directly) more than 10% in value of the
reasonable diligence were used, of coverage. For example, the coverage pe-
employer's stock, or
that this requirement was not met. riod can end earlier if you cancel all of your
3) Among the highest paid 25% of all em- group health plans, if the beneficiary does not
ployees, other than those who can be However, even if you meet one of these ex- pay the premiums on time, or if the benefi-
excluded from the plan. ceptions you may have to pay a minimum tax, ciary becomes entitled to Medicare.
discussed next. Required notice to employees and
Minimum tax. Even if you meet one of spouses. You must give your employees
For more information, see section 105(h)
the preceding exceptions to the excise tax, and their spouses written notice of their rights
of the Internal Revenue Code and the related
you may still owe a minimum tax. To avoid to continuation of coverage when their cov-
regulations.
all tax, you must correct the failure to meet erage under a plan begins.
the continuation-of-coverage requirement be- You must generally notify the plan admin-
fore the IRS sends you a notice of an income istrator within 30 days of the death, termi-
Group Health Plans tax examination for a period during which nation, reduction in hours, or Medicare
If your accident or health plan includes cov- your plan failed to meet this requirement. For entitlement of any covered employee, or of
erage under a group health plan, you will be more information on this excise tax, see sec- your own Title 11 bankruptcy proceeding.
subject to an excise tax if the group health tion 4980B of the Internal Revenue Code. Employees or other qualified beneficiaries
plan does not meet certain requirements. are responsible for notifying the plan admin-
These requirements are explained in the fol- Plans exempt from the excise tax. The istrator if there is a divorce or legal sepa-
lowing discussions. excise tax for failing to meet this requirement ration, or if a child's eligibility under the plan
does not apply to any plan maintained only ends. They must generally do this within 60
by employers who normally employed fewer days after the date of the event.
Group health plan defined. This is a plan Also, within 14 days of being notified of the
(including a self-insured plan) that provides than 20 employees on a typical business day
in the preceding calendar year. In addition, occurrence of a qualifying event, plan admin-
medical care to your employees, former em- istrators generally must inform qualified ben-
ployees, or their families. The plan can pro- government plans and church plans are not
subject to the excise tax. eficiaries of their right to choose continuation
vide care directly or through insurance, re- coverage.
imbursement, or otherwise. For more
information on insurance, see chapter 10. Continuation of coverage. Your plan must
provide qualified beneficiaries the choice of Other Requirements
continuing to be covered if they would other- You (or the plan, if a multi-employer plan)
Coverage Requirements wise lose coverage because of any of the may also be subject to an excise tax if your
following events. plan does not meet certain other require-
You will be subject to an excise tax if your
plan does not cover the working aged, active ments. These requirements generally do the
1) Death of the covered employee.
disabled, or those with end-stage renal dis- following.
ease. The tax is 25% of the expenses you 2) Termination of the covered employee
incur for all of your group health plans during (other than for gross misconduct) or re- • Ensure accessibility by barring group
the year. duction in hours of employment. health plans from using an individual's
Page 20 Chapter 5 Employee Benefit Programs
health status to exclude him or her from Plans exempt from the excise tax. The Portability. Your group health plan must limit
coverage. excise tax for failing to meet these require- exclusions based on preexisting conditions
ments does not apply to any plan maintained and give credit for certain periods of previous
• Increase portability by limiting the cir- by a small employer whose coverage is from coverage.
cumstances under which plans can deny a contract with an insurance company. In Preexisting conditions. Your plan can
coverage for preexisting conditions. addition, government plans and plans that on exclude an individual for a preexisting condi-
• Guarantee renewability by limiting the the first day of the plan year had fewer than tion only if all of the following tests are met.
circumstances under which continued two participants who are current employees
access to health coverage can be denied are not subject to the excise tax. 1) The exclusion relates to a condition
to an employer under a multi-employer Small employer. You are a small em- (whether physical or mental), regardless
plan. ployer if you employed an average of at least of the cause, for which medical advice,
two but not more than 50 employees on diagnosis, care, or treatment was re-
• Obligate plans to pay for a minimum business days during the preceding calendar commended or received within the
hospital stay following birth for mothers year. If you were not in business throughout 6-month period ending on the enrollment
and newborns if the plan otherwise pro- the preceding calendar year, you are a small date.
vides benefits for hospital stays in con- employer if you can reasonably be expected
nection with childbirth. to employ an average of at least two but not 2) The exclusion extends for not more than
more than 50 employees on business days in 12 months (18 months for a late
• Prevent certain special limits from being enrollee) after the enrollment date.
the current year.
placed on mental health benefits.
3) Any creditable coverage the individual
Benefits exempt from these requirements. has on the enrollment date reduces the
Collective bargaining agreement. If your These requirements do not apply to any length of the preexisting condition ex-
plan stems from a collective bargaining group health plan in relation to its provision clusion period.
agreement ratified before August 21, 1996, of the following benefits.
the accessibility, portability, and renewability Your plan cannot impose preexisting condi-
requirements (discussed later) will first apply 1) Accident or disability income insurance. tion exclusions on certain newborns and
to your plan for plan years that begin after the adopted children. Also, pregnancy cannot be
2) Liability insurance and supplemental
collective bargaining agreement expires, if treated as a preexisting condition. For more
coverage.
that is later than June 30, 1997. information on preexisting conditions, see
3) Workers' compensation or similar insur- section 9801 of the Internal Revenue Code
ance. and the related regulations.
Excise tax. The excise tax generally is $100 Creditable coverage. Creditable cover-
per day during the noncompliance period 4) Automobile medical payment insurance.
age is coverage that your employee had be-
for each beneficiary. This period begins on fore he or she enrolled in your plan. You do
5) Credit-only insurance.
the first day your plan does not meet these not have to count coverage an individual had
requirements and ends on the first day your 6) Coverage for on-site medical clinics. before any period of 63 or more days during
plan meets these requirements and the past which the individual was not covered under
failures have been corrected. 7) In certain circumstances, the following
benefits: any creditable coverage.
Exceptions. The tax does not apply: Creditable coverage is coverage under
a) Limited-scope dental or vision ben- any of the following.
1) For any period during which: efits,
b) Long-term care benefits, • A group health plan.
a) You did not know that your plan
failed to meet these requirements, c) Coverage only for a specified dis- • Health insurance.
and ease or illness, • Certain other health plans.
b) By exercising reasonable diligence d) Hospital indemnity or other fixed
you would not have known that your For more information on creditable coverage,
indemnity insurance, and
plan failed to meet these require- see section 9801 of the Internal Revenue
ments, or e) Medicare supplemental health in- Code and the related regulations.
surance and similar supplemental Special enrollment rights. Your plan
2) If: coverage. must provide special enrollment rights to cer-
tain employees and their dependents who are
a) Your plan failed to meet these re- For more information on exempt benefits, see eligible for coverage but are not enrolled in
quirements due to reasonable Internal Revenue Code sections 9831(b), your plan. Loss-of-other-coverage special
cause (not willful neglect), and 9831(c), and 9832(c) and the related regu- enrollment rights occur if someone declines
lations. to enroll under your plan when first eligible
b) The plan's failure is corrected within due to other health coverage and then later
a 30-day period beginning when Accessibility. Your group health plan must loses that other coverage. Dependent special
you knew, or would have known if not base eligibility rules for any individual on enrollment rights occur when an employee
reasonable diligence were used, any of the following factors in relation to the gets married or has a child (by birth, adoption,
that these requirements were not individual or his or her dependent. or placement for adoption). For more infor-
met. If your plan is a church plan, mation, see Internal Revenue Code section
the 30-day period is replaced by a • Health status. 9801(f) and the related regulations.
special period described in section
414(e)(4)(C) of the Internal Reve- • Medical condition (physical or mental).
Renewability. A group health plan that is a
nue Code. • Claims experience. multi-employer plan or a multiple employer
• Receipt of health care. welfare arrangement can deny an employer
However, even if you meet one of these ex- continued access to the same or different
ceptions, you may have to pay a minimum • Medical history. coverage under the plan only for one of the
tax, discussed next. • Genetic information. following reasons.
Minimum tax. Even if you meet one of
the preceding exceptions to the excise tax, • Evidence of insurability. 1) Nonpayment of contributions.
you may still owe a minimum tax unless your • Disability.
plan is a church plan. To avoid all tax, you 2) Fraud or other intentional misrepresen-
must correct the failure to meet these re- Also, your plan cannot use these factors to tation of material fact.
quirements before the IRS sends you a no- charge a higher premium or contribution for 3) Noncompliance with material plan pro-
tice of an income tax examination for a period certain individuals. Special rules apply to visions.
during which your plan failed to meet these church plans.
requirements. For more information on this For more information, see section 9802 4) Because the plan is ceasing to offer any
excise tax, see section 4980D of the Internal of the Internal Revenue Code and the related coverage in the employer's geographic
Revenue Code. regulations. area.
Chapter 5 Employee Benefit Programs Page 21
5) If a network plan, because there is no limited to the amount of the employee's Exclusion of Certain Fringe Benefits). To
longer any individual enrolled through wages. (See Publication 969.) determine whether your program meets
the employer who lives, resides, or this test, do not consider employees ex-
works in the plan's service area. Form W–2. Show all contributions to cluded from your program who are cov-
TIP an employee's MSA in box 13 of the ered by a collective bargaining agree-
6) Failure to meet the terms of, to renew, employee's Form W–2. Use code “R” ment, if there is evidence that adoption
or to employ employees covered by, a to identify this amount. For more information, assistance was a subject of good-faith
collective bargaining agreement. see the Form W–2 instructions. bargaining.
For more information, see section 9803 2) The program does not provide more than
of the Internal Revenue Code. 5% of its benefits during the year for
Failure to make comparable contributions. shareholders or owners. A shareholder
Mother and newborn hospital stays. For Generally, you will be subject to an excise tax or owner is someone who owns (on any
plan years beginning after 1997, your group if you make a contribution during any calen- day of the year) more than 5% of the
health plan generally must not restrict benefits dar year to an employee's MSA and do not stock or of the capital or profits interest
for a mother or newborn's hospital stay fol- make comparable contributions for all com- of your business.
lowing birth to either of the following periods. parable participating employees for each 3) You give reasonable notice of the pro-
coverage period during that year. gram to eligible employees.
• Less than 48 hours following a normal Comparable contributions. These are
delivery. contributions that are either: 4) Employees provide reasonable substan-
• Less than 96 hours following a caesarean tiation that payments or reimbursements
section. 1) The same amount, or are for qualifying adoption expenses.
2) The same percentage of the annual
However, these minimum stay requirements Employee's exclusion. Your employee may
deductible limit under the high-
do not apply when the decision to discharge be able to exclude from gross income a lim-
deductible health plan covering the em-
the mother or her newborn child earlier is ited amount of the adoption assistance you
ployees.
made by the attending provider in consulta- provide through an adoption assistance pro-
tion with the mother. Comparable participating employees. gram. For more information, see Publication
These requirements also do not apply to These are employees who: 968, Tax Benefits for Adoption.
a plan that does not provide benefits for a
hospital stay following either a normal delivery 1) Are covered by your high-deductible Employment taxes. The cost of providing
or a caesarean section. health plan and eligible to establish an adoption assistance to an employee through
For more information, see section 9811 MSA, an adoption assistance program is subject to
of the Internal Revenue Code. social security, Medicare, and federal unem-
2) Have the same category of coverage ployment taxes. However, these amounts are
(either self-only or family coverage), and not subject to federal income tax withholding.
Mental health benefits. For plan years be-
ginning after 1997, the following rules apply 3) Have the same category of employment
Form W–2. Report all qualifying
if your group health plan provides both med- (either part-time or full-time).
TIP adoption expenses you paid or reim-
ical and surgical benefits and mental health bursed under your adoption assist-
benefits. Part-time employees are those who usually
work fewer than 30 hours a week. ance program for each employee in box 13
1) Your plan cannot impose an annual or Excise tax. The excise tax for not making of the employee's Form W–2. Use code “T”
aggregate lifetime limit on mental health comparable contributions is 35% of the total to identify this amount. Also include this
benefits if it does not impose one on amount the employer contributes to MSAs amount with the wages you report in boxes
substantially all medical and surgical during the calendar year. If your failure to 3 and 5. However, do not include this amount
benefits. make comparable contributions was due to with the wages you report in box 1. For more
reasonable cause and not willful neglect, the information, see the Form W–2 instructions.
2) If the plan does impose an annual or IRS may waive the part of the excise tax that
aggregate lifetime limit on medical and would be excessive relative to the degree of
surgical benefits, the plan must either: noncompliance involved.
a) Include mental health benefits un-
der the same limit, or
b) Use a separate limit for mental
health benefits that is not less than Adoption Assistance Cafeteria Plans
this limit. This section provides basic tax information This section provides basic tax information
about adoption assistance programs. about cafeteria plans.
For more information, see section 9812
of the Internal Revenue Code and the related Deducting the cost. You can deduct the Deducting the cost. You can deduct the
regulations. cost of an adoption assistance program on cost of the benefits provided under a cafeteria
the “employee benefit programs” line of your plan on the “employee benefit programs” line
business income tax return. of your business income tax return.
Medical Savings Accounts
If your health plan for your employees has a Exclusion from wages. You can exclude Cafeteria plan. A cafeteria plan is a written
higher annual deductible than typical health adoption assistance you provide to an em- plan that allows your employees to choose
plans, your employees may be able to set up ployee through an adoption assistance pro- between receiving cash or certain qualified
medical savings accounts (MSAs) to set aside gram from the employee's wages subject to benefits.
money for medical expenses not reimburs- income tax withholding. You should not with- Generally, a cafeteria plan does not in-
able by the plan. Generally, your employees hold federal income tax on these amounts. clude any plan that offers a benefit that defers
can set up MSAs only if you have 50 or fewer However, you must withhold social security pay. However, a cafeteria plan can include a
employees and your high-deductible health and Medicare taxes on these amounts. qualified 401(k) plan as a benefit. Also, cer-
plan has a limit on the annual out-of-pocket tain life insurance plans maintained by edu-
expenses that an employee must pay for Adoption assistance program. An adoption cational institutions can be offered as a ben-
covered expenses. For more information, see assistance program is a separate written plan efit even though they defer pay.
Publication 969, Medical Savings Accounts that provides adoption assistance only to your The fact that your employee can choose
(MSAs). employees. The program qualifies only if all between cash and qualified benefits does not
If you contribute to an employee's MSA, the following tests are met. make the qualified benefits your employee
treat your contribution as accident or health chooses to receive taxable to the employee.
plan benefits up to the maximum annual 1) The program benefits employees who Qualified benefits. A qualified benefit is
contribution allowed for that employee. Gen- qualify under rules set up by you, which a benefit that you can exclude from an em-
erally, this is 75% (65% for self-only cover- do not favor highly compensated em- ployee's wages because of specific tax rules,
age) of the health plan's annual deductible, ployees (as defined in chapter 4 under including those discussed in this chapter.
Page 22 Chapter 5 Employee Benefit Programs
However, a cafeteria plan cannot offer schol- You will need these records to file Form 5500 This is basically the same as the work-related
arship or fellowship grants, educational as- or Form 5500–C/R after the end of the plan expense test that the employee would use if
sistance, medical savings accounts, long- year. he or she paid the expenses and claimed the
term care insurance, or, generally, the fringe dependent care credit. For more information,
benefits discussed in chapter 4. including the definition of the term “qualifying
person,” see Qualifying Person Test and
Exclusion from wages. You can generally Forms 5500 and 5500–C/R. If you maintain Work-Related Expense Test in Publication
exclude the cost of providing qualified bene- a cafeteria plan, you must file information 503.
fits chosen by an employee in a cafeteria plan about the plan each year by the last day of Assistance provided to a highly com-
from the employee's wages as you withhold, the 7th month after the plan year ends. Use pensated employee. Dependent care as-
pay, and report employment taxes. However, Form 5500 and Schedule F (Form 5500) for sistance provided to a highly compensated
see Employment taxes, later. Also, if your a plan with 100 or more participants. Use employee is treated as provided under a de-
plan favors highly compensated or key em- Form 5500–C/R and Schedule F (Form 5500) pendent care assistance program and can be
ployees, see the following discussions. for a plan with fewer than 100 participants. excluded from the employee's wages only if
See the instructions for those forms for infor- the following tests are met.
Plans that favor highly compensated em- mation on extensions of time to file.
1) The benefits provided under the program
ployees. If your plan favors highly compen- do not favor highly compensated em-
sated employees as to eligibility to participate, ployees.
contributions, or benefits, you must include in
their wages the value of taxable benefits they
could have selected. A plan you maintain
Dependent Care 2) The program benefits employees who
qualify under rules set up by you, which
under a collective bargaining agreement does Assistance do not favor highly compensated em-
not favor highly compensated employees. ployees. To determine whether your
This section provides basic tax information
Highly compensated employee defined. program meets this test, do not consider:
about dependent care assistance programs.
A highly compensated employee (for this
purpose) is: a) Employees who are under age 21
Deducting the cost. You can generally de- and have not completed 1 year of
1) An officer, duct the cost of a dependent care assistance service, and
program on the “employee benefit programs”
2) A shareholder who owns more than 5% line of your business income tax return. b) Employees excluded from your
of the voting power or value of all classes However, if you provide the care in kind (op- program who are covered by a col-
of the employer's stock, erate a dependent care facility), deduct your lective bargaining agreement, if
costs as depreciation, utilities, salaries, etc. there is evidence that dependent
3) An employee who is highly compensated care assistance was a subject of
based on the facts and circumstances, good-faith bargaining.
Exclusion from wages. You can generally
or
exclude a limited amount of dependent care
3) The program does not provide more than
4) A spouse or dependent of a person de- assistance you provide to an employee
25% of its benefits during the year for
scribed in (1), (2), or (3). through a dependent care assistance pro-
shareholders or owners. A shareholder
gram from the employee's wages as you
or owner is someone who owns (on any
withhold, pay, and report employment taxes.
Plans that favor key employees. If more day of the year) more than 5% of the
However, if your program does not meet cer-
than 25% of the total of the nontaxable ben- stock or of the capital or profits interest
tain tests, you must include the assistance
efits you provide for all employees under the of your business.
you provide to each highly compensated em-
plan go to key employees, you must include
ployee in his or her wages. See Dependent 4) You give reasonable notice of the pro-
in their wages the value of taxable benefits
care assistance program, later. gram to eligible employees.
they could have selected. A plan you maintain
Exclusion limit. You can generally ex-
under a collective bargaining agreement does 5) By January 31, you provide each em-
clude from an employee's wages up to $5,000
not favor key employees. ployee with a Form W–2 showing the
of dependent care assistance each year. This
Key employee defined. The term “key amount of dependent care assistance (if
limit is reduced to $2,500 for married em-
employee” is defined later under Group-Term furnished in kind, its fair market value)
ployees filing separate returns.
Life Insurance. provided to the employee during the
However, the exclusion cannot be more
than the earned income of either: preceding year.
Employment taxes. The amount you ex-
clude from an employee's wages is generally 1) The employee, or 6) The average benefits provided to your
not subject to social security, Medicare, and employees who are not highly compen-
federal unemployment taxes, or income tax 2) The employee's spouse. sated is at least 55% of the average
withholding. However, group-term life insur- benefits provided to your highly com-
Special rules apply to determine the earned pensated employees under all your de-
ance coverage that exceeds $50,000 is sub-
income of a spouse who is either a student pendent care programs. To determine
ject to social security and Medicare taxes.
or not able to care for himself or herself. For whether your programs meet this test,
Also, adoption benefits are subject to social
more information on the earned income limit, do not consider:
security, Medicare, and federal unemploy-
see Publication 503.
ment taxes.
a) Employees who are under age 21
Recordkeeping requirements. If you Dependent care assistance program. A and have not completed 1 year of
maintain a cafeteria plan, you must dependent care assistance program is a service,
RECORDS keep complete records showing all separate written plan that provides dependent
care assistance only to your employees. b) Employees excluded from your
the following.
However, the plan will not be treated as a program who are covered by a col-
dependent care assistance program for as- lective bargaining agreement, if
1) The number of your employees.
sistance provided to a highly compensated there is evidence that dependent
2) The number of your employees eligible employee (as defined in chapter 4 under Ex- care assistance was a subject of
to participate in the plan. clusion of Certain Fringe Benefits) unless the good-faith bargaining, and
3) The number of your employees partic- tests described later are met. c) If you provide the benefits through
ipating in the plan. Dependent care assistance defined. a salary reduction agreement, em-
Dependent care assistance means the pay- ployees whose pay is less than
4) The total cost of the plan during the year. ment of, or the providing of, work-related $25,000 before the reduction.
household and dependent care services. The
5) Your name, address, and taxpayer services are work related only if:
identifying number (TIN). If all of these tests are not met, you must in-
1) They allow the employee to work, and clude the dependent care assistance pro-
6) The type of business you are engaged vided to each highly compensated employee
in. 2) They are for a qualifying person's care. in his or her wages.
Chapter 5 Employee Benefit Programs Page 23
Employment taxes. The amount you ex- Your program can cover former employees if under Cost To Include in Employee Wages,
clude from an employee's wages is not sub- their employment is the reason for the cover- later.
ject to social security, Medicare, and federal age.
unemployment taxes, or income tax with- Educational assistance defined. Edu-
holding. cational assistance means amounts you pay Group-Term Life Insurance
or incur for your employees' education ex- Defined
Form W–2. Report all dependent care penses. These expenses generally include
TIP assistance provided to an employee the cost of books, equipment, fees, supplies, This is life insurance that meets all of the fol-
during the year in box 10 of the em- and tuition. However, these expenses do not lowing conditions.
ployee's Form W–2. For more information, include the cost of graduate-level courses of
see the Form W–2 instructions. 1) It provides a general death benefit that
a kind normally taken by a person pursuing
is not included in income.
a program leading to an advanced academic
or professional degree. Also, these expenses 2) You provide it to a group of employees.
do not include the cost of a course or other
education involving sports, games, or hob- 3) You provide it under a policy you carry
bies, unless the education: directly or indirectly. Even if you do not
pay any of the policy's cost, you are
considered to carry it if you arrange for
Educational 1) Has a reasonable relationship to your
business, or payment of its cost by your employees
Assistance 2) Is required as part of a degree program.
and charge at least one employee less
than the cost of his or her insurance and
This section provides basic tax information at least one other employee more than
about educational assistance programs. Education expenses do not include the
the cost of his or her insurance. Deter-
cost of tools or supplies (other than text-
mine the cost of the insurance, for this
Deducting the cost. You can deduct the books) that your employee is allowed to keep
purpose, using the table for the monthly
cost of an educational assistance program on at the end of the course. Nor do they include
cost per $1,000 of insurance under Cost
the “employee benefit programs” line of your the cost of lodging, meals, or transportation.
To Include in Employee Wages, later.
business income tax return.
Employment taxes. The amount you ex- 4) It provides an amount of insurance to
Exclusion from wages. You can exclude a clude from an employee's wages is not sub- each employee based on a formula that
limited amount of educational assistance you ject to social security, Medicare, and federal prevents individual selection, using fac-
provide to an employee through an educa- unemployment taxes, or income tax with- tors such as age, years of service, pay,
tional assistance program from the employ- holding. or position.
ee's wages as you withhold, pay, and report Form W–2. You may choose to use
employment taxes. Employee. For this purpose, an employee
TIP box 14 of Form W–2 to show the cost is one of the following.
Exclusion limit. You can exclude from of providing the employee with edu-
an employee's wages up to $5,250 of edu- cational assistance.
cational assistance each year. 1) A person who works for you whose legal
Assistance over the limit. If you provide relationship to you is that of an em-
an employee with more than $5,250 of edu- ployee.
cational assistance during the year, you may 2) A full-time life insurance agent.
be able to exclude part or all of the excess
as a working condition fringe benefit. (See 3) A person who was formerly your em-
chapter 4.) ployee.
Expiration date. This exclusion will not Group-Term
apply to expenses paid for courses beginning Effect of permanent benefits. Permanent
after May 31, 2000. Life Insurance benefits are economic values you provide
This section provides basic tax information under a life insurance policy that extend be-
Educational assistance program. An edu- about group-term life insurance plans. yond one policy year, such as paid-up or cash
cational assistance program is a separate surrender value.
written plan that provides educational assist- Life insurance that includes permanent
Deducting the cost. You can generally de-
ance only to your employees. The program benefits is group-term life insurance only if it
duct the cost of group-term life insurance on
qualifies only if all of the following tests are meets both of the following conditions.
the “employee benefit programs” line of your
met. business income tax return. However, you 1) The policy or you, as the employer, state
cannot deduct the cost if you are directly or in writing which part of each employee's
1) The program benefits employees who
indirectly the beneficiary of the policy. For death benefit is group-term life insur-
qualify under rules set up by you, which
more information on life insurance, see ance.
do not favor highly compensated em-
chapter 10.
ployees (as defined in chapter 4 under
2) That part for any policy year is not less
Exclusion of Certain Fringe Benefits). To
Exclusion from wages. You can generally than the employee's total death benefit
determine whether your program meets
exclude a limited amount of group-term life minus the employee's deemed death
this test, do not consider employees ex-
insurance coverage you provide to an em- benefit at the end of the policy year. For
cluded from your program who are cov-
ployee from the employee's wages as you information on figuring the deemed
ered by a collective bargaining agree-
withhold, pay, and report employment taxes. death benefit, see section 1.79–1(d)(3)
ment, if there is evidence that
However, if your plan favors key employees, of the Income Tax Regulations.
educational assistance was a subject of
good-faith bargaining. see Plans That Favor Key Employees, later.
Exclusion limit. You can generally ex- Ten-employee rule. Generally, group-term
2) The program does not provide more than clude from an employee's wages the cost of life insurance is life insurance that you pro-
5% of its benefits during the year for up to $50,000 of group-term life insurance vide to at least 10 full-time employees at
shareholders or owners. A shareholder coverage. some time during the year.
or owner is someone who owns (on any Coverage over the limit. If you provide For this rule, count employees who
day of the year) more than 5% of the an employee with more than $50,000 of cov- choose not to receive the insurance unless,
stock or of the capital or profits interest erage at any time during the year, you must to receive it, they must contribute to the cost
of your business. include in the employee's wages the cost of of benefits other than the group-term life in-
insurance that is more than the cost of surance. For example, count an employee
3) The program does not allow employees
$50,000 of coverage reduced by any amount who could receive insurance by paying part
to choose to receive cash or other ben-
the employee pays toward the insurance. of the cost, even if that employee chooses
efits that must be included in gross in-
The cost of this insurance that you must not to receive it. However, do not count an
come instead of educational assistance.
include in your employees' wages is not the employee who must pay part or all of the cost
4) You give reasonable notice of the pro- actual cost of the excess coverage. Instead, of permanent benefits to get insurance, un-
gram to eligible employees. you figure this cost with monthly costs listed less that employee chooses to receive it.
Page 24 Chapter 5 Employee Benefit Programs
Exceptions. Even if you do not meet the A plan favors key employees if it favors Benefits test. Your plan meets this test if it
ten-employee rule, two exceptions allow you them as to eligibility to participate or as to the does not favor key employees as to the type
to treat insurance as group-term life insur- type and amount of benefits it provides. Apply and amount of life insurance it provides. Your
ance. the participation and benefits tests (discussed plan does not favor key employees just be-
Under the first exception, you do not have later) separately to your active and former cause the amount of insurance you provide
to meet the ten-employee rule if all the fol- employees. to your employees is uniformly related to their
lowing conditions are met. pay.
Key employee. A key employee during 1998
1) If evidence that the employee is is an employee or former employee who was
insurable is required, it is limited to a one of the following. Cost To Include
medical questionnaire (completed by the
employee) that does not require a phys-
in Employee Wages
1) An officer having, for any year listed be-
ical. Generally, you must include in an employee's
low, annual pay of more than the listed
wages the cost of group-term life insurance
2) You provide the insurance to all your amount.
that is more than the cost of $50,000 of this
full-time employees or, if the insurer re- a) 1994 — $59,400 insurance reduced by any amount the em-
quires the evidence mentioned in (1), to ployee pays toward the insurance. However,
all full-time employees who provide evi- b) 1995 — $60,000 do not reduce the cost by the amount of an
dence the insurer accepts. c) 1996 — $60,000 employee's before-tax contributions for insur-
ance coverage through a cafeteria plan.
3) You figure the coverage based on either d) 1997 — $62,500
a uniform percentage of pay or the
insurer's coverage brackets. e) 1998 — $65,000 No cost included for certain employees.
Do not include any cost of this insurance in
Under the second exception, you do not 2) A person who, for 1998 or any of the 4 your employee's wages if any of the following
have to meet the ten-employee rule if all the preceding years, was: apply.
following conditions are met. a) One of the 10 employees having 1) Your employee is disabled and no longer
annual pay of more than $30,000 works for you.
1) You provide the insurance under a and owning (or considered to own
common plan covering your employees under the related-person rules) the 2) Your employee's policy named you the
and the employees of at least one other largest interests in your business, beneficiary for the entire period it was in
employer who is not related to you. force during the year.
b) A 5% owner of your business, or
2) The insurance is restricted to, but man- 3) Your employee's policy named a charity
datory for, all your employees who be- c) A 1% owner of your business to which contributions are deductible as
long to or are represented by an organ- whose annual pay was more than the only beneficiary for the entire period
ization (such as a union) that carries on $150,000. it was in force during the year.
substantial activities besides obtaining
insurance. A former employee who was a key employee 4) Your employee is retired and meets
upon retirement or separation from service is certain requirements. (See Retired em-
3) Evidence of whether an employee is also a key employee. ployees under Group-Term Life Insur-
insurable does not affect an employee's Related person rules. To determine ance Premiums in Publication 525.)
eligibility for insurance or the amount of ownership in (2) above, count any related
insurance that employee gets. person's interest. Treat your employee as Entire cost included for certain employ-
owning both his or her own interest and any ees. You must include in your employee's
To apply either exception, do not consider related person's interest. The term “related wages the entire actual cost of group-term life
employees who were denied insurance for person” includes members of the employee's insurance coverage you provide through a
any of the following reasons. immediate family (including spouse, children, qualified pension, profit-sharing, stock bonus,
grandchildren, and parents). It also includes or annuity plan.
1) They were 65 or older. any corporations, partnerships, estates, or You must also include the entire cost in
2) They customarily work 20 hours or less trusts in which the employee has at least a the wages of key employees if the plan favors
a week or 5 months or less in a calendar 5% interest. key employees as discussed earlier under
year. Plans That Favor Key Employees. Include the
Participation test. Your plan meets this test larger of:
3) They have not been employed for the if all of the following are true.
waiting period given in the policy. This 1) The actual cost of the insurance, or
waiting period cannot be more than 6 1) It benefits at least 70% of your employ-
months. 2) The cost of the insurance you figure us-
ees.
ing the monthly cost table, shown later.
Accidental or other death benefits. A pol- 2) At least 85% of those employees are not
icy that provides accidental death benefits or key employees. Permanent benefits. If your policy includes
death benefits other than general death ben- permanent benefits (defined earlier), you
3) It benefits employees who qualify under must include in your employees' wages the
efits (travel insurance, for example), is not a set of rules you set up that do not favor
group-term life insurance. cost of the permanent benefits minus the
key employees. amount the employee pays for them.
Policy covering employee's spouse or de- Figure the cost of these benefits as ex-
Your plan also meets this test if it is part
pendent. A policy that provides insurance plained in section 1.79–1(d)(2) of the Income
of a cafeteria plan (discussed earlier) and it
on the life of your employee's spouse or de- Tax Regulations.
meets the participation test for those plans.
pendent is not group-term life insurance. When applying this test do not consider
However, you may be able to exclude the cost employees who: Figuring the cost to include in employee
of this insurance from your employee's wages wages. Follow these steps to figure the cost
as a de minimis fringe benefit. (See chapter 1) Have not completed 3 years of service, to include in your employee's wages for the
4.) year.
2) Are part time or seasonal, Step one. Subtract 50 (if the $50,000
3) Are nonresident aliens who receive no exclusion applies) from the amount of your
Plans That Favor U.S. source earned income from you, or employee's insurance coverage for a given
month (in thousands, figured to the nearest
Key Employees 4) Are not included in the plan but are in a tenth) to get the excess insurance coverage.
Generally, if your group-term life insurance unit of employees covered by a collective Step two. Multiply the result from step
plan favors key employees you must include bargaining agreement, if the benefits one by the cost you find using the employee's
the entire cost of the insurance in your key provided under the plan were the subject age at the end of the year and the following
employees' income. However, this rule gen- of good-faith bargaining between you table to get the cost of the excess insurance
erally does not apply to church plans. and employee representatives. for one month.
Chapter 5 Employee Benefit Programs Page 25
Cost Per $1,000 Of Protection the cost of coverage exceeding $50,000 dur- 1) Any life insurance contract covering the
For One Month ing periods after the employees stopped life of yourself, an employee, or any
Age Cost working for you. person with a financial interest in your
Under 30 ........................................................ $.08 business if you are a beneficiary of the
30 through 34 ................................................ .09 • The cost is not subject to income tax policy, or
withholding and is exempt from federal
35 through 39 ................................................ .11 unemployment tax. 2) Any other insurance contract that:
40 through 44 ................................................ .17
• The cost is subject to social security and a) Has no guarantee of renewal, and
45 through 49 ................................................ .29 Medicare taxes, but not subject to with-
50 through 54 ................................................ .48 holding for these taxes. The former em- b) Other than for insurance protection,
55 through 59 ................................................ .75 ployee must pay the uncollected em- provides payments only for
ployee's portion of these taxes with his experience-rated refunds or policy
60 through 64 ................................................ 1.17
or her federal income tax return. dividends that are not guaranteed
65 through 69 ................................................ 2.10 and that are determined by factors
• The employer must report the cost of other than the amount of welfare
70 and older ................................................... 3.76
coverage exceeding $50,000 and the
Step three. Multiply the result from step benefits you pay to your employees
amount of the uncollected social security
two by the number of full months during the or their beneficiaries.
and Medicare taxes to the former em-
year the employee had that coverage. If you ployee on Form W–2.
provide less than a full month of coverage for Your fund's qualified cost. Your fund's
any month, you must prorate the cost from the In completing a Form W–2 for the former qualified cost is the total of the “qualified di-
table. This step gives you the cost of the employee, include in boxes 1, 3, and 5 the rect cost” plus any addition to a “qualified
employee's excess insurance for the tax year. cost of coverage exceeding $50,000. Show asset account” for the year. You must reduce
Step four. If the amount of your employ- in box 13: this qualified cost by any after-tax income the
ee's insurance coverage changed during the fund has for the year.
year, repeat steps one through three for each 1) The cost of coverage exceeding $50,000 “After-tax income” means the gross in-
other level of coverage. For any month during with code C, come of your fund less the total of:
which the level of coverage changed, use the
average of the coverage at the beginning of 2) The uncollected social security tax with
the month and the end of the month as the code M, and 1) The deductions directly related to
coverage for that month. Add the step three producing the gross income, and
3) The uncollected Medicare tax with code
result for each coverage level to get the total N. 2) The fund's income tax liability for the
cost of the employee's excess insurance for year.
the tax year.
Step five. Subtract any amount your
employee paid from the step four result. In- The gross income of your fund for this
clude the resulting amount in your employee's purpose includes any amounts received from
wages. Welfare Benefit Funds your employees. However, it does not include
This section provides basic tax information your contributions.
Example. You provide $80,000 of about welfare benefit funds. Qualified direct cost. Qualified direct
group-term life insurance coverage to an cost is the total cost (including administrative
employee for the entire year. Your employee expenses) that you would deduct for benefits
Deducting the cost. You can deduct a lim- provided during the tax year if:
was 51 years old at the end of the year. Your ited amount of the cost of a welfare benefit
employee pays premiums of $50 a year. You fund on the “employee benefit programs” line
figure the amount to include in your employ- of your business income tax return. 1) You provided the benefits directly, and
ee's wages as follows: Deduction limit. You cannot deduct 2) You used the cash method of account-
more than the fund's qualified cost, discussed ing.
Coverage (in thousands) ........................... $80
later, for the tax year. However, if you pay
Minus: Exclusion (in thousands) ................ − 50 more than the fund's qualified cost, you can
Excess amount (in thousands) .................. $30 carry the excess over to the next tax year. Treat a benefit as provided by you to the
employee when the benefit would be included
Multiply by cost per $1,000 per month,
in the employee's gross income if you pro-
age 51 (from table) .................................... × .48 Welfare benefit fund defined. A welfare
vided it directly to the employee (or would be
Cost of excess insurance for 1 month ...... $14.40 benefit fund is any fund that is part of a plan
included but for any rule excluding the benefit
through which you provide welfare benefits to
Multiply by number of full months from income).
coverage at this cost ................................. × 12 your employees, independent contractors, or
Child care facility. You must use a spe-
their beneficiaries.
Cost of excess insurance for tax year ....... $172.80 cial rule to figure the qualified direct costs of
Welfare benefits include any benefit other
Minus: Premiums the employee paid ........ − 50.00
a child care facility you provide for your em-
than:
ployees' use. Beginning with the month the
Cost to include in wages ........................ $122.80 facility is placed in service, deduct the ad-
1) The transfer of restricted property in re-
justed basis of the facility ratably over 60
turn for services (as described in chapter
months rather than depreciating it. A child
2), and
Employment Taxes care facility is any tangible depreciable prop-
2) Amounts you put in a deferred pay plan. erty located in the United States primarily for
The cost of group-term life insurance that you children of your employees.
must include in your employee's wages is not The term “fund” means: Qualified asset account. A qualified as-
subject to income tax withholding and is ex- set account is an account holding assets set
empt from federal unemployment tax. How- 1) Any corporation, trust, or other organ- aside to provide supplemental unemploy-
ever, the cost is subject to social security and ization that is subject to income tax, ment, severance pay, disability, medical, or
Medicare taxes. life insurance benefits. A “qualified cost” does
Report the cost of group-term life insur- 2) Any exempt organization described in not include any part of an addition to a qual-
ance coverage exceeding $50,000 in box 13 IRC 501(c)(7), IRC 501(c)(9), IRC ified asset account that is more than the ac-
of the employee's Form W–2. Use code C to 501(c)(17), or IRC 501(c)(20), and count limit. The account limit for a tax year
identify this amount. Also include this amount is generally the amount actuarially necessary
3) Any account held for you by any person,
with the wages you report in boxes 1, 3, and to fund:
as described under Temporary Regu-
5. For more information, see the Form W–2
lations section 1.419–1T (as modified by
instructions.
Announcement 86–45, IRB 1986–15, 1) Claims incurred but not paid (as of the
and section 1851(a)(8)(B) of the Tax close of the year) for the benefits listed,
Former employees. If you provide group- Reform Act of 1986). and
term life insurance to former employees, in-
cluding retirees, the following rules apply to The term “fund” does not include: 2) Administrative costs for the claims.
Page 26 Chapter 5 Employee Benefit Programs
tributions. Employee contributions do not Pension-Individual Retirement
have to satisfy the minimum funding require- Accounts Contribution Agreement
6. ments for your plan. For example, a retire-
ment plan can require after-tax employee m 5305A–SEP Salary Reduction and Other
contributions that, by themselves, do not meet Elective Simplified Employee
Pension-Individual Retirement
Retirement the minimum funding requirements. Em-
ployee contributions can be mandatory or Accounts Contribution Agreement
voluntary.
Plans A plan can allow your employees to make
elective deferrals, although they are consid-
m 5304–SIMPLE Savings Incentive Match
Plan for Employees of Small Em-
ployers (SIMPLE) (Not subject to
ered employer contributions. This allows
the Designated Financial Institu-
employees to elect to have you contribute
tion Rules)
part of their current compensation (pay) to a
retirement plan. Only the remaining portion m 5305–SIMPLE Savings Incentive Match
Important Changes of their pay is currently taxable. The income Plan for Employees of Small Em-
tax on the contributed pay (and earnings on
for 1998 it) is deferred.
ployers (SIMPLE) (for Use With a
Designated Financial Institution)

Participant's compensation. Beginning in Employer contributions. Your contributions m 5500–EZ Annual Return of One-
1998, a plan participant's compensation in- as an employer to an employer-sponsored Participant (Owners and Their
cludes certain deferrals unless you elect not retirement plan generally are deductible as Spouses) Retirement Plan
to include any amount contributed under a discussed later under Deduction Limits. See chapter 17 for information about get-
salary reduction agreement (that is not in- Employer contributions that must be ting publications and forms.
cluded in the gross income of the employee). capitalized. You cannot currently deduct your
The new rule, which takes into account employer contributions to a retirement plan
amounts deferred in certain employee benefit (or any other expenses) if the uniform cap-
plans, will increase the tax-deferred amount italization rules apply to you. If you are subject
that you can contribute to a deferred contri-
bution plan at the election of the employee.
to these rules, you must capitalize (include in
the basis of certain property or in inventory
Qualified Plans
The deferrals include amounts contributed by costs) your contributions. See chapter 1. A qualified retirement plan is a written plan
an employee under a: that you can establish for the exclusive ben-
efit of your employees and their beneficiaries.
Kinds of plans. Retirement plans are either: Contributions to the plan may be made by
• Qualified cash or deferred arrangement
(section 401(k) plan), or a you, or by both you and your employees. If
1) Qualified plans. This includes retirement
your plan meets the qualification require-
• Salary reduction agreement to contribute plans for small businesses, including the
ments, you generally can deduct your contri-
to a SIMPLE IRA plan or a SARSEP. self-employed (such as HR–10 (Keogh)
butions to the plan when you make them,
plans, SIMPLE plans, and simplified
except for any amount capitalized. For more
employee pensions (SEPs)), or
The limit on elective deferrals is discussed information, get Publication 560.
later under Salary Reduction Arrangement. 2) Nonqualified plans. Your employees generally are not taxed
on your contributions or increases in the
Matching contributions for self-employed Also, in general, individuals who work can set plan's assets until they are distributed to
individuals. Beginning in 1998, matching up and contribute to individual retirement ar- them. However, certain loans made from
contributions to a 401(k) plan on behalf of a rangements (IRAs). qualified employer plans are treated as taxa-
self-employed individual will no longer be ble distributions. For more information, get
treated as elective contributions subject to the Publication 575.
Topics
limit on elective deferrals. The matching con- This chapter discusses:
tributions for partners and other self- Qualification requirements. To be a qual-
employed individuals will receive the same • Qualified plans ified plan, the plan must meet many require-
treatment as the matching contributions of ments. Among these are rules concerning:
other employees. • Retirement plans for small businesses
• SIMPLE retirement plans 1) Who must be covered by the plan,
Contributions to a SEP-IRA or a SIMPLE • Nonqualified plans
IRA. A SEP-IRA or a SIMPLE IRA cannot 2) How contributions to the plan are to be
be designated as a Roth IRA. Contributions • Individual retirement arrangements invested,
to a SEP-IRA or a SIMPLE IRA will not affect (IRAs)
3) How contributions to the plan and bene-
the amount that an individual can contribute fits under the plan are to be determined,
to a Roth IRA. For information about Roth and
IRAs, see Publication 590. Useful Items
You may want to see: 4) How much of an employee's interest in
Tax law changes for 1999. This chapter the plan must be guaranteed (vested).
does not cover the changes to pension pro- Publication
visions that may affect your 1999 tax return. For more information, get Publication 560.
These changes are covered in Publication m 15 Circular E, Employer's Tax Guide
553. More than one job. If you are self-employed
m 533 Self-Employment Tax
and also work for someone else, you can
m 560 Retirement Plans for Small Busi- participate in retirement plans for both jobs.
ness (SEP, SIMPLE, and Keogh Generally, your participation in a retirement
Introduction Plans) plan for one job does not affect your partic-
ipation in a plan for the other job. However,
Retirement plans are savings plans that offer m 575 Pension and Annuity Income if you have an IRA, you might not be permit-
you tax advantages to set aside money for ted to deduct some or all of your IRA contri-
m 590 Individual Retirement Arrange-
your own and your employees' retirement. butions.
In general, a sole proprietor or a partner ments (IRAs) (Including Roth
IRAs and Education IRAs) Your deduction for IRA contributions might
also is considered an employee for purposes be limited if you also participate in a SEP-IRA.
of participating in a retirement plan. See Publication 560. In addition, your IRA
Form (and Instructions)
deduction might be limited because you are
Funding the plan. A retirement plan can be m W–2 Wage and Tax Statement covered by an employer's retirement plan and
funded entirely by your contributions or by a your income is above a certain amount. See
mix of your contributions and employee con- m 5305–SEP Simplified Employee Publication 590.
Chapter 6 Retirement Plans Page 27
• Mutual funds. ceed the limits discussed under Limits on
Kinds of Qualified Plans Contributions and Benefits in Publication 560.
There are two basic kinds of qualified retire- Adoption of a master or prototype plan does
ment plans: defined contribution plans and not mean that your plan is automatically
defined benefit plans. qualified. It must still meet all of the quali- The deduction limit for contributions to a
fication requirements stated in the tax law. defined benefit plan may be greater than the
defined contribution plan limits just described,
Defined Contribution Plans but actuarial calculations are needed to de-
These are plans that provide for a separate termine the amount. For more information
account for each person covered by the plan. about these plans, see Kinds of Plans in
Benefits are based only on amounts contrib- Retirement Plans for Publication 560.
uted to or allocated to each account.
There are three types of defined contri- Small Businesses
bution plans: profit-sharing plans, stock bonus Deduction of contributions for yourself.
If you are the owner of a small business (in-
plans, and money purchase pension plans. To take a deduction for contributions you
cluding a self-employed person), you can set
make for yourself to a plan, you must have
up certain qualified retirement plans. See
net earnings from the trade or business for
Profit-sharing plan. This is a plan that lets Qualified Plans, earlier. These plans gener-
which the plan was established.
your employees or their beneficiaries share ally are called Keogh or HR–10 plans. You
Limit on deduction. If the Keogh plan is
in the profits of your business. The plan must also can set up a less complicated tax-
a profit-sharing plan, your deduction for
have a definite formula for allocating the advantaged retirement plan. See Simplified
yourself is limited to the smaller of $30,000
contributions made to the plan among the Employee Pension (SEP), later.
or 13.0435% (15% reduced as discussed
participating employees and for distributing A small employer can also set up a SIM-
below) of your net earnings from the trade or
the funds in the plan. PLE retirement plan. See SIMPLE Retire-
business that has the plan. If the plan is a
ment Plans after the Simplified Employee
money purchase pension plan, the de-
Stock bonus plan. This type of plan is sim- Pension (SEP) discussion.
duction is limited to the smaller of $30,000
ilar to a profit-sharing plan, but it can be set or 20% (25% reduced as discussed below)
up only by a corporation. Benefits are payable of your net earnings.
in stock of the employer. Keogh Plans Net earnings. Your net earnings must
Only a sole proprietor or a partnership (but be from self-employment in a trade or busi-
Money purchase pension plan. Under this not a partner) can set up a Keogh plan. For ness in which your personal services are a
plan, your contributions are a stated amount, plan purposes, a self-employed person is material income-producing factor. If you are
or are based on a stated formula that is not both an employer and an employee. It is not a partner who only contributed capital, and
subject to your discretion. For example, your necessary to have employees besides your- who did not perform personal services, you
formula could be 10% of each participating self to set up a Keogh plan. The plan must cannot participate in the partnership's plan.
employee's compensation. Your contributions be for the exclusive benefit of employees or Your net earnings do not take into account
to the plan are not based on your profits. their beneficiaries. You generally can deduct tax-exempt income (or deductions related to
contributions to the plan. Contributions are that income) other than foreign earned in-
not taxed to your employees until plan bene- come and foreign housing cost amounts.
Defined Benefit Plans fits are distributed to them. Your net earnings are your business gross
These are any plans that are not defined income minus allowable deductions from that
contribution plans. In general, a qualified See Publication 560 for the definition
TIP of employer, employee, and com- business. Allowable deductions include con-
defined benefit plan must provide for set tributions to the plan for your common-law
benefits. Your contributions to the plan are mon-law employee.
employees along with your other business
based on actuarial assumptions. Generally, expenses.
you will need continuing professional help to Deduction Limits If you are a partner other than a limited
have a defined benefit plan. The limit on your deduction for your contribu- partner, your net earnings include your dis-
tions to a Keogh plan depends on the kind tributive share of the partnership income or
of plan you have. loss (other than separately computed items
Plan Approval such as capital gains and losses) and any
The Internal Revenue Service (IRS) will issue Defined contribution plans. The deduction guaranteed payments you receive from the
a determination or opinion letter regarding a limit for a defined contribution plan depends partnership. If you are a limited partner, your
plan's qualification. The determination or on whether it is a profit-sharing plan or a net earnings include only guaranteed pay-
opinion of the IRS will be based on how the money purchase pension plan. ments you receive for services rendered to
plan is written, not on how it operates. Profit-sharing plan. Your deduction for or for the partnership. For more information,
You do not have to request a determi- contributions to a profit-sharing plan cannot see Partners under Who Must Pay Self-
nation or opinion letter to get all the tax ben- be more than 15% of the compensation from Employment Tax in Publication 533.
efits of a plan. But, if your plan does not have the business paid (or accrued) during the year Net earnings do not include income
a determination letter, you may want to re- to the common-law employees participating passed through to shareholders of S corpo-
quest one to ensure that your plan meets the in the plan. You must reduce this 15% limit in rations.
requirements for tax benefits. figuring the deduction for contributions you Adjustments. You must reduce your net
A request for a determination, opinion, or make for your own account. See Deduction earnings by the income tax deduction for
ruling letter can be complex; therefore, you of contributions for yourself, later. one-half of your self-employment tax. Also,
may need professional help. Also, the IRS Money purchase pension plan. Your net earnings must be reduced by the de-
charges a fee for issuing these letters. Attach deduction for contributions to a money pur- duction for contributions you make for your-
Form 8717, User Fee for Employee Plan De- chase pension plan is generally limited to self. This reduction is made indirectly, as ex-
termination Letter Request, to your determi- 25% of the compensation from the business plained next.
nation letter application. paid during the year to a participating com- Net earnings reduced by adjusting
mon-law employee. You must reduce this contribution rate. You must reduce net
Master and prototype plans. It may be 25% limit in figuring the deduction for contri- earnings by your deduction for contributions
easier for you to adopt an existing butions you make for yourself, as discussed for yourself. The deduction and the net
IRS-approved master or prototype retirement later. earnings depend on each other. You can
plan than to set up your own original plan. make the adjustment to your net earnings in-
Master and prototype plans can be provided Defined benefit plans. The deduction for directly by reducing the contribution rate
by the following sponsoring organizations. contributions to a defined benefit plan is called for in the plan and using the reduced
based on actuarial assumptions and compu- rate to figure your maximum deduction for
• Trade or professional organizations. tations. Consequently, an actuary must figure contributions for yourself.
your deduction limit. Annual compensation limit. You gen-
• Banks (including some savings and loan erally cannot take into account more than
associations and federally insured credit
In figuring the deduction for contribu- $160,000 of your compensation in figuring
unions).
• Insurance companies.
!
CAUTION
tions, you cannot take into account
any contributions or benefits that ex-
your contribution to a defined contribution
plan.
Page 28 Chapter 6 Retirement Plans
For employees in a collective bar- 2) The deduction for contributions on behalf
TIP gaining unit covered by a plan for
Simplified Employee of yourself to the plan.
which the $160,000 limit does not Pension (SEP)
apply, the compensation limit is $250,000. A simplified employee pension (SEP) is a The deduction amount for (2), above, and
written plan that allows you to make deduct- your compensation (net earnings) are each
ible contributions toward your own and your dependent on the other. For this reason, the
Figuring your deduction. Use the Rate deduction amount for (2) is figured indirectly
Worksheet for Self-Employed illustrated in the employees' retirement without getting in-
volved in more complex retirement plans. A by reducing the contribution rate called for in
following example to find the reduced contri- your plan. This is done by using the Rate
bution rate for yourself. Make no reduction to corporation also can have a SEP and make
deductible contributions toward its employ- Worksheet for Self-Employed, shown earlier
the contribution rate for any common-law in the chapter.
employees. ees' retirement. But some advantages avail-
After you have your self-employed rate, able to Keogh and other qualified plans, such
as the special tax treatment that may apply SEP and profit-sharing plans. If you also
you can figure your maximum deduction for
to lump-sum distributions, do not apply to contributed to a qualified profit-sharing plan,
contributions for yourself by using the De-
SEPs. you must reduce the 15% deduction limit for
duction Worksheet for Self-Employed also il-
Under a SEP, you make the contributions that plan by the allowable deduction for con-
lustrated in the example:
to an individual retirement arrangement tributions to the SEP-IRAs of those partic-
Example. You are a sole proprietor and (called a SEP-IRA in this chapter), which is ipating in both the SEP and the profit-sharing
have employees. The terms of your plan owned by you or your common-law employee. plan.
provide that you contribute 101/2% (.105) of SEP-IRAs are set up for, at a minimum,
your compensation, and 101/2% of your com- each qualifying employee. A SEP-IRA may SEP and other qualified plans. If you also
mon-law employees' compensation. Your net have to be set up for a leased employee, but contributed to any other type of qualified plan,
earnings from line 31, Schedule C (Form need not be set up for an excludable em- treat the SEP as a separate profit-sharing
1040) are $200,000. In figuring this amount, ployee. You may be able to use Form plan for purposes of applying the overall 25%
you deducted your common-law employees' 5305–SEP in setting up your SEP. For more deduction limit described in section 404(h)(3)
pay of $100,000 and contributions for them information, get Publication 560. of the Internal Revenue Code.
of $10,500 (101/2% x $100,000). You figure
your self-employed rate and maximum de- Contribution limits. Contributions you make Employee contributions. Participants can
duction for employer contributions for your for a year to a common-law employee's also make contributions of up to $2,000 to
benefit as follows: SEP-IRA cannot exceed the smaller of 15% their SEP-IRAs independent of the employer's
of the employee's compensation or $30,000. SEP contributions. The portion of the IRA
Rate Worksheet for Self-Employed Compensation, for this purpose, generally contributions that is deductible may be re-
1) Plan contribution rate as a decimal (for does not include employer contributions to the duced or eliminated because the participant
example, 101/2% would be 0.105) ....... 0.105 SEP. is covered by an employer retirement plan
Annual compensation limit. You gener- (the SEP plan). See Publication 590 for de-
2) Rate in line 1 plus one, (for example,
0.105 plus one would be 1.105) ......... 1.105 ally cannot consider the part of compensation tails.
3) Self-employed rate as a decimal (di- of an employee that is over $160,000 when
vide line 1 by line 2) ........................... 0.0950 you figure your contributions limit for that Salary Reduction Arrangement
employee.
An employer is no longer allowed to
Deduction Worksheet for Self-Employed For employees in a collective bar- ! establish a SARSEP. However, par-
Step 1
Enter the contribution rate shown in
! gaining unit for which the $160,000
CAUTION limit does not apply, the compen-
CAUTION ticipants in a SARSEP established

before 1997 (including employees hired after


line 3 above ........................................ 0.0950 sation limit is $250,000 1996) can continue to elect to have their em-
Step 2 ployer contribute part of their pay to the plan.
Enter the amount from: line 31, More than one plan. If you also contrib-
Schedule C (Form 1040); line 3, ute to a defined contribution retirement plan, A SEP can include a salary reduction
Schedule C–EZ (Form 1040); line 36,
annual additions to an account are limited to (elective deferral) arrangement. Under the
Schedule F (Form 1040); or line 15a,
Schedule K–1 (Form 1065) ................ $200,000 the lesser of (1) $30,000 or (2) 25% of the arrangement, employees can elect to have
participant's compensation. When you figure you contribute part of their pay to their
Step 3 these limits, your contributions to all of the SEP-IRAs. The income tax on the part con-
Enter your deduction for self-
employment tax from line 27, Form plans must be added. Since a SEP is con- tributed is deferred. This choice is called an
1040 .................................................... $6,733 sidered a defined contribution plan for pur- elective deferral, which remains tax free until
poses of these limits, your contributions to a distributed (withdrawn).
Step 4
Subtract step 3 from step 2 and enter SEP must be added to your contributions to This election is available only if:
the result ............................................. $193,267 defined contribution plans.
Reporting on Form W–2. Do not include 1) At least 50% of your employees eligible
Step 5 to participate choose the salary re-
Multiply step 4 by step 1 and enter the
SEP contributions on Form W–2, Wage and
Tax Statement, unless there are contributions duction arrangement,
result ................................................... $18,360
under a salary reduction arrangement. 2) You had 25 or fewer employees who
Step 6
Multiply $160,000 by your plan contri-
Contributions for yourself. The annual were eligible to participate in the SEP (or
bution rate. Enter the result, but not limits on your contributions to a common-law would have been eligible to participate if
more than $30,000 .............................. $16,800 employee's SEP-IRA also apply to contribu- you had maintained a SEP) at any time
tions you make to your own SEP-IRA. How- during the preceding year, and
Step 7
Enter the smaller of step 5 or step 6. ever, special rules apply when you figure your
This is your maximum deductible maximum deductible contribution. See De- 3) The deferral each year by each eligible
contribution Enter your deduction on duction of contributions for yourself, later. highly compensated employee (as
line 29, Form 1040 .............................. $16,800 defined in Publication 560) as a per-
Deduction limits. The most you can deduct centage of pay (deferral percentage) is
for employer contributions for common-law no more than 125% of the average
When to make contributions. To take a deferral percentage (ADP) of all non-
employees is 15% of the compensation paid
deduction for contributions for a particular highly compensated employees eligible
to them during the year from the business that
year, you must make the contributions not to participate (the ADP test). You gen-
has the plan.
later than the due date (plus extensions) of erally cannot consider compensation of
Deduction of contributions for yourself.
your tax return for that year. an employee in excess of $160,000 in
When figuring the deduction for employer
contributions made to your own SEP-IRA, figuring an employee's deferral percent-
More information. See Publication 560 for compensation is your net earnings from self- age.
more information about retirement plans for employment, which takes into account:
small business owners, including the self- Limits on elective deferrals. In general, the
employed. It also discusses the reporting 1) The deduction allowed to you for one- total income an employee can defer under a
forms that must be filed for these plans. half of the self-employment tax, and salary reduction arrangement included in a
Chapter 6 Retirement Plans Page 29
SEP and certain other elective deferral ar- make elective contributions to a SIMPLE re- Eligible employee. Any employee who re-
rangements for 1998 is limited to the lesser tirement account on behalf of each eligible ceives at least $5,000 in compensation during
of 15% of the participant's compensation (as employee. An eligible employer is not al- any 2 years preceding the plan year can elect
defined in Publication 560) or $10,000. This lowed to maintain another retirement plan. to have his or her employer make contribu-
limit applies only to the amounts that repre- tions to a SIMPLE retirement account under
sent a reduction from the employee's pay, not a qualified salary reduction arrangement. The
to any contributions from employer funds. Setting Up a SIMPLE Plan employee must be expected to earn at least
If an employer has 100 or fewer employees $5,000 during the calendar year.
Employment taxes. Elective deferrals, not (who received at least $5,000 of compen-
exceeding the ADP test, are not subject to sation from the employer for the preceding Compensation. Compensation for employ-
income tax in the year of deferral, but are in- year), the employer may be able to set up a ees is the total amount of wages required to
cluded in wages for social security, Medicare, SIMPLE retirement plan on behalf of eligible be reported on Form W-2, plus elective
and unemployment (FUTA) tax purposes. employees. The plan can be either: deferrals. For the self-employed individual,
compensation is the net earnings from self-
• An IRA for each eligible employee, or employment (without regard to any contribu-
Reporting SEP Contributions tion made to the SIMPLE plan for the self-
• Part of a qualified cash or deferred ar-
on Form W–2 rangement (a 401(k) plan). employed individual).
Your SEP contributions are excluded from Any SIMPLE elective deferrals relat-
your employees' income. Unless there are The SIMPLE plan must be the only retire- TIP ing to an employee's wages under a
contributions under a salary reduction ar- ment plan of the employer to which contribu- salary reduction arrangement are in-
rangement, do not include these contributions tions are made, or benefits are accrued, for cluded in the Form W-2 wages for social se-
in your employees' wages on Form W–2, for service in any year beginning with the year curity and Medicare tax purposes only.
income, social security, or Medicare tax pur- the SIMPLE plan becomes effective.
poses. Your SEP contributions under a sal- Under the qualified salary reduction ar-
ary reduction arrangement are included in rangement the employer's contributions on Contribution Limits
your employees' Form W–2 wages for social behalf of the employee (elective deferrals) are Contributions are made up of employee
security and Medicare tax purposes only. stated as a percentage of the employee's elective deferrals and employer contributions.
compensation and are limited to $6,000. The The employer is required to satisfy one of two
Example. Jim's salary reduction ar- dollar limit is indexed for inflation in $500 in- contribution formulas: the matching contribu-
rangement calls for a deferral contribution crements. tion formula or a 2% nonelective contribution.
rate of 10% of his salary to be contributed by Under the qualified salary reduction ar- No other contributions can be made to the
his employer as an elective deferral to Jim's rangement the employer is also required to SIMPLE plan. These contributions, which are
SEP-IRA. Jim's salary for the year is $30,000 make either a matching contribution to the deductible by the employer, must be made
(before reduction for the deferral). The em- SIMPLE retirement account on behalf of each timely.
ployer did not elect to treat deferrals as com- employee who elects to make elective defer-
pensation under the arrangement. To figure rals, or a nonelective contribution to the SIM- Employee elective deferral limit. The
the deferral amount, the employer multiplies PLE retirement account on behalf of each el- amount that the employee elects to have the
Jim's salary of $30,000 by 9.0909%, the re- igible employee. These two methods for employer contribute to a SIMPLE retirement
duced rate equivalent of 10%, to get the determining the employer contribution formula account on his or her behalf (elective defer-
deferral amount of $2,727.27. (This method are explained under Dollar-for-dollar em- rals) must not exceed $6,000 for any year and
is the same one that you, as a self-employed ployer matching contributions and Nonelec- must be expressed as a percentage of the
person, use to figure the contributions you tive contributions. employee's compensation.
make on your own behalf.) See Rate Work- Contributions to a SIMPLE plan are
sheet for Self-Employed, earlier in the chap- deductible by the employer and are excluded Dollar-for-dollar employer matching con-
ter. from the gross income of the employee. tributions. The employer is required to
On Jim's Form W-2, the employer shows match all eligible employees' elective contri-
total wages of $27,272.73 ($30,000 minus
$2,727.27), social security wages of $30,000,
Definitions butions, on a dollar-for-dollar basis, up to 3%
of the employee's compensation.
and Medicare wages of $30,000. Jim reports
$27,272.73 as wages on his individual income SIMPLE retirement account. The SIMPLE If the employer elects a matching
retirement account of an eligible employee is
tax return.
If the employer elects to treat deferrals as an individual retirement plan that can be ei- ! contribution that is less than 3%, the
CAUTION percentage must not be less than 1%.

compensation under the salary reduction ar- ther an individual retirement account or an The employer must notify the employees of
rangement, Jim's deferral amount would be individual retirement annuity, as described in the lower match within a reasonable time be-
$3,000 ($30,000 x 10%) because, in this Publication 590. Employees' rights to the fore the employee's 60-day election period for
case, the employer uses the rate called for contributions cannot be forfeited. the calendar year. A percentage less than 3%
under the arrangement (not the reduced rate) A SIMPLE plan can also be set up as a cannot be elected for more than two years
to figure the deferral and the ADP test. On 401(k) plan. See Publication 560 for informa- during a five-year period.
Jim's Form W-2, the employer shows total tion on how to adopt a SIMPLE plan as part
wages of $27,000 ($30,000 minus $3,000), of a 401(k) plan.
Nonelective contributions. In lieu of the
social security wages of $30,000, and Medi- dollar-for-dollar matching contributions, the
care wages of $30,000. Jim reports $27,000 Qualified salary reduction arrangement. employer may elect to make nonelective
as wages on his return. An employee eligible to participate in the contributions of 2% of compensation on be-
In either case, the maximum deductible SIMPLE plan may elect (during the 60-day half of each eligible employee. Only
contribution would be $3,913.05 ($30,000 x period before the beginning of any year) to $160,000 of the employee's compensation
13.0435%). have the employer make contributions (called can be taken into account to figure the con-
elective deferrals) to the SIMPLE retirement tribution limit.
For more information on employer with- account on his or her behalf. An employee
holding requirements, see Publication 15. who so elects may also stop making elective If the employer elects this 2% contri-
For more information on SEPs, see Pub- deferrals at any time during the year. The
employer is required to match the employee's
! bution formula, he or she must notify
CAUTION the employees timely (within the em-
lication 560.
contributions or to make nonelective contri- ployee's 60-day election period described
butions. No other types of contributions are earlier).
allowed under the qualified salary reduction
arrangement. Time limits for contributing funds. The
SIMPLE Retirement employer is required to contribute the em-
Plans Eligible employer. Any employer who has
100 or fewer eligible employees in any year
ployee's deferral to the SIMPLE account
within 30 days after the end of the month for
A SIMPLE plan is a written salary reduction can establish a SIMPLE plan provided the which the payments to the employee were
arrangement that allows a small business (an employer does not maintain another deferred. The employer's matching contribu-
employer with 100 or fewer employees) to employer-sponsored retirement plan. tions to the SIMPLE plan, however, are re-
Page 30 Chapter 6 Retirement Plans
quired to be made by the tax return filing business. If you have or will receive equity in
deadline, including extensions, for the tax or title to the property, the rent is not deduct-
year that begins with or within the calendar Individual Retirement ible.
year for which the contributions are made.
Arrangements (IRAs) Unreasonable rent. You cannot take a
Distributions (Withdrawals) An individual retirement arrangement (IRA) is rental deduction for rents that are unreason-
a personal savings plan that allows you to set able. Ordinarily, the issue of reasonableness
Distributions from a SIMPLE retirement ac- aside money for your retirement or for certain of the rent will not arise unless you and the
count are subject to IRA rules and are education expenses. You may be able to de- lessor are related. Rent paid to a related
includible in income when withdrawn. Tax- duct your contributions in whole or in part, person is reasonable if it is the same amount
free rollovers can be made from one SIMPLE depending on the kind of IRA and your cir- you would pay to a stranger for use of the
account into another SIMPLE account or into cumstances. Generally, amounts in your IRA, same property. A percentage rental is rea-
an IRA. Early withdrawals generally are sub- including earnings and gains, are not taxed sonable if the rental paid is reasonable. For
ject to a 10% (or 25%) additional tax. until they are distributed. They may not be a definition of related persons, see chapter
See Publication 590 for information about taxed at all if they are distributed according 2.
IRA rules, including those on the tax treat- to the rules. For more information on IRAs,
ment of distributions, rollovers, required dis- see Publication 590.
tributions, and income tax withholding. Rent on your home. If you rent rather than
Exceptions. A rollover to an IRA can be own a home and use part of your home as
made tax free only after a 2-year participation your place of business, you may be able to
in the SIMPLE plan. A 25% additional tax for deduct the rent you pay for that part. You
early withdrawal applies if funds are with- must meet the requirements for business use
drawn within 2 years of beginning partic- of your home. For more information, see
ipation. 7. Qualifying for a Deduction in Publication 587,
Business Use of Your Home (Including Use
Employee notification. The employer who by Day-Care Providers).
sets up a SIMPLE plan must notify each eli-
gible employee of his or her opportunity to
Rent Expense Rent paid in advance. Generally, rent paid
make contributions under the plan. The em- in your trade or business is deductible in the
ployer must also notify all eligible employees year paid or accrued. If you pay rent in ad-
of the contribution alternative that was cho- vance, you can deduct only the amount that
sen. This information must be provided be-
fore the beginning of the employee's 60-day
Introduction applies to your use of the rented property
during the tax year. You can deduct the rest
This chapter discusses the tax treatment of of your payment only over the period to which
election period.
rent or lease payments you make for property it applies.
you use in your business but do not own. It
More information. This chapter does not also discusses how to treat other kinds of Example 1. In May, you leased a building
contain all the rules and exceptions that apply payments you make that are related to your for 5 years beginning July 1 and ending June
to a SIMPLE IRA or a SIMPLE 401(k) plan. use of this property. These include payments 30 five years later. According to the terms of
See Publication 560 for additional informa- you make for taxes on the property, im- the lease, your rent is $12,000 per year. You
tion, including reporting and disclosure re- provements to the property, and getting a paid the first year's rent ($12,000) on June
quirements for SIMPLE plans. You can also lease. At the end of the chapter is a dis- 30. You can deduct only $6,000 (6/12 ×
get Form 5304–SIMPLE or Form cussion about capitalizing (including in the $12,000) for the rent that applies to the first
5305–SIMPLE and their instructions. cost of property) certain rent expenses. year.
The rules in this chapter can apply to sole
proprietors, partnerships, corporations, es- Example 2. Last January you leased
tates, trusts, and any other entity that carries property for 3 years for $6,000 a year. You
Nonqualified Plans on a trade or business. paid the full $18,000 (3 × $6,000) during the
first year of the lease. Each year you can
You can deduct contributions made to a
Topics deduct only $6,000, the part of the rent that
nonexempt trust or premiums paid under a
This chapter discusses: applies to that year. You can deduct the rest
nonqualified annuity plan. Your employees
($12,000) over the remaining 2-year term of
generally must include the contributions or
• The definition of rent the lease at $6,000 each year.
premiums in their gross income.
Deduct your contributions to the plan in • Taxes on leased property
the tax year in which any of your employees Lease or purchase. There may be in-
must include an amount of the contributions • The cost of getting a lease stances in which you must determine whether
in their gross income. You can deduct contri- your payments are for rent or for the purchase
• Improvements by the lessee
of the property. You must first determine
butions only if you maintain separate ac-
counts for each participating employee. • Capitalizing rent expenses whether your agreement is a lease or a con-
ditional sales contract. If, under the agree-
Transferable interest. When an employee's ment, you acquired or will acquire title to or
interest in your contributions or premiums for Useful Items equity in the property, you should treat the
that employee is transferable, the employee You may want to see: agreement as a conditional sales contract.
must include those amounts in gross income Payments made under a conditional sales
for the tax year in which you make them. This contract are not deductible as rent expense.
Publication
rule also applies if the employee's interest is Whether the agreement is a conditional
not subject to a substantial risk of forfeiture m 334 Tax Guide for Small Business sales contract depends on the intent of the
(that is, there is not much of a risk that the parties. Determine intent based on the facts
m 538 Accounting Periods and Methods and circumstances that exist when you make
employee will lose his or her interest) when
you make contributions or pay premiums for m 946 How To Depreciate Property the agreement.
that employee. Determining the intent. In general, an
See chapter 17 for information about get- agreement may be considered a conditional
ting publications and forms. sales contract rather than a lease if any of the
Nontransferable interest. If, when you following is true.
make the contributions, the employee's inter-
est in the trust or in the value of the annuity
contract is not transferable and is subject to
• The agreement applies part of each pay-
a substantial risk of forfeiture, the employee Rent ment toward an equity interest that you
will receive.
does not include that interest in gross income Rent is any amount you pay for the use of
until the tax year in which the interest be- property that you do not own. In general, you • You get title to the property upon the
comes transferable or is no longer subject to can deduct rent as an expense only if the rent payment of a stated amount required
a substantial risk of forfeiture. is for property that you use in your trade or under the contract.
Chapter 7 Rent Expense Page 31
• The amount you pay to use the property a lessor at the end of the lease term except the tax bills are issued. Oak cannot deduct
for a short time is a large part of the for continued leasing or transfer to a member the real estate taxes as rent until the tax bill
amount you would pay to get title to the of the lessee group. See Revenue Procedure is issued. This is when Oak's liability under
property. 76–30 for examples of limited-use property the lease becomes fixed.
and property that is not limited-use property. If, according to the terms of the lease, Oak
• You pay much more than the current fair is liable for the real estate taxes when the
rental value for the property. owner of the property becomes liable for
Leases over $250,000. Special rules are
• You have an option to buy the property provided for certain leases of tangible prop- them, Oak will deduct the real estate taxes
at a nominal price compared to the value erty. The rules apply if the lease calls for total as rent on its tax return for the earlier year.
of the property when you may take ad- payments of more than $250,000 and either This is the year in which Oak's liability under
vantage of the option. Determine this of the following apply. the lease becomes fixed.
value when you make the agreement.
• You have an option to buy the property • Any rents are payable after the close of
at a nominal price compared to the total the calendar year following the calendar
amount you have to pay under the lease. year the use occurs. Cost of
• Rents increase during the lease.
• The lease designates some part of the
payments as interest, or part of the pay-
Getting a Lease
Generally, if these conditions exist, you You may either enter into a new lease with
ments are easy to recognize as interest. must accrue rents for the periods to which the the lessor of the property or get an existing
Leveraged leases. Leveraged lease rents are allocated under the lease. If a lease lease from another lessee. Very often when
transactions may be considered leases. Lev- only contains a rent payment schedule, the you get an existing lease from another lessee,
eraged leases generally involve three parties: rents payable for a period during the lease besides paying the rent on the lease, you
a lessor, a lessee, and a lender to the lessor. are the rents allocated to that period. If the must pay the previous lessee money to get
Usually the lease term covers a large part of lease allocates any rent to a calendar year the lease.
the useful life of the leased property, and the that is not payable until after the close of the If you get an existing lease on property
lessee's payments to the lessor are enough succeeding calendar year, only the present or equipment for your business, you must
to cover the lessor's payments to the lender. value of that rent should be accrued and in- amortize any amount you pay to get that
If you plan to take part in what appears to terest on the unpaid rent accrues until the rent lease over the remaining term of the lease.
be a leveraged lease, you may want to get is paid. For certain leases designed to For example, if you pay $10,000 to get a
an advance ruling. The following revenue achieve tax avoidance, IRS may require the lease and there are 10 years remaining on the
procedures contain the guidelines the IRS will parties to accrue rent and interest on rent lease with no option to renew, you can deduct
use to determine if a leveraged lease is a using the constant rental method. $1,000 each year.
lease for federal income tax purposes. The cost of getting a lease is not subject
to the amortization rules that apply to section
• Revenue Procedure 75–21, 1975–1 C.B. 197 intangibles discussed in chapter 12.
715 Taxes on
• Revenue Procedure 75–28, 1975–1 C.B. Option to renew. The term of the lease for
752
Leased Property amortization includes all renewal options if
If you lease business property, you can de- less than 75% of the cost is for the term re-
• Revenue Procedure 76–30, 1976–2 C.B. duct as additional rent any taxes that you maining on the purchase date. Treat as re-
647 have to pay to or for the lessor. When you newal options any period for which the lessee
• Revenue Procedure 79–48, 1979–2 C.B. can deduct these taxes as additional rent and lessor reasonably expect the lease to be
529 depends on your accounting method. renewed. In determining the term of the lease
remaining on the purchase date, do not in-
In general, the revenue procedures pro- Cash method. If you use the cash method clude any period for which the lessee may
vide that, for advance ruling purposes only, of accounting, you can deduct the taxes as choose to renew, extend, or continue the
the IRS will consider the lessor in a leveraged additional rent only for the tax year in which lease. Allocate the lease cost to the original
lease transaction to be the owner of the you pay them. term and any option term based on the facts
property and the transaction to be a valid and circumstances. Make the allocation using
lease if all the factors in the revenue proce- Accrual method. If you use an accrual a present value computation. For more infor-
dures are met, including the following. method of accounting, you can deduct taxes mation, see section 1.178–1(b)(5) of the In-
as additional rent for the tax year in which you come Tax Regulations.
• The lessor must maintain a minimum can determine all of the following.
unconditional “at risk” equity investment Example 1. You paid $10,000 to get a
in the property (at least 20%) during the lease with 20 years remaining on it and two
• That you have a liability for taxes on the options to renew for 5 years each. Of this
entire lease term. leased property. cost, you paid $7,000 for the original lease
• The lessee may not have a contractual • How much the liability is. and $3,000 for the renewal options. Because
right to buy the property from the lessor $7,000 is less than 75% of the total cost of the
at less than fair market value when the • That economic performance occurred. lease of $10,000, you must amortize the
right is exercised. $10,000 over 30 years. That is the remaining
The liability and amount of taxes are de-
• The lessee may not invest in the property, termined by state or local law and the lease life of your present lease plus the periods for
except as provided by Revenue Proce- agreement. Economic performance occurs as renewal.
dure 79–48. you use the property. Example 2. Assume the same facts as
• The lessee may not lend any money to Example. Oak Corporation is a calendar in Example 1, except that the amount that
the lessor to buy the property or guaran- applies to the original lease is $8,000. You
year taxpayer that uses an accrual method
tee the loan used to buy the property. can amortize the entire $10,000 over the
of accounting. Oak leases land for use in its
• The lessor must show that it expects to business. Under the law, owners of real 20-year remaining life of the original lease.
receive a profit apart from the tax de- property become liable (incur a lien on the The $8,000 cost of getting the original lease
ductions, allowances, credits, and other property) for real estate taxes for the year on was not less than 75% of the total cost of the
tax attributes. January 1 of that year. However, they do not lease.
have to pay these taxes until July 1 of the next
The IRS may charge you a user fee for year (18 months later) when tax bills are is- Cost of a modification agreement. You
issuing a tax ruling. See Publication 1375 for sued. This means that property owners be- may have to pay an additional “rent” amount
more information. come liable for real estate taxes for a year over part of the lease period to change certain
Leveraged leases of limited-use prop- on January 1 of that year, but do not have to provisions in your lease. You must capitalize
erty. The IRS will not issue advance rulings pay them until July 1 of the next year. these payments and amortize them over the
on leveraged leases of so-called limited-use remaining period of the lease. You cannot
property. Limited-use property is property not Under the terms of the lease, Oak be- deduct the payments as additional rent, even
expected to be either useful to or usable by comes liable for the real estate taxes when if they are described as rent in the agreement.
Page 32 Chapter 7 Rent Expense
Example. You are a calendar year tax- Generally, you are subject to the uniform Topics
payer and sign a 20-year lease to rent part capitalization rules if you do any of the fol- This chapter discusses:
of a building starting on January 1. However, lowing.
before you occupy it, you decide that you re- • Allocation of interest
ally need less space. The lessor agrees to • Produce real or tangible personal prop-
reduce your rent from $7,000 to $6,000 per erty for use in a trade or business or an • Interest you can deduct
year and to release the excess space from activity engaged in for profit. • Interest you cannot deduct
the original lease. In exchange, you agree to • Produce real or tangible personal prop-
pay an additional rent amount of $3,000, • Capitalization of interest
erty for sale to customers.
payable in 60 monthly installments of $50 • When to deduct interest
each. • Acquire property for resale. However, this
rule does not apply to personal property • Below-market interest rate loans
You must capitalize the $3,000 and if your average annual gross receipts are
amortize it over the 20-year term of the lease. not more than $10 million.
Your amortization deduction each year will Useful Items
be $150 ($3,000 ÷ 20). You cannot deduct the Indirect costs include amounts incurred for You may want to see:
$600 that you will pay during each of the first rent of equipment, facilities, or land.
5 years as rent. Publication
Example 1. You rent construction equip-
Commissions, bonuses, and fees. Com- ment to build a storage facility. You must m 537 Installment Sales
missions, bonuses, fees, and other amounts capitalize as part of the cost of the building
the rent you paid for the equipment. You re- m 538 Accounting Periods and Methods
that you pay to get a lease on property you
cover your cost by claiming a deduction for
use in your business are capital costs. You m 550 Investment Income and Expenses
must amortize these costs over the term of depreciation on the building.
the lease. m 936 Home Mortgage Interest De-
Example 2. You rent space in a facility duction
to conduct your business of manufacturing
Loss on merchandise and fixtures. If you tools. You must include the rent you paid to
sell at a loss merchandise and fixtures that occupy the facility in the cost of the tools you Form (and Instructions)
you bought solely to get a lease, the loss is produce.
a cost of getting the lease. You must capital- m Sch A (Form 1040) Itemized De-
ize the loss and amortize it over the remaining ductions
More information. For more information,
term of the lease. see the regulations under section 263A of the m Sch E Supplemental Income and Loss
Internal Revenue Code. m Sch K–1 (Form 1065) Partner's Share
of Income, Credits, Deductions,
etc.
Improvements
m Sch K–1 (Form 1120S) Shareholder's
by Lessee Share of Income, Credits, De-
If you add buildings or make other permanent
improvements to leased property, depreciate
8. ductions, etc.
m 1098 Mortgage Interest Statement
the cost of the improvements using the mod-
ified accelerated cost recovery system
(MACRS). Depreciate the property over its
Interest m 3115 Application for Change in Ac-
counting Method
appropriate recovery period. You cannot m 4952 Investment Interest Expense De-
amortize the cost over the remaining term of duction
the lease.
If you do not keep the improvements when m 8582 Passive Activity Loss Limitations
you end the lease, figure your gain or loss Important Reminder See chapter 17 for information about get-
based on your adjusted basis of the im- ting publications and forms.
provements then. Interest on loans with respect to life in-
For more information, see the discussion surance policies. For tax years ending after
of MACRS in Publication 946. May 31, 1997, you generally cannot deduct
interest paid or accrued with respect to any
Assignment of a lease. If a long-term lessee life insurance, annuity, or endowment con- Allocation of Interest
makes permanent improvements to land and tract that was issued or deemed issued after The rules for deducting interest vary, de-
later assigns all lease rights to you for money June 8, 1997, and covers any individual, un- pending on whether the loan proceeds are
and you pay the rent required by the lease, less that individual is a key person. used for business, personal, home mortgage,
the amount you pay for the assignment is a A new rule reduces interest deductions investment, or passive activities. If you use
capital investment. If the rental value of the allocable to the unborrowed policy cash val- the proceeds of a loan for more than one ex-
leased land increased since the lease began, ues of certain life insurance, endowment, or pense, you must make an allocation to de-
part of your capital investment is for that in- annuity contracts issued after June 8, 1997. termine the amount of interest for each use
crease in the rental value. The rest is for your For more information, see Interest on loans of the loan's proceeds. However, qualified
investment in the permanent improvements. with respect to life insurance policies, later. home mortgage interest is fully deductible
The part that is for the increased rental regardless of how the funds are used. For
value of the land is a cost of getting a lease, more information on home mortgage interest,
and you amortize it over the remaining term see Publication 936.
of the lease. You can depreciate the part that Introduction The best way to allocate interest is to keep
is for your investment in the improvements This chapter discusses the tax treatment of the proceeds of a particular loan separate
as discussed earlier. business interest expenses. Interest is the from any other funds. You can treat a pay-
amount charged for the use of borrowed ment made from any account (or in cash)
money. You can generally deduct all interest within 30 days before or after the debt pro-
you pay or accrue during the tax year on ceeds are deposited (or received in cash) as
Capitalizing debts related to your trade or business. being made from the debt proceeds.
However, special rules apply to the following. In general, you allocate interest on a
Rent Expenses TIP loan the same way you allocate the
Under the uniform capitalization rules, you • Interest you must capitalize (see Capital- loan. This is true even if the funds are
have to capitalize direct costs and an ization of Interest, discussed later). paid directly to a third party. You allocate
allocable part of most indirect costs that ben- • Loans on which the interest rate is less loans by tracing disbursements to specific
efit or are incurred because of production or than the applicable federal rate (see uses. Use the following categories to allocate
resale activities. Below-Market Interest Rate Loans, later). your interest expense.
Chapter 8 Interest Page 33
1) Trade or business interest. 1) Any unborrowed amounts held in the you can treat any payment from that account
same account, and as being made first from the interest. When
2) Passive activity interest. the interest earned is used up, any remaining
2) Any amounts deposited after these loan
3) Investment interest. payments are from loan proceeds.
proceeds.
4) Portfolio expenditure interest. Example. In April you borrowed $20,000
Example. On January 9, Edith opened a
5) Personal interest. checking account, depositing $500 of the and used the proceeds of this loan to open a
proceeds of Loan A and $1,000 of unbor- new savings account. The account earned
rowed funds. The following table shows the interest of $867 during the year. Interest paid
Any interest allocated to proceeds used
transactions in her account during the tax on the loan proceeds while they remain in the
for personal purposes is treated as personal
year. account is investment interest.
interest, which is not deductible. Proceeds
If you withdraw $20,000 from the savings
are used for personal purposes if they are not
Date Transaction account for personal purposes, you can treat
used in connection with your trade or busi-
January 9 $500 proceeds of Loan A and the $20,000 as coming first from the interest,
ness, passive activity, or investment activity.
$1,000 unborrowed funds $867, and then from the loan proceeds,
deposited $19,133 ($20,000 − $867). The total amount
Allocation based on use of loan's pro- January 13 $500 proceeds of Loan B of interest you are charged on the $20,000
ceeds. Loan proceeds and the related inter- deposited from the time it was deposited in the account
est are allocated based on the use of the February 18 $800 used for personal purposes until the time of the withdrawal is investment
proceeds. The allocation is not affected by the February 27 $700 used for passive activity
interest. The amount charged on the pro-
use of property that secures the loan. June 19 $1,000 proceeds of Loan C
deposited ceeds used for personal purposes ($19,133)
Example. You secure a loan with prop- November 20 $800 used for an investment from the time you withdraw it until you either
erty used in your business. You use the loan December 18 $600 used for personal purposes repay it or reallocate it to some other use is
proceeds to buy an automobile for personal personal interest. The amount charged on the
Edith treats the $800 used for personal
use. You must allocate interest expense on proceeds you left in the account ($867) con-
purposes as made from the $500 proceeds
the loan to personal use (purchase of the tinues to be investment interest until you ei-
of Loan A and $300 of the proceeds of Loan
automobile) even though the loan is secured ther repay it or reallocate it to some other use.
B. She treats the $700 used for a passive
by business property. activity as made from the remaining $200
proceeds of Loan B and $500 of unborrowed Loan proceeds received in cash. If you
Allocation period. The period for which funds. She treats the $800 used for an in- receive the proceeds of a loan in cash, you
a loan is allocated to a particular use begins vestment as made entirely from the proceeds can treat any payment (up to the amount of
on the date the proceeds are used and ends of Loan C. the proceeds) made from any account you
on the earlier of the date the loan is: Edith treats the $600 used for personal own, or from cash, as made from those pro-
purposes as made from the remaining $200 ceeds. This applies to any payment you
1) Repaid, or make within 30 days before or after you re-
proceeds of Loan C and $400 of unborrowed
2) Reallocated to another use. funds. Note that for the periods during which ceive the proceeds of the loan. Also, you can
loan proceeds are held in the account, they treat the payment as made on the date you
Proceeds not disbursed to borrower. Even are treated as property held for investment. received the cash instead of the date you
if the lender pays the loan proceeds to a third actually made the payment.
Payments from checking accounts.
party, the allocation of the loan is still based
Generally, you treat a payment from a Example. Frank gets a loan of $1,000 on
on your use of the funds. This applies if you
checking or similar account as made at the August 4 and receives the proceeds in cash.
pay for property, services, or anything else
time the check is written if you mail or deliver Frank deposits $1,500 in an account on Au-
by incurring a loan, or if you take property
it to the payee within a reasonable period af- gust 18 and on August 28 writes a check on
subject to a debt.
ter you write it. You can treat checks written the account for a passive activity expense.
on the same day as written in any order. Also, Frank deposits his paycheck, deposits
Proceeds deposited in borrower's ac- Amounts paid within 30 days. If loan other loan proceeds, and pays his bills during
count. Treat loan proceeds deposited in an proceeds are deposited in an account, you the same period. Regardless of these other
account as property held for investment. It can treat any payment (up to the amount of transactions, Frank can treat $1,000 of the
does not matter whether the account pays the proceeds) made from any account you deposit he made on August 18 as being paid
interest. Any interest you pay on the loan is own, or from cash, as made from those pro- from the loan proceeds on August 4. In addi-
investment interest expense. If you withdraw ceeds. This applies to any payment made tion, Frank can treat the passive activity ex-
the proceeds of the loan, you must reallocate within 30 days before or after the proceeds pense he paid on August 28 as made from
the loan based on the use of the funds. are deposited in your account. You can apply the $1,000 loan proceeds treated as depos-
Example. Connie, a calendar-year tax- this rule even if the rules stated earlier under ited in the account.
payer, borrows $100,000 on January 4 and Order of funds spent would otherwise require
immediately uses the proceeds to open a you to treat the proceeds as used for other Loan repayments. When you repay any part
checking account. No other amounts are purposes. If you apply this rule to any pay- of a loan allocated to more than one use, treat
deposited in the account during the year, and ments, disregard those payments (and the it as being repaid in the following order.
no part of the loan principal is repaid during proceeds from which they are made) when
the year. On April 1, Connie uses $20,000 applying the rules stated under Order of funds 1) Amounts allocated to personal use.
from the checking account for a passive ac- spent.
Optional method for determining date 2) Amounts allocated to investments and
tivity expenditure. On September 1, Connie
of reallocation. You can use the following passive activities (other than those in-
uses an additional $40,000 from the account
method to determine the date loan proceeds cluded in (3) below).
for personal purposes.
Under the interest allocation rules, the are reallocated to another use. You can treat
3) Amounts allocated to passive activities
entire $100,000 loan is treated as property all payments from loan proceeds in the ac-
count during any month as taking place on the in connection with a rental real estate
held for investment for the period of January activity in which you actively participate.
4 through March 31. From April 1 through later of:
August 31, Connie must treat $20,000 of the 4) Amounts allocated to former passive
1) The first day of that month, or activities.
loan as used in the passive activity and
$80,000 of the loan as property held for in- 2) The date the loan proceeds are depos-
5) Amounts allocated to trade or business
vestment. From September 1 through De- ited in the account.
use and to expenses for certain low-
cember 31, she must treat $40,000 of the loan
However, you can use this optional method income housing projects.
as used for personal purposes, $20,000 as
used in the passive activity, and $40,000 as only if you treat all payments from the account
property held for investment. during the same calendar month in the same Continuous borrowings. The following
way. rules apply if you have a line of credit or
Order of funds spent. Generally, you Interest on a separate account. If you similar arrangement that allows you to borrow
treat loan proceeds deposited in an account have an account that contains only loan pro- funds periodically under a single loan agree-
as used (spent) before: ceeds and interest earned on the account, ment.
Page 34 Chapter 8 Interest
1) Treat all borrowings on which interest name of the entity in column (a) and the to your trade or business. Interest relates to
accrues at the same fixed or variable amount in column (i). your trade or business if you use the pro-
rate as a single loan. For passive activity use, enter the interest ceeds of the loan for a trade or business ex-
on Form 8582 as a deduction from the pas- pense. It does not matter what type of prop-
2) Treat borrowings or parts of borrowings sive activity of the entity. Show any deductible erty secures the loan. You can deduct
on which interest accrues at different amount in Part II, Schedule E (Form 1040). interest on a debt only if you meet all of the
fixed or variable rates as different loans. On a separate line, put “passive interest” and following requirements.
Treat these loans as repaid in the order the name of the entity in column (a) and the
shown on the loan agreement. amount in column (g). • You are legally liable for that debt.
For investment use, enter the interest on
Form 4952. Carry any deductible amount al-
• Both you and the lender intend that the
Loan refinancing. Allocate the replacement debt be repaid.
loan to the same items to which the repaid located to royalties to Part II, Schedule E
loan was allocated. This is true only to the (Form 1040). On a separate line enter “in- • You and the lender have a true debtor-
extent you use the proceeds of the new loan vestment interest” and the name of the entity creditor relationship.
to repay any part of the original loan. in column (a) and the amount in column (i).
Carry the balance to line 13, Schedule A You cannot currently deduct interest that
(Form 1040). must be capitalized and (except for corpo-
Partnerships and Any interest allocated to proceeds used rations) you can never deduct personal inter-
est.
for personal purposes is personal interest
S Corporations which is not deductible.
Special rules apply to the allocation of interest Mortgages. Generally, mortgage interest
expense in connection with debt-financed Debt-financed distributions. Generally, if paid or accrued on real estate you own legally
acquisitions of, and distributions from, part- the entity borrows funds, the general allo- or equitably is deductible. However, rather
nerships and S corporations. These rules do cation rules discussed earlier in this section than deducting the interest currently, you may
not apply if the partnership or S corporation apply. If those funds are allocated to distri- have to add it to the cost basis of the property
is formed or used for the principal purpose butions made to partners or shareholders, the as explained later under Capitalization of In-
of avoiding the interest allocation rules. distributed loan proceeds and related interest terest.
expense must be reported to the partners and Statement. If you paid $600 or more of
Debt-financed acquisitions. This is the use shareholders separately. This is because the mortgage interest (including certain points)
of loan proceeds to purchase an interest in loan proceeds and the interest expense must during the year on any one mortgage, you
an entity or to make a contribution to the be allocated depending on how the partner generally will receive a Form 1098 or a simi-
capital of the entity. or shareholder uses the proceeds. For ex- lar statement. You will receive the statement
If you purchase an interest in an entity, ample, if a shareholder uses distributed loan if you pay interest to a person (including a
(other than by way of a contribution to capi- proceeds to invest in a passive activity, that financial institution or a cooperative housing
tal), allocate the loan proceeds and the inter- shareholder's portion of the entity's interest corporation) in the course of that person's
est expense among all the assets of the en- expense on the loan proceeds is allocated to trade or business. A governmental unit is a
tity. You can use any reasonable method. a passive activity use. person for purposes of furnishing the state-
Reasonable methods include a pro-rata allo- Optional method. The entity can choose ment.
cation based on the fair market value, book to allocate the distributed loan proceeds to If you receive a refund of interest you
value, or adjusted basis of the assets, re- other expenditures it makes during the tax overpaid in an earlier year, this amount will
duced by any debts allocated to the assets. year of the distribution. This allocation is lim- be reported in box 3 of Form 1098. You
If you contribute to the capital of an entity, ited to the amount of the other expenditures cannot deduct this amount. For information
make the allocation using any reasonable less any loan proceeds already allocated to on how to report this refund, see Refunds of
method. For this purpose, reasonable meth- them. For any distributed loan proceeds that interest later in this chapter.
ods ordinarily include allocating the debt are more than the amount allocated to the Expenses paid to obtain a mortgage.
among all the assets or tracing the loan pro- other expenditures, the rules in the previous Certain expenses you pay to obtain a mort-
ceeds to the entity's expenditures. paragraph apply. gage cannot be deducted as interest. These
Treat the purchase of an interest in an How to report. If the entity does not use expenses, which include mortgage commis-
entity as a contribution to capital to the extent the optional method, it reports the interest sions, abstract fees, and recording fees, are
the entity receives any proceeds of the pur- expense on the loan proceeds on the line on capital expenses. If the property mortgaged
chase. Schedule K–1 (Form 1065 or Form 1120S) for is business or income-producing property,
“Other deductions.” The expense is identified you can deduct the costs over the life of the
Example. You purchase an interest in a on an attached schedule as “Interest expense mortgage.
partnership for $20,000 using borrowed allocated to debt-financed distributions.” The Prepayment penalty. If you pay off your
funds. The partnership's only assets include partner or shareholder claims the interest ex- mortgage early and pay the lender a penalty
machinery used in its business valued at pense depending on how the distribution was for doing this, you can deduct the penalty as
$60,000 and stocks valued at $15,000. You used. interest.
allocate the loan proceeds based on the value If the entity uses the optional method, it
of the assets. Therefore, you allocate $16,000 reports the interest expense on the loan pro- Points. The term “points” is often used to
of the loan proceeds ($60,000/$75,000 × ceeds allocated to other expenditures on the describe some of the charges paid by a bor-
$20,000) and the interest expense on that appropriate line or lines of Schedule K–1. For rower when the borrower takes out a loan or
part to trade or business use. You allocate the example, if the entity chooses to allocate the a mortgage. These charges are also called
remaining $4,000 ($15,000/$75,000 × loan proceeds and related interest to a rental loan origination fees, maximum loan
$20,000) and the interest on that part to in- activity expenditure, the entity will take the charges, or premium charges. If any of these
vestment use. interest into account in figuring the net rental charges (points) are solely for the use of
income or loss reported on Schedule K–1. money, they are interest.
Reallocation. If you allocate the loan Points paid when you take out a loan or
proceeds among the assets, you must make More information. For more information on mortgage result in original issue discount
a reallocation if the assets or the use of the allocating and reporting these interest ex- (OID). In general, the points (OID) are
assets change. penses, see Notice 88–37, 1988–1 C.B. 522, deductible as interest unless they must be
How to report. Individuals should report and Notice 89–35, 1989–1 C.B. 675, which capitalized. How you figure the amount of
their deductible interest expense either on are available at most IRS offices. points (OID) you can deduct each year de-
Schedule A or Schedule E of Form 1040 de- pends on whether or not your total OID, in-
pending on the type of asset (or expenditure cluding the OID resulting from the points, is
if the allocation is based on the tracing of loan de minimis. If the OID is not de minimis, you
proceeds) to which the interest expense is must use the constant-yield method to figure
allocated. Interest You how much you can deduct.
For interest allocated to trade or business De minimis rule. In general, the OID is
assets (or expenditures), report the interest Can Deduct de minimis if it is less than one-fourth of 1%
in Part II, Schedule E (Form 1040). On a You can generally deduct all interest you pay (.0025) of the stated redemption price at ma-
separate line, put “business interest” and the or accrue during the tax year on debts related turity (generally, the principal amount of the
Chapter 8 Interest Page 35
loan) multiplied by the number of full years consult your lender or tax advisor. In general,
from the date of original issue to maturity (the the YTM is the discount rate that, when used
term of the loan). in computing the present value of all principal Interest You
If the OID is de minimis, you can choose and interest payments, produces an amount
one of the following ways to figure the amount equal to the principal amount of the loan. Cannot Deduct
you can deduct each year. Qualified stated interest (QSI) generally Some interest payments cannot be deducted.
is stated interest that is unconditionally paya- In addition, certain other expenses that may
1) Constant-yield basis over the term of the ble in cash or property (other than debt in- seem to be interest are not and you cannot
loan. struments of the issuer) at least annually at deduct them as interest.
a single fixed rate.
2) Straight line basis over the term of the
loan. Example of constant yield. The facts Payment by cash or equivalent. A cash-
are the same as in the previous example. The basis taxpayer generally cannot deduct inter-
3) In proportion to stated interest payments. yield to maturity on your loan is 10.2467%, est unless it is paid in cash or its equivalent.
compounded annually. You figure the If you use the cash method of accounting, you
4) Entire amount at maturity of the loan. cannot deduct interest you pay with borrowed
amount of points (OID) you can deduct each
year as follows. funds you get from the original lender through
You make this choice by deducting the OID a second loan, an advance, or any other ar-
in a manner consistent with the method cho- Principal amount of the loan ................... $100,000 rangement similar to a loan. You can deduct
sen on your timely filed tax return for the Minus: Points .......................................... 1,500 the interest expense once you start making
taxable year in which the loan or mortgage is Issue price of the loan ............................ $98,500 payments on the new loan. When you make
issued. Multiplied by: YTM .................................. × .102467 partial payments on loans, you first apply the
Total ........................................................ 10,093 payment to interest and then to the principal.
Example of de minimis amount. On Minus: QSI .............................................. 10,000 All amounts you apply to the interest on the
Points (OID) deductible in 1998 $93 first loan are deductible, along with any inter-
January 1, 1998, you take out a loan for
$100,000. The loan matures on January 1, est you pay on the second loan, subject to
2008 (a 10-year term) and the stated principal In 1999, you can deduct $103 of the points any limits that apply.
amount of the loan ($100,000) is payable on (OID). You figure the deduction for 1999 as
that date. An interest payment of $10,000 is follows. Capitalized interest. In addition to the cap-
payable to the bank on January 1 of each italization of interest rules, discussed later,
year, beginning on January 1, 1999. When Issue price .............................................. $98,500 there are certain interest expenses you must
the loan is made, you pay $1,500 in points to Plus: Points (OID) deducted in 1998 ...... 93
Adjusted issue price ............................... $98,593
capitalize rather than deduct.
the bank. The points reduce the issue price If you buy property and pay interest owed
Multiplied by: YTM .................................. × .102467
of the loan from $100,000 to $98,500, result- by the seller (for example, by assuming the
Total ........................................................ 10,103
ing in $1,500 of OID. You determine that the Minus: QSI .............................................. 10,000 debt and any interest accrued on the prop-
points (OID) you paid are de minimis based Points (OID) deductible in 1999 ............. $103 erty), you cannot deduct the interest. Add to
on the following computation. the basis of the property the interest you paid
Loan or mortgage ends. If your loan or
mortgage ends, you may be able to deduct that the seller owed.
Redemption price at maturity (principal
amount of the loan) ................................. $100,000 any remaining points (OID) in the taxable year
Multiplied by: The term of the loan in in which the loan or mortgage ends. A loan Commitment fees or standby charges.
complete years ........................................ × 10 or mortgage may end due to a refinancing, Fees you incur to have business funds avail-
Multiplied by ............................................. × .0025 prepayment, foreclosure, or similar event. able on a standby basis, but not for the actual
De minimis amount $2,500 However, if the refinancing is with the same use of the funds, are not deductible as inter-
The points (OID) you paid ($1,500) are less lender, the remaining points (OID) generally est payments. You may be able to deduct
than the de minimis amount; therefore, you are not deductible in the year in which the them as business expenses.
have de minimis OID and you can choose one refinancing occurs, but may be deductible If the funds are for inventory or certain
of the four ways discussed earlier to figure the over the term of the new mortgage or loan. property used in your business, the fees are
amount you can deduct each year. Under the indirect costs and you must capitalize them
straight line method, you can deduct $150 under the uniform capitalization rules. For
Partial liability. If you are liable for part of
each year for 10 years. more information on uniform capitalization
a business debt, you can deduct only your
rules, see section 1.263A–8 through
share of the total interest paid or accrued.
Constant-yield method. If the OID is not 1.263A–15 of the Income Tax Regulations.
de minimis, you must use the constant-yield
Example. You and your brother borrow
method to figure how much you can deduct Income tax owed. Interest charged on in-
money. You are liable for 50% of the note.
each year. You figure your deduction for the come tax assessed on your individual income
You use your half of the loan in your busi-
first year in the following manner. tax return is not a business deduction even
ness, and you make one-half of the loan
payments. You can deduct your half of the though the tax due is related to income from
1) Determine the issue price of the loan. total interest payments as a business de- your trade or business. Treat this interest as
For example, if you paid points on a loan duction. a business deduction only in figuring a net
subtract the points you paid from the operating loss deduction.
principal amount of the loan to get the Penalties. Penalties on deficiencies and
issue price. Partial payments on a nontax debt. If you underestimated tax are not interest. You
make partial payments on a debt (other than cannot deduct them. Generally, you cannot
2) Multiply the issue price (the result in (1)) a debt owed IRS), the payments are applied deduct any fines or penalties.
by the yield to maturity. first to interest and any remainder to principal.
You can deduct only the interest.
3) Subtract any qualified stated interest Interest on loans with respect to life in-
payments from the result in (2). surance policies. For contracts issued be-
Installment purchases. If you make an in- fore June 9, 1997, you generally cannot de-
4) The result in (3) is the amount of OID stallment purchase of business property, the duct interest paid or accrued after October
you can deduct in the first year. contract between you and the seller generally 13, 1995, on debt incurred with respect to any
provides for the payment of interest. If no in- life insurance, annuity or endowment contract
To figure your deduction in any subse- terest or a low rate of interest is charged un- covering someone who is or was an em-
quent years, you start with the adjusted is- der the contract, a portion of the stated prin- ployee, officer, or someone financially inter-
sue price. To get the adjusted issue price, cipal amount payable under the contract may ested in your business unless that person is
add to the issue price any OID previously be recharacterized as interest (unstated in- a key person. For contracts issued or
deducted. Then follow steps (2) through (4) terest). The amount recharacterized as inter- deemed issued after June 8, 1997, you gen-
above. est reduces your basis in the property and erally cannot deduct interest with respect to
The yield to maturity (YTM) is generally increases your interest expense. For more any life insurance, annuity or endowment
shown in the literature you receive from your information on installment sales and unstated contract that covers any individual, unless
lender. If you do not have this information, interest, see Publication 537. that individual is a key person.
Page 36 Chapter 8 Interest
If the policy or contract covers a key per- Limit on investment interest. Your de- corporation or partnership for your own pro-
son, you can deduct the interest to the extent: duction for investment interest expense is duction costs. You must provide the required
limited to the amount of your net investment information in an attachment to the Schedule
1) The aggregate debt is not more than income. This rule applies only if: K–1 to properly capitalize interest for this
$50,000 for that key person, and purpose.
1) You are a noncorporate taxpayer (in-
2) The interest paid or accrued for any cluding shareholders and partners of S
month beginning after 1995 is not more Additional information. The procedures for
corporations and partnerships), and applying the uniform capitalization rules are
than the Moody's Corporate Bond Yield
Average-Monthly Average Corporates 2) You paid or accrued interest on money complex and beyond the scope of this publi-
(Moody's rate) for that month. you borrowed to buy or carry property cation. For more information, see section
held for investment (including amounts 1.263A–8 through 1.263A–15 of the Income
Key person. A key person is an officer allowable as a deduction in connection Tax Regulations and Internal Revenue Notice
or 20% owner. However, the number of indi- with personal property used in a short 88–99, 1988–2 C.B. 422, (as amended by
viduals you can treat as key persons is limited sale). Announcement 89-72) available at most IRS
to the greater of: offices.
For more information about the limit on the
1) Five individuals, or investment interest expense deduction, see
Publication 550.
2) The lesser of 5% of the total officers and
employees of the company or 20 indi- When To Deduct
viduals.
Interest
Proration rule. A rule applies to disallow Capitalization of If the earlier discussion of capitalized interest
a portion of the entire interest deduction for does not apply to you, deduct interest as fol-
the taxable year of corporations, partnerships Interest lows.
and S corporations allocable, under proration Under the uniform capitalization rules, you
rules, to the unborrowed cash values of cer- generally must capitalize interest on debt Cash method. In general, you can deduct
tain life insurance, annuity or endowment equal to the amount of expenditures used to only the interest you actually paid during the
contracts issued or deemed issued after June produce real or certain tangible personal tax year. You cannot deduct a promissory
8, 1997, of which they are a direct or indirect property. The property must be produced by note you gave as payment because it is a
(including by separate agreement) benefi- you for use in your trade or business or for promise to pay and not an actual payment.
ciary. These proration rules generally do not sale to customers. Interest related to property Prepaid interest. Under the cash
apply with respect to such contracts that acquired and held for resale is not capitalized. method, you generally cannot deduct any in-
cover only a single officer, director, employee Interest you paid or incurred during the terest paid before the year it is due. Interest
or 20% owner of the taxpayer. See section production period must be capitalized if the paid in advance can be deducted over the
264(f) of the Internal Revenue Code. property produced is designated property. term of the loan.
Existing debt and contracts. Notwith- Designated property is: Discounted loans. If interest or a dis-
standing the general rules of nondeductibility, count is subtracted from your loan proceeds,
a limited deduction exists for otherwise al- 1) Real property, it is not a payment of interest and you cannot
lowable interest expense paid or accrued af- deduct it when you get the loan. The amount
ter October 13, 1995, but before January 1, 2) Tangible personal property with a class
life of 20 years or more, of interest or discount subtracted from your
1999, on debt with respect to certain life in- loan produces original issue discount (OID).
surance, endowment or annuity contracts, if 3) Tangible personal property with an esti- If the OID is de minimis, you can choose to
the debt was incurred within an applicable mated production period of more than 2 deduct the OID in one of the following ways.
period before 1997. Also, special rules allow years, or
income arising from the complete surrender 1) Constant-yield basis over the term of the
of certain life insurance, endowment and an- 4) Tangible personal property with an esti- loan.
nuity contracts in 1996, 1997 or 1998 to be mated production period of more than
spread over a 4-year period. For more infor- one year if the estimated cost of pro- 2) Straight line basis over the term of the
mation, see PL 104–191, section 501(c) and duction is more than $1 million. loan.
(d).
Pre-June 21, 1986 contracts. With a few You produce property if you construct, 3) In proportion to stated interest payments.
exceptions, otherwise allowable interest (not build, install, manufacture, develop, improve, 4) Entire amount at maturity of the loan.
in excess of the maximum rates set by law) create, raise, or grow the property. Treat the
paid or accrued on debt with respect to con- property produced for you under a contract You make this choice by reporting the OID in
tracts purchased before June 21, 1986, can as produced by you up to the amount you pay a manner consistent with the method chosen
be deducted no matter when the debt was or incur for the property. on your timely filed tax return for the taxable
incurred. year in which the loan is issued. If the OID is
For more information, see section 264 of Capitalized interest. Treat capitalized inter- more than a de minimis amount, it is deduct-
the Internal Revenue Code. est as a cost of the property produced. You ible over the term of the loan based on a
recover the interest when you sell or use the constant yield. Discount on a short-term obli-
Interest related to tax-exempt income. property, or dispose of it under the rules that gation is not deductible until paid. For infor-
Generally, you cannot deduct interest related apply to such transactions. You recover mation on the de minimis rule and the
to tax-exempt income. You cannot take a capitalized interest through cost of goods constant-yield method, see the discussion
deduction for any of the following. sold, an adjustment to basis, depreciation, earlier under Points.
amortization, or other method. Refunds of interest. If you pay interest
1) Interest on a debt incurred to buy or and then receive a refund in the same tax
carry tax-exempt securities. Partnerships and S corporations. The in- year of any part of the interest, reduce your
terest capitalization rules are applied first at interest deduction by the refund. If you re-
2) Amounts paid or incurred in connection ceive the refund in a later tax year, include the
the level of the partnership or S corporation,
with personal property used in a short refund in income if the deduction for the in-
and then at the level of the partners or
sale. terest reduced your tax. You should include
shareholders. These rules are applied to the
3) Amounts paid or incurred by others for extent the partnership or S corporation has in income only the amount of the interest de-
the use of any collateral used in con- insufficient debt to support the production or duction that reduced your tax.
nection with a short sale. construction costs.
If you are a shareholder in an S corpo- Accrual method. You can deduct only in-
If you deposit cash as collateral in a sale and ration or a partner in a partnership, you may terest that has accrued during the tax year.
the cash does not earn a material return dur- have to capitalize interest you incur during the Prepaid interest. Under the accrual
ing the period of sale, item (2) above does tax year for the production costs of the S method, you generally cannot deduct any in-
not apply. For more information on short corporation or partnership. You may also terest paid before it is due. Instead, deduct it
sales, see Short Sales in Publication 550. have to capitalize interest incurred by the S over the term of the loan.
Chapter 8 Interest Page 37
Discounted loans. If interest or a dis- Gift and demand loans. A gift loan is 1) Loans made available by lenders to the
count is subtracted from your loan proceeds, any below-market loan where the forgone in- general public on the same terms and
it is not a payment of interest and you cannot terest is in the nature of a gift. A demand conditions that are consistent with the
deduct it when you get the loan. For more loan is one payable in full at any time upon lender's customary business practices,
information, see Discounted loans earlier un- the lender's demand.
2) Loans subsidized by a federal, state, or
der Cash method. If you receive a below-market gift loan or
municipal government that are made
Tax deficiency. If you contest a federal demand loan, you are treated as receiving an
available under a program of general
income tax deficiency, interest does not ac- additional payment (as a gift, dividend, etc.)
application to the public,
crue until the tax year the final determination equal to the forgone interest on the loan. You
of liability is made. If you do not contest the then treat this amount as being transferred 3) Certain employee-relocation loans,
deficiency, then the interest accrues in the back to the lender as interest. You may be
4) Certain loans to or from a foreign person,
year the tax was asserted and agreed to. entitled to deduct that amount as an interest
unless the interest income would be ef-
However, if you contest but pay the pro- expense, if it qualifies. The lender must report
fectively connected with the conduct of
posed tax deficiency and interest, and you do this amount as interest income. These trans-
a U.S. trade or business and not exempt
not designate the payment as a cash bond, fers are considered to occur annually, gener-
from U.S. tax under an income tax treaty,
then the interest is deductible in the year paid. ally on December 31.
and
Term loans. If you receive a below-
Related persons. If you use the accrual market term loan (a loan that is not a demand 5) Any loan if the taxpayer can show the
method, you cannot deduct interest owed to loan), you are treated as receiving a cash interest arrangement has no significant
a related person who uses the cash method payment (as a gift, dividend, etc.) on the date effect on the federal tax liability of the
until payment is made and the interest is the loan is made. This payment is equal to the lender or the borrower. See Significant
includible in the gross income of that person. loan amount minus the present value of all effect on federal tax liability, later.
The relationship is determined as of the end payments due under the loan. This excess
of the tax year for which the interest would amount is also treated as original issue dis- Certain loans to qualified continuing
otherwise be deductible. If a deduction is de- count on the loan and the original issue dis- care facilities. The below-market interest
nied under this rule, the rule will continue to count rules apply. See Original Issue Dis- rules do not apply to loans made by a lender
apply even if your relationship with the person count (OID) in Publication 550. to a qualified continuing care facility pursuant
ceases to exist before the interest is includible to a continuing care contract. These loans are
in the gross income of that person. See Re- Loans subject to the rules. The rules for exempt if both of the following requirements
lated Persons in Publication 538. below-market loans apply to: are met.

1) Gift loans, 1) The principal amount of the loan, when


added to the total outstanding amount
2) Compensation-related loans, of all loans from the lender (or lender's
Below-Market 3) Corporation-shareholder loans,
spouse) does not exceed $134,800 for
1998.
Interest Rate Loans 4) Tax avoidance loans, 2) The lender (or lender's spouse) is age
A below-market loan is a loan on which no
5) Loans to qualified continuing care facili- 65 or older by the end of the calendar
interest is charged or on which interest is
ties (made after October 11, 1985), and year.
charged at a rate below the applicable federal
rate. A below-market loan generally is treated 6) Other below-market loans to the extent A continuing care facility is one or more
as an arm's-length transaction in which you, provided in the Regulations. facilities that are designed to provide services
the borrower, are treated as having received: under continuing care contracts and where
Exceptions. The rules for below-market substantially all of the residents living there
1) A loan in exchange for a note that re- loans do not apply to certain loans on days have entered into continuing care contracts.
quires the payment of interest at the on which the total amount of outstanding In addition, substantially all of the facilities
applicable federal rate, and loans between the borrower and lender is used to provide services required under the
2) An additional payment. $10,000 or less. This exception applies only continuing care contract must be owned or
to: operated by the loan borrower.
The additional payment is treated as a gift, A written contract between an individual
dividend, contribution to capital, payment of 1) Gift loans between individuals if the gift and a qualified continuing care facility must
compensation, or other payment, depending loan is not directly used to buy or carry meet all four of the following conditions.
on the substance of the transaction. income-producing assets, or
In the case of a demand loan covered by 1) The individual and/or the individual's
2) Compensation-related loans or spouse must be entitled to use the facil-
the below-market loan rules, two transactions
corporation-shareholder loans if the ity for the rest of their life or lives.
are assumed to have taken place:
avoidance of federal tax is not a principal
1) A transfer of forgone interest from the purpose of the loan. 2) The residential use must begin in a
lender to the borrower, and separate, independent living unit pro-
A compensation-related loan is any vided by the continuing care facility and
2) A retransfer of the forgone interest from below-market loan between an employer and continue until the individual (or individ-
the borrower to the lender. an employee or between an independent ual's spouse) is incapable of living inde-
contractor and a person for whom the con- pendently. The facility must provide var-
Forgone interest. For any period, forgone tractor provides services. ious “personal care” services to the
interest is: Limit on forgone interest for gift loans resident such as maintenance of the
of $100,000 or less. For gift loans between residential unit, meals, and daily aid and
1) The amount of interest that would be individuals, if the outstanding loans between supervision relating to routine medical
payable for that period if interest accrued the lender and borrower total $100,000 or needs.
at the applicable federal rate and was less, the forgone interest included in income
payable annually on December 31, mi- by the lender and deemed paid by the bor- 3) The facility must also be obligated to
nus rower is limited to the borrower's net invest- provide long-term nursing care if the
ment income for the year. This limit does not resident is no longer capable of living
2) Any interest actually payable on the loan independently.
for the period. apply to a loan if the avoidance of federal tax
is one of the main purposes of the interest 4) The contract must require the facility to
Applicable federal rates are published by the arrangement. Additionally, if the borrower's provide the “personal services” and
IRS each month in the Internal Revenue Bul- net investment income is $1,000 or less, the “long-term nursing care” without sub-
letin. You can also contact an Internal Reve- borrower's net investment income is treated stantial additional cost to the individual.
nue Service office to get these rates. as zero.
How you treat the forgone interest de- Tax avoidance loans. If one of the principal
pends on the type of loan you have. The Loans not subject to the rules. Some loans purposes of structuring a transaction as an
various loans and types of treatment of for- are specifically exempted from the rules for exempted loan is the avoidance of federal tax,
gone interest are discussed next. below-market loans, such as: the loan will be considered a tax avoidance
Page 38 Chapter 8 Interest
loan and will be subject to the rules for Uniform capitalization rules. Uniform cap- diction. Deductible real estate taxes generally
below-market loans. italization rules apply to certain taxpayers who do not include taxes charged for local benefits
produce real or tangible personal property for and improvements that increase the value of
Significant effect on federal tax liability. use in a trade or business or for sale to cus- the property. See Taxes for local benefits,
Whether an interest arrangement has a sig- tomers. They also apply to taxpayers who later.
nificant effect on the federal tax liability (see acquire property for resale. Under these rules, If you use an accrual method of account-
item 5, earlier under Loans not subject to the you may have to either include in inventory ing, you generally cannot accrue real estate
rules) of the lender or the borrower will be costs or capitalize certain expenses related taxes until you pay them to the government
determined by all the facts and circum- to the property, such as taxes. For more in- authority. You can, however, choose to
stances. Consider all of the following factors. formation, see Publication 551. ratably accrue the taxes during the year. See
Election to ratably accrue, later.
1) Whether items of income and deduction Carrying charges. Carrying charges include
generated by the loan offset each other. taxes you pay to carry or develop real estate Taxes for local benefits. Generally, you
or to carry, transport, or install personal cannot deduct taxes charged for local benefits
2) The amount of the items.
property. You can choose to capitalize carry- and improvements that tend to increase the
3) The cost of complying with the below- ing charges not subject to the uniform cap- value of your property. These include as-
market loan provisions if they applied. italization rules if they are otherwise deduct- sessments for streets, sidewalks, water
ible. For more information, see chapter 11. mains, sewer lines, and public parking facili-
4) Any reasons, other than taxes, for
You cannot deduct federal estate and ties. You should increase the basis of your
structuring the transaction as a below-
property by the amount of the assessment.
market loan. !
CAUTION
gift taxes, or state inheritance, legacy,
and succession taxes. You can deduct taxes for these local
benefits only if the taxes are for maintenance,
Effective dates. Except as provided above, repairs, or interest charges related to those
these rules apply to term loans made after Refunds of taxes. If you receive a refund for benefits. If part of the tax is for maintenance,
June 6, 1984, and to demand loans out- any taxes you deducted in an earlier year, repairs, or interest, you can deduct that part.
standing after that date. include the refund in income only to the extent But you have to be able to show how much
For more information, see section 7872 the deduction reduced your tax in the earlier it is. Otherwise, you cannot deduct any of it.
of the Internal Revenue Code and 1.7872–5T year. For more information, see Recovery of
of the regulations. amount deducted in chapter 1. Example. City X, to improve downtown
You must include any interest you commercial business, converted a downtown
Sale or exchange of property. Different TIP receive with state or local tax refunds business area street into an enclosed pedes-
rules generally apply to a loan connected with in income. trian mall. The city assessed the full cost of
the sale or exchange of property. If the loan construction, financed with 10-year bonds,
does not provide adequate stated interest, against the affected properties. The city is
part of the principal payment may be consid- paying the principal and interest with the an-
ered interest. However, there are exceptions Topics nual payments made by the property owners.
that may require you to apply the below- This chapter discusses: The assessments for construction costs
market interest rate rules to these loans. See are not deductible as taxes or as business
the Unstated Interest discussion in Publica- • Real estate taxes expenses, but are depreciable capital ex-
tion 537. penses. The part of the payments that is to
• Income taxes
pay the interest charges on the bonds is
• Employment taxes deductible as taxes.
• Other taxes
Charges for services. Water bills,
sewerage, and other service charges as-
9. Useful Items
You may want to see:
sessed against your business property are
not real estate taxes, but are deductible as
business expenses.
Taxes Publication
Purchase or sale of real estate. If real es-
m 15 Circular E, Employer's Tax Guide tate is sold during the year, the real estate
taxes must be divided between the buyer and
m 378 Fuel Tax Credits and Refunds the seller.
Introduction m 533 Self-Employment Tax The buyer and seller must divide the real
estate taxes according to the number of days
You can deduct various federal, state, local, m 538 Accounting Periods and Methods in the real property tax year (the period to
and foreign taxes directly attributable to your which the tax imposed relates) that each
m 551 Basis of Assets
trade or business as business expenses. owned the property. Treat the seller as pay-
ing the taxes up to but not including the date
When to deduct taxes. Generally, you can Form (and Instructions) of sale. Treat the buyer as paying the taxes
only deduct taxes in the year you pay them. beginning with the date of sale. For this pur-
m 1040 U.S. Individual Income Tax Return
This applies whether you use the cash pose, disregard the accrual or lien dates un-
method or an accrual method of accounting. m Sch SE (Form 1040) Self-Employment der local law. You can usually find this infor-
If you use an accrual method, you can Tax mation on the settlement statement you
deduct a tax before you pay it. But you must received at closing.
meet the exception for recurring items dis- m 3115 Application for Change in Ac- If you (the seller) cannot deduct taxes until
cussed under Economic Performance in counting Method they are paid because you use the cash
Publication 538. You can also choose to See chapter 17 for information about get- method of accounting and the buyer of your
ratably accrue real estate taxes as discussed ting publications and forms. property is personally liable for the tax, you
later under Real Estate Taxes. are considered to have paid your part of the
Limit on accrual of taxes. A taxing ju- tax at the time of the sale. This lets you de-
risdiction can require the use of a date for duct the part of the tax to the date of sale
accruing taxes that is earlier than the date it even though you did not pay it. You must also
previously required. However, if you use an Real Estate Taxes include the amount of that tax in the selling
accrual method and can deduct the tax before Deductible real estate taxes are any state, price of the property.
you pay it, a special rule applies. The special local, or foreign taxes on real estate levied for If you (the seller) use an accrual method
rule sets the accrual date for federal income the general public welfare. The taxing au- and have not chosen to ratably accrue real
tax purposes as the date on which the tax thority must base the taxes on the assessed estate taxes, you are considered to have ac-
would have accrued had no action been value of the real estate and charge them crued your part of the tax on the date you sell
taken. uniformly against all property under its juris- the property.
Chapter 9 Taxes Page 39
Example. Al Green, a calendar year ac- ship as business expenses. An individual can Excise taxes. You can deduct all excise
crual method taxpayer, owns real estate in X deduct state income taxes imposed on him taxes you pay or incur as ordinary and nec-
County. He has not chosen to ratably accrue or her only as an itemized deduction on essary expenses of carrying on your trade or
property taxes. November 30 of each year is Schedule A (Form 1040). business.
the assessment and lien date. He sold the However, an individual can deduct a state
property on June 30, 1998. Under his ac- tax on gross income (as distinguished from
Franchise taxes. You can deduct corporate
counting method he would not be able to net income) directly attributable to a trade or
franchise taxes as a business expense. If you
claim a deduction for the taxes because the business as a business expense.
are a cash method taxpayer, deduct the
sale occurred before November 30. He is Accrual of contested income taxes. If
franchise tax in the year paid. If you are an
treated as having accrued his part of the tax, you use an accrual method, can deduct taxes
180/365 (January 1–June 29), on June 30, and accrual method taxpayer, deduct the tax in
before you pay them, and contest a state or
the year you become legally liable to pay it
he can deduct it for 1998. local income tax liability, a special rule ap-
regardless of the year the tax is based on.
plies. Under this special rule, you must accrue
For example, if your state imposes a fran-
and deduct any contested amount only in the
Election to ratably accrue. If you use an chise tax for 1998 that is based on your cor-
tax year in which the liability is finally deter-
accrual method, you can choose to accrue porate net income for 1997, deduct the tax in
mined.
real estate tax that is related to a definite pe- 1998 if you use an accrual method because
Filing a tax return is not considered con-
riod ratably over that period. that is the year you became legally liable for
testing a liability. If you do not make an ob-
the tax.
jective act of protest or show some affirmative
Example. John Smith is a calendar year evidence of denial of the liability, you can
taxpayer who uses an accrual method. His deduct any additional state or local income Fuel taxes. Taxes on gasoline, diesel fuel,
real estate taxes for the real property tax year, taxes found to be due for a prior year only in and other motor fuels that you use in your
July 1, 1998, to June 30, 1999, amount to the year for which they were originally im- business are usually included as part of the
$1,200. July 1 is the assessment and lien posed. You cannot deduct them in the year cost of the fuel. Do not deduct these taxes
date. in which the liability is finally determined. as a separate item.
If John chooses to ratably accrue the You may be entitled to a credit or refund
taxes, $600 will accrue in 1998 ($1,200 × for federal excise tax you paid on fuels used
6/12, July 1–December 31) and the balance
Foreign income taxes. Generally, you can for certain purposes. For more information,
will accrue in 1999. take either a deduction or a credit for income see Publication 378.
taxes imposed on you by a foreign country
Separate elections. You can make a or a U.S. possession. However, an individual
choice for each separate trade or business Occupational taxes. You can deduct as a
cannot take a deduction or credit for foreign
and for nonbusiness activities if you account business expense an occupational tax
income taxes paid on income that is exempt
for them separately. Once you choose to charged at a flat rate by a locality for the
from U.S. tax under the foreign earned in-
ratably accrue real estate taxes, you must use privilege of working or conducting a business
come exclusion or the foreign housing exclu-
that method unless you get permission from in the locality.
sion. For information on these exclusions, see
the IRS to change from that method. See Publication 54, Tax Guide for U.S. Citizens
Revoking the election, later. and Resident Aliens Abroad. Personal property tax. You can deduct any
Making the election. If you make your tax imposed by a state or local government
election for the first year in which you incur on personal property used in your trade or
real estate taxes, attach a statement to your business.
income tax return for that year. You must file
your return by the due date (including exten-
sions). The statement should show all of the
following items.
Employment Taxes Sales tax. Treat any sales tax you pay on a
service or on the purchase or use of property
If you have employees, you must withhold as part of the cost of the service or property.
1) The trades or businesses to which the various taxes from your employees' pay. Most If the service or the cost or use of the property
election applies and the accounting employers must withhold their employees' is a deductible business expense, you can
method or methods used. share of social security and Medicare taxes deduct the tax as part of that service or cost.
along with state and federal income taxes. If the property is merchandise bought for re-
2) The period to which the taxes relate. You may also need to pay certain taxes from sale, the sales tax is part of the cost of the
your own funds. These include your share of merchandise. If the property is depreciable,
3) The computation of the real estate tax social security and Medicare taxes along with add the sales tax to the basis for depreciation.
deduction for the first year of the unemployment taxes. For more information on basis, see Publica-
election. You should treat the taxes you withhold tion 551.
from your employees' pay as wages on your
If you make the election for a year after tax return. You can deduct the employment Do not deduct state and local sales
the first year in which you incur real estate taxes you must pay from your own funds as ! taxes imposed on the buyer that you
CAUTION must collect and pay over to the state
taxes, file Form 3115, Application for Change taxes.
in Accounting Method. Generally, you must or local government. Do not include these
file this form during the tax year for which the taxes in gross receipts or sales.
Example. You pay your employee
election is to be effective. For more informa- $18,000 a year. However, after you withhold
tion, see the instructions for Form 3115. various taxes, your employee receives Self-employment tax. You can deduct one-
Revoking the election. To revoke an $14,500. You also pay an additional $1,500 half of your self-employment tax as a busi-
election to ratably accrue real estate taxes, in employer taxes. You should deduct the full ness expense in figuring your adjusted gross
file Form 3115, as discussed above. $18,000 as wages. You can deduct the income. This deduction only affects your in-
$1,500 you pay from your own funds as taxes. come tax. It does not affect your net earnings
from self-employment or your self-
employment tax.
For more information on employment To deduct the tax, enter on Form 1040,
Income Taxes taxes, see Publication 15. line 27, the amount shown on the “Deduction
This section discusses federal, state, local, for one-half of self-employment tax” line of
and foreign income taxes. Schedule SE (Form 1040).
For more information on self-employment
tax, see Publication 533.
Federal income taxes. You cannot deduct
federal income taxes. Other Taxes
Unemployment fund taxes. As an em-
The following are other taxes that you can ployer, you may have to make payments to
State and local income taxes. A corpo- deduct if you incur them in the ordinary a state unemployment compensation fund or
ration or partnership can deduct state income course of your trade or business. to a state disability benefit fund. Deduct these
taxes imposed on the corporation or partner- payments as taxes.
Page 40 Chapter 9 Taxes
1) Fire, theft, flood, or similar insurance. 2) A general partner (or a limited partner
receiving guaranteed payments) in a
2) Credit insurance on losses from unpaid
10. debts.
partnership.
3) A shareholder owning more than 2% of
3) Group hospitalization and medical insur- the outstanding stock of an S corpo-
Insurance ance for employees, including long-term
care insurance.
ration.

You are allowed this deduction whether


a) If a partnership pays accident and you paid the premiums yourself or your part-
health insurance premiums for its nership or S corporation paid them and you
partners, it can deduct them as included the premium amounts in your gross
Important Change guaranteed payments made to the income. Take this deduction on line 28 of
partners. Form 1040.
for 1998
b) If an S corporation pays accident
and health insurance premiums for Percentage increases after 1998. For tax
Health insurance deduction for the self-
its 2% shareholder-employees, it years beginning after 1998, the deductible
employed. In 1998, the deduction for health
can deduct the premiums. percentage of your health insurance premi-
insurance of self-employed individuals in-
ums gradually increases. The increases are
creases from 40% to 45%. See Health Insur-
4) Liability insurance. shown in the following table.
ance Deduction for the Self-Employed, later.
5) Malpractice insurance that covers your Deductible
professional personal liability for For Tax Years Beginning in: Percentage
negligence resulting in injury or damage 1999 through 2001 ............................. 60%
Important Change to patients or clients. 2002 ....................................................
After 2002 ...........................................
70%
100%
for 1999 6) Workers' compensation insurance set by
state law that covers any claims for
Long-term care insurance. If you pay the
Health insurance deduction for the self- bodily injuries or job-related diseases
premiums on a qualified long-term care in-
employed. For 1999, this deduction is in- suffered by employees in your business,
surance contract for yourself, your spouse,
creased to 60% of the amount you paid for regardless of fault.
or your dependents, you can include those
medical insurance for yourself and your fam- premiums when figuring your deduction. But
ily. After 2001, the deduction will increase a) If a partnership pays workers' com-
pensation premiums for its partners, you can include only the lesser of the follow-
again. For more information, see Health In- ing amounts.
surance Deduction for the Self-Employed, it can deduct these amounts as
later. guaranteed payments to the part-
ners. 1) The amount you pay.
2) The amount shown below.
b) If an S corporation pays the work-
ers' compensation premiums for its a) Age 40 or less — $210
Introduction shareholders, it can deduct these
b) Age 41 to 50 — $380
You generally can deduct the ordinary and amounts.
necessary cost of insurance as a business c) Age 51 to 60 — $770
expense if it is for your trade, business, or 7) Contributions to a state unemployment
profession. However, you may have to capi- insurance fund. You can deduct these d) Age 61 to 70 — $2,050
talize certain insurance costs under the uni- contributions as taxes if they are con-
e) Age 71 and above — $2,570
form capitalization rules. For more informa- sidered taxes under state law.
tion, see Capitalizing Premiums, later. 8) Overhead insurance. This insurance
pays you for business overhead ex- Use your age at the end of the tax year.
Topics penses you have during long periods of Long-term care insurance contract. A
This chapter discusses: disability caused by your injury or sick- long-term care insurance contract is any in-
ness. surance contract that only provides coverage
• Deductible premiums of qualified long-term care services. The
9) Car and other vehicle insurance. This contract must:
• Nondeductible premiums insurance covers vehicles used in your
• Capitalizing premiums business for liability, damages, and other 1) Be guaranteed renewable,
• When to deduct premiums losses. If you operate a vehicle partly for 2) Provide that refunds, other than refunds
personal use, you can deduct only the on the death of the insured or complete
part of your insurance premiums that surrender or cancellation of the contract,
applies to the business use of the vehi- and dividends under the contract may
Useful Items cle. If you use the standard mileage rate
You may want to see: be used only to reduce future premiums
to figure your car expenses, you cannot or increase future benefits,
deduct any car insurance premiums.
Publication 3) Not provide for a cash surrender value
10) Life insurance covering your officers and or other money that can be paid, as-
m 525 Taxable and Nontaxable Income employees if you are not directly or indi- signed, pledged as collateral for a loan,
m 538 Accounting Periods and Methods rectly the beneficiary under the contract. or borrowed, and
m 547 Casualties, Disasters, and Thefts 11) Use and occupancy and business inter- 4) Generally, not pay or reimburse ex-
ruption insurance. This insurance pays penses incurred for services or items
you for lost profits if your business is shut that would be reimbursed under Medi-
Form (and Instructions)
down due to a fire or other cause. care, except where Medicare is a sec-
m 1040 U.S. Individual Income Tax Return ondary payer or the contract makes per
diem or other periodic payments without
See chapter 17 for information about get- regard to expenses.
ting publications and forms. Health Insurance Deduction
for the Self-Employed Qualified long-term care services.
You can deduct 45% of the amount paid Qualified long-term care services are:
during 1998 for medical insurance and qual-
Deductible Premiums ified long-term care insurance for yourself and • Necessary diagnostic, preventive,
your family, if you are one of the following. therapeutic, curing, treating, mitigating,
You can generally deduct premiums you pay
and rehabilitative services, and
for the following kinds of insurance related to
your trade or business. 1) A self-employed individual. • Maintenance or personal care services.
Chapter 10 Insurance Page 41
The services must be required by a chron-
ically ill individual and prescribed by a li-
censed health care practitioner. Table 10-1. Self-Employed Health Insurance Deduction
Chronically ill individual. A chronically Worksheet (Keep for your records.)
ill individual is a person who has been certi-
fied as one of the following. 1) Enter total payments made during the taxable year for health
insurance coverage for yourself, your spouse, and your
• An individual who, for at least 90 days, is dependents. (Do not include payments for coverage for any
unable to perform at least two activities month during which you were eligible to participate in a health
of daily living without substantial assist- plan subsidized by your or your spouse’s employer.)
ance due to loss of functional capacity. 2) Percentage used to figure deduction for 1998 .45
Activities of daily living are eating,
toileting, transferring, bathing, dressing, 3) Multiply the amount on line 1 by the percentage on line 2
and continence. 4) Enter your net profit and any other earned income* from the trade
or business under which the insurance plan is established. (If the
• An individual who requires substantial business is an S corporation, skip to line 11.)
supervision to be protected from threats
to health and safety due to severe cog- 5) Enter the total of all net profits from: line 31, Schedule C (Form
nitive impairment. 1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F
(Form 1040); or line 15a, Schedule K-1 (Form 1065); plus any
The certification must have been made by a other income allocable to the profitable businesses. See the
licensed health care practitioner within the instructions for Schedule SE (Form 1040). (Do not include any
previous 12 months. net losses shown on these schedules.)
Benefits received. For information on 6) Divide the amount on line 4 by the amount on line 5
excluding from gross income benefits you re-
7) Multiply the amount on Form 1040, line 27, by the percentage on
ceive from a long-term care contract, see
line 6
Publication 525.
8) Subtract the amount on line 7 from the amount on line 4
9) Enter the amount, if any, from Form 1040, line 29, attributable to
Limits. You cannot deduct an amount more the same trade or business in which the health insurance plan is
than your net earnings from the trade or established
business in which the medical insurance plan
or long-term care insurance plan is estab- 10) Subtract the amount on line 9 from the amount on line 8
lished. If the business in which the insurance 11) Enter your wages from your S corporation in which the health
plan is established is an S corporation, you insurance plan is established
cannot deduct more than your wages from the
S corporation. Do not subtract the health in- 12) Enter the amount from Form 2555, line 43, attributable to the
surance deduction when figuring net earnings amount entered on line 4 or 11 above, or the amount from Form
for your self-employment tax. However, sub- 2555-EZ, line 18, attributable to the amount entered on line 11
tract the amount of this deduction from your above
medical insurance when figuring your medical 13) Subtract the amount on line 12 from the amount on line 10 or 11,
expenses on Schedule A (Form 1040) if you whichever applies
itemize your deductions.
Other coverage. You cannot take the 14) Compare the amounts on lines 3 and 13 above. Enter the
deduction for any month if you were eligible smaller of the two amounts here and on Form 1040, line 28. (Do
to participate in any employer (including your not include this amount when figuring a medical expense
spouse's) subsidized health plan at any time deduction on Schedule A (Form 1040).)
during that month. This rule is applied sepa-
rately to plans that provide long-term care in- *Earned income includes net earnings and gains from the sale, transfer, or licensing of property you
surance and plans that do not provide long- created. It does not include capital gain income.
term care insurance. However, any medical
insurance payments not deductible on line 28 are directly or indirectly a beneficiary of
of Form 1040 can be included as part of your the policy. You are included among
medical expenses on Schedule A (Form Nondeductible possible beneficiaries of the policy if the
1040) if you itemize your deductions. policy owner is obligated to repay a loan
Premiums from you using the proceeds of the pol-
You cannot deduct the following kinds of in- icy. A person has a financial interest in
How to figure the deduction. Generally, you surance premiums. your business if the person is an owner
can use the worksheet in the Form 1040 in- or part owner of the business or has lent
structions to figure your deduction. However, money to the business.
if either of the following applies, you must use 1) Self-insurance reserve funds. You For contracts issued after June 8,
the worksheet that follows. cannot deduct amounts credited to a re- 1997, you generally cannot deduct the
serve you set up for self-insurance. This premiums on any life insurance policy,
applies even if you cannot get business endowment contract, or annuity contract
• You have more than one source of in- insurance coverage for certain business if you are directly or indirectly a benefi-
come subject to self-employment tax. risks. However, your actual losses may ciary. The disallowance applies without
be deductible. See Publication 547. regard to whom the policy covers.
• You file Form 2555 or Form 2555–EZ
(relating to foreign earned income). Partners. If, as a partner in a part-
2) Loss of earnings. You cannot deduct
nership, you take out an insurance policy
premiums for a policy that pays for your
on your own life and name your partners
lost earnings due to sickness or disabil-
as beneficiaries to induce them to retain
If you have more than one health plan ity. However, see the earlier discussion
their investments in the partnership, you
on overhead insurance, item (8), under
! during the year, and each plan is es-
CAUTION tablished under a different business,
Deductible Premiums.
are considered a beneficiary. You cannot
deduct the insurance premiums.
you must use separate worksheets (in this 3) Certain life insurance and annuities.
chapter) to figure each plan's net earnings For contracts issued before June 9, 4) Insurance to secure a loan. If you take
limit. Include your insurance payments under 1997, you cannot deduct the premiums out a policy on your life or on the life of
that plan on line 1 of the separate worksheet on a life insurance policy covering your- another person with a financial interest
and your net profit (or wages) from that busi- self, an employee, or any person with a in your business to get or protect a
ness on line 4 (or line 11). financial interest in your business if you business loan, you cannot deduct the

Page 42 Chapter 10 Insurance


premiums as a business expense. Nor year in which you make the payment or incur For more information on alternative mini-
can you deduct the premiums as interest the liability, you can deduct only the part of mum tax, see the instructions for Form 6251
on business loans or as an expense of the premium that applies to that year. For (individuals) or Form 4626 (corporations).
financing loans. In the event of death, each later tax year, you can deduct the part
the proceeds of the policy are not taxed that applies to that tax year.
as income even if they are used to liqui-
date the debt.
Topics
Example. You operate a business and This chapter discusses:
file your returns on a calendar-year basis.
You bought a fire insurance policy on your • Carrying charges
building effective October 1, 1998, and paid
a premium of $1,200 for 2 years of coverage. • Research and experimental costs
On your 1998 return, you can deduct only the
Capitalizing Premiums part of the total premium that applies to the
• Drilling and development costs

Under the uniform capitalization rules, you 3 months of coverage in 1998. For 1999 and • Exploration costs
must capitalize the direct costs and part of the 2000, you can deduct the part of the premium • Circulation costs
indirect costs for production or resale activ- that applies to each of those years. Since the
total policy premium is $1,200 for 2 years, the • Costs of removing barriers to the disabled
ities. Include these costs in the basis of and the elderly
property you produce or in inventory rather yearly rate is $600 and the monthly rate is
than claiming them as a current deduction. $50. For the 3-month period in 1998, you can
Also, recover the costs through depreciation, deduct $150; for 1999, you can deduct $600;
amortization, cost of goods sold, or by an and for the 9-month period in 2000, you can Useful Items
adjustment to basis when you use, place in deduct $450. You may want to see:
service, or dispose of the property. If you use the cash method of accounting
and you pay the $1,200 premium in January Publication
1999, you cannot deduct any amount on your
When the uniform capitalization rules ap- m 538 Accounting Periods and Methods
1998 return. However, you can deduct $750
ply. You must use the uniform capitalization
(the $150 that applies to 1998 plus the $600 m 544 Sales and Other Dispositions of
rules if, in your trade or business or activity
that applies to 1999) on your return for 1999. Assets
carried on for profit, you:
m 946 How To Depreciate Property
1) Produce real property or tangible per- Dividends received. If you receive dividends
sonal property for use in the business from business insurance and you deducted
or activity, the premiums in prior years, part of the divi- Form (and Instructions)
dends are income. For more information, m 3115 Application for Change in
2) Produce real property or tangible per- seeTax Benefit Rule in Publication 525.
sonal property for sale to customers, or Accounting Method
m 3468 Investment Credit
3) Acquire property for resale. However,
you generally do not have to use the m 6251 Alternative Minimum
uniform capitalization rules for personal Tax—Individuals
property acquired for resale if your av-
erage annual gross receipts are not m 6765 Credit for Increasing Research
Activities
more than $10,000,000.
11. m 8826 Disabled Access Credit
Indirect costs include premiums for insur-
See chapter 17 for information about get-
ance on your plant or facility, machinery,
equipment, materials, property produced, or Costs You Can ting publications and forms.
property acquired for resale.
Deduct or
More information. For more information on
the uniform capitalization rules, see Uniform Capitalize Carrying Charges
Capitalization Rules in Publication 538 and Carrying charges include the taxes and in-
the regulations under Internal Revenue Code terest you pay to carry or develop real prop-
section 263A. erty or to carry, transport, or install personal
property. Certain carrying charges must be
capitalized under the uniform capitalization
Introduction rules. (For more information on capitalization
of interest, see chapter 8.) You can choose
When To Deduct This chapter discusses the two ways of
treating certain costs—deduction or capital- to capitalize carrying charges not subject to
the uniform capitalization rules, but only if
Premiums ization.
If you deduct a cost (expense), you gen- they are otherwise deductible.
You can usually deduct insurance premiums erally recover it by subtracting it from your You can choose to capitalize carrying
in the tax year to which they apply. income in either the year you incur it or the charges separately for each project you have
year you pay it. and for each type of carrying charge. For un-
Cash method. If you use the cash method If you capitalize a cost, you may be able improved and unproductive real property,
of accounting, you must generally deduct in- to recover it over a period of years through your choice is good for only one year. You
surance premiums in the tax year in which periodic deductions for amortization, de- must decide whether to capitalize carrying
you actually pay them, even if you incurred pletion, or depreciation. When you capitalize charges each year the property remains un-
them in an earlier year. a cost, you add it to the basis of property to improved and unproductive. For other prop-
which it relates. erty, your choice to capitalize carrying
Except for exploration costs for mineral charges remains in effect until construction,
Accrual method. If you use an accrual development, or installation is completed (or,
deposits, a partnership, corporation, estate,
method of accounting, you can generally de- for personal property, the date you first use
or trust makes the choice to deduct or capi-
duct insurance premiums in the tax year in it, if later).
talize these costs. Each individual partner,
which you incur a liability for them, whether
shareholder, or beneficiary chooses whether
or not you pay them in the same year. How to make the choice. To make the
to deduct or capitalize exploration costs.
choice to capitalize a carrying charge, write
Cash or accrual method prepayments. You may be subject to the alternative a statement saying which charges you
You cannot deduct the entire premium for an
insurance policy that covers more than one
! minimum tax (AMT) if you deduct any
CAUTION of the expenses listed in the topics
choose to capitalize. Attach it to your original
tax return for the year the choice is to be ef-
tax year in the year you make the payment area except carrying charges and the costs fective. You may be able to extend the time
or incur a liability for the payment. For the of removing architectural barriers. you have to make the choice.
Chapter 11 Costs You Can Deduct or Capitalize Page 43
If you: Then:
Research and
Deduct research and experimental costs as Deduct all research and experimental costs
Experimental Costs a current business expense, for the year of choice and all later years.
The costs of research and experimentation
are generally capital expenses. However, you Do not deduct research and experimental Amortize them over at least 60 months,
can choose to deduct these costs as current costs as a current business expense, starting the month you first receive an
business expenses. economic benefit from the research.
For information on amortizing these costs,
see Research and Experimental Costs in
chapter 12. well by filing an amended return that does not
claim the loss.
Intangible
Research and experimental costs defined. Costs incurred outside the United States.
Research and experimental costs are rea- Drilling Costs You cannot deduct, in one year, all of the in-
sonable costs you incur in your trade or The costs of developing oil, gas, or tangible drilling and development costs paid
business for activities intended to provide in- geothermal wells are ordinarily capital ex- or incurred for an oil, gas, or geothermal well
formation to help eliminate uncertainty about penses. You can usually recover them located outside the United States. However,
the development or improvement of a prod- through depreciation or depletion. However, you can choose to include them in the ad-
uct. Uncertainty exists if the information you can choose to deduct as current business justed basis of the well to figure depletion. If
available to you does not establish how to expenses certain drilling and development you do not make this choice, you can deduct
develop or improve a product or the appro- costs for wells in the United States in which the costs over the 10–year period beginning
priate design of a product. Whether costs you hold an operating or working interest. You with the tax year in which you paid or incurred
qualify as research and experimental costs can only deduct costs for drilling or preparing them. These rules do not apply to a nonpro-
depends on the nature of the activity related a well for the production of oil, gas, ductive well.
to the costs. Neither the nature of the product geothermal steam, or geothermal hot water.
or improvement being developed nor the level You can choose to deduct only costs for
of technological advancement matters when items that do not have a salvage value. These
making this determination.
The costs of obtaining a patent, including
include wages, fuel, repairs, hauling, and Exploration Costs
supplies related to drilling wells and preparing The costs of determining the existence, lo-
attorneys' fees in making and perfecting a them for production. The costs to you of any
patent application, are research and exper- cation, extent, or quality of any mineral de-
drilling or development work (other than posit that lead to the development of a mine
imental costs. amounts properly allocable to the cost of
Product. The term “product” includes are ordinarily capital expenses. You recover
depreciable property and amounts paid only these costs through depletion as the mineral
any: out of production or proceeds from production is removed from the ground. However, you
are depletable income to the recipient) done can deduct currently the costs of exploration
1) Pilot model, by contractors under any form of contract is in the United States (except those for oil, gas,
also an intangible drilling and development and geothermal wells) you paid or incurred
2) Process, cost. before the development stage began.
You can also choose to deduct the cost
3) Formula, of drilling bore holes to determine the location
Partnerships. Each partner, not the part-
and delineation of offshore hydrocarbon de-
4) Invention, nership, chooses whether to capitalize or to
posits if the shaft is capable of conducting
deduct that partner's share of exploration
5) Technique, hydrocarbons to the surface on completion.
costs.
It does not matter whether there is any intent
6) Patent, or to produce hydrocarbons.
If you do not choose to deduct your in- How to make the choice. To deduct explo-
tangible drilling and development costs cur- ration costs currently, take the deduction on
7) Similar property.
rently, you can choose to deduct them over your income tax return or an amended in-
the 60-month period beginning with the month come tax return. Your return must adequately
It also includes products used by you in your describe and identify each property or mine,
trade or business or held for sale, lease, or they were paid or incurred.
and clearly state how much is being deducted
license. for each one. The choice applies to all the
Costs not included. Research and ex- domestic exploration costs you have during
perimental costs do not include expenses for: How to make the choice. You choose to
deduct intangible drilling and development the tax year that you make this choice and
costs currently by taking the deduction on all following tax years.
1) Quality control testing, your income tax return for the first tax year
you have eligible costs. No formal statement Reduced corporate deductions for explo-
2) Efficiency surveys, is required. If you file Form 1040 (Schedule ration costs. A corporation (other than an
C), enter these costs under “Other S corporation) can deduct only 70% of its
3) Management studies, domestic exploration costs. It must capitalize
expenses.”
the remaining 30% and amortize them over
4) Consumer surveys,
the 60-month period starting with the month
5) Advertising or promotions, Energy credit for costs of geothermal the exploration costs are paid or incurred. The
wells. If you capitalize the drilling and de- 30% the corporation capitalizes cannot be
6) The acquisition of another's patent, velopment costs of geothermal wells that you added to its basis in the property for purposes
model, production or process, or place in service, you may be able to claim a of figuring cost depletion. However, the
business energy credit. See Form 3468 for amount amortized is treated as additional
7) Research in connection with literary, more information. depreciation and is subject to recapture as
historical, or similar projects. ordinary income on a disposition of the prop-
erty. See Section 1250 Property under De-
Nonproductive well. If you capitalize your preciation Recapture in chapter 3 of Publica-
intangible drilling and development costs for tion 544.
When and how to choose. Generally, you a nonproductive well, you have another op- These rules also apply to the deduction
can only make the choice to deduct these tion. You can deduct these costs as an ordi- of development costs for corporations. See
costs in the first year you incur such costs. nary loss if you indicate and clearly state your Development Costs, later.
You choose to deduct research and ex- choice on your tax return for the year the well
perimental costs, rather than capitalize them, is completed. Once made, the choice for oil Recapture of exploration expenses. When
by deducting them on your tax return for the and gas wells is binding for all later years. your mine reaches the producing stage, you
year in which you first have this type of cost. You can revoke your choice for a geothermal must recapture any exploration costs you
Page 44 Chapter 11 Costs You Can Deduct or Capitalize
chose to deduct for it. Use either of the fol- Foreign development costs. The same Deduction limits. The most you can deduct
lowing methods. rules discussed earlier for foreign exploration as a cost of removing barriers to the disabled
costs apply to foreign development costs. and the elderly for any tax year is $15,000.
Method 1—include the deducted costs in However, you can add any amount over this
gross income for the tax year the mine limit to the basis of the property and depreci-
Reduced corporate deductions for devel-
reaches the producing stage. You must ate.
opment costs. The treatment of corporate
choose this recapture method by the due
deductions for exploration costs, discussed
date (including extensions) of your return.
earlier, also applies to corporate deductions Partners and partnerships. The $15,000
Your choice must be clearly indicated on
for development costs. limit applies to a partnership and also to each
the return. Increase your adjusted basis in
See Reduced corporate deductions for partner in the partnership. A partner can di-
the mine by the amount included in in-
come.
exploration costs, earlier. vide the $15,000 limit in any manner among
the partner's individually incurred costs and
Method 2— do not claim any depletion de- the partner's distributive share of partnership
duction for the tax year the mine reaches costs. If the partner cannot deduct the entire
the producing stage and following tax
years until the amount of depletion you Circulation Costs share of partnership costs, the partnership
can add any costs not deducted back to the
would have deducted equals the amount A publisher can deduct as a business ex- basis of the improved property.
of deducted exploration costs. pense the costs of establishing, maintaining, A partnership must be able to show that
and increasing the circulation of a newspaper, any amount added back to basis was not
You must also recapture deducted explo- magazine, or other periodical. For example, deducted by the partners and that it was over
ration costs if you receive a bonus or royalty a publisher can deduct the cost of hiring extra a partner's $15,000 limit (as determined by
from mine property before it reaches the employees for a limited time to get new sub- the partner). If the partnership cannot show
producing stage. Do not claim any depletion scriptions through telephone calls. Circulation this, it is presumed all the partners were able
deduction for the tax year you receive the costs are deductible even if they result in an to deduct their distributive shares of the part-
bonus or royalty and following tax years, until asset (for example, a subscriber list) having nership's costs in full.
the amount of depletion you would have de- a useful life of more than one year.
ducted equals the amount of your deducted
exploration costs. Example. John Duke's distributive share
If you dispose of the mine before your Other treatment of circulation costs. A of ABC partnership's deductible expenses for
deducted exploration costs have been fully publisher can choose to capitalize the costs the removal of architectural barriers was
recaptured, recapture the balance by treating of establishing or increasing circulation. Also, $20,000. John had $10,000 of similar ex-
all or part of your gain as ordinary income. a publisher can choose to deduct circulation penses in his sole proprietorship. He chose
costs over the 3–year period beginning with to deduct $5,000 of them. John allocated the
the tax year they were paid or incurred. remaining $10,000 of the $15,000 limit to his
Foreign exploration costs. If you pay or
These rules do not apply to the purchase share of ABC's expenses. John can add the
incur exploration costs for a mine or other
of land or depreciable property or to acquisi- excess $5,000 in the sole proprietorship to
natural deposit located outside the United
tions of circulation through the purchases of the basis of his property. Also, if ABC can
States, you cannot deduct all of the costs in
any part of the business of another publisher show that John could not deduct $10,000 of
the current year. You can choose to include
of a newspaper, magazine, or other period- his share of the partnership's expenses be-
the costs (other than for an oil, gas, or
ical. These costs must be capitalized. cause of the limit as applied by John, ABC
geothermal well) in the adjusted basis of the
can add that amount to the basis of its prop-
mineral property to figure cost depletion. If
erty.
you do not make this choice, you must deduct How to make the choice. Indicate your
the costs over the 10-year period beginning choice to capitalize circulation costs by at-
with the tax year in which you pay or incur taching a statement to your return for the first Qualification standards. You must meet the
them. These rules also apply to foreign de- tax year the choice applies. Your choice is following specific standards for improved ac-
velopment costs. binding for the year it is made and for all later cess for the disabled or the elderly to deduct
Cost depletion is discussed in chapter 13. years, unless you get IRS approval to revoke your costs as a current expense.
it. Grading. The ground must be graded to
the level of a normal entrance to make the
facility accessible to people with physical
Development Costs disabilities.
Walks.
You can deduct costs paid or incurred during Costs of Removing
the tax year for developing a mine or any
other natural deposit (other than an oil or gas Barriers to the 1) A public walk must be at least 48 inches
wide and cannot slope more than 5%.
well) located in the United States. These
costs must be paid or incurred after the dis- Disabled and the A fairly long walk of maximum or near
maximum steepness must have level
covery of ores or minerals in commercially
marketable quantities. Development costs in- Elderly areas at regular intervals. A walk or
clude those incurred by a contractor for you. driveway must have a nonslip surface.
The cost of an improvement to a business
Also, development costs include depreciation asset is normally a capital expense. However, 2) A walk must have a continuing common
on improvements used in the development you can choose to deduct the costs of making surface and must not have steps or
of ores or minerals. They do not include costs a facility or public transportation vehicle sudden changes in level.
of depreciable property. owned or leased by you for use in connection
You can choose to treat development with your trade or business more accessible 3) Where a walk crosses another walk, a
costs as deferred expenses and deduct them to and usable by those who are disabled or driveway, or a parking lot, they must
ratably as the units of produced ores or min- elderly. blend to a common level. However, this
erals related to the expenses are sold. This A facility is all or any part of buildings, does not require the removal of curbs
choice applies each tax year to expenses structures, equipment, roads, walks, parking which are a safety feature for those with
paid or incurred in that year. Once made, the lots, or similar real or personal property. A disabilities, especially blindness.
choice is binding for the year and cannot be public transportation vehicle is a vehicle, such
revoked for any reason. as a bus or railroad car, that provides trans- 4) A sloping walk must have a level plat-
portation service to the public (including ser- form at the top and at the bottom. If a
How to make the choice. The choice to vice for your customers, even if you are not door swings out onto the platform at the
deduct development costs ratably as the ores in the business of providing transportation top or bottom of the walk, the platform
or minerals are sold must be made for each services). must be at least 5 feet deep and 5 feet
mine or other natural deposit by a clear indi- You cannot deduct any costs that you paid wide. If a door does not swing onto the
cation on your return or by a statement filed or incurred to completely renovate or build a platform, the platform must be at least 3
with the IRS office where you file your return. new facility or public transportation vehicle, feet deep and 5 feet wide. The platform
You must make the choice by the due date or to replace depreciable property in the must extend at least 1 foot past the
of the return (including extensions). normal course of business. opening side of any doorway.
Chapter 11 Costs You Can Deduct or Capitalize Page 45
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.
facility must be set aside and marked for Water fountains.
use by persons with disabilities. 3) Stairs must have at least one handrail
that extends at least 18 inches past the 1) A water fountain and a cooler must have
2) A parking space must be open on one top step and the bottom step. But this 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
get in and out of a car onto a level sur- hand-operated or hand-and-foot-
face suitable for wheeling and walking. 4) Each step must not be more than 7 operated.
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. 4) A wall-mounted, hand-operated water
wide. cooler must be mounted with the basin
2) Floors on each story of a building must
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 5) A water fountain must not be fully re-
or crutches does not have to go behind previously. cessed and must not be set into an
parked cars. alcove unless the alcove is at least 36
Toilet rooms. inches wide.
Ramps.
1) A toilet room must have enough space Public telephones.
1) A ramp must not rise more than 1 inch for persons in wheelchairs to move
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- that the dial and the headset can be
that is 32 inches high, measured from let stall that— reached by a person in a wheelchair.
the surface of the ramp. The handrail 2) A public telephone must be equipped for
must be smooth and extend at least 1 a) Is at least 36 inches wide,
a person who is hearing impaired and it
foot past the top and bottom of the ramp. b) Is at least 56 inches deep, must be identified as such with in-
However, this does mean that a handrail structions for its use.
extension which is itself a hazard is re- c) Has a door, if any, that is at least
quired. 32 inches wide and swings out, 3) Coin slots of public telephones must not
be more than 48 inches from the floor.
3) A ramp must have a nonslip surface. d) Has handrails on each side that are
33 inches high and parallel to the Elevators.
4) A ramp must have a level platform at the floor, 11/2 inches in outside diam-
top and at the bottom. If a door swings eter, 11/2 inches away from the wall, 1) An elevator must be accessible to, and
out onto the platform, the platform must and fastened securely at the ends usable by, persons with disabilities and
be at least 5 feet deep and 5 feet wide. and center, and the elderly on the levels they use to enter
If a door does not swing onto the plat- the building and all levels and areas
form, the platform must be at least 3 feet e) Has a toilet with a seat 19 to 20 normally used.
deep and 5 feet wide. The platform must inches from the finished floor.
extend at least 1 foot past the opening 2) Cab size must measure at least 54 by
3) A toilet room must have, in addition to 68 inches to allow for turning a wheel-
side of any doorway. or instead of the toilet stall described in chair.
5) A ramp must have level platforms no (2), at least one toilet stall that:
farther than 30 feet apart and at any turn. 3) Door clear opening width must be at
a) Is at least 66 inches wide, least 32 inches.
6) A curb ramp with a nonslip surface must b) Is at least 60 inches deep,
be provided at an intersection. The curb 4) All controls needed must be within 48 to
ramp must not be less than 4 feet wide c) Has a door, if any, that is at least 54 inches from the cab floor. These
and must not rise more than 1 inch in 32 inches wide and swings out, controls must be usable by a person with
each foot of length. The two surfaces a visual impairment and must be iden-
d) Has a handrail on one side, 33 tifiable by touch.
must blend smoothly.
inches high and parallel to the floor,
Entrances. A building must have at least 11/2 inches in outside diameter, 11/2 Controls. Switches and controls for light,
one main entrance a person in a wheelchair inches away from the wall, and heat, ventilation, windows, draperies, fire
can use. The entrance must be on a level fastened securely at the ends and alarms, and all similar controls needed or
accessible to an elevator. center, and used often must be placed within the reach
Doors and doorways. of a person in a wheelchair. These switches
e) Has a toilet with a seat 19 to 20 and controls must not be higher than 48
inches from the finished floor with inches from the floor.
1) A door must have a clear opening at
a centerline 18 inches from the side Identification.
least 32 inches and must be operable
wall on which the handrail is lo-
by a single effort.
cated. 1) Raised letters or numbers must be used
2) The floor on the inside and outside of a to identify rooms and offices. These
4) A toilet room must have sinks with nar-
doorway must be level for at least 5 feet identification marks must be placed on
row aprons. Drain pipes and hot water
from the door in the direction the door the wall to the right or left of the door at
pipes under a sink must be covered or
swings and must extend at least 1 foot a height of 54 to 66 inches above the
insulated.
past the opening side of the doorway. finished floor.
5) A mirror and a shelf above a sink must
3) There must not be any sharp slopes or 2) A door that might prove dangerous if a
not be higher than 40 inches above the
sudden changes in level at a doorway. person who is blind were to use it, such
floor, measured from the top of the shelf
The threshold must be flush with the as a door leading to a loading platform,
and the bottom of the mirror.
floor. The door closer must be selected, boiler room, stage, or fire escape, must
placed, and set so as not to impair the 6) A toilet room for men must have wall- be identifiable by touch.
use of the door by persons with disabili- mounted urinals with the opening of the
ties. basin 15 to 19 inches from the finished Warning signals.
floor or floor-mounted urinals that are
Stairs. level with the main floor. 1) An audible warning signal must be ac-
companied by a simultaneous visual
1) Stairsteps must have round nosing of 7) Towel racks, towel dispensers, and other signal for the benefit of those who are
between 1 and 11/2 inch radius. dispensers and disposal units must not hearing impaired.
Page 46 Chapter 11 Costs You Can Deduct or Capitalize
2) A visual warning signal must be accom- paying the fare. This system must in- 1) The removed barrier must be a sub-
panied by a simultaneous audible signal clude a rail across the front of the bus stantial barrier to access or use of a fa-
for the benefit of persons who are blind. interior that passengers can lean against cility or public transportation vehicle by
while paying fares. Overhead handrails persons who have a disability or are el-
Hazards. Hanging signs, ceiling lights, must be continuous except for a gap at derly.
and similar objects and fixtures must be at the rear doorway.
2) The removed barrier must have been a
least 7 feet above the floor.
6) Floors and steps must have nonslip sur- barrier for at least one major group of
International accessibility symbol. The
faces. Step edges must have a band of persons who have a disability or are el-
international accessibility symbol must be
bright contrasting color running the full derly (such as people who are blind,
displayed on routes to a wheelchair-
width of the step. deaf, or wheelchair users).
accessible entrance to a facility, at the en-
trance itself, and at wheelchair-accessible 7) A stepwell next to the driver must have, 3) The barrier must be removed without
entrances to public transportation vehicles. when the door is open, at least 2 foot- creating any new barrier that significantly
candles of light measured on the step impairs access to or use of the facility
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 (such
measured on the step tread. as people who are blind, deaf, or
wheelchair users).
8) The doorways of the bus must have
outside lighting that provides at least 1 How to make the choice. If you choose to
foot-candle of light on the street surface deduct your costs for removing barriers to the
for a distance of 3 feet from the bottom disabled or the elderly, claim the deduction
step edge. This lighting must be below on your income tax return (partnership return
window level and must be shielded from for partnerships) for the tax year the ex-
the eyes of entering and exiting pas- penses were paid or incurred. Identify the
sengers. deduction as a separate item. For your choice
9) The fare box must be located as far for- to be valid, you must file your return by its due
ward as practical and must not block date, including extensions. Your choice is
traffic in the vestibule. irrevocable after the due date, including ex-
tensions of your return. The choice applies to
Rapid and light rail vehicles. all the qualifying costs you have during the
year, up to the $15,000 limit. If you make this
1) Passenger doorways on the vehicle choice, you must maintain adequate records
Rail facilities. sides must have clear openings at least to support your deduction.
32 inches wide.
1) A rail facility must have a fare control Disabled access credit. If you make your
area with at least one entrance with a 2) Audible or visual warning signals must business accessible to persons with a disa-
clear opening at least 36 inches wide. be provided to alert passengers of clos- bility and your business is an eligible small
ing doors. business, you may be able to take the disa-
2) A boarding platform edge bordering a
drop-off or other dangerous condition 3) Handrails and stanchions must permit bled access credit. If you make this choice,
must be marked with a strip of floor ma- safe boarding, moving around, sitting you must reduce the amount you deduct or
terial different in color and texture from and standing assistance, and getting off capitalize by the amount of the credit.
the rest of the floor surface. The gap by persons who have a disability or are For more information, see Form 8826.
between the boarding platform and ve- elderly. On a level-entry vehicle,
hicle doorway must be as small as pos- handrails, stanchions, and seats must
sible. be located to allow a wheelchair user to
enter the vehicle and position the
Buses. wheelchair in a location that does not

1) A bus must have a mechanism such as


block the movement of other passen-
gers. On a vehicle with steps that must
12.
a lift or ramp to enter the bus and be used in boarding, handrails and
enough clearance to let a wheelchair
user reach a secure location.
stanchions must be provided in the en-
trance so that persons who have a dis-
Amortization
ability or are elderly can grasp them and
2) The bus must have a wheelchair- use them from outside the vehicle while
securing device. However, this does not boarding.
mean that a wheelchair-securing device
that is itself a barrier or hazard is re- 4) Floors must have nonslip surfaces. Step Introduction
quired. edges on a light rail vehicle must have You may be able to amortize and deduct each
a band of bright contrasting color running year a part of certain capital expenses.
3) The vertical distance from a curb or from the full width of the step. Amortization allows you to recover these ex-
street level to the first front doorstep penses in a manner similar to straight line
must not be more than 8 inches. Each 5) A stepwell next to the driver must have,
when the door is open, at least 2 foot- depreciation. It also allows you to write off
front doorstep after the first step up from expenses that are not ordinarily deductible.
the curb or street level must also not be candles of light measured on the step
tread. Other stepwells must have, at all The purpose of this chapter is to explain
more than 8 inches high. The steps at the following.
the front and rear doors must be at least times, at least 2 foot-candles of light
12 inches deep. measured on the step tread.
• The rules of amortization.
4) The bus must have clear signs that indi- 6) Doorways on a light rail vehicle must • What expenses you can amortize.
cate that seats in the front of the bus are have outside lighting that provides at
priority seats for persons who have a least 1 foot-candle of light on the street • How and when you can amortize ex-
surface for a distance of 3 feet from the penses.
disability or are elderly. The signs must
encourage other passengers to make bottom step edge. This lighting must be
below window level and must be These subjects are discussed later under
these seats available to those who have each type of expense.
priority. shielded from the eyes of entering and
exiting passengers.
5) Handrails and stanchions must be pro- Topics
vided in the entrance to the bus so that Other barrier removals. To be deduct- This chapter discusses:
passengers who have a disability or are ible, expenses of removing any barrier not
elderly can grasp them from outside the covered by the above standards must meet • Amortizing costs of section 197 intangi-
bus and use them while boarding and all three of the following tests. bles
Chapter 12 Amortization Page 47
• Amortizing costs of going into business Optional write-off of tax preferences. includes value based on the ability of a busi-
There are optional write-off periods for intan- ness to continue to function and generate in-
• Amortizing reforestation costs gible drilling and development costs, circu- come even though there is a change in own-
• Amortizing costs of pollution control fa- lation costs, and mining exploration and de- ership.
cilities velopment costs. They are discussed in
Internal Revenue Code section 59(e). Workforce in place, etc. This includes the
• Amortizing costs of research and exper- composition of a workforce (for example, its
imentation
experience, education, or training). It also in-
• Amortizing bond premiums cludes the terms and conditions of employ-
• Amortizing the cost of getting a lease Section 197 ment, whether contractual or otherwise, and
any other value placed on employees or any
Intangibles of their attributes.
For example, you must amortize the part
You must amortize over 15 years the capital-
Useful Items ized costs of “section 197 intangibles” you
of a purchase price of a trade or business
You may want to see: based on the existence of a highly skilled
acquired after August 10, 1993. Section 197
workforce. You must also amortize the cost
intangibles are defined later. You must
Publication of acquiring an existing employment contract
amortize these costs if you hold the section
or relationship with employees or consultants
197 intangibles in connection with your trade
m 544 Sales and Other Dispositions of as part of the acquisition of a trade or busi-
or business or in an activity engaged in for the
Assets ness.
production of income. Your deduction each
m 550 Investment Income and Expenses year is the part of the adjusted basis (for
purposes of determining gain) of the intangi- Business books and records, etc. This in-
ble amortized ratably over a 15-year period, cludes the cost of technical manuals, training
m 551 Basis of Assets beginning with the month acquired. You are manuals or programs, data files, and ac-
not allowed any other depreciation or amorti- counting or inventory control systems. It also
zation deduction for a section 197 intangible. includes the cost of customer lists, sub-
Form (and Instructions) scription lists, insurance expirations, patient
or client files, and lists of newspaper, maga-
m 3468 Investment Credit
Section 197 zine, radio, or television advertisers.
m 4562 Depreciation and Amortization
Intangibles Defined Patents, copyrights, etc. This category in-
m 6251 Alternative Minimum The following assets are section 197 intangi- cludes package designs, computer software,
Tax—Individuals bles. and any interest in a film, sound recording,
See chapter 17 for information about get- videotape, book, or other similar property,
ting publications and forms. 1) Goodwill. except as discussed later under Assets That
2) Going concern value. Are Not Section 197 Intangibles.
3) Workforce in place, including its compo- Customer-based intangible. A customer-
sition and the terms and conditions based intangible is the composition of market,
How To Deduct (contractual or otherwise) of its employ- market share, and any other value resulting
ment.
Amortization 4) Business books and records, operating
from the future provision of goods or services
because of relationships with customers in
The purpose of this section is to explain how systems, or any other information base, the ordinary course of business. You must
you can deduct amortization. including lists or other information con- amortize that part (if any) of the purchase
cerning current or prospective custom- price of a trade or business that is for the
Form 4562. You elect to amortize your ex- ers. following intangible.
penses in Part VI of Form 4562 in the year in
which you make the election. For information 5) A patent, copyright, formula, process, • Customer base.
on how to report bond premium, see Publi- design, pattern, know-how, format, or
similar item. • Circulation base.
cation 550.
For later years, do not report your de- 6) A customer-based intangible. • Undeveloped market or market growth.
duction for amortization on Form 4562 unless • Insurance in force.
you must file the form for another reason. 7) A supplier-based intangible.
You must file Form 4562 in any of the fol- • Mortgage servicing contract.
8) Any item similar to items 3) through 7).
lowing situations. • Investment management contract.
9) A license, permit, or other right granted
by a governmental unit or agency (in- • Any other relationship with customers
• You start claiming amortization this tax that involves the future provision of goods
year. cluding renewals).
or services.
• You claim depreciation on property 10) A covenant not to compete entered into
placed in service this year. in connection with the acquisition of an Accounts receivable or other similar rights
interest in a trade or business. to income for goods or services provided to
• You claim a section 179 deduction. customers before the acquisition of that trade
11) A franchise, trademark, or trade name
• You claim a deduction for any vehicle (including renewals). or business are not section 197 intangibles.
reported on a form other than Schedule
C (Form 1040) or Schedule C–EZ (Form You cannot amortize any of the in- Supplier-based intangible. A supplier-
1040). ! tangibles listed in items 1) through 8)
CAUTION that you created, unless you created
based intangible is the value resulting from
the future acquisition of goods or services
• You claim depreciation on any vehicle or because of relationships in the ordinary
other listed property (regardless of when them in connection with the acquisition of
assets constituting a trade or business or a course of business with suppliers of goods
it was placed in service). or services. These goods and services must
substantial part of a trade or business.
• You claim depreciation on a return for a be used or sold by the business.
corporation (other than an S corporation). Goodwill. Goodwill is the value of a trade or For example, you must amortize the part
business based on expected continued cus- of the purchase price of a trade or business
tomer patronage due to its name, reputation, that is based on the existence of any one of
Other forms to use. If you do not have to file or any other factor. the following.
Form 4562, claim amortization directly on the
“Other expenses” line of Schedule C (Form Going concern value. Going concern value • A favorable relationship with distributors
1040) or the “Other deductions” line of Form is the additional value of a trade or business (such as favorable shelf or display space
1065 or Form 1120. For information on how that attaches to property because the prop- at a retail outlet).
to report bond premium, see Publication 550. erty is an integral part of a going concern. It • A favorable credit rating.
Page 48 Chapter 12 Amortization
• A favorable supply contract. or business or a substantial part of a
trade or business:
Disposition of Section
Government-granted license, permit, etc. a) An interest in a film, sound record-
197 Intangibles
Any license, permit, or other right granted by ing, videotape, book, or similar A section 197 intangible is treated as depre-
a governmental unit or an agency or instru- property, ciable property used in your trade or busi-
mentality of a governmental unit is a section ness. If you dispose of property held for more
197 intangible. For example, you must amor- b) A right to receive tangible property than one year, any gain on the disposition,
tize the capitalized costs of acquiring (includ- or services under a contract or up to the amount of allowable amortization,
ing issuing or renewing) a liquor license, a granted by a governmental agency, is ordinary income (section 1245 gain). Any
taxicab medallion or license, or a television remaining gain, or loss, is a section 1231 gain
c) An interest in a patent or copyright, or loss. If you held the property one year or
or radio broadcasting license.
d) A right under a contract (or a right less, any gain or loss on its disposition is an
granted by a governmental agency) ordinary gain or loss. For more information
Covenant not to compete. A covenant not on ordinary or capital gain or loss, see chap-
to compete (or similar arrangement) entered if the right:
ter 2 in Publication 544, Sales and Other
into in connection with the acquisition of an i) Has a fixed life of less than 15 Dispositions of Assets.
interest in a trade or business or substantial years, or If you acquire more than one section 197
portion of a trade or business, is a section 197 intangible in a transaction (or series of related
intangible. An interest in a trade or business ii) Is of a fixed amount that, ex- transactions) and later dispose of one of them
includes an interest in a partnership or stock cept for the section 197 intan- or if one of them becomes worthless, you
in a corporation engaged in a trade or busi- gible provisions, would be re- cannot recognize any loss on the intangible.
ness. coverable under a method Instead, increase the adjusted basis of each
If you pay or incur an amount under a similar to the unit-of-production remaining amortizable section 197 intangible
covenant not to compete (or similar arrange- method of cost recovery. by the part of the loss not recognized. Figure
ment) after the year in which you entered into the increase by multiplying the loss not rec-
the covenant (or similar arrangement), you 6) An interest under either:
ognized on the disposition by the following
must amortize that amount over the months a) An existing lease or sublease of fraction.
remaining in the 15-year amortization period. tangible property, or
You cannot amortize amounts paid under • The numerator is the adjusted basis of
a covenant not to compete (or similar ar- b) A debt that was in existence when that remaining intangible as of the date
rangement) that represent additional consid- the interest was acquired. of its disposition.
eration for the purchase of stock in a corpo-
ration. You must add them to the basis of the 7) A professional sports franchise and any • The denominator is the total adjusted
acquired stock. item acquired in connection with the basis of all retained amortizable section
franchise. 197 intangibles as of the date of the dis-
position.
Franchise, trademark, or trade name. A 8) A right to service residential mortgages
franchise, trademark, or trade name is a unless the right is acquired in the acqui-
Covenant not to compete. A covenant not
section 197 intangible. You can deduct sition of a trade or business or a sub-
to compete, or similar arrangement, is not
amounts paid or incurred on the transfer, stantial part of a trade or business.
considered disposed of or worthless before
sale, or other disposition of a franchise, you dispose of your entire interest in the trade
trademark, or trade name if all of the following 9) Certain transaction costs under a corpo-
rate organization or reorganization in or business for which you entered into the
apply to the amounts. covenant.
which any part of a gain or loss is not
recognized.
• They are contingent on the productivity, Nonrecognition transfers. If you dispose
use, or disposition of the franchise, of one section 197 intangible and acquire
trademark, or trade name. Computer software. Section 197 intangibles
do not include computer software that is: another in a nonrecognition transfer, treat the
• They are part of a series of payments part of the adjusted basis of the acquired in-
payable at least annually throughout the 1) Readily available for purchase by the tangible that is not more than the adjusted
term of the transfer agreement. general public, basis of the transferred intangible as the
transferred section 197 intangible. This in-
• They are part of a series of payments 2) Subject to a nonexclusive license, and cludes your continuing to amortize the part
which are substantially equal in amount of the adjusted basis treated as the trans-
or payable under a fixed formula. 3) Not substantially changed. ferred section 197 intangible over its remain-
ing amortization period. Nonrecognition
You must amortize any other amount, Software that is not acquired in the acquisition transfers include transfers to a corporation,
whether fixed or contingent that you paid or of a substantial part of a business is not a partnership contributions and distributions,
incurred because of the transfer of a fran- section 197 intangible. like-kind exchanges, and involuntary conver-
chise, trademark, or trade name. If you are allowed to depreciate any com- sions.
puter software that is not a section 197 in-
tangible, use the straight line method with a Example. You own a section 197 intan-
Assets That Are Not useful life of 36 months. gible you have amortized for 4 full years. It
For more information on depreciation of has a remaining unamortized basis of
Section 197 Intangibles computer software, see Publication 946. $30,000. You exchange the asset plus
The following assets are not section 197 in- Computer software defined. Computer $10,000 for a like-kind section 197 intangible.
tangibles. software includes all programs designed to The nonrecognition provisions of like-kind
cause a computer to perform a desired func- exchanges apply. You amortize $30,000 of
1) Any interest in a corporation, partner- tion. It also includes any database or similar the basis of the acquired section 197 intangi-
ship, trust or estate. item in the public domain and incidental to the ble over the 11 years remaining in the original
operation of qualifying software. 15-year amortization period for the trans-
2) Any interest under an existing futures ferred asset and the other $10,000 of ad-
contract, foreign currency contract, Costs associated with nonsection 197 in- justed basis over 15 years.
notional principal contract, or similar fi- tangibles. Amounts you take into account in
nancial contract. determining the cost of nonsection 197 prop-
erty are not considered section 197 intangi- Anti-Churning Rules
3) Any interest in land.
bles. These amounts are added to the basis You cannot amortize certain section 197 in-
4) Most computer software (see Computer of the property. For example, none of the tangible over 15 years. Special rules prevent
software defined, later). costs of acquiring real property held for the you from converting section 197 intangibles
production of rental income are considered from property that does not qualify for
5) Any of the following not acquired in goodwill, going concern value, or any other amortization to property that would qualify for
connection with the acquisition of a trade section 197 intangible. amortization.
Chapter 12 Amortization Page 49
You cannot use 15-year amortization for • Two S corporations if the same persons
goodwill, going concern value, or any intan- own more than 20% in value of the out-
Incorrect Amount of
gible for which you cannot claim a depreci- standing stock of each corporation. Amortization Deducted
ation deduction and for which an amortization If you did not deduct the correct amount of
deduction is only allowable under section 197 • Two corporations, one of which is an S
corporation, if the same persons own amortization for a section 197 intangible in
if: any year, you may be able to make a cor-
more than 20% in value of the outstand-
ing stock of each corporation. rection for that year by filing an amended re-
1) You acquired the goodwill, going con- turn. See Amended Return, later. If you are
cern value, or other intangible after Au- • Two partnerships if the same persons not allowed to make the correction on an
gust 10, 1993, and own, directly or indirectly, more than 20% amended return, you can change your ac-
2) Any of the following conditions apply: of the capital or the profits interests in counting method to claim the correct amount
both partnerships. of amortization. See Changing Your Ac-
a) You or a related person (defined counting Method, later.
later) held or used the intangible at
• A person and a partnership when the
person owns, directly or indirectly, more
any time from July 25, 1991, Basis adjustment. Even if you do not claim
than 20% of the capital or profits interests
through August 10, 1993, amortization you are entitled to deduct, you
in the partnership.
must reduce the basis of the section 197 in-
b) You acquired the intangible from a
Treat these persons as related to you if tangible by the full amount of amortization you
person who held the intangible at
the relationship exists immediately before or were entitled to deduct. If you deduct more
any time from July 25, 1991,
immediately after you acquire the intangible. amortization than you should, you must de-
through August 10, 1993, and as
Ownership of stock. In determining crease your basis by any amount deducted
part of the transaction, the user
whether an individual owns, directly or indi- from which you received a tax benefit.
does not change, or
rectly, any of the outstanding stock of a cor-
c) You grant the right to use the in- poration, the following rules apply. Amended Return
tangible to a person (or a person Rule 1. Stock owned, directly or indi- If you did not deduct the correct amount of
related to that person) who held or rectly, by or for a corporation, partnership, amortization, you can file an amended return
used the intangible at any time from estate, or trust is considered owned propor- to make any of the following three corrections.
July 25, 1991, through August 10, tionately by or for its shareholders, partners,
1993. or beneficiaries. • To correct a mathematical error made in
Rule 2. An individual is considered as any year.
Exception. The anti-churning rules do not owning the stock owned, directly or indirectly,
apply to an intangible acquired from a dece- by or for his or her family. Family includes
• To correct a posting error made in any
dent if the property's basis is stepped up to year.
only brothers and sisters, half-brothers and
fair market value. half-sisters, spouse, ancestors, and lineal • To correct the amount of amortization for
descendants. section 197 intangibles for which you
Related person. For purposes of the anti- Rule 3. An individual owning (other than have not adopted a method of account-
churning rules, the following are related per- by applying rule 2) any stock in a corporation ing. See Changing Your Accounting
sons. is considered to own the stock owned, directly Method, later.
or indirectly, by or for his or her partner.
Rule 4. For purposes of applying rule 1, If you did not deduct the correct amount of
• Members of a family, including only
2, or 3, treat stock constructively owned by a amortization for the section 197 intangible on
brothers, sisters, half-brothers, half-
person under rule 1 as actually owned by that two or more consecutively filed tax returns,
sisters, spouse, ancestors (parents,
person. Do not treat stock constructively you have adopted a method of accounting for
grandparents, etc.), and lineal descend-
owned by an individual under rules 2 or 3 as that property. If you have adopted a method
ants (children, grandchildren, etc.).
owned by the individual for reapplying rule 2 of accounting, you cannot change the method
• An individual and a corporation when the or 3 to make another person the constructive by filing amended returns.
individual owns, directly or indirectly, owner of the stock. If an amended return is allowed, you must
more than 20% in value of the corpo- file it by the later of the following two dates.
ration's outstanding stock.
Exception. An exception to the anti-churning • 3 years from the date you filed your ori-
• Two corporations that are members of rules applies if you acquire an intangible from ginal return for the year in which you did
the same controlled group as defined in a person related to you by more than 20%, not deduct the correct amount.
section 1563(a) of the Internal Revenue but not more than 50%, under both of the
Code, except that “more than 20%” is following conditions. • 2 years from the time you paid your tax
substituted for “at least 80%” in that defi- for that year.
nition and the determination is made • The seller recognizes gain on the dispo-
without regard to subsection (a)(4) and A return filed early is considered filed on the
sition of the intangible. due date.
(e)(3)(C) of section 1563.
• The tax the seller pays on the gain plus
• A trust fiduciary and a corporation when any other federal income tax imposed on Changing Your
the trust or grantor of the trust owns, di- the gain equals tax on the gain at the
rectly or indirectly, more than 20% in highest tax rate.
Accounting Method
value of the corporation's outstanding If you did not deduct the correct amount of
stock. If this exception applies, the anti-churning amortization for the section 197 intangible on
rules apply only to the amount of your ad- any two or more consecutively filed tax re-
• A grantor and fiduciary, and the fiduciary turns, you have adopted a method of ac-
and beneficiary, of any trust. justed basis in the intangible that is more than
the gain recognized by the seller. counting for that property. You can claim the
• Fiduciaries of two different trusts, and the correct amount of amortization only by
fiduciary and beneficiary of two different Note. The seller reports any additional tax changing your method of accounting for
trusts, if the same person is the grantor under this exception on line 40 of the seller's amortization. You will then be able to take
of both trusts. Form 1040. On the dotted line next to line 40, into account any unclaimed or excess
the seller should also write “197.” amortization from years before the year of
• A tax-exempt educational or charitable change.
organization and a person who, directly
or indirectly, controls the organization, or Anti-abuse rule. You cannot amortize any
section 197 intangible acquired in a trans- Consent required. You must have the con-
a member of that person's family.
action in which either of the following was one sent of the Commissioner of Internal Revenue
• A corporation and a partnership if the of the principal purposes. to change your method of accounting. You
same persons own more than 20% in can get the Commissioner's consent by fol-
value of the outstanding stock of the 1) To avoid the requirement that the intan- lowing the instructions in Revenue Procedure
corporation and more than 20% of the gible be acquired after August 10, 1993. 97–27 which is in Internal Revenue Bulletin
capital or profits interest in the partner- (IRB) 1997–21. Internal Revenue Bulletins
ship. 2) To avoid any of the anti-churning rules. are available at many libraries and IRS of-
Page 50 Chapter 12 Amortization
fices. To get the consent, you must file Form Revenue Procedure 97–37 and section 2.01 Disposition of business. You can deduct
3115 requesting a change to a permissible of the Appendix of Revenue Procedure any remaining deferred start-up costs for the
method of accounting for amortization. You 97–37, Internal Revenue Bulletin 1997–33. business if you completely dispose of your
cannot use Revenue Procedure 97–27 to business before the end of the amortization
correct any mathematical or posting error. period. However, you can only deduct these
See Amended Return, earlier. Recapture of Amortization deferred start-up costs to the extent they
In some instances, you can receive auto- Amortization you claim on section 197 prop- qualify as a loss from a business.
matic consent from the Commissioner to erty is subject to the recapture rules of section
change your method of accounting. See Au- 1245 of the Internal Revenue Code. For more
tomatic consent, next. information on these rules, see chapter 3 in Costs of Organizing a
Publication 544. Corporation
Automatic consent. You may be able to
The costs of organizing a corporation are the
obtain automatic consent from the Commis-
direct costs of creating the corporation.
sioner if you deducted less than the allowable
amount of amortization for the section 197 Going Into Business Qualifying costs. You can amortize an or-
intangible in at least two years immediately
When you go into business, treat all costs you ganizational cost only if it meets all three of
preceding the year of change. Instead of fol-
incur to get your business started as capital the following tests.
lowing the instructions in Revenue Procedure
expenses. Capital expenses are part of your
97–27, you can receive an automatic consent
basis in the business. Generally, you recover • It must be for the creation of the corpo-
by following the instructions in Revenue Pro-
costs for particular assets through depreci- ration.
cedure 97–37 and section 2.01 of the Ap-
ation deductions. However, you generally
pendix of Revenue Procedure 97–37, which • It must be chargeable to a capital ac-
cannot recover other costs until you sell the
are in Internal Revenue Bulletin (IRB) count.
business or otherwise go out of business. See
1997–33. This will enable you to change your
Capital Expenses in chapter 1 for a dis- • You could amortize the cost over the life
accounting method to take into account pre-
cussion of how to treat these costs if you do of the corporation, if the corporation had
viously unclaimed allowable amortization. To
not go into business. a fixed life.
get the consent, you must file Form 3115 re-
You can elect to amortize certain costs for
questing a change to a permissible method You must have incurred the cost before the
setting up your business. To be amortizable,
of accounting for amortization. end of the first tax year in which the corpo-
the cost must qualify as one of the following.
You generally can use this procedure for ration was in business. A corporation using
property that meets all of the following three • A business start-up cost. the cash method of accounting can amortize
conditions. organizational expenses incurred within the
• An organizational cost for a corporation.
first tax year, even if it does not pay them in
• It is property for which you compute • An organizational cost for a partnership. that year.
amortization under section 197 of the Examples of organizational costs are
Internal Revenue Code. listed next.
• It is property for which, under your pres- Business Start-Up Costs
ent accounting method, you claimed less Start-up costs are costs for setting up an ac- • Expenses of temporary directors.
than the amount of amortization allowable tive trade or business or investigating the
possibility of creating or acquiring an active • The cost of organizational meetings.
in at least the two years immediately
preceding the year of change. (The year trade or business. Start-up costs include any • State incorporation fees.
of change is the year you designate on amounts paid or incurred in connection with
any activity engaged in for profit and for the • Accounting services for setting up the
the Form 3115 and for which you have organization.
timely filed the Form 3115.) production of income before the trade or
business begins, in anticipation of the activity • The cost of legal services (such as draft-
• It is property you owned at the beginning becoming an active trade or business. ing the charter, bylaws, terms of the ori-
of the year of change. To be amortizable, your start-up cost must ginal stock certificates, and minutes of
meet both of the following tests. organizational meetings).
Exceptions. You generally cannot use
the automatic consent procedure if any of the 1) It must be a cost you could deduct if you
exceptions listed in section 2.01(2)(b) of the Costs you cannot amortize. You cannot
paid or incurred it to operate an existing
Appendix of Revenue Procedure 97–37 ap- amortize costs for issuing and selling stock
active trade or business.
ply. or securities, such as commissions, profes-
Other restrictions. You generally cannot 2) You must pay or incur the cost before sional fees, and printing costs, because they
use the automatic consent procedure under the day your active trade or business are not organizational costs. Also, you can-
any of the following situations. begins. not amortize cost associated with the transfer
of assets to the corporation. You must capi-
Start-up costs include what you pay for talize these costs.
• You (your federal income tax return) are investigating a prospective business and get-
under examination. ting the business started. They may include
• You are before a federal court or an ap- costs for the following items. Costs of Organizing a
peals office for any income tax issue and
the method of accounting to be changed • A survey of potential markets. Partnership
is an issue under consideration by the • An analysis of available facilities, labor, Partnership organizational costs are the direct
federal court or appeals office. supplies, etc. costs of creating a partnership.
• You changed the same method of ac- • Advertisements for the opening of the Qualifying costs. You can amortize an or-
counting (with or without obtaining the business. ganizational cost only if it meets all three of
consent of the Commissioner) during the
• Salaries and wages for employees who the following tests.
four years before the year of change.
are being trained, and their instructors.
• You filed a Form 3115 to change the • It must be for the creation of the partner-
same method of accounting during the • Travel and other necessary costs for se- ship and not for starting or operating the
four years before the year of change but curing prospective distributors, suppliers, partnership trade or business.
did not make the change because the or customers.
Form 3115 was withdrawn, not perfected,
• It must be chargeable to a capital ac-
• Salaries and fees for executives and count.
denied, or not granted. consultants, or for other professional
services. • You could amortize the cost over the life
More information. For more information of the partnership if the partnership had
on how to get this automatic consent to Start-up costs do not include deductible a fixed life.
change your method of accounting in order interest, taxes, and research and exper-
to claim previously unclaimed allowable imental costs. See Research and Exper- Organizational costs include the following
amortization and when you cannot use it, see imental Costs, later. fees.
Chapter 12 Amortization Page 51
• Legal fees for services incident to the Corporations and partnerships. If your or carry back qualifying expenses over the
organization of the partnership, such as business is organized as a corporation or annual limit. The annual limit applies to ex-
negotiation and preparation of the part- partnership, only your corporation or partner- penses you pay or incur during a tax year on
nership agreement. ship can elect to amortize its start-up or or- all of your qualified timber property.
ganizational costs. A shareholder or partner If you pay or incur more than $10,000 in
• Accounting fees for services incident to cannot make this election. expenses for more than one piece of timber
the organization of the partnership. You, as shareholder or partner, cannot property, you can divide the annual limit
• Filing fees. amortize any costs you incur in setting up among any of the properties in any manner
your corporation or partnership. The corpo- you wish.
Costs you cannot amortize. You cannot ration or partnership can amortize these For example, if you incurred $10,000 of
amortize expenses connected with any of the costs, but only if it reimburses you for them. qualifying expenses on each of four qualified
following activities. These costs then become part of the basis timber properties last year, you can divide
of your interest in the business. You can re- $2,500 to each property, $5,000 to two prop-
• Acquiring assets for the partnership or cover them only when you sell your interest erties, the entire $10,000 to any one property,
transferring assets to the partnership. in the corporation or partnership. or you can divide the $10,000 among some
• Admitting or removing partners, other or all of the properties in any other manner.
You, as an individual, can elect to Partnerships and S corporations. Sim-
than at the time the partnership is first TIP amortize costs you incur to investigate
organized. ilar rules apply to partnerships and S corpo-
an interest in an existing partnership. rations.
• Making a contract concerning the opera- These costs qualify as business start-up costs A partnership or S corporation makes the
tion of the partnership trade or business if you succeed in acquiring an interest in the election to amortize its qualified expenses.
(including a contract between a partner partnership. The annual limit ($10,000) applies to the
and the partnership). partnership or S corporation, as well as to
• Syndication fees. each partner or shareholder. The amortizable
expenses (limited to $10,000) are allocated
Syndication fees are costs for issuing and among the partners or shareholders.
marketing interests in the partnership (such
as commissions, professional fees, and
Reforestation A partner or shareholder is also subject to
the annual limit of $10,000 ($5,000, if married
printing costs). You must capitalize syndi- Expenses and filing a separate return) regardless of the
cation fees. You cannot depreciate or amor- source of the expenses. For example, if a
You can elect to amortize part of your qual-
tize them. married individual is a partner in two or more
ified timber property reforestation expenses.
partnerships that elect to amortize qualified
These are the direct costs of planting or
expenses, the individual's total share of part-
How To Amortize seeding for forestation or reforestation.
nership amortizable basis acquired during the
Qualifying expenses. Qualifying ex-
You deduct start-up and organizational costs year cannot be more than $10,000 on a joint
penses include only those costs you must
in equal amounts over a period of 60 months return or $5,000 on a separate return.
capitalize and include in the adjusted basis
or more. You can elect a period for start-up Amortizable basis is the part of the basis of
of the property. They include costs for the
costs that is different from the period you elect qualified property that is from reforestation
following items.
for organizational costs, as long as both are expenses.
60 months or more. Once you elect an • Site preparation.
Estates. Estates can elect to amortize
amortization period, you cannot change it. up to $10,000 of qualified reforestation ex-
To figure your deduction, divide your total • Seeds or seedlings. penses paid or incurred in each tax year. Any
start-up or organizational costs by the months • Labor. amortizable basis acquired by an estate is
in the amortization period. The result is the divided between the estate and the income
amount you can deduct each month. • Tools. beneficiary based on the income of the estate
• Depreciation on equipment used in allocable to each. The amortizable basis dis-
A partnership using the cash method tributed from an estate to a beneficiary is
planting and seeding.
! of accounting cannot deduct an ex-
CAUTION pense it has not paid by the end of the
taken into account in determining the benefi-
Costs you can deduct currently are not quali- ciary's annual limit.
tax year. However, any expense the partner- Life tenant and remainderman. If one
fying expenses.
ship could have deducted as an organiza- person holds the property for life with the re-
If the government reimburses you for ex-
tional expense in an earlier tax year can be mainder going to another person, the life
penses under a cost-sharing program, you
deducted in the tax year of payment. tenant is entitled to the full amortization (up
can amortize these expenses only if you in-
clude the reimbursement in your income. to the annual limit) for reforestation expenses
When to begin amortization. The amorti- made by the life tenant. Any remainder inter-
zation period starts with the month you begin est in the property is ignored for amortization
business operations. Qualified timber property. Qualified timber
property can be a woodlot or other site that purposes.
you own or lease. To qualify, the property
Making the election. You must complete Amortization period. You can amortize
must meet all of the following requirements.
Part VI of Form 4562 and attach it to your qualified reforestation expenses over a period
income tax return. You must also attach one 1) It must be located in the United States. of 84 months. The 84-month period starts on
or more statements to your return. If you have the first day of the first month of the second
both start-up and organizational costs, attach 2) It must be held for the growing and cut-
half of the tax year you incur the expenses
a separate statement to your return for each ting of timber you will either use in, or
(July 1st for a calendar year taxpayer). You
type of cost. Each statement should have the sell for use in the commercial production
can claim amortization deductions for no
following information. of timber products.
more than 6 months of the first and last
3) It must consist of at least one acre (eighth) tax years of the period.
• The total start-up or organizational costs
you will amortize. planted with tree seedlings in the man-
ner normally used in forestation or Example. Last year (a full 12-month tax
• A description of what each cost is for. reforestation. year), John Jones incurred qualified
reforestation expenses of $8,400. His monthly
• The date each cost was incurred. deduction ($100) is figured by dividing $8,400
Qualified timber property does not include
• The month your active business began property on which you have planted shelter by 84 months. Since it was the first year of
(or the month you acquired the business). belts or ornamental trees, such as Christmas the 84-month period, he can deduct only $600
• The number of months in your amorti- trees. ($100 × 6 months).
zation period (not less than 60).
Annual limit. Each year, you can elect to Maximum annual amortization. The maxi-
Attach Form 4562 and the accompanying amortize up to $10,000 of qualified expenses mum annual amortization deduction for ex-
statements to your return for the first tax year you pay or incur during the tax year. If you penses incurred in any taxable year is
you are in business. You must file the return are married and file a separate return, the $1,428.57 ($10,000 ÷ 7). The maximum de-
by the due date (including any extensions). annual limit is $5,000. You cannot carry over duction in the first and last tax year of the
Page 52 Chapter 12 Amortization
84-month amortization period is one half of or reduce the total operating costs of the plant
$1,428.57 or $714.29. or other property. It also must not significantly
change the nature of the manufacturing or Bond Premium
Recapture. If you dispose of qualified timber production process or facility. Bond premium is the amount by which your
property within 10 years after the tax year you The federal certifying authority will not basis in a bond right after you get it is more
create an amortizable basis in the property, certify your property to the extent it appears than the total of all amounts payable on the
report any gain as ordinary income up to the you will recover (over the property's useful bond after you get it (other than payments of
amount of the amortization you took. life) all or part of its cost of a facility from the qualified stated interest).
profit based on its operation (such as through The term “bond,” as used in this dis-
sales of recovered wastes). The federal cer- cussion, means any interest-bearing bond,
Investment credit. Reforestation expenses
tifying authority will describe the nature of the debenture, note, or certificate or other evi-
eligible to be amortized qualify for the invest-
potential cost recovery. You must then reduce dence of debt issued by a corporation or a
ment credit, whether or not they are amor-
the amortizable basis of the facility. government or political subdivision of a gov-
tized. See the instructions for Form 3468 for
New identifiable treatment facility. A ernment. The term does not include any ob-
information on the investment credit.
new identifiable treatment facility is tangible ligation listed below.
depreciable property which is identifiable as
How to elect amortization. To make this a treatment facility. This does not include a
election, attach Form 4562 to your income tax • Your stock in trade.
building and its structural components unless
return and enter the deduction in Part VI. the exclusively building is a treatment facility. • Properly that would properly be included
Also, attach a statement to Form 4562 that For more information, see section 169 of in your inventory if on hand at the close
describes the expenses and provides the the Internal Revenue Code and the appropri- of the taxable year.
dates you incurred them. Show the type of ate Income Tax Regulations.
timber being grown and the purpose for which • Property held by you primarily for sale to
it is grown. Attach a separate statement for Alternative minimum tax. Individ- customers in the ordinary course of your
trade or business.
each property for which you amortize
reforestation expenses. You can make the
! uals, estates, and trusts who elect
CAUTION amortization may be liable for alter-

election only on a timely filed return (including native minimum tax. Individuals should see Tax-exempt bonds. You must amortize the
extensions) for the tax year in which you in- Form 6251 and its instructions. Estates and premium on tax-exempt bonds. You cannot
curred the expenses. trusts should see Form 1041. deduct the amortizable premium in figuring
your taxable income. You must reduce your
Where to report. If you do not have to file basis in the bond each year by the premium
Schedule C, C-EZ, or F for the activity in amortized for the year.
which you incurred reforestation expenses,
include your amortization deduction in the Taxable bonds. You can elect to amortize
total on line 32 of Form 1040. Enter the the premium on taxable bonds. This gener-
amount and “RFST” (for reforestation) on the ally means that each year, over the life of the
dotted line next to line 32. bond, you use part of the premium to reduce
Research and the amount of interest includible in your in-
Revocation. You must get IRS ap- come. If you make this choice, you must re-
proval to revoke an election to amor- Experimental Costs duce your basis in the bond by the amorti-
tize reforestation expenses. Your ap- zation for the year. The premium on the bond
You can either amortize your research and
plication to revoke the election must include is part of your basis in the bond.
experimental costs, deduct them as current
your name, address, the years for which your Inflation-indexed instruments. An
business expenses, or write them off over a
election was in effect, and your reason for inflation-indexed debt instrument is generally
10-year period. If you choose to amortize
revoking it. You, or your duly authorized rep- a debt instrument on which the payments are
these costs, deduct them in equal amounts
resentative, must sign the application and file adjusted for inflation and deflation (such as
over 60 months or more. The amortization
it at least 90 days before the due date (with- Treasury Inflation-Indexed Securities). De-
period begins the month you first receive an
out extensions) for filing your income tax re- termine the premium on an inflation-indexed
economic benefit from the research. For a
turn for the first tax year for which your debt instrument, as of the date you acquire
definition of “research and experimental
election is to end. the instrument, by assuming that there will be
costs” and information on deducting them as
current business expenses, see chapter 11. no inflation or deflation over the remaining
term of the instrument. Allocate the premium
over the remaining term of the instrument by
Optional write-off method. Rather than making the same assumption. Reduce the
Send the application to: amortize these costs or deduct them as a instrument's interest income for the tax year
current expense, you have the option of de- by the premium allocable to the tax year. Use
Commissioner of Internal Revenue ducting (writing off) research and exper-
Washington, DC 20224 any excess premium allocable to the tax year
imental costs ratably over a 10-year period to offset the original issue discount on the in-
beginning with the tax year in which you in- strument for the year.
curred the costs.
For more information on the optional
write-off method, see Internal Revenue Code Basis adjustment. If you are required to
amortize bond premium, or elect to do so, you
Pollution Control section 59(e).
must decrease the basis of the bond by the
Facilities Costs you can amortize. You can amortize
amortizable bond premium. The result is the
adjusted basis you use to figure gain or loss
You can elect to amortize over 60 months the costs chargeable to a capital account if both on the sale or redemption of the bond.
cost of a certified pollution control facility. of the following apply.
More information. For more information and
Certified pollution control facility. A certi- • You paid or incurred the costs in your a discussion of how to report bond premium,
fied pollution control facility is a new identifi- trade or business. see Publication 550.
able treatment facility used, in connection with • You are not deducting the costs currently.
a plant or other property in operation before
1976, to reduce or control water or atmo-
spheric pollution or contamination. The facility
must do so by removing, changing, disposing, For more information, see sections 174 Cost of Getting
storing, or preventing the creation or emission and 59(e) of the Internal Revenue Code and
of pollutants, contaminants, wastes, or heat. the Income Tax Regulations. a Lease
The facility must be certified by state and If you get a lease for business property, you
federal certifying authorities. Election to amortize. To make this election, recover the cost by amortizing it over the term
The facility must not significantly increase attach Form 4562 to your income tax return of the lease. The term of the lease for
the output or capacity, extend the useful life, and enter the deduction in Part VI. amortization includes all renewal options (and
Chapter 12 Amortization Page 53
any other period for which the lessee and timber, to which you must look for a re- percentage depletion for oil and gas wells.
lessor reasonably expect the lease to be re- turn of your capital investment. See Oil and Gas Wells, later.
newed) if less than 75% of the cost of getting
the lease is attributable to the term of the A contractual relationship you have that al- Cost depletion. Figure cost depletion by di-
lease remaining on the acquisition date. The lows you an economic or monetary advantage viding the property's basis for depletion (ex-
term of the lease remaining on the acquisition from products of the mineral deposit or plained later) by the total recoverable units
date does not include any period for which the standing timber is not, in itself, an economic (explained later) in the property's natural de-
lease may later be renewed, extended, or interest. A production payment carved out of, posit. The result is the rate per unit. Multiply
continued under an option exercisable by the or retained on the sale of, mineral property is the rate per unit by the number of units sold
lessee. not an economic interest. during the tax year, which is one of the fol-
Enter your deduction in Part VI of Form The term “mineral property” means each lowing.
4562, if you must file that form, or on the ap- separate interest you own in each mineral
propriate line of your tax return. Enter “178” deposit in each separate tract or parcel of 1) The units sold for which you receive
as the code section under which you are land. You can treat mineral properties sepa- payment during your tax year (regard-
amortizing these costs. rately or as a group. See section 614 of the less of the year of sale), if you use the
Internal Revenue Code for rules on how to cash method of accounting.
treat separate properties.
The term “timber property” means your 2) The units sold based on your invento-
economic interest in standing timber in each ries, if you use the accrual method of
tract or block representing a separate timber accounting.
account.
13. Alternative minimum tax. Individ-
The number of units sold during the tax
year does not include any on which depletion
! uals, corporations, estates, and trusts deductions were allowed or allowable in ear-
Depletion CAUTION who claim depletion deductions may

be liable for alternative minimum tax.


lier years.
Basis for depletion. To figure the prop-
erty's basis for depletion, subtract all of the
following from the property's adjusted basis.

1) The amounts recoverable through:


Important Changes For more information on individual alter-
native minimum tax, see the instructions for a) Depreciation deductions,
for 1998 Form 6251. For more information on corpo-
rate alternative minimum tax, see Publication b) Deferred expenses (including de-
542. For more information on estate and trust ferred exploration and development
Certain partnerships must figure depletion costs), and
alternative minimum tax, see Form 1041 and
allowance. For partnership tax years begin-
its instructions. c) Deductions other than depletion.
ning after 1997, an electing large partnership,
rather than each partner, generally must fig- 2) The residual value of land and improve-
ure the depletion allowance for the partner- Topics ments at the end of operations.
ship's oil and gas property. For more infor- This chapter discusses:
mation, see Certain partnerships must figure 3) The cost or value of land acquired for
depletion allowance, later. • Mineral property purposes other than mineral production.
• Timber Adjusted basis. The adjusted basis of
Temporary suspension of taxable income
your property is your original cost or other
limit for certain percentage depletion. For
basis, plus certain additions and improve-
tax years beginning after 1997 and before Useful Items ments, and minus certain deductions such as
2000, percentage depletion on the marginal You may want to see: depletion allowed or allowable and casualty
production of oil or natural gas is not limited
losses. Your adjusted basis can never be less
to taxable income from the property figured
Publication than zero. See Publication 551 for more in-
without the depletion deduction. For more in-
formation on adjusted basis.
formation, see Temporary suspension of tax- m 544 Sales and Other Dispositions of Total recoverable units. The total re-
able income limit for marginal production,
Assets coverable units is the sum of the following two
later.
items.
Form (and Instructions)
1) The number of units of mineral remaining
m T at the end of the year (including units
Introduction Forest Activities Schedules
recovered but not sold).
m Sch E (Form 1040) Supplemental In-
Depletion is the using up of natural resources 2) The number of units sold during the tax
by mining, quarrying, drilling, or felling. The come and Loss
year (determined under your method of
depletion deduction allows an owner or oper- m 6198 At-Risk Limitations accounting, as explained earlier).
ator to account for the reduction of a product's
reserves. m 6251 Alternative Minimum
Tax—Individuals You can estimate or determine recovera-
There are two ways of figuring depletion: ble units (tons, pounds, ounces, barrels,
cost depletion and percentage depletion. For m 8582 Passive Activity Loss Limitations thousands of cubic feet, or other measure)
mineral property, you generally must use the of mineral products using the method current
method that gives you the larger deduction; See chapter 17 for information about get-
ting publications and forms. in the industry and using the most accurate
for standing timber, you must use cost de- and reliable information you can obtain.
pletion.
If you have an economic interest in min- Percentage depletion. Figure percentage
eral property or standing timber, you can take depletion by multiplying a certain percentage,
a deduction for depletion. More than one Mineral Property specified for each mineral, by your gross in-
person can have an economic interest in the Mineral property includes oil and gas wells, come from the property during the tax year.
same mineral deposit or timber. mines, and other natural deposits (including Taxable income. The depletion de-
You have an economic interest if both geothermal deposits). duction under this method cannot be more
of the following apply. There are two ways of figuring depletion than 50% (100% for oil and gas property) of
1) You have acquired by investment a legal on mineral property: cost depletion and per- your taxable income from the property figured
interest in mineral deposits or standing centage depletion. You generally must use without the depletion deduction. See Taxable
timber. the method that gives you the larger de- income, later for more information about fig-
duction. uring your taxable income from the property.
2) You have the right to income from the However, unless you are a small producer See Mines and other natural deposits, later
extraction of the mineral or cutting of the or royalty owner, you generally cannot use for the percentages for each mineral.
Page 54 Chapter 13 Depletion
For tax years beginning after 1997 crude oil and the refinery runs of you and that benefit because of your direct or indirect
! and before 2000, percentage de-
CAUTION pletion on the marginal production of
related person are more than 50,000 barrels
on any day during the tax year.
ownership interest in the person.
You are not considered to be selling
oil or natural gas is not limited to taxable in- Related person. You and another person through a related person who is a retailer if
come from the property figured without the are related persons if either of you hold a all of the following apply.
depletion deduction. For more information, significant ownership interest in the other
see Temporary suspension of taxable income person or if a third person holds a significant • You do not have a significant ownership
limit for marginal production, later. ownership interest in both of you. interest in the retailer.
For example, a corporation, partnership,
• You sell your production to persons who
Gross income. When figuring your per- estate, or trust and anyone who holds a sig-
are not related to either you or the
centage depletion, exclude from your gross nificant ownership interest in it are related
retailer.
income from the property an amount equal to persons. A partnership and a trust are related
any rents and royalties you pay or incur for persons if one person holds a significant • The retailer does not buy oil or natural
the property. ownership interest in each of them. gas from your customers or persons re-
Also, exclude from your gross income For purposes of the related person rules, lated to your customers.
from the property an amount equal to the part significant ownership interest means direct • There are no arrangements for the
of any bonus you paid for a lease on the or indirect ownership of 5% or more of any retailer to acquire oil or natural gas you
property that is allocable to the product sold one of the following interests. produced for resale or made available for
(or that otherwise gives rise to gross income) purchase by the retailer.
for the tax year. This includes a bonus for • The value of the outstanding stock of a
either a mineral lease or an oil and gas lease. corporation. • Neither you nor the retailer knows of or
controls the final disposition of the oil or
Figure the part of the bonus to exclude by • The interest in the profits or capital of a natural gas you sold or the original source
multiplying the total bonus you paid by a partnership. of the petroleum products the retailer ac-
fraction. The numerator of the fraction is the
• The beneficial interests in an estate or quired for resale.
number of units you sold in that tax year and
the denominator is the total estimated recov- trust.
erable units from the property. Transferees who cannot claim percentage
Taxable income. When figuring your tax- Any interest owned by or for a corporation, depletion. You cannot claim percentage
able income from the property for purposes partnership, trust, or estate is considered to depletion if you received your interest in a
of the taxable income limit, follow the three be owned directly both by itself and propor- proven oil or gas property by transfer after
rules listed here. tionately by its shareholders, partners, or 1974 and before October 12, 1990. For this
beneficiaries. rule the term “transfer” usually does not in-
1) Do not deduct any net operating loss clude any of the following.
deduction from the gross income from Retailers who cannot claim percentage
the property. depletion. You cannot claim percentage • Transfers at death.
2) Corporations do not deduct charitable
depletion if both of the following apply. • Certain transfers to controlled corpo-
rations.
contributions from the gross income from
1) You sell oil or natural gas or their by-
the property.
products directly or through a related
• Certain changes of beneficiaries of a
trust.
3) If during the year, you dispose of an item person in any of the following situations.
of section 1245 property which had been • Transfers between businesses under
a) Through a retail outlet operated by common control.
used in connection with the property,
you or a related person.
reduce any allowable deduction for min- • Transfers between members of the same
ing expenses by the part of any gain you b) To any person who is required un- family.
must report as ordinary income that is der an agreement with you or a re-
allocable to the property. See Regu- lated person to use a trademark, • Transfers between a trust and related
lations section 1.613–5(b)(1) for infor- trade name, or service mark or persons in the same family.
mation on how to determine the amount name owned by you or a related • Certain transfers by individuals to corpo-
of ordinary gain allocable to the property. person in marketing or distributing rations solely in exchange for stock.
oil, natural gas, or their by-products.
• Reversions of all or part of an interest that
Oil and Gas Wells c) To any person given authority under make a small producer eligible for de-
an agreement with you or a related pletion.
Generally, only small producers and royalty
person to occupy any retail outlet • Conversions of a retained interest, that is
owners can claim percentage depletion for
owned, leased, or controlled by you eligible for such depletion, into an interest
any oil or gas well. However, if you are not a
or a related person. which was all or part of an interest previ-
small producer or royalty owner, you may be
able to claim percentage depletion for the 2) The combined gross receipts from sales ously owned that is also eligible for de-
following items. (not counting resales) of oil, natural gas, pletion.
or their by-products of all retail outlets
• Natural gas sold under a fixed contract taken into account in 1) are more than An election by a corporation to become
(see Natural Gas Wells, later). $5 million for the tax year. an S corporation is treated as a transfer of
all its properties on the day on which the
• Natural gas from geopressured brine (see election first takes effect. If an S corporation
Natural Gas Wells, later). For this purpose, do not count any of the
following. ceases to be an S corporation and becomes
• Domestic gas and oil production — if you a C corporation, each shareholder is treated
are a small producer (explained next). as transferring to the corporation the share-
• Bulk sales of oil or natural gas to com- holder's pro rata share of all the S corpo-
mercial or industrial users. ration's assets.
Small Producers • Bulk sales of aviation fuels to the De-
You figure percentage depletion using a rate partment of Defense. Figuring percentage depletion. If your av-
of 15% of the gross income from the property • Sales of oil or natural gas or their by- erage daily production (explained later) for the
on your average daily production of domestic products outside the United States if year is more than your depletable oil or na-
crude oil or domestic natural gas up to your none of your domestic production or that tural gas quantity (explained later), figure your
depletable oil or natural gas quantity. Average of a related person is exported during the allowance for depletion for each domestic oil
daily production and depletable oil or natural tax year or the prior tax year. or natural gas property as follows.
gas quantity are explained later.
1) Figure your average daily production of
Sales through a related person. You oil or natural gas for the year.
Refiners who cannot claim percentage are considered to be selling through a related
depletion. You cannot claim percentage person if any sale by the related person 2) Figure your depletable oil or natural gas
depletion if you or a related person refine produces gross income from which you may quantity for the year.
Chapter 13 Depletion Page 55
3) Figure depletion for all oil or natural gas in chapter 15 except that the term “family” is Partnerships
produced from the property using a per- limited to a spouse and minor children.
Generally, each partner, and not the partner-
centage depletion rate of 15%. Limit. If you are an independent producer
ship, figures the depletion allowance sepa-
or royalty owner of oil and gas, your deduction
rately. (However, see Certain partnerships
4) Multiply the result figured in 3) by a for percentage depletion is limited to the
must figure depletion allowance, later.) Each
fraction, the numerator of which is the smaller of the following two amounts.
partner must decide whether to use cost or
result figured in 2) and the denominator
percentage depletion. If a partner uses per-
of which is the result figured in 1). This • Your taxable income from the property centage depletion, the partner must apply the
is your depletion allowance for that figured without the deduction for de- 65% of taxable income limit to the partner's
property for the year. pletion. taxable income from all sources.

Average daily production. Figure your • 65% of your taxable income from all
sources, figured without the depletion al- Partner's adjusted basis. The partnership
average daily production by dividing your total must allocate to each partner that partner's
production for the tax year by the number of lowance, any net operating loss
carryback, and any capital loss proportionate share of the adjusted basis of
days in your tax year. each partnership domestic oil or gas property.
Part interest. If you have a part interest carryback.
The partnership makes the allocation as of
in the production from a property, figure your the date it acquires the oil or gas property.
share of the production by multiplying total You can carry over to the following year any The partner's share of the adjusted basis of
production from the property by your per- amount you cannot deduct because of the the oil or gas property generally is figured
centage of interest in the revenues from the 65% (of taxable income) limit. Add it to your according to that partner's interest in part-
property. depletion allowance (before applying any nership capital. However, in some cases, it is
You have a part interest in property, for limits) for the following year. figured according to the partner's interest in
example, if you have a net profits interest. To partnership income.
figure the share of production for your net The partnership adjusts the partner's
profits interest, you must determine your per- Temporary suspension of taxable income
limit for marginal production. For tax years share of the adjusted basis of the oil and gas
centage participation (as measured by the net property for any capital expenditures made for
profits) in the gross revenue from the prop- beginning after 1997 and before 2000, per-
centage depletion on the marginal production the property and for any change in partner-
erty. To figure this percentage, you divide the ship interests.
income you receive for your net profits inter- of oil or natural gas is not limited to taxable
est by the gross revenue from the property. income from the property figured without the Recordkeeping. Each partner, after
depletion deduction. receiving the information from the
Marginal production. This is domestic RECORDS partnership, must separately keep
Example. John Oak owns oil property in crude oil or domestic natural gas produced
which Paul Elm owns a 20% net profits inter- records of the partner's share of the adjusted
during any tax year from a property that is basis in each oil and gas property of the
est. During the year, the property produced either of the following.
10,000 barrels of oil, which John sold for partnership. Later, in those separate records,
$200,000. John had expenses of $90,000 at- the partner must reduce the share of the ad-
tributable to the property. The property gen- • A stripper well property for the calendar justed basis of each property by the depletion
erated a net profit of $110,000. Paul received year in which the tax year begins. taken on the property each year by that part-
income of $22,000 ($110,000 × .2) for his net ner. The partner must use that reduced ad-
• A property from which substantially all of justed basis to figure any cost depletion or the
profits interest. the production during the calendar year
Paul determined his percentage partic- partner's gain or loss if the partnership dis-
is heavy oil. poses of the property.
ipation to be 11% by dividing $22,000 (the
income he received) by $200,000 (the gross
revenue from the property). Paul determined Stripper well property. For any calendar
his share of the oil production to be 1,100 year, stripper well property is any property for
barrels (10,000 barrels × 11%). which the average daily production per well
Reporting the deduction. Deduct oil and
is 15 barrel equivalents or less. Determine the
gas depletion for a partnership interest on
average daily production per week by dividing
Depletable oil or natural gas quantity. Schedule E (Form 1040). If you have a loss,
the average daily production of domestic
Generally, your depletable oil quantity is see the Schedule E (Form 1040) instructions
crude oil and domestic natural gas from
1,000 barrels and your depletable natural gas for Parts II and III to determine whether you
producing wells on the property for the cal-
quantity is 6,000 cubic feet multiplied by the first need to use Form 6198 to figure the
endar year by the number of producing wells
number of barrels of your depletable oil deductible loss. Further, if the loss is from a
on the property.
quantity that you choose to apply. If you claim passive activity, you generally need to com-
Heavy oil. This means, as used here,
depletion on both oil and natural gas, you plete Form 8582 to figure the allowable loss
domestic crude oil produced from any prop-
must reduce your depletable oil quantity by to enter in Part II, column (g) of Schedule E,
erty if the crude oil had a weighted average
the number of barrels you use to figure your for that activity.
gravity of 20 degrees API or less (corrected
depletable natural gas quantity. If you are in- Enter your net income or loss from the
to 60 degrees Fahrenheit).
volved in marginal production, see section partnership, before depletion, in either the
613A(c) of the Internal Revenue Code and passive or nonpassive section of Part II. Use
the related regulations to figure your Gross income from oil and gas property. the same lettered line for which you enter the
depletable oil or natural gas quantity. For purposes of percentage depletion, gross name of the partnership, the employer iden-
You must allocate the depletable oil or income from oil and gas property is the tification number and other partnership infor-
natural gas quantity among corporations that amount you receive from the sale of the oil mation. On the next lettered line of that
are members of the same controlled group. or gas in the immediate vicinity of the well. If section's loss column, enter the depletion
The common control test is more than 50%. you do not sell the oil or gas on the property, deduction. If you are entitled to a depletion
You must allocate the depletable oil but manufacture or convert it into a refined deduction from more than one oil and gas
among the following. product before sale or transport it before sale, partnership, show this information for each
the gross income from the property is the partnership.
representative market or field price (RMFP)
• Corporations, trusts, and estates if 50% of the oil or gas, before conversion or trans- Certain partnerships must figure depletion
or more of the beneficial interest is owned portation. allowance. For partnership tax years begin-
by the same or related persons (consid- If you sold gas after you removed it from ning after 1997, an electing large partnership,
ering only persons that own at least 5% the premises, for a price that is lower than the rather than each partner, generally must fig-
of the beneficial interest). RMFP, determine gross income from the ure the depletion allowance. The partnership
• You and your spouse and minor children. property for percentage depletion purposes figures the depletion allowance without taking
without regard to the RMFP. into account the limits on the amount of pro-
Gross income from the property does not duction and taxable income. Also, the ad-
For purposes of this allocation, a related per- include lease bonuses, advance royalties, or justed basis of a partner's interest in the
son is anyone mentioned in Related person other amounts payable without regard to partnership is not affected by the depletion
production from the property. allowance.
Page 56 Chapter 13 Depletion
An electing large partnership is one under a contract provided that the price can- • Extracting ores or minerals from the
which had 100 or more partners in the pre- not be adjusted to reflect any increase in the ground.
ceding year and elects to be an electing large seller's tax liability because of the repeal of
partnership. The election applies to the year percentage depletion for gas. The contract • Applying certain treatment processes.
made and all subsequent years unless re- must have been in effect from February 1, • Transporting ores or minerals (generally,
voked with the consent of the IRS. 1975, until the date of sale of the gas. Price not more than 50 miles) from the point
Treatment of disqualified partners. A increases after February 1, 1975, are pre- of extraction to the plants or mills in which
disqualified partner's distributive share of any sumed to take the increase in tax liability into the treatment processes are applied.
income, deduction, gain, loss, or credit attrib- account unless demonstrated otherwise by
utable to any partnership oil or gas property clear and convincing evidence. Excise tax. Gross income from mining
is treated the same way as discussed in includes the separately stated excise tax re-
Partnerships, earlier. ceived by a mine operator from the sale of
Natural gas from geopressured brine. coal to compensate the operator for excise
Disqualified partners. All of the following Qualified natural gas from geopressured brine
are disqualified partners. tax the mine operator must pay to finance
is eligible for a percentage depletion rate of black lung benefits.
10%. Qualified natural gas from geopres- Extraction. Extracting ores or minerals
• Refiners who cannot claim percentage sured brine is natural gas produced from a
depletion (discussed under Small Pro- from the ground includes extraction by mine
well you began to drill after September 1978 owners or operators of ores or minerals from
ducers, earlier).
and before 1984 determined in accordance the waste or residue of prior mining. This
• Retailers who cannot claim percentage with section 503 of the Natural Gas Policy Act does not apply to extraction from waste or
depletion (discussed under Small Pro- of 1978 to be produced from geopressured residue of prior mining by the purchaser of the
ducers, earlier). brine. waste or residue or the purchaser of the rights
• Any partner whose average daily pro- to extract ores or minerals from the waste or
duction of domestic crude oil and natural residue.
gas is more than 500 barrels during the Mines and Treatment processes. The processes
tax year in which the partnership tax year Geothermal Deposits that are included as mining depend on the ore
ends. or mineral mined. To qualify as mining, the
Certain mines, wells, and other natural de-
treatment processes must be applied by the
Average daily production is discussed posits, including geothermal deposits, qualify
mine owner or operator. For a listing of
earlier. for percentage depletion.
treatment processes considered as mining,
see section 613(c)(4) of the Internal Revenue
S Corporation Mines and other natural deposits. The Code and the related regulations.
Each shareholder, and not the S corporation, percentage of your gross income from a na- Transportation of more than 50 miles.
figures the depletion allowance separately in tural deposit that you can deduct as depletion If the Internal Revenue Service finds that the
the same way as a partner in a partnership. is based on the type of deposit. ore or mineral must be transported more than
The S corporation must allocate to each Some of the depletion percentages for the 50 miles to plants or mills to be treated be-
shareholder that shareholder's adjusted basis more common minerals follow. cause of physical and other requirements, the
of each oil or gas property held by the S cor- additional transportation that is authorized is
DEPOSITS PERCENT included in the computation of gross income
poration. The corporation makes the allo-
cation as of the date it acquires the property. Sulphur, uranium, and, if from deposits from mining.
The S corporation adjusts the shareholder's in the United States, asbestos, lead ore, If you wish to include transportation
share of the adjusted basis of the oil and gas zinc ore, nickel ore, and mica ............... 22
of more than 50 miles in the compu-
property for any capital expenditures made for Gold, silver, copper, iron ore, and certain tation of gross income from mining,
the property and for any change in the oil shale, if from deposits in the United file an application in duplicate. Include on the
shareholder's interest. States ..................................................... 15
application the facts concerning the physical
Coal, lignite, and sodium chloride ......... 10 and other requirements which prevented the
Recordkeeping. Each shareholder
must separately keep records of the Clay and shale used or sold for use in construction and operation of the plant within
RECORDS shareholder's pro rata share of the making sewer pipe or bricks or used or 50 miles of the point of extraction. Send this
sold for use as sintered or burned light- application to:
adjusted basis in each oil and gas property
weight aggregates ................................. 71/2
of the S corporation. The shareholder must
Clay used or sold for use in making Internal Revenue Service
reduce the share of the adjusted basis by the
drainage and roofing tile, flower pots, Washington, DC 20224
depletion taken on the property by the
and kindred products, and gravel, sand, Attention: Assistant Chief Counsel,
shareholder. The shareholder must use that and stone (other than stone used or sold Passthroughs and Special Industries
reduced adjusted basis to figure cost de- for use by a mine owner or operator as
pletion or the shareholder's gain or loss on dimension or ornamental stone) ............ 5
the disposition of the property by the S cor- Borax, granite, limestone, marble, Disposal of coal or iron ore. You cannot
poration. mollusk shells, potash, slate, soapstone, take a depletion deduction on coal (including
and carbon dioxide produced from a well 14 lignite) or iron ore mined in the United States
You can find a complete list of deposits that you disposed of after holding it for more
and the percentage depletion rates that apply than 1 year if you retained an economic in-
For any distribution of the oil or gas prop- terest in it. Treat any gain on the disposition
to them in section 613(b) of the Internal Rev-
erty to its shareholders by the S corporation, as a capital gain.
enue Code.
the corporation's adjusted basis in the prop- Disposal to related person. This rule
Corporate deduction for iron ore and
erty is the total of all the shareholders' ad- does not apply if you dispose of the coal or
coal. The percentage depletion deduction of
justed bases in the property. iron ore to one of the following persons.
a corporation for iron ore and coal (including
See Reporting the deduction earlier under
lignite) is reduced by 20% of:
Partnerships, for information on how S cor- • A related person (as listed in chapter 15).
poration shareholders should report their de-
duction. • The percentage depletion deduction for • A person owned or controlled by the
the tax year (figured without regard to this same interests that own or control you.
reduction), minus
Natural Gas Wells Geothermal deposits. Geothermal deposits
You are allowed percentage depletion for • The adjusted basis of the property at the located in the United States or its pos-
natural gas sold under a fixed contract or close of the tax year (figured without the sessions qualify for a percentage depletion
produced from geopressured brine. depletion deduction for the tax year). rate of 15%. A geothermal deposit is a
geothermal reservoir of natural heat stored in
Fixed contract. Natural gas sold under a Gross income from mining. In the case of rocks or in a watery liquid or vapor. For per-
fixed contract qualifies for a percentage de- property other than a geothermal deposit or centage depletion purposes, a geothermal
pletion rate of 22%. an oil or gas well, gross income from the deposit is not considered a gas well.
Natural gas sold under a fixed contract property means the gross income from min- Figure gross income from a geothermal
is domestic natural gas sold by the producer ing. Mining includes all of the following. steam well in the same way as for oil and gas
Chapter 13 Depletion Page 57
wells. See Gross income from oil and gas Figure your depletion allowance by
property, earlier, under Oil and Gas Wells. multiplying the number of timber units cut by
your depletion unit.
Figure your depletion unit by doing the 14.
following.
Lessor's Gross Income
A lessor's gross income from the lease of gas, 1) Determine your cost or adjusted basis
Business Bad
oil, or mineral property for percentage de-
pletion purposes usually is the total of the
of the timber on hand at the beginning
of the year.
Debts
royalties received from the lease, excluding
rentals that are not payment for units of min- 2) Add to the amount determined in 1) the
eral produced or to be produced. cost of any units acquired during the
year and any additions to capital.
Introduction
Bonuses and advanced royalties. Bonuses 3) Figure the number of units to take into If someone owes you money you cannot col-
received upon the grant of rights and ad- account by adding the number of units lect, you have a bad debt. You may be able
vanced royalties are payments a lessee acquired during the year to the number to deduct the uncollectible amount when you
makes to a lessor for the lease or for min- of units on hand in the account at the figure your tax.
erals, gas, or oil to be extracted from leased beginning of the year and then adding There are two kinds of bad debts — busi-
property. Both types of payments are made (or subtracting) any correction to the es- ness bad debts and nonbusiness bad debts.
before production. If you are the lessor, your timate of the number of units remaining A business bad debt is generally one that
income from bonuses and advanced royalties in the account. comes from operating your trade or business.
is subject to an allowance for depletion. You can deduct business bad debts as an
Figuring cost depletion on bonuses 4) Divide the result of 2) by the result of 3). expense on your business tax return to figure
and advanced royalties. To figure cost de- This is your depletion unit. your business income or loss.
pletion on a bonus, multiply your adjusted All other bad debts are nonbusiness bad
basis in the property by a fraction, the nu- debts and deductible as short-term capital
merator of which is the bonus and the de- Example. You bought a timber tract for losses on Schedule D (Form 1040). For more
nominator of which is the total bonus and $160,000 and the land was worth as much information on nonbusiness bad debts, see
royalties expected to be received. To figure as the timber. Your basis for the timber is Publication 550.
cost depletion on advanced royalties, use the $80,000. Based on an estimated one million
computation explained earlier under Cost de- board feet (1,000 MBF) of standing timber,
pletion, treating the units for which the ad- you figure your depletion unit to be $80 per Topics
vanced royalty is received as the units sold. MBF ($80,000 divided by 1,000). If you cut This chapter discusses:
When you figure percentage depletion 500 MBF of timber, your depletion allowance
would be $40,000 (500 MBF multiplied by • Definition of business bad debts
(for other than gas, oil, or geothermal prop-
erty), the bonus or advanced royalty pay- $80). • How to treat business bad debts
ments are part of your gross income from the • Where to deduct business bad debts
property.
Terminating the lease. For a bonus on When to claim depletion. Claim your de-
a lease that has expired, been terminated, or pletion allowance as a deduction in the year
of sale or other disposition of the products cut Useful Items
abandoned before you derived any income You may want to see:
from the extraction of mineral or cutting of from the timber, unless you elect to treat the
timber, include in income the depletion de- cutting of timber as a sale or exchange. In-
duction you took. Also increase your adjusted clude allowable depletion for timber products Publication
basis in the property to restore the depletion not sold during the tax year the timber is cut
m 525 Taxable and Nontaxable Income
deduction you previously subtracted. as a cost item in the closing inventory of tim-
For advanced royalties, include in income ber products for the year. The inventory is m 536 Net Operating Losses
the depletion claimed on minerals for which your basis for determining gain or loss in the
m 544 Sales and Other Dispositions of
the advanced royalties were paid if the min- tax year that you sell the timber products.
Assets
erals were not produced before lease termi-
nation. Increase your adjusted basis in the Example. In the previous example if you m 550 Investment Income and Expenses
property by the amount you include in in- sold half of the timber products in the cutting m 556 Examination of Returns, Appeal
come. year, you would deduct $20,000 of the Rights, and Claims for Refund
$40,000 depletion that year. You would add
the remaining $20,000 depletion to your See chapter 17 for information about get-
Delay rentals. These are payments for de- closing inventory of timber products. ting publications and forms.
ferring development of the property. Since
delay rentals are ordinary rent, they are ordi-
nary income that is not subject to depletion. Electing to treat the cutting of timber as a
These rentals can be avoided by either sale or exchange. You can elect, under Defined
abandoning the lease, beginning develop- certain circumstances, to treat the cutting of A business bad debt is a loss from the
ment operations, or obtaining production. timber as a sale or exchange. You must make worthlessness of a debt that was either:
the election in your income tax return for the
taxable year it applies. If you make this 1) Created or acquired in your trade or
election, subtract the adjusted basis for de- business, or
pletion from the fair market value of the timber 2) Closely related to your trade or business
Timber at the beginning of the tax year in which you
cut it to figure the gain or loss to report on the
when it became partly or totally
worthless.
You can figure timber depletion only by the cutting. You generally report the gain as
cost method. Percentage depletion does not long-term capital gain. The fair market value The bad debts of a corporation are always
apply to timber. Base your depletion on your then becomes your basis for figuring your or- business bad debts.
cost or other basis in the timber. Your cost dinary gain or loss on the sale or other dis- A debt is closely related to your trade or
does not include the cost of land. position of the products cut from the timber. business if your primary motive for incurring
See Publication 544. the debt is a business reason.
Figuring the deduction. Depletion takes Example. John Smith, an advertising
place when you cut standing timber. You can Form T. Attach Form T to your income tax agent, made loans to certain clients to keep
figure your depletion deduction when the return if you are claiming a deduction for tim- their business. His main reason for making
quantity of cut timber is first accurately ber depletion. these loans was to help his business. One of
measured in the process of exploitation. these clients later went bankrupt and could
Page 58 Chapter 14 Business Bad Debts
not repay him. Since John's business was the Debt acquired from a decedent. The outlet. Elegant Fashions is one of Zayne's
main reason for making the loan, the debt character of a loss from debt of a business largest clients. Elegant Fashions later filed for
was a business debt and he can take a busi- acquired from a decedent is determined in the bankruptcy and defaulted on the loan. Mr.
ness bad debt deduction. same way as a debt sold by a business. If you Zayne made full payment to the bank. He can
are in a trade or business, a loss from the take a business bad debt deduction, since his
When debt is worthless. You do not have debts is a business bad debt if you acquired guarantee was made in the course of his
to wait until a debt is due to determine them in your trade or business or if the debts trade or business for a good faith business
whether it is worthless. A debt becomes were closely related to your trade or business purpose. He was motivated by the desire to
worthless when there is no longer any chance when they became worthless. Otherwise, a retain one of his better clients and keep a
that the amount owed will be paid. loss from these debts is a nonbusiness bad sales outlet.
It is not necessary to go to court if you can debt.
Liquidation. If you liquidate your busi- Rights against a borrower. When you
show that a judgement from the court would make payment on a loan you guaranteed, you
be uncollectible. You must only show that you ness and some of your accounts receivable
become worthless, they are business bad may have the right to take the place of the
have taken reasonable steps to collect the lender. The debt is then owed to you. If you
debt. Bankruptcy of your debtor is generally debts.
have this right, or some other right to demand
good evidence of the worhtlessness of at payment from the borrower, you cannot take
least a part of an unsecured and unpreferred Debts of political parties. If a political party
(or other organization that accepts contribu- a bad debt deduction until these rights be-
debt. come partly or totally worthless.
tions or spends money to influence elections)
owes you money and the debt becomes
Debts from sales or services. Business worthless, you cannot take a bad debt de-
bad debts are mainly the result of credit sales duction unless you use an accrual method of
to customers. They can also be the result of
loans to suppliers, clients, employees, or dis-
accounting and meet all the following tests. How To Treat
tributors. Goods and services customers have 1) The debt was from the sale of goods or There are two ways to treat business bad
not paid for are shown in your books as either services in the ordinary course of your debts: the specific charge-off and nonaccru-
accounts receivable or notes receivable. If trade or business. al-experience methods. Most taxpayers, ex-
you are unable to collect any part of these cept certain financial institutions, must use the
accounts or notes receivable, the uncollect- 2) More than 30% of all your receivables specific charge-off method. However, certain
ible part is a business bad debt. Accounts or accrued in the year of the sale were from taxpayers can use the nonaccrual-experience
notes receivable valued at fair market value sales made to political parties. method if they meet the requirements dis-
at the time of the transaction are deductible cussed later.
3) You made substantial continuing efforts
only at that fair market value, even though the to collect on the debt.
value may be less than face value. Recovery of bad debt. If you deduct a bad
You can take a bad debt deduction for debt and later recover (collect) all or part of
Loan or capital contribution. You cannot
these accounts and notes receivable only if it, you may have to include all or part of the
take a bad debt deduction for a loan you
the amount owed you was included in your recovery in gross income. The amount you
made to a corporation if, based on the facts
gross income; either for the year the de- include is limited to the amount you actually
and circumstances, the loan is actually a
duction is claimed or for a prior year. This deducted. You can exclude the amount de-
contribution to capital.
applies to amounts owed you from all sources ducted that did not reduce your tax.
of taxable income, such as sales, services, Debts of an insolvent partner. If your Example. In 1997, the Willow Corporation
rents, and interest. business partnership breaks up and one of had gross income of $158,000, a bad debt
If you qualify under certain rules, you can your former partners is insolvent and cannot deduction of $3,500, and other allowable de-
use the nonaccrual-experience method of pay any of the partnership's debts, you may ductions of $49,437. The corporation reported
accounting, discussed later. Under this have to pay more than your share of the on the accrual method of accounting and
method, you do not have to accrue income partnership's debts. If you pay any part of the used the specific charge-off method for bad
that, based on your experience, you expect insolvent partner's share of the debts, you can debts. The entire bad debt deduction reduced
to be uncollectible. take a bad debt deduction. the tax on the 1997 corporate return. In 1998,
Accrual method taxpayers. Accrual
the corporation recovers part of the $3,500
method taxpayers normally report income as Business loan guarantee. If you guarantee deducted in 1997. It must include the part
they earn it. They can take a bad debt de- a debt that becomes worthless, the debt can recovered in income for 1998. For 1998,
duction for an uncollectible receivable if they qualify as a business bad debt. However, all Willow reports the recovery as “Other
have included the uncollectible amount in in- the following requirements must be met. income” on its corporate return.
come.
Cash method taxpayers. Cash method 1) You made the guarantee in the course Net operating loss (NOL) carryover. If
taxpayers normally report income when they of your trade or business. a bad debt deduction increases an NOL car-
receive payment. They cannot take a bad ryover that has not expired before the begin-
debt deduction for amounts owed to them that 2) You have a legal duty to pay the debt.
ning of the tax year in which the recovery
they have not received and cannot collect if 3) You made the guarantee before the debt takes place, the deduction is treated as hav-
they never included those amounts in income. became worthless. You meet this re- ing reduced your tax. A bad debt deduction
quirement if you reasonably expected that contributes to a net operating loss helps
Debts from a former business. If you sell that you would not have to pay the debt lower taxes in the year to which you carry the
your business but keep its accounts receiv- without full reimbursement from the net operating loss.
able, these debts are business debts since issuer. See Publication 536 for more information
they arose in your trade or business. If an about net operating losses.
4) You receive reasonable consideration More information. See Recoveries in
account becomes worthless, the loss is a for making the guarantee. You meet this
business bad debt. These accounts would Publication 525 for more information on re-
requirement if you made the guarantee covered amounts.
also be business debts if sold to the new in accord with normal business practice
owner of the business. or for a good faith business purpose.
If you sell your business to one person Bankruptcy claim. You can deduct as a bad
and sell your accounts receivable to someone Consider any guarantee you make to debt only the difference between the amount
else, the character of the debts as business protect or improve your job as closely related owed to you by a bankrupt entity and the
or nonbusiness is based on the activities of to your trade or business as an employee. amount you received from the distribution of
the new holder of these debts. A loss from the Deductible in the year paid. You can its assets.
debts is a business bad debt to the new deduct a payment you make on a loan you
holder if that person acquired the debts in his guaranteed in the year of payment unless you Sale of mortgaged property. If mortgaged
or her trade or business or if the debts were have rights against the borrower. or pledged property is sold for less than the
closely related to the new holder's trade or debt, the unpaid, uncollectible balance of the
business when they became worthless. Oth- Example. Bob Zayne owns the Zayne debt after the sale is a bad debt. If the debt
erwise, a loss from these debts is a nonbusi- Dress Company. He guaranteed payment of represents capital or an amount you previ-
ness bad debt. a $20,000 note for Elegant Fashions, a dress ously included in income, you can deduct it
Chapter 14 Business Bad Debts Page 59
as a bad debt in the year it becomes totally formation on the sale of an asset, see Publi- operating a farm business on line 34 of
worthless or in the year you charged it off as cation 544. Schedule F (Form 1040).
partially worthless. Corporations. Corporations deduct bad
debts on line 15 of Form 1120, line 15 of Form
1120–A, or line 10 of Form 1120S.
Nonaccrual-Experience Partnerships. Partnerships deduct busi-
Specific Charge-Off Method Method ness bad debts on line 12 of Form 1065.
If you use the specific charge-off method, you If you use an accrual method of accounting
can deduct specific business bad debts that and qualify under the rules explained in this
become either partly or totally worthless dur- section, you can use the nonaccrual-
ing the tax year. experience method of accounting for bad
debts. Under this method, you do not accrue
income that you expect to be uncollectible.
Partly worthless debts. You can deduct
specific bad debts that are partly uncollect-
If you determine, based on your experi-
ence, that certain amounts (accounts receiv-
15.
ible. Your deduction is limited to the amount
able) are uncollectible, do not include them in
you charge–off on your books during the tax
year. You do not have to charge–off and de-
your gross income for the tax year. Electric and
duct your partly worthless debts annually. You
can delay the charge-off until a later year. You
can wait until more of the debt becomes
Amounts must be for performing services. Clean-Fuel
You can use the nonaccrual-experience
worthless, or you have collected all you can
and it is totally worthless. You cannot, how-
method only for amounts earned by perform-
ing services that you would otherwise include
Vehicles
ever, deduct any part of a debt after the year in income. You cannot use this method for
it becomes totally worthless. amounts owed to you from activities such as
Deduction disallowed. You can gener- lending money, selling goods, or acquiring
ally take a partial bad debt deduction only in receivables or other rights to receive pay-
the year you make the charge–off on your ments. Introduction
books. If the Internal Revenue Service (IRS) You are allowed a limited deduction for the
does not allow your deduction and the debt cost of clean-fuel vehicle property and clean-
becomes partly worthless in a later tax year, Interest or penalty charged. Generally, you
cannot use the nonaccrual-experience fuel vehicle refueling property you place in
you can deduct the amount you charge–off in service during the tax year. Also, you are al-
that year, plus the amount charged off in the method for amounts due on which you charge
interest or a late payment penalty. However, lowed a tax credit of 10% of the cost of any
earlier year. The charge–off in the earlier qualified electric vehicle you place in service
year, unless reversed on your books, fulfills do not treat a discount offered for early pay-
ment as interest or a late payment penalty during the tax year.
the charge-off requirement for the later year.
charged if: You can take the electric vehicle
TIP credit or the deduction for clean-fuel
Totally worthless debts. Deduct a totally 1) You otherwise accrue the full amount vehicle property regardless of
worthless debt only in the tax year it becomes due as gross income at the time you whether you use the vehicle or vehicle prop-
totally worthless. You cannot include any provide the services, and erty in a trade or business. However, you can
amount deducted in an earlier tax year when
take a deduction for clean-fuel vehicle refuel-
the debt was only partly worthless. 2) You treat the discount allowed for early ing property only if you use the property in
You do not have to make an actual payment as an adjustment to gross in- your trade or business.
charge–off on your books to claim a bad debt come in the year of payment.
deduction for a totally worthless debt. How-
ever, you may want to do so. If you do not
and the IRS later rules the debt is only partly How to apply this method. You can apply
worthless, you will not be allowed a deduction the nonaccrual-experience method under ei- Topics
for the debt in that tax year. A deduction of ther a separate receivable system or a peri- This chapter discusses:
a partly worthless bad debt is limited to the odic system. Under the separate receivable
amount actually charged–off. system, apply the nonaccrual-experience • The deduction for clean-fuel vehicle
method separately to each account receiv- property
able. Under the periodic system, apply the
Filing a claim for refund. If you do not de- nonaccrual-experience method to total qual- • The deduction for clean-fuel vehicle re-
duct a bad debt on your original return for the ified accounts receivable at the end of your fueling property
year it becomes worthless, you can file a tax year. • Recapture of the deductions
claim for a credit or refund due to the bad Treat each system as a separate method
debt. You must use Form 1040X, Amended of accounting. You generally cannot change • The electric vehicle credit
U.S. Individual Income Tax Return, to amend from one system to the other without IRS • Recapture of the credit
your return for the year the debt became approval.
worthless. If the bad debt was totally Generally, you also need IRS approval to
worthless, you must file the claim within 7 change to either system under the nonaccru-
years from the date your original return for al-experience method from a different ac- Useful Items
that year had to be filed, or 2 years from the counting method. You may want to see:
date you paid the tax, whichever is later. For more information on the separate
(Claims not due to totally worthless bad debts receivable system, see section 1.448–2T of Publication
generally must be filed within 3 years from the the Income Tax Regulations. For more infor-
date the tax is paid.) For more information mation on the periodic system, see Notice m 463 Travel, Entertainment, Gift, and
about filing a claim, see Publication 556, Ex- 88–51, 1988–1 C.B. 535.
Car Expenses
amination of Returns, Appeal Rights, and
Claims for Refund. m 544 Sales and Other Dispositions of
Assets
Property received for debt. If you receive
property in partial settlement of a debt, reduce
Where To Deduct m 946 How To Depreciate Property

the debt by the fair market value of the prop- Use the following guide to find where to de- Form (and Instructions)
erty received. You can deduct the remaining duct your business bad debts.
debt as a bad debt in the year you determine Individuals. Deduct a bad debt from op- m 8834 Qualified Electric Vehicle Credit
it is worthless. erating a trade or business on line 9 of
If you later sell the property, include any Schedule C (Form 1040) or line 2 of Schedule See chapter 17 for information about get-
gain from the sale in gross income. For in- C–EZ (Form 1040). Deduct a bad debt from ting publications and forms.
Page 60 Chapter 15 Electric and Clean-Fuel Vehicles
For vehicles that may be propelled by both tive charging equipment. It does not include
a clean-burning fuel and any other fuel, your property used to generate electricity, such as
Deductions for deduction is generally the additional cost of solar panels or windmills, and does not in-
permitting the use of the clean-burning fuel. clude the battery used in the vehicle.
Clean-Fuel Vehicle Clean-fuel vehicle property does not
and Refueling ! include an electric vehicle that quali-
CAUTION fies for the qualified electric vehicle
Deduction limit. The maximum deduction
you can claim for clean-fuel vehicle refueling
Property credit discussed later.
property placed in service at one location is
$100,000. To figure your maximum deduction
You are allowed a limited deduction for the for any tax year, subtract from $100,000 the
cost of clean-fuel vehicle property. You are Motor vehicle defined. A motor vehicle is total you (or any related person or predeces-
also allowed a limited deduction for the cost any vehicle that has four or more wheels and sor) claimed for clean-fuel vehicle refueling
of clean-fuel vehicle refueling property. These is manufactured primarily for use on public property placed in service at that location for
deductions are allowed only in the tax year streets, roads, and highways. It does not in- all earlier years.
you place the property in service. clude a vehicle operated exclusively on a rail
or rails. You must specify on your tax return
Nonqualifying property. You cannot deduct
Qualifying requirements. For your property
! the property (and portions of the
CAUTION property's cost) that you are using as
the part of a property's cost that you claim as
a section 179 deduction. You also cannot to qualify for the deduction: a basis for the deduction.
claim the deduction for property used: 1) It must be acquired for your own use and Related person. For this purpose, a re-
1) Predominantly outside the United States, not for resale, lated person includes the following persons.
2) Its original use must begin with you,
2) Predominantly to furnish lodging or in 1) An individual and his or her brothers and
connection with the furnishing of lodging, 3) The motor vehicle of which it is a part sisters, half-brothers, half-sisters,
must satisfy any federal or state emis- spouse, ancestors, and lineal descend-
3) By certain tax-exempt organizations, or sions standards that apply to each fuel ants.
4) By governmental units or foreign per- by which the vehicle is designed to be
sons or entities. propelled, and 2) An individual and a corporation when the
individual owns, directly or indirectly,
4) It must satisfy any federal and state more than 50% in value of the out-
Clean-burning fuels. Clean-burning fuels emissions certification, testing, and war- standing stock of the corporation.
include: ranty requirements that apply if it is in-
stalled on a retrofitted vehicle. 3) Two corporations that are members of
1) Natural gas, the same controlled group as defined in
Deduction limit. The maximum deduction section 267(f) of the Internal Revenue
2) Liquefied natural gas, Code.
you can claim for qualified clean-fuel vehicle
3) Liquefied petroleum gas, property with respect to any motor vehicle is: 4) A grantor and a fiduciary of any trust.
4) Hydrogen, 1) $50,000 for a truck or van with a gross 5) Fiduciaries of two separate trusts if the
5) Electricity, and vehicle weight rating over 26,000 pounds same person is a grantor of both trusts.
or for a bus with a seating capacity of
6) Any fuel that is at least 85% alcohol (any at least 20 adults (excluding the driver), 6) A fiduciary and a beneficiary of the same
kind) or ether. trust.
2) $5,000 for a truck or van with a gross
vehicle weight rating over 10,000 pounds 7) A fiduciary and a beneficiary of two
separate trusts if the same person is a
Deduction for Clean-Fuel but not more than 26,000 pounds, or
grantor of both trusts.
Vehicle Property 3) $2,000 for a vehicle not included in (1)
8) A fiduciary of a trust and a corporation
The deduction for this property may be or (2).
when the trust or a grantor of the trust
claimed regardless of whether the property is owns, directly or indirectly, more than
used in a trade or business. Deduction for Clean-Fuel 50% in value of the outstanding stock
of the corporation.
Clean-fuel vehicle property. Clean-fuel ve- Vehicle Refueling Property
hicle property is made up of two kinds of Property is eligible for the deduction if: 9) A person and a tax-exempt educational
property. or charitable organization that is con-
1) The property is depreciable property, trolled directly or indirectly by that person
1) Motor vehicles produced by an original and or by members of the family of that per-
equipment manufacturer and designed son.
2) The original use of the property begins
to be propelled by a clean-burning fuel. with you. 10) A corporation and a partnership if the
The only part of a vehicle's basis that same person owns more than 50% in
qualifies for the deduction is: Clean-fuel vehicle refueling property de- value of the outstanding stock of the
a) A clean-fuel engine that can use a fined. Clean-fuel vehicle refueling property corporation and more than 50% of the
clean-burning fuel, includes any property (other than a building capital or profits interest in the partner-
or its structural components) used to: ship.
b) The property used to store or de-
liver the fuel to the engine, or 1) Store or dispense a clean-burning fuel 11) Two S corporations or an S corporation
into the fuel tank of a motor vehicle pro- and a regular corporation if the same
c) The property used to exhaust gases pelled by the fuel, but only if the storage persons own more than 50% in value of
from the combustion of the fuel. or dispensing is at the point where the the outstanding stock of each corpo-
fuel is delivered into the tank, or ration.
2) Any property installed on a motor vehicle
(including installation costs) to enable it 2) Recharge motor vehicles propelled by 12) A partnership and a person owning, di-
to be propelled by a clean-burning fuel electricity, but only if the property is lo- rectly or indirectly, more than 50% of the
if: cated at the point where the vehicles are capital or profits interest in the partner-
recharged. ship.
a) The property is an engine (or mod-
ification of an engine) that can use 13) Two partnerships if the same persons
a clean-burning fuel, or Recharging property. This property in- own, directly or indirectly, more than
cludes any equipment used to provide elec- 50% of the capital or profits interest in
b) The property is used to store or tricity to the battery of a vehicle propelled by both partnerships.
deliver that fuel to the engine or to electricity. It includes low-voltage and high-
exhaust gases from the combustion voltage (quick) charging equipment and an- 14) An executor of an estate and a benefi-
of that fuel. cillary connection equipment, such as induc- ciary of the estate, except in the case
Chapter 15 Electric and Clean-Fuel Vehicles Page 61
of a sale or exchange in satisfaction of 2) Ceases to be a qualified clean-fuel ve- to recharge motor vehicles propelled by
a pecuniary bequest. hicle property (such as failing to meet electricity, whichever applies,
emissions standards), or
2) No longer used 50% or more in your
For the indirect stock ownership rules, see
3) Is used— trade or business, or
Indirect ownership of stock, under Unpaid
Salaries, in chapter 2. a) Predominantly outside the United 3) Is used—
States, a) Predominantly outside the United
States,
How To Claim b) Predominantly to furnish lodging or
in connection with the furnishing of b) Predominantly to furnish lodging or
the Deductions lodging, in connection with the furnishing of
How you claim the deductions for clean-fuel lodging,
vehicles and refueling property depends on c) By certain tax-exempt organiza-
the use of the property and the kind of income tions, or c) By certain tax-exempt organiza-
tax return you file. d) By governmental units or foreign tions, or
persons or entities. d) By governmental units or foreign
Nonbusiness use of clean-fuel vehicle persons or entities.
property by individuals. Individuals can Sales or other dispositions. If you sell or
claim the deduction for the nonbusiness use otherwise dispose of the vehicle and know Sales or other dispositions. If you sell or
of clean-fuel vehicle property by including the or have reason to know that it will be used in otherwise dispose of the property and know
deduction in the total on line 32 of Form 1040. a manner described above, you are subject or have reason to know that it will be used in
Also, enter the amount of your deduction and to the recapture rules. In other sales or dis- a manner described above, you are subject
“Clean-Fuel” on the dotted line next to line 32. positions (including a disposition by reason to the recapture rules. In other sales or dis-
If you use the vehicle partly for business, see of an accident or other casualty), the recap- positions, the recapture rules do not apply.
the next two discussions. ture rules do not apply. The deduction (minus any recapture
If the vehicle was subject to depreciation, amount) is considered depreciation when fig-
Business use by employees. Employees the deduction (minus any recapture) is con- uring the part of the gain that is ordinary in-
who use clean-fuel vehicle property for busi- sidered depreciation when figuring the part come upon its disposition. See Publication
ness or partly for business and partly for of the gain that is ordinary income. See Pub- 544 for more information on dispositions of
nonbusiness purposes should enter the entire lication 544 for more information on disposi- depreciable property.
deduction in the total on line 32 of Form 1040. tions of depreciable property.
Also, enter the amount of your deduction and Recapture amount. Figure your recapture
“Clean-Fuel” on the dotted line next to line 32. Recapture amount. Figure your recapture amount by multiplying the deduction you
amount by multiplying the deduction by a re- claimed by the following fraction.
Business use by sole proprietors. Individ- capture percentage. The percentages are as
follows. Total recovery period for _ Recovery years before
uals who operate a business as a sole pro- the property the recapture year
prietor can claim their deduction for the busi-
ness use of clean-fuel vehicles and clean-fuel • 100% if the recapture date is within the Total recovery period for the property
vehicle refueling property on the Other ex- first full year after the date the vehicle
penses line of either Schedule C (Form 1040) was placed in service.
How to report. How you report the recapture
or Schedule F (Form 1040). If clean-fuel ve- • 662/3% if the recapture date is within the amount for clean-fuel vehicle refueling prop-
hicle property is used partly for nonbusiness second full year after the date the vehicle erty depends on how you claimed the de-
purposes, claim the nonbusiness part of the was placed in service. duction for that property.
deduction as explained earlier under Non- Business use by sole proprietors. In-
business use of clean-fuel vehicle property • 331/3% if the recapture date is within the
third full year after the date the vehicle clude the amount on the Other income line
by individuals. of either Schedule C (Form 1040) or Sched-
was placed in service.
ule F (Form 1040).
Partnerships. Partnerships claim the de- Recapture date. The recapture date is Partnerships and corporations (includ-
duction for the business use of clean-fuel ve- generally the date of the event that causes ing S corporations). Include the amount on
hicle and clean-fuel vehicle refueling property the recapture. However, the recapture date the Other income line of the form you file.
on line 20 of Form 1065. for item (3), earlier, is the first day of the year
in which the use occurs.
S corporations. S corporations claim the
Basis Adjustment
deduction for the business use of clean-fuel How to report. How you report the recapture You must reduce the basis of your clean-fuel
vehicle and clean-fuel vehicle refueling prop- amount for clean-fuel vehicle property as in- vehicle or clean-fuel vehicle refueling property
erty on line 19 of Form 1120S. come depends on how you claimed the de- by the amount of the deduction claimed. If, in
duction for that property. a later year, you must recapture part or all of
Nonbusiness use by individuals. In- the deduction, increase the basis of the
Other corporations. Corporations claim the
clude the amount on line 21 of Form 1040. property by the amount recaptured.
deduction for the business use of clean-fuel
Business use by employees. Include If the property is depreciable property, you
vehicle and clean-fuel vehicle refueling prop-
the amount on line 21 of Form 1040. can recover the additional basis over the
erty on line 26 of Form 1120 (line 22 of Form
Business use by sole proprietors. In- property's remaining recovery period begin-
1120–A).
clude the amount on the Other income line ning with the tax year of recapture.
of either Schedule C (Form 1040) or Sched- If you were using the percentage ta-
Recapture of the ule F (Form 1040).
! bles to figure your depreciation on the
Partnerships and corporations (includ- CAUTION property, you will not be able to con-
Deductions ing S corporations). Include the amount on tinue to do so. See Publication 946 for infor-
If the property no longer qualifies, you must the Other income line of the form you file. mation on figuring your depreciation without
recapture the deduction. You recapture the the tables.
deduction by including it, or a part of it, in your
income in the year recapture occurs.
Clean-Fuel Vehicle
Refueling Property
Your clean-fuel vehicle refueling property no
Clean-Fuel Vehicle Property
Clean-fuel vehicle property no longer qualifies
longer qualifies if, at any time before the end
of its depreciation recovery period, the prop-
Electric Vehicle Credit
if, within 3 years after the date you placed it erty is: You can choose to claim a tax credit for a
in service, the property: qualified electric vehicle you place in service
1) No longer used to store or dispense during the year. You can make this choice
1) Is modified so that it can no longer be clean-burning fuel into the fuel tanks of regardless of whether the property is used in
propelled by a clean-burning fuel, motor vehicles propelled by the fuel, or a trade or business.
Page 62 Chapter 15 Electric and Clean-Fuel Vehicles
in the total for line 4c of Schedule J (Form
Qualified Electric Vehicle 1120) and checking the Form 8834 box to the
Basis Adjustment
A vehicle is a qualified electric vehicle if it left of the entry. See the instructions for Form If you claim a tax credit for a qualified electric
meets all of the following requirements. 1120. vehicle you place in service during the year,
you must reduce your basis in that vehicle by
1) It has at least four wheels and is manu- the lesser of:
factured primarily for use on public Recapture of the Credit
streets, roads, and highways. 1) $4,000, or
The electric vehicle credit is subject to re-
2) It is powered primarily by an electric capture if, within 3 years after the date you 2) 10% of the cost of the vehicle.
motor drawing current from rechargeable place the vehicle in service, it ceases to
batteries, fuel cells, or other portable qualify for the electric vehicle credit. This basis reduction rule applies even if the
sources of electrical current. The vehicle ceases to qualify if it is: credit allowed is less than that amount.
If you must recapture part or all of the
3) You were the first person to use it. 1) Modified so that it is no longer primarily credit, increase the basis of your vehicle by
4) You acquired it for your own use and not powered by electricity, the amount recaptured. If the qualified electric
for resale. 2) Used predominantly outside the United vehicle is depreciable property, you can re-
States, cover the additional basis over the vehicle's
Generally, an electric vehicle is not qual- remaining recovery period beginning with the
ified if it is: 3) Used predominantly to furnish lodging tax year of recapture.
or in connection with the furnishing of
1) Operated exclusively on a rail or rails, lodging, If you were using the percentage ta-
2) Used predominantly outside the United
4) Used by certain tax-exempt organiza-
! bles to figure your depreciation on the
CAUTION vehicle, you will not be able to con-
States,
tions, or tinue to do so. See Publication 946 for infor-
3) Used predominantly to furnish lodging mation on figuring your depreciation without
5) Used by governmental units or foreign
or in connection with the furnishing of the tables.
persons or entities.
lodging,
4) Used by certain tax-exempt organiza- Sales or other dispositions. If you sell or
tions, or dispose of the vehicle and know or have
5) Used by governmental units or foreign reason to know that it will be used in a man-
persons or entities. ner described above, you are subject to the
recapture rules. In other sales or dispositions,

Amount of the Credit


the recapture rules do not apply.
If the vehicle was subject to depreciation,
16.
The credit is generally 10% of the cost of the credit (minus any recapture amount) is
each vehicle you place in service during the
year. If your vehicle is a depreciable business
considered depreciation when figuring the
part of the gain that is ordinary income. See
Other Expenses
asset, you must reduce the cost of the vehicle Publication 544 for more information on dis-
by any section 179 deduction before figuring positions of depreciable property.
the 10% credit. If you need information on the
section 179 deduction, get Publication 946. Recapture amount. Figure your recapture
amount by multiplying the credit by a recap- Important Changes for
ture percentage. The percentages are as fol-
Credit limits. The credit is limited to $4,000
for each vehicle. The total credit is limited to lows. 1998
the excess of your regular tax liability, re-
duced by certain credits, over your tentative • 100% if the recapture date is within the Standard mileage rate. The standard mile-
minimum tax. To figure the amount of credit first full year after the date the vehicle age rate for the cost of operating your car,
you can take, complete Form 8834 and attach was placed in service. van, pickup, or panel truck in 1998 is 32.5
it to your tax return. cents per mile for all business miles. You can
• 662/3% if the recapture date is within the use the standard mileage rate for a vehicle
second full year after the date the vehicle you lease, as well as one you own.
was placed in service.
How To Claim
• 331/3% if the recapture date is within the Meal expense deduction increases for
the Credit third full year after the date the vehicle certain individuals. Beginning in 1998, if
You must complete and attach Form 8834 to was placed in service. employees are subject to the Department of
your tax return to claim the electric vehicle Transportation's hours of service limits, you
credit. Enter your credit on your tax return as Recapture date. The recapture date is may be able to deduct 55% of the meal and
discussed next. generally the date of the event that causes beverage expenses you reimburse for their
the recapture. However, the recapture date travel away from their tax home. For more
Individuals. Individuals claim the credit by for items (2) through (5), earlier, is the first information, see Meal expenses when subject
entering the amount from line 19 of Form day of the year in which the use occurs. to “hours of service” limits later.
8834 on line 47 of Form 1040. Check box
“d” and specify Form 8834. How to report. How you report the recapture
amount of the electric vehicle credit depends
Partnerships. Partnerships enter the
amount from line 19 of Form 8834 on line 13
on how the credit was claimed.
Individuals. Include the amount on line
Introduction
of Schedule K (Form 1065). The partnership 56 of Form 1040. Write “QEVCR” on the dot- This chapter covers some expenses you as
then allocates the credit to the partners on ted line next to line 56. a business owner may have that are not ex-
line 13 of Schedule K–1 (Form 1065). See the Partnerships. Include on line 25 of plained earlier.
instructions for Form 1065. Schedule K-1 (Form 1065) the information a
partner needs to figure the recapture of the Topics
S corporations. S corporations enter the credit. This chapter discusses:
amount from line 19 of Form 8834 on line 13 S corporations. Include on line 23 of
of Schedule K (Form 1120S). The S corpo- Schedule K-1 (Form 1120S) the information • Travel, meals, and entertainment
ration then allocates the credit to the share- a shareholder needs to figure the recapture
holders on line 13 of Schedule K–1 (Form of the credit. • Bribes and kickbacks
1120S). See the instructions for Form 1120S. Other corporations. Include the amount • Charitable contributions
on line 8 of Schedule J (Form 1120), or line
Other corporations. Corporations other 5 of Part I (Form 1120–A). Write “QEV re-
• Education expenses
than S corporations claim the credit by en- capture” on the dotted line next to that entry • Franchises, trademarks, and trade
tering the amount from line 19 of Form 8834 space. names
Chapter 16 Other Expenses Page 63
• Lobbying expenses Table 16-1. Reporting Reimbursements
• Penalties and fines
IF the type of reimbursement (or other
• Repayments (claim of right) expense allowance) arrangement is
under: Then the employer reports on Form W-2:
Useful Items An accountable plan with:
You may want to see:
Actual expense reimbursement: No amount.
Publication Adequate accounting made and excess
returned
m 463 Travel, Entertainment, Gift, and
Car Expense Actual expense reimbursement: The excess amount as wages in box 1.
m 529 Miscellaneous Deductions Adequate accounting and return of excess
both required but excess not returned
m 542 Corporations
m 946 How To Depreciate Property Per diem or mileage allowance up to the No amount.
federal rate:
m 1542 Per Diem Rates
Adequate accounting and excess returned

Form (and Instructions) Per diem or mileage allowance up to the The excess amount as wages in box 1. The
federal rate: amount up to the federal rate is reported
m Sch A (Form 1040) Itemized Deduction
Adequate accounting and return of excess only in box 13—it is not reported in box 1.
m 1099–MISC Miscellaneous Income both required but excess not returned
m 6069 Return of Excise Tax on Excess
Per diem or mileage allowance exceeds the The excess amount as wages in box 1. The
Contributions to Black Lung Ben- federal rate: amount up to the federal rate is reported
efit Trust Under Section 4953 and
Adequate accounting up to the federal rate only in box 13—it is not reported in box 1.
Computation of Section 192 De-
duction only and excess not returned

See chapter 17 for information about get- A nonaccountable plan with:


ting publications and forms.
Either adequate accounting or return of The entire amount as wages in box 1.
excess, or both, not required by plan

Travel, Meals, and No reimbursement plan The entire amount as wages in box 1.

Entertainment
deduct them as wages. See Table 16-1, Re- stead, treat the reimbursed expenses as paid
To be deductible, expenses incurred for
porting Reimbursements. under a nonaccountable plan, discussed
travel, meals, and entertainment must be or-
later.
dinary and necessary expenses of carrying
on your trade or business. Generally, you also Accountable Plans
How to deduct. You can take a deduction
must show that entertainment expenses (in- To be an accountable plan, your reimburse- for travel, meals, and entertainment if you
cluding meals) are directly related to, or as- ment or allowance arrangement must require reimburse your employees for these ex-
sociated with, the conduct of your trade or your employees to meet all of the following penses under an accountable plan. The
business. rules. amount you deduct for meals and enter-
The following discussion explains how you
tainment, however, may be subject to a 50%
deduct any reimbursements or allowances 1) They must have paid or incurred
limit, discussed later. If you are a sole pro-
you make for these expenses incurred by deductible expenses while performing
prietor, deduct the reimbursement on line 24
your employees. If you are self-employed and services as your employees.
of Schedule C (Form 1040). If you file a cor-
incur these expenses yourself, see Publica-
2) They must adequately account to you for poration income tax return, include the re-
tion 463 for information on how you can de-
these expenses within a reasonable pe- imbursement in the amount claimed on the
duct them.
riod of time. “Other deductions” line of Form 1120 or Form
1120–A. If you file any other income tax re-
3) They must return any excess re- turn, such as a partnership or S Corporation
Reimbursements imbursement or allowance within a rea- return, deduct the reimbursement on the ap-
How you deduct a reimbursement or allow- sonable period of time. propriate line of the return, as provided in the
ance arrangement (including per diem allow- instructions for that return.
ances, discussed later) for travel, meals, and A reasonable period of time depends
entertainment expenses incurred by your TIP on the facts and circumstances.
employees depends on whether you have an Generally, you can consider the pe- Per Diem and Car Allowances
accountable plan or a nonaccountable plan. riod reasonable if your employees adequately You may reimburse your employees under
A reimbursement or allowance arrangement account for the expenses within 60 days after an accountable plan based on travel days,
is a system by which you pay advances, re- they pay or incur them and if they return any miles, or some other fixed allowance. In
imbursements, and charges for your employ- excess reimbursement within 120 days after these cases, your employee is considered to
ees' business expenses and they substantiate they pay or incur the expense. Also, the pe- have accounted to you for the amount of the
their expenses to you so you can substantiate riod is considered reasonable if you give your expense that does not exceed the rates es-
your deduction of the advance, reimburse- employees a periodic statement (at least tablished by the federal government. Your
ment, or charge. If you make a single pay- quarterly) that asks them to either return or employee must actually substantiate to you
ment to your employees and it includes both adequately account for outstanding amounts the other elements of the expense, such as
wages and an expense reimbursement, you and they do so within 120 days of the state- time, place, and business purpose.
must specify the amount of the reimburse- ment.
ment. Car allowance. Your employee is consid-
If you reimburse these expenses under If any expenses reimbursed under this ered to have accounted to you for car ex-
an accountable plan, deduct them as travel, arrangement are not substantiated, or are an penses that do not exceed the standard
meal, and entertainment expenses. If you excess reimbursement that is not returned mileage rate. For 1998, the standard mileage
reimburse these expenses under a nonac- within a reasonable period of time by an em- rate is 32.5 cents for all business miles. The
countable plan, you must report the re- ployee, you cannot treat these expenses as standard mileage rate is considered to be the
imbursements as wages on Form W–2 and reimbursed under an accountable plan. In- federal rate. If the car allowance you pay is
Page 64 Chapter 16 Other Expenses
equal to or less than 32.5 cents a mile, see different for different locations. Publication Drilling rigs. The 50% limit does not apply
Per diem allowance LESS than or EQUAL to 1542 lists the rates in the continental U.S. to the food or beverages an employer pro-
the federal rate, later. If the car allowance you The federal rates for meal and incidental vides on an oil or gas platform or drilling rig
pay is more than 32.5 cents per mile, see Per expenses are the same as those rates dis- located offshore or in Alaska. This exception
diem allowance MORE than the federal rate, cussed under Standard Meal Allowance in also applies to food and beverages provided
later. chapter 1 in Publication 463. by an employer at a support camp that is near
You can choose to reimburse your em- High-low method. This is a simplified and integral to an oil or gas drilling rig located
ployees using a fixed and variable rate method of computing the federal per diem in Alaska.
(FAVR) allowance. This is an allowance that rate for lodging and meal expenses for trav-
includes a combination of payments covering eling within the continental United States. It Meal expenses when subject to “hours of
fixed and variable costs, such as a cents- eliminates the need to keep a current list of service” limits. Beginning in 1998, you can
per-mile rate to cover your employees' vari- the per diem rate in effect for each city in the deduct 55% of the reimbursed meals your
able operating costs (such as gas, oil, etc.) continental United States. employees consume while away from their
plus a flat amount to cover your employees' Under the high-low method, the per diem tax home on business during or incident to
fixed costs (such as depreciation, insurance, amount for travel during 1998 is $180 for any period subject to the Department of
etc.). For information on using a FAVR al- certain locations. All other areas have a per Transportation's hours of service limits. The
lowance, see Revenue Procedure 97–58 in diem amount of $113. The areas eligible for percentage remains 55% for 1999, and it
the 1997–52 Internal Revenue Bulletin. You the $180 per diem amount under the high-low gradually increases to 80% by the year 2008.
can read Revenue Procedure 97–58 at many method are listed in Publication 1542. Individuals subject to the Department of
public libraries. Transportation's hours of service limits in-
clude the following:
Meals and Entertainment
Per diem allowance. If your employee ac-
Under an accountable plan, you can generally 1) Certain air transportation workers (such
tually substantiates to you the other elements
deduct only 50% of any otherwise deductible as pilots, crew, dispatchers, mechanics,
(discussed earlier) of the expenses reim-
business-related meal and entertainment ex- and control tower operators) who are
bursed using the per diem allowance, how
penses that you reimburse your employees. under Federal Aviation Administration
you report and deduct the allowance depends
The deduction limit applies even if you reim- regulations,
on whether the allowance is for lodging and
meal expenses or for meal expenses only and burse them for 100% of the expenses.
2) Interstate truck operators and bus driv-
whether the allowance is more than the fed- ers who are under Department of
eral rate. For allowances for lodging and meal Application of the 50% limit. The 50% de- Transportation regulations,
expenses, the federal rate can be figured duction limit applies to reimbursements you
using either of the following two methods: make to your employees for expenses they 3) Certain railroad employees (such as en-
incur while traveling away from home on gineers, conductors, train crews, dis-
1) The regular federal per diem rate (dis- business and for entertaining business cus- patchers, and control operations per-
cussed later), or tomers at your place of business, a restau- sonnel) who are under Federal Railroad
rant, or other location. It applies to attending Administration regulations, and
2) The high-low method (discussed later). a business convention or reception, business 4) Certain merchant mariners who are un-
meeting, or business luncheon at a club. The der Coast Guard regulations.
For an allowance for meal expenses only, deduction limit may also apply to meals you
the federal rate is the standard meal allow- furnish on your premises to your employees
De minimis (minimal) fringe benefit. The
ance (see chapter 1 in Publication 463). You (discussed in chapter 3).
50% limit does not apply to an expense for
may pay an allowance for meal expenses Related expenses. Taxes and tips relat- food or beverage that is excluded from the
only if, for example, you reimburse actual ing to a meal or entertainment activity that you
gross income of an employee because it is a
lodging expenses or do not reimburse lodging reimburse to your employee under an ac-
de minimis fringe benefit. See chapter 4 for
expenses because there are none. countable plan are included in the amount
additional information on de minimis fringe
Per diem allowance LESS than or that is subject to the 50% limit. Reimburse-
benefits.
EQUAL to the federal rate. If your per diem ments you make for expenses, such as cover
allowance for the employee is less than or charges for admission to a nightclub, rent
equal to the appropriate federal rate, that al- paid for a room to hold a dinner or cocktail Company cafeteria or executive dining
lowance is not part of the employee's pay. party, or the amount you pay for parking at a room. You can deduct the cost of food and
Deduct the allowance as travel expenses (in- sports arena, are all subject to the 50% limit. beverages you provide primarily to your em-
cluding meals that may be subject to the 50% However, the cost of transportation to and ployees on your business premises. This in-
limit, discussed later). See How to deduct from a business meal or entertainment activity cludes the cost of maintaining the facilities for
under Accountable Plans, discussed earlier. that is otherwise allowable is not subject to providing the food and beverages. These ex-
Per diem allowance MORE than the the 50% limit. penses are subject to the 55% limit unless
federal rate. If your employee's per diem they qualify as de minimis fringe benefits,
allowance is more than the appropriate fed- discussed in chapter 4.
How to apply the 50% limit. If you provide
eral rate, you must report the allowance as your employees with a per diem allowance
two separate items. Employee activities. You can deduct the
(discussed earlier) only for meal and inci- expense of providing recreational, social, or
You include the allowance amount up to dental expenses, the amount treated as an
the federal rate in box 13 (code L) of the similar activities (including the use of a facil-
expense for food and beverages is the lesser ity) for your employees. The benefit must be
employee's Form W–2. Deduct it as travel of:
expenses (as explained above). This part of primarily for your employees who are not
the allowance is treated as reimbursed under highly compensated employees. The defi-
1) The per diem allowance, or nition of highly compensated employee is the
an accountable plan.
You include the allowance amount that is 2) The federal meal and incidental expense same as the one given in chapter 4 under
more than the federal rate in box 1 (and in rate (M & IE). Exclusion of Certain Fringe Benefits, with the
boxes 3 and 5 if they apply) of the employee's following exceptions.
Form W–2. Deduct it as wages subject to in- If you provide your employee with a per diem
come tax withholding, social security, Medi- allowance that covers lodging, meals, and • An employee owning less than a 10%
care, and federal unemployment taxes. This incidental expenses, you must treat an interest in your business is not consid-
part of the allowance is treated as reimbursed amount equal to the federal M & IE rate for ered a shareholder or other owner.
under a nonaccountable plan as explained the area of travel as an expense for food and • An employee is treated as owning any
later under Nonaccountable Plans. beverages. If you use the high-low method, interest owned by a family member.
Regular federal per diem rate. The the federal M & IE rate is treated as $40 for Family members include brothers, sis-
regular federal per diem rate is the highest a high-cost locality and $32 for any other lo- ters, a spouse, ancestors, and lineal de-
amount that the federal government will pay cality. If the per diem allowance you provide scendants.
to its employees for lodging, meal, and inci- for a full day of travel is less than the federal
dental expenses (or meal and incidental ex- per diem rate for the area of travel, you can These expenses are not subject to the
penses only) while they are traveling away treat 40% of the per diem allowance as the 50% limit. For example, the expenses for
from home in a particular area. The rates are amount for food and beverages. food, beverages, and entertainment for a
Chapter 16 Other Expenses Page 65
company-wide picnic are not subject to the vision or radio show is deductible. You can 1) Payments directly or indirectly to an offi-
50% limit. also deduct the expense of distributing free cial or employee of any government or
food and beverages to the general public. an agency or instrumentality of any gov-
These expenses are not subject to the 50% ernment in violation of the law. If the
Nonaccountable Plans limit. government is a foreign government, the
A nonaccountable plan is an arrangement payments are not deductible if they are
that does not meet the requirements for an Charitable sports event. The 50% limit unlawful under the Foreign Corrupt
accountable plan. All amounts paid, or treated does not apply to the expenses covered by Practices Act of 1977.
as paid, under a nonaccountable plan are a package deal that includes a ticket to a
reported as wages on Form W–2. The pay- 2) Payments directly or indirectly to a per-
charitable sports event if the event meets
ments are subject to income tax withholding, son in violation of any federal or state
certain conditions. See Entertainment tickets
social security, Medicare, and federal unem- law (but only if that state law is generally
in chapter 2 of Publication 463 for a list of the
ployment taxes. You can deduct the re- enforced) that provides for a criminal
conditions a charitable sports event must
imbursement as compensation or wages only penalty or for the loss of a license or
meet.
to the extent it meets the deductibility tests for privilege to engage in a trade or busi-
employees' pay in chapter 2. Deduct the al- ness.
lowable amount as compensation or wages
on the appropriate line of your income tax Meaning of “generally enforced.” A
return, as provided in its instructions. Miscellaneous state law is considered generally enforced
unless it is never enforced or enforced only
Other Reimbursed Expenses
Expenses for infamous persons or persons whose vio-
In addition to travel, meal, and entertainment lations are extraordinarily flagrant. For exam-
You may provide meals and entertainment expenses, there are other expenses that you ple, a state law is generally enforced unless
expenses to individuals who are not your can deduct. This section briefly covers some proper reporting of a violation of the law re-
employees. These expenses may or may not of these expenses (listed in alphabetical or- sults in enforcement only under unusual cir-
be subject to the 50% limit, depending on the der). cumstances.
circumstances. Kickbacks. A kickback includes a pay-
Advertising expenses. You generally can ment for referring a client, patient, or cus-
Nonemployee. If you provide a person who deduct reasonable advertising expenses if tomer. The common kickback situation occurs
is not your employee with meals, goods, ser- they relate to your business activities. Gen- when money or property is given to someone
vices, or the use of a facility and the item you erally, you cannot deduct the cost of adver- as payment for influencing a third party to
provide is considered entertainment, you can tising to influence legislation. See Lobbying purchase from, use the services of, or other-
deduct the expense only to the extent it is expenses, later. wise deal with the person who pays the
included in the gross income of the recipient You can usually deduct as a business kickback. In many cases, the person whose
as compensation for services or as a prize expense the cost of institutional or “good business is being sought or enjoyed by the
or award. If you are required to include these will” advertising to keep your name before the person who pays the kickback does not know
expenses on an information return (Form public if it relates to business you reasonably of the payment.
1099–MISC), you cannot claim a deduction expect to gain in the future. For example, the
for them unless you file the necessary infor- Example 1. Mr. Green, an insurance
cost of advertising that encourages people to
mation return. For more information about broker, pays part of the insurance commis-
contribute to the Red Cross, to buy U.S.
when to file Form 1099–MISC, see the sepa- sions he earns to car dealers who refer in-
saving bonds, or to participate in similar
rate Instructions for Forms 1099, 1098, 5498, surance customers to him. The car dealers
causes is usually deductible.
and W–2G. These expenses are not subject are not licensed to sell insurance. Mr. Green
Foreign expenses. You cannot deduct cannot deduct these payments if they are in
to the 50% limit. the costs of advertising on foreign radio and
violation of any federal or state law as ex-
television (including cable) where the adver-
Director, stockholder, or employee plained previously in (2).
tising is primarily for a market in the United
meetings. You can deduct entertainment States. However, this rule only applies to ad- Example 2. The Yard Corporation is in
expenses directly related to business vertising expenses in countries that deny a the business of repairing ships. It returns
meetings of your employees, partners, stock- deduction for advertising on a United States 10% of the repair bills as kickbacks to the
holders, agents, or directors. You can provide broadcast primarily for that country's market. captains and chief officers of vessels it re-
some minor social activities, but the main pairs. It considers kickbacks necessary to get
purpose of the meeting must be your com- Anticipated liabilities. Anticipated liabilities business. The owners of the ships do not
pany's business. These expenses are subject or reserves for anticipated liabilities are not know of these payments.
to the 50% limit. deductible. For example, assume you sold In the state where the corporation oper-
one-year TV service contracts this year total- ates, it is unlawful to attempt to influence the
Trade association meetings. You can de- ing $50,000. From experience, you know you actions of any employee, private agent, or
duct expenses directly related to and neces- will have expenses of about $15,000 in the fiduciary in relation to the principal's or em-
sary for attending business meetings or con- coming year for these contracts. You cannot ployer's affairs by giving or offering anything
ventions of certain exempt organizations. deduct any of the $15,000 this year by of value without the knowledge and consent
These organizations include business charging expenses to a reserve or liability of the principal or employer. The state gen-
leagues, chambers of commerce, real estate account. You can deduct your expenses only erally enforces the law. The kickbacks paid
boards, and trade and professional associ- when you actually pay or accrue them, de- by the Yard Corporation are not deductible.
ations. These expenses are subject to the pending on your accounting method.
50% limit. Medicare or Medicaid. Kickbacks,
Black lung benefit trust contributions. If bribes, and rebates paid in Medicare or
Sale of meals or entertainment. You can you, as a coal mine operator, make a contri- Medicaid programs are not deductible.
deduct the cost of providing meals, enter- bution to a qualified black lung benefit trust, Form 1099–MISC. If you pay kickbacks
tainment, goods and services, or use of facil- you may be able to deduct your contribution. during your tax year, whether or not they are
ities that you sell to the public. For example, To be deductible, you must make your con- deductible on your return, include them when
if you run a nightclub, your expense for the tribution during the tax year or pay it to the figuring if you must file an information return,
entertainment you furnish to your customers, trust by the due date for filing your federal Form 1099–MISC. For more information
such as a floor show, is a business expense. income tax return (including extensions). You about when to file Form 1099–MISC, see the
These expenses are not subject to the 50% must make the contribution in cash or in separate Instructions for Forms 1099, 1098,
limit. property the trust is permitted to hold. 5498, and W–2G.
Figure your allowable deduction for con-
Advertising to promote goodwill. You can tributions to a black lung benefit trust on Car and truck expenses. You can deduct
deduct the cost of providing meals, enter- Schedule A of Form 6069. the cost of operating a car, truck, or other
tainment, or recreational facilities to the gen- vehicle in your business. These costs include
eral public as a means of advertising or pro- Bribes and kickbacks. You cannot deduct gas, oil, repairs, license tags, insurance, and
moting goodwill in the community. For bribes, kickbacks, or similar payments if they depreciation. Only the expenses for business
example, the expense of sponsoring a tele- are either of the following. use are deductible. Traveling between your
Page 66 Chapter 16 Other Expenses
home and your place of business is not busi- Damages recovered. Special rules apply to • You reasonably expect a financial return
ness use. compensation you receive for damages sus- in line with your donation.
Under certain conditions, you can use the tained as a result of patent infringement,
standard mileage rate instead of deducting breach of contract or fiduciary duty, or anti- • The donation is not a nondeductible lob-
the actual expenses for your vehicle. The trust violations. You must include this com- bying expense as discussed later under
standard mileage rate for 1998 is 32.5 cents pensation in your income. However, you may Lobbying expenses.
a mile for all business miles put on a car, van, be able to take a special deduction. The de- For example, a donation you make to a
pick-up, or panel truck you own or lease. For duction applies only to amounts recovered for committee organized by the Chamber of
more information on how to figure your de- actual injury, not any additional amount. The Commerce to bring a national convention to
duction, see Publication 463. deduction is the smaller of: your city may be deductible.
Charitable contributions. Cash payments 1) The amount you received or accrued for
damages in the tax year reduced by the Education expenses. You can deduct the
to charitable, religious, educational, scientific, ordinary and necessary expenses you pay for
or similar organizations may be deductible as amount you paid or incurred in the year
to recover that amount, or the education and training of your employees.
business expenses if the payments are not For more information, see Education Ex-
charitable contributions or gifts. If the pay- 2) Your losses from the injury you have not penses in chapter 2.
ments are charitable contributions or gifts, deducted. You can also deduct your own education
you cannot deduct them as business ex- expenses (including certain related travel)
penses. However, corporations can deduct Demolition expenses or losses. You can- that are related to your trade or business. You
charitable contributions on their income tax not deduct any amount paid or incurred to must be able to show the education maintains
returns. See Charitable Contributions in Pub- demolish a structure or any loss for the un- or improves skills required in your trade or
lication 542 for more information. Individuals, depreciated basis of a demolished structure. business, or it is required by law or regu-
partners in a partnership, or shareholders in Add these amounts to the basis of the land lations for keeping your pay, status, or job.
an S corporation may be able to deduct where the demolished structure was located. You cannot deduct education expenses
charitable contributions made by their busi- you incur to meet the minimum requirements
ness on their individual income tax returns. of your present trade or business, or those
Depreciation. If property you buy to use in
Example. You paid $15 to a local church your business has a useful life longer than that qualify you for a new trade or business.
for a half-page ad in a program for a concert one year, you generally cannot deduct the This is true even if the education maintains
it is sponsoring. The purpose of the ad was entire cost as a business expense in the year or improves skills presently required in your
to encourage readers to buy your products. you buy it. You must spread the cost over business.
Since your payment is not a contribution, you more than one tax year and deduct part of it
each year. This method of deducting the cost Example 1. Dr. Carter, who is a psychi-
cannot deduct it as such. However, you can atrist, begins a program of study at an ac-
deduct it as an advertising expense. of business property is called depreciation.
However, you can choose to deduct a credited psychoanalytic institute to qualify as
limited amount of the cost of certain depre- a psychoanalyst. She can deduct the cost of
Inventory. You can take a charitable
ciable property in the year you place it in the program because the study maintains or
contribution deduction for inventory items do-
service in your business. This is referred to improves skills required in her profession and
nated to a qualified charitable organization.
as a “section 179 deduction.” does not qualify her for a new one.
Your deduction is limited to the fair market
value of the property on the date of the con- For information on depreciation and the Example 2. Herb Jones owns a repair
tribution less any gain you would have real- section 179 deduction, see Publication 946. shop for electronic equipment. The bulk of
ized if you had sold the property at its fair the business is television repairs, but occa-
market value. You must remove from opening Dues and subscriptions. Generally, you sionally he fixes tape decks and disc players.
inventory (for the year you make the contri- cannot deduct amounts you pay or incur for To keep up with the latest technical changes,
bution) any costs for the donated property membership in any club organized for busi- he takes a special course to learn how to re-
included from prior years. These costs are not ness, pleasure, recreation, or any other social pair disc players. Since the course maintains
part of the cost of goods sold for determining purpose. This includes country clubs, athletic and improves skills required in his trade, he
gross income for the year of the contribution. clubs, luncheon clubs, sporting clubs, airline can deduct its cost.
Use them in figuring the basis of the donated clubs, and hotel clubs.
property. However, you can include (as part Exception. Unless a main purpose is to Example 3. Peter Green, an architect in
of the cost of goods sold) costs in the year conduct entertainment activities for members New York, decided to take a special 2-week
of the contribution if you treat them as part or their guests or to provide members or their course in Los Angeles on the latest building
of the cost of goods sold under your ac- guests with access to entertainment facilities, techniques. While there, he spent an extra 8
counting method. Do not use these costs to the following organizations will not be treated weeks on personal activities. The time he
increase the basis of the donated property. as clubs organized for business, pleasure, spent on personal activities indicates his main
recreation, or other social purpose. reason for going to Los Angeles was to take
Example 1. You own an auto repair shop a vacation. He can deduct his education ex-
and in 1998 you donated auto parts to your 1) Boards of trade. penses and meals and lodging for the 2
local school for its auto repair class. The fair weeks he attended the course. He cannot
market value of the parts at the time of the 2) Business leagues.
deduct his round trip transportation expense
contribution was $600 and you had included 3) Chambers of commerce. to Los Angeles or any of the expenses for the
$400 for the parts in your opening inventory 8 weeks spent on personal activities.
for 1998. Your charitable contribution is $400, 4) Civic or public service organizations.
determined as follows: 5) Professional organizations such as bar Environmental cleanup costs. You can
Fair market value ............................................ $600 associations and medical associations. deduct certain costs to clean up land and to
Minus: Gain if sold ($600 − $400 basis) ........ 200 treat groundwater that you contaminated with
6) Real estate boards. hazardous waste from your business oper-
Charitable contribution ................................ $400
7) Trade associations. ations. You can deduct the costs you incur to
You reduce your opening inventory by the
restore your land and groundwater to the
$400 for the donated property.
You can deduct as a business expense same physical condition that existed prior to
Example 2. Assume the same facts as subscriptions to professional, technical, and contamination. You cannot deduct costs for
Example 1, except you purchased the auto trade journals that deal with your business the construction of groundwater treatment fa-
parts in 1998 for $400 (not part of the opening field. cilities. You must capitalize those costs and
inventory). The $400 is included as part of the you can recover them through depreciation.
cost of goods sold for 1998 but not in figuring Donations to business organizations. You
the basis of the property. Your charitable can deduct donations to business organiza- Franchise, trademark, trade name. If you
contribution is $0, determined as follows: tions as business expenses if all the following buy a franchise, trademark, or trade name,
conditions are met. you can deduct the amount you pay or incur
Fair market value ............................................ $600 for the transfer as a business expense only
Minus: Gain if sold ($600 − $0 basis) ............ 600 • The donation relates directly to your trade if the payments are part of a series of pay-
Charitable contribution ................................ $0 or business. ments that are:
Chapter 16 Other Expenses Page 67
1) Contingent on productivity, use, or dis- 3) The amortization claimed on section 197 You cannot take a charitable deduction
position of the item, intangibles. or business expense for amounts paid to an
organization described in section 170(c) of
2) Payable at least annually for the entire the Internal Revenue Code if:
term of the transfer agreement, and Interview expense allowances. Re-
imbursements you make to job candidates for
3) Substantially equal in amount (or paya- transportation or other expenses related to 1) The organization conducts lobbying ac-
ble under a fixed formula). interviews for possible employment are not tivities on matters of direct financial in-
wages. They are not subject to social security terest to your business, and
When determining the term of the transfer and Medicare taxes (FICA), federal unem- 2) A principal purpose of your contribution
agreement, include all renewal options and ployment taxes (FUTA), or the withholding of is to avoid the rules discussed earlier
any other period for which you and the income tax. You can deduct the reimburse- that prohibit a business deduction for
transferor reasonably expect the agreement ments as a business expense. However, ex- lobbying expenses.
to be renewed. penses for food, beverages, and enter-
A franchise includes an agreement that tainment are subject to the 50% limit If a tax-exempt organization, other than a
gives one of the parties to the agreement the discussed earlier under Meals and Enter- section 501(c)(3) organization, provides you
right to distribute, sell, or provide goods, ser- tainment. with a notice on the portion of dues that are
vices, or facilities within a specified area. allocable to nondeductible lobbying and poli-
Property acquired after August 10, Legal and professional fees. Legal and tical expenses, you cannot deduct that portion
1993 (or after July 25, 1991, if elected). Any professional fees, such as fees charged by of the dues.
amounts you pay or incur for the transfer that accountants, that are ordinary and necessary Covered executive branch official. For
are not described in (1) through (3) above expenses directly related to operating your purposes of this discussion, a covered exec-
must be charged to a capital account. These business are deductible as business ex- utive branch official includes:
are “section 197 intangibles” and are amor- penses. However, you usually cannot deduct
tized over 15 years. See chapter 12 for more 1) The President,
legal fees you pay to acquire business assets.
information on amortization. Add them to the basis of the property. 2) The Vice President,
You can also elect to apply this same If the fees include payments for work of a
treatment to any franchise, trademark, or personal nature (such as making a will), you 3) Any officer or employee of the White
trade name acquired after July 25, 1991. This take a business deduction only for the part House Office of the Executive Office of
election is binding and cannot be revoked of the fee related to your business. The per- the President, and the two most senior
without consent from the IRS. sonal portion of legal fees for producing or level officers of each of the other agen-
Property acquired before August 11, collecting taxable income, doing or keeping cies in the Executive Office,
1993. For a transfer not treated as a sale or your job, or for tax advice may be deductible 4) Any individual who:
exchange of a capital asset, you can deduct on Schedule A (Form 1040) if you itemize
a lump-sum payment of an agreed upon deductions. See Publication 529. a) Is serving in a position in Level I of
principal amount ratably over the shorter of: Tax preparation fees. You can deduct the Executive Schedule under sec-
as a trade or business expense the cost of tion 5312 of title 5, United States
1) 10 years, or preparing that part of your tax return relating Code,
2) The period of the transfer agreement. to your business as a sole proprietor. The b) Has been designated by the Presi-
remaining cost is deductible on Schedule A dent as having Cabinet-level status,
For a transfer not treated as a sale or ex- (Form 1040) if you itemize your deductions. or
change of a capital asset, you can deduct, in You can also take a business deduction
the year made, a payment that is one of a for the amount you pay or incur in resolving c) Is an immediate deputy of an indi-
series of approximately equal payments pay- asserted tax deficiencies for your business vidual listed in items (a) or (b)
able over: as a sole proprietor. above.
Exceptions to denial of deduction. The
1) The period of the transfer agreement, or Licenses and regulatory fees. Licenses general denial of the deduction does not ap-
2) A period of more than 10 years, regard- and regulatory fees for your trade or business ply to:
less of the period of the agreement. paid each year to state or local governments
generally are deductible. Some licenses and 1) Expenses of appearing before, or com-
The above business deductions do fees may have to be amortized. See chapter municating with, any local council or
! not apply to transfers after October
CAUTION 2, 1989, and before August 11, 1993,
12 for more information. similar governing body concerning its
legislation (local legislation) if the leg-
if the principal sum is over $100,000. Lobbying expenses. Generally, you cannot islation is of direct interest to you or to
deduct lobbying expenses. Lobbying ex- you and an organization of which you
Charge any payment not deductible be- penses include amounts paid or incurred for are a member. An Indian tribal govern-
cause of these rules to a capital account. any of the following activities. ment is treated as a local council or
However, you can deduct the payments similar governing body.
charged to a capital account over the life of • Influencing legislation. 2) Any in-house expenses for influencing
the asset if you can determine the useful life • Participating, or intervening, in any poli- legislation and communicating directly
of the asset. Otherwise, you can amortize the tical campaign for, or against, any candi- with a covered executive branch official
payment over a 25-year period beginning with date for public office. if those expenses for the tax year do not
the tax year the transfer occurs. exceed $2,000 (excluding overhead ex-
Contracts entered into before October • Attempting to influence the general pub- penses).
3, 1989. For contracts to buy a franchise, lic, or segments of the public, about
trademark, or trade name entered into before elections, legislative matters, or referen- 3) Expenses incurred by taxpayers en-
October 3, 1989, you can deduct payments dums. gaged in the trade or business of lobby-
contingent on productivity, use, or disposition. ing (professional lobbyists) on behalf
• Communicating directly with covered
The rules discussed earlier for annual and of another person (but does apply to
executive branch officials (defined later)
substantially equal payments do not apply. payments by the other person to the
in any attempt to influence the official
Recapture. You must recapture the pay- lobbyist for lobbying activities).
actions or positions of such officials.
ments as ordinary income if you transfer, sell,
or otherwise dispose of a franchise, trade- • Researching, preparing, planning, or co- Impairment-related expenses. If you are
mark, or trade name for which payments were ordinating any of the preceding activities. disabled, you can deduct expenses neces-
deducted as: sary for you to be able to work (impairment-
Your expenses for influencing legislation related expenses) as a business expense,
1) A lump-sum or serial payment of a prin- and communicating directly with a covered rather than as a medical expense.
cipal amount not treated as a sale or executive branch official include a portion of You are disabled if you have:
exchange of an asset, your labor costs and general and administra-
tive costs of your business. For information 1) A physical or mental disability (for ex-
2) An amortized payment deducted over 25 on making this allocation, see section ample, blindness or deafness) that func-
years, or 1.162-28 of the income tax regulations. tionally limits your being employed, or
Page 68 Chapter 16 Other Expenses
2) A physical or mental impairment that Examples of nondeductible penalties and • Repainting the inside and outside of a
substantially limits one or more of your fines include the following. building.
major life activities.
1) Fines for violating city housing codes. • Repairing roofs and gutters.
You can deduct the expense as a busi- 2) Fines paid by truckers for violating state • Mending leaks.
ness expense if: maximum highway weight laws and air
quality laws. You cannot deduct the cost of repairs that
1) Your work clearly requires the expense you added to the cost of goods sold as a
for you to satisfactorily perform the work, 3) Civil penalties for violating federal laws separate business expense.
regarding mining safety standards and
2) The goods or services purchased are discharges into navigable waters.
clearly not needed or used, other than Repayments (claim of right). If you had to
incidentally, in your personal activities, repay an amount that you had included in
A fine or penalty does not include the fol-
and your income in an earlier year because at that
lowing.
time you thought you had an unrestricted right
3) Their treatment is not specifically pro- 1) Legal fees and related expenses to de- to it, you can deduct the amount repaid from
vided for under other tax law provisions. fend yourself in a prosecution or civil your income in the year in which you repay
action for a violation of the law imposing it.
Example. You are blind. You must use the fine or civil penalty.
a reader to do your work, both at and away Type of deduction. The type of deduction
from your place of work. The reader's ser- 2) Court costs or stenographic and printing you are allowed in the year of repayment de-
vices are only for your work. You can deduct charges. pends on the type of income you included in
your expenses for the reader as a business 3) Compensatory damages paid to a gov- the earlier year. For instance, if you repay an
expense. ernment. amount that you previously reported as a
capital gain, deduct the repayment as a cap-
Nonconformance penalty. You can de- ital loss.
Moving machinery. Generally, the cost of
moving your machinery from one city to an- duct a nonconformance penalty assessed by
other is a deductible expense. So is the cost the Environmental Protection Agency for fail- Repayment—$3,000 or less. If the amount
of moving machinery from one plant to an- ing to meet certain emission standards. you repaid was $3,000 or less, deduct it from
other, or from one part of your plant to an- your income in the year you repaid it. If you
other. You can deduct the cost of installing Political contributions. You cannot deduct reported it as wages, unemployment com-
the machinery in the new location. However, contributions or gifts to political parties or pensation, or other ordinary income, enter it
you must capitalize the costs of installing or candidates as business expenses. In addi- on line 22 of Schedule A (Form 1040). If you
moving newly purchased machinery. tion, you cannot deduct expenses you pay or reported it as a capital gain, deduct it on
incur to take part in any political campaign of Schedule D (Form 1040).
a candidate for public office.
Outplacement services. You can deduct the
Indirect political contributions. You Repayment—over $3,000. If the amount you
costs of outplacement services you provide
also cannot deduct indirect political contribu- repaid was more than $3,000, you can take
to your employees to help them find new
tions and costs of taking part in political ac- a deduction for the amount repaid (Method
employment (such as career counseling, re-
tivities as business expenses. Examples of 1) or you can take a credit against your tax
sume assistance, skills assessment, etc.).
nondeductible expenses include the following. (Method 2). Figure your tax under both
The costs of outplacement services may
cover more than one deduction category. For methods and use the method that results in
1) Advertising in a convention program of less tax.
example, deduct as a utilities expense the a political party, or in any other publica-
cost of telephone calls made under this ser- Method 1. Figure your tax for 1998
tion if any of the proceeds from the claiming a deduction for the repaid amount.
vice, and deduct as rental expense the cost publication are for, or intended for, the
of renting machinery and equipment for this Method 2. Follow these steps.
use of a political party or candidate.
service.
2) Admission to a dinner or program (in- 1) Figure your tax for 1998 without de-
cluding, but not limited to, galas, dances, ducting the repaid amount.
Penalties and fines. Penalties you pay for
film presentations, parties, and sporting
late performance or nonperformance of a 2) Refigure your tax from the earlier year
events) if any of the proceeds from the
contract are generally deductible. For in- without including in income the amount
function are for, or intended for, the use
stance, if you contracted to construct a build- you repaid in 1998.
of a political party or candidate.
ing by a certain date and had to pay an
amount for each day the building was not 3) Admission to an inaugural ball, gala, 3) Subtract the tax in (2) from the tax shown
finished after that date, you can deduct the parade, concert, or similar event if iden- on your return for the earlier year. This
amounts paid or incurred. tified with a political party or candidate. is the credit.
On the other hand, you cannot deduct
4) Subtract the answer in (3) from the tax
penalties or fines you pay to any government Repairs. The cost of repairing or improving for 1998 figured without the deduction
agency or instrumentality because of a vio- property used in your trade or business is ei- (step 1).
lation of any law. These fines or penalties in- ther a deductible or capital expense. You can
clude the following amounts. deduct repairs that keep your property in a If the amount from Method 1 is less tax,
normal efficient operating condition, but that deduct the amount repaid on the same form
1) Paid because of a conviction for a crime do not add to the value or usefulness of or schedule on which you previously reported
or after a plea of guilty or no contest in property or appreciably lengthen its life. If the it. For example, if you reported it as self-
a criminal proceeding. repairs add to the value or usefulness of your employment income, deduct it as a business
property or significantly increase its life you deduction on Schedule C or Schedule C-EZ
2) Paid as a penalty imposed by federal,
must capitalize them. Although you cannot (Form 1040). If you reported it as wages, de-
state, or local law in a civil action, in-
deduct capital expenditures as current ex- duct it as an individual deduction on line 27
cluding certain additions to tax and ad-
penses, you can usually deduct them over a of Schedule A (Form 1040).
ditional amounts and assessable penal-
period of time as depreciation. If using Method 2 results in less tax, claim
ties imposed by the Internal Revenue
Code. the credit on line 63 of Form 1040, and write
The cost of repairs includes the costs “I.R.C. 1341” next to line 63.
TIP of labor, supplies, and certain other
3) Paid in settlement of actual or possible items. You cannot deduct the value
liability for a fine or penalty, whether civil Example. For 1997 you filed a return and
of your own labor. reported your income on the cash method. In
or criminal.
1998 you repaid $5,000 included in your 1997
4) Forfeited as collateral posted for a pro- The following are examples of repairs. gross income under a claim of right. Your fil-
ceeding that could result in a fine or ing status in 1998 and 1997 is single. Your
penalty. • Patching and repairing floors. income and tax for both years are as follows:
Chapter 16 Other Expenses Page 69
1997 1997 3) This method does not distort your in- • Direct dial (by modem) 703–321–8020
With Income Without Income come.
Taxable
Income $15,000 $10,000 You can also deduct the cost of books,
Tax professional instruments, equipment, etc., if
TaxFax Service. Using the phone
Liability $ 2,254 $ 1,504 you normally use them up in less than a year.
attached to your fax machine, you can
1998 1998 receive forms, instructions, and tax
Utilities. Your business expenses for heat, information by calling 703–368–9694. Follow
Without Deduction With Deduction lights, power, and telephone are deductible. the directions from the prompts. When you
Taxable However, any part due to personal use is not
Income $49,950 $44,950 order forms, enter the catalog number for the
deductible. form you need. The items you request will be
Tax Telephone. If you have an office in your faxed to you.
Liability $10,698 $ 9,298 home, even though you are in business, you
Your tax under method (1) is $9,298. Your tax cannot deduct the cost of basic local tele-
under method (2) is $9,948, figured as fol- phone service (including any taxes) for the
lows: first telephone line you have in your home.
Cellular telephone. Generally, any cel- Phone. Many services are available
Tax previously determined for 1997 ........ $2,254 lular telephone or similar telecommunications by phone.
Less: Tax as refigured ............................. − 1,504 equipment is listed property. If listed property
Decrease in 1997 tax $750 is not used more than 50% for qualified busi-
Regular tax liability for 1998 .................... $10,698
ness use during any tax year, special rules
• Ordering forms, instructions, and publi-
Less: Decrease in 1997 tax ..................... − 750 cations. Call 1–800–829–3676 to order
Refigured tax for 1998 $9,948 apply to the section 179 deduction and the
current and prior year forms, instructions,
depreciation deduction. See chapter 4 of
Because you pay less tax under method (1), and publications.
Publication 946.
you should take a deduction for the repay- • Asking tax questions. Call the IRS with
ment in 1998. your tax questions at 1–800–829–1040.

Repayment does not apply. This discussion • TTY/TDD equipment. If you have access
does not apply to the following. to TTY/TDD equipment, call 1–800–829–
4059 to ask tax questions or to order
1) Deductions for bad debts. 17. forms and publications.
2) Deductions from sales to customers, • TeleTax topics. Call 1–800–829–4477 to
listen to pre-recorded messages covering
such as returns and allowances, and
similar items. How To Get various tax topics.

3) Deductions for legal and other expenses


of contesting the repayment.
More Evaluating the quality of our telephone
services. To ensure that IRS representatives

Year payment deducted. If you use the Information give accurate, courteous, and professional
answers, we evaluate the quality of our tele-
cash method, you can take the deduction for phone services in several ways.
the tax year in which you actually make the You can order free publications and forms,
repayment. If you included the amount in in- ask tax questions, and get more information • A second IRS representative sometimes
come because of the rule of constructive re- from the IRS in several ways. By selecting the monitors live telephone calls. That person
ceipt, but never received it, you can deduct method that is best for you, you will have only evaluates the IRS assistor and does
the amount in the tax year you must give up quick and easy access to tax help. not keep a record of any taxpayer's name
your right to receive it. If you use any other or tax identification number.
accounting method, you can deduct the re- Free tax services. To find out what services
• We sometimes record telephone calls to
payment only for the tax year in which it is a are available, get Publication 910, Guide to
evaluate IRS assistors objectively. We
proper deduction under your accounting Free Tax Services. It contains a list of free tax
hold these recordings no longer than one
method. For example, if you use an accrual publications and an index of tax topics. It also
week and use them only to measure the
method, you are entitled to the deduction in describes other free tax information services,
quality of assistance.
the tax year in which the obligation for the including tax education and assistance pro-
repayment accrues. grams and a list of TeleTax topics. • We value our customers' opinions.
Accounting for repayments. If you use Throughout this year, we will be survey-
Personal computer. With your per- ing our customers for their opinions on
the cash method of accounting, you can claim sonal computer and modem, you can
the deduction only in the year the income item our service.
access the IRS on the Internet at
is repaid. If you included the amount in in- www.irs.ustreas.gov. While visiting our Web
come because of the rule of constructive re- Site, you can select:
ceipt, but never received it, you can deduct
the amount in the tax year you must give up Walk-in. You can pick up certain
• Frequently Asked Tax Questions to find
your right to receive it. If you use any other forms, instructions, and publications
answers to questions you may have.
accounting method, you can deduct the re- at many post offices, libraries, and
payment only in the proper tax year under that • Fill-in Forms to complete tax forms on- IRS offices. Some libraries and IRS offices
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Page 70 Chapter 17 How To Get More Information
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• Popular tax forms which may be filled in available in late January.
electronically, printed out for submission,
and saved for recordkeeping.

Index

Car and truck expenses .... 3, 4, 66 How to deduct amortization ...... 48


A Carrying charges ....................... 43 E
Accident and health plans, self- Cellular telephone ..................... 70 Economic performance ............... 4
insured .................................. 20 Cents-per-mile rule .................... 14 Education expenses .............. 9, 67
Accident plans ........................... 19 Charitable: Educational assistance I
Accountable plan ....................... 64 Contributions ........................ 67 programs .............................. 24 Improvements:
Achievement award ..................... 7 Sports event ......................... 66 Elderly, improvements for ......... 45 By lessee .............................. 33
Adoption assistance programs .. 22 Child care (dependent care pro- Electric vehicle credit ................ 62 For disabled and elderly ...... 45
Advertising ................................. 66 gram) .................................... 23 Employee benefit programs: To business assets ................ 3
Amortization: Circulation costs, newspapers and Accident and health plans .... 19 Income taxes ............................. 40
Anti-abuse rule ..................... 50 periodicals ............................ 45 Adoption assistance ............. 22 Incorrect amount of amortization
Anti-churning rules ............... 49 Clean-fuel property .................... 61 Cafeteria plans ..................... 22 deducted ............................... 50
Bond premium ...................... 53 Cleanup costs, environmental ... 67 Dependent care assistance . 23 Individual retirement arrange-
Corporate organization costs 51 Club dues .................................. 67 Educational assistance ........ 24 ments (IRAs) ........................ 31
Dispositions of section 197 in- Commitment fees ...................... 36 Group-term life insurance .... 24 Injury, pay for .............................. 8
tangibles .......................... 49 Computer software .................... 49 Welfare benefit funds ........... 26 Insurance:
Experimental costs ............... 53 Constant-yield method .............. 36 Employees' pay ........................... 6 Accident and health plans .... 19
Going into business Contested liabilities ..................... 5 Employment taxes ..................... 40 Capitalizing premiums .......... 43
expenses ......................... 51 Contributions: Entertainment tickets ................. 66 Deductible premiums ........... 41
How to amortize ................... 52 Charitable ............................. 67 Environmental cleanup costs .... 67 Group-term life ..................... 24
How to deduct ...................... 48 Political ................................. 69 Excise taxes .............................. 40 Nondeductible premiums ..... 42
Incorrect amount deducted .. 50 Copyrights ................................. 48 Experimentation costs ......... 44, 53 Self-employed individuals .... 41
Partnership organization Corporate franchise taxes ......... 40 Exploration costs ....................... 44 Intangible drilling costs .............. 44
costs ................................ 51 Cost depletion ........................... 54 Intangibles, amortization ........... 48
Pollution control facilities ...... 53 Cost of getting lease ........... 32, 53 Interest you cannot deduct ........ 36
Recapture of ......................... 51 Cost of goods sold ...................... 3 Interest:
Reforestation expenses ....... 52 Covenant not to compete .......... 49 F Allocation of .......................... 33
Related person ..................... 50 Credit, electric vehicle ............... 62 Fees: Below-market ....................... 38
Research costs .................... 53 Commitment ......................... 36 Business expense for ........... 33
Section 197 intangibles Legal and professional ......... 68 Capitalized ...................... 36, 37
defined ............................ 48 Loan origination .................... 35 Carrying charge .................... 43
Start-up costs ....................... 51 Regulatory ............................ 68 Deductible ............................ 35
Anticipated liabilities .................. 66 D Tax return preparation ......... 68 Life insurance policies .......... 36
Assessments, local .................... 39 Day care (dependent care pro- Fines .......................................... 69 Refunds of ............................ 37
Assistance (See More information) gram) .................................... 23 Franchise ............................. 49, 67 Interview expenses .................... 68
Attorney fees ............................. 68 De minimis rule, OID ................. 35 Franchise taxes ......................... 40 Investment interest expense limit 37
Awards: Death benefits ............................. 6 Free tax services ....................... 70 IRAs ........................................... 31
Deduction limit ........................ 7 Debt-financed: Fringe benefit:
Employee achievement .......... 7 Acquisitions .......................... 35 Definitions ............................. 11
Length-of-service .................... 7 Distributions .......................... 35 Exclusions ............................ 16
Safety ..................................... 7 Definitions: Nondiscrimination rules ........ 16 K
Achievement award ................ 7 Valuation rules ..................... 12 Keogh plans .............................. 28
Business bad debt ............... 58 Fuel taxes .................................. 40 Kickbacks .................................. 66
Clean-burning fuel ................ 61 Fund, welfare benefit ................. 26
B Clean-fuel vehicle property .. 61
Bad debts .................................. 58 Clean-fuel vehicle refueling
Black lung payments ................. 66 property ........................... 61 L
Bond premium ........................... 53 Fringe benefit ....................... 11 G Leases:
Necessary expense ................ 3 Gas wells ................................... 57 Cost of getting ................ 32, 53
Bonuses:
Ordinary expense ................... 3 Geothermal wells ................. 44, 57 Improvements by lessee ...... 33
Employee ............................... 7
Qualified electric vehicle ...... 63 Gifts, nominal value ..................... 7 Leveraged ............................ 32
Royalties ............................... 58
Related person ....................... 8 Going into business ............... 3, 51 Mineral .................................. 58
Bribes ........................................ 66
Restricted property ................. 9 Goodwill ..................................... 48 Oil and gas ........................... 58
Business meal expenses .......... 65
Section 197 intangibles ........ 48 Group health plans: Sales distinguished .............. 31
Business use of your car .......... 66
Dependent care assistance ....... 23 Continuation-of-coverage ..... 20 Taxes on .............................. 32
Business:
Depletion: Other requirements .............. 20 Legal and professional fees ...... 68
Assets ..................................... 3
Deduction ............................. 54 Group-term life insurance .......... 24 Licenses .............................. 49, 68
Bad debts ............................. 58
Mineral property ................... 54 Guaranteed annual wage ............ 8 Loans:
Books and records ............... 48
Oil and gas wells .................. 55 Below-market interest rate ... 38
Use of car ............................... 4
Percentage table .................. 57 Discounted ........................... 37
Use of home ........................... 4
Timber .................................. 58 Origination fees .................... 35
Depreciation .............................. 67 H To employees ......................... 7
Development costs, miners ....... 45 Health insurance, deduction for Lobbying expenses ................... 68
Disabled: self-employed ....................... 41 Lodging and meals ...................... 8
C Dependent care program ..... 23 Health plans .............................. 19 Lodging, employee ...................... 9
Cafeteria plans .......................... 22 Improvements for ................. 45 Health plans, group ................... 20 Long-term care insurance ......... 41
Campaign contribution .............. 69 Drilling and development costs . 44 Help (See More information) Losses:
Capital expenses ......................... 3 Dues, membership .................... 67 Highly compensated employee . 16 Limits ...................................... 4
Capitalization of interest ............ 37 Hobby losses, not for profit ......... 5 Not-for-profit rules .................. 5

Page 71
Clean-fuel vehicle deduction 61 Supplies and materials .............. 70
M P Definition ................................ 8
Materials and supplies .............. 70 Parking ...................................... 18 Refiners ................................ 55
Meals and entertainment ........... 65 Payments: Unpaid salaries ...................... 8
Meals and lodging ....................... 8 In kind ..................................... 4 Unreasonable rent ................ 31
T
Meals, employee ......................... 9 Restricted property ................. 9 Tax help (See More information)
Relatives as employees .............. 6
Medical expenses, business or Penalties: Tax preparation fees ................. 68
Rent expense, capitalizing ........ 33
personal ................................ 68 Deductible ............................ 69 Taxes:
Repairs ...................................... 69
Medical reimbursement plans ... 19 Nondeductible ...................... 69 Carrying charge .................... 43
Repayments (claim of right) ...... 69
Medical savings accounts ......... 22 Prepayment .......................... 35 Corporate franchise .............. 40
Replacements .............................. 3
Mining: Percentage depletion ................ 54 Employment ......................... 40
Research costs .................... 44, 53
Depletion .............................. 57 Personal property tax ................ 40 Excise ................................... 40
Restricted property ...................... 9
Development costs ............... 45 Points ......................................... 35 Franchise .............................. 40
Retirement plans:
Exploration costs .................. 44 Political contributions ................. 69 Fuel ...................................... 40
Defined benefit ..................... 28
Money purchase pension plan .. 28 Pollution control facilities ........... 53 Income .................................. 40
Defined contribution ............. 28
More information ....................... 70 Prepaid expenses: Leased property ................... 32
IRAs ...................................... 31
Mortgages: General rule ........................... 5 Personal property ................. 40
Keogh ................................... 28
Cost of acquiring .................. 35 Insurance .............................. 43 Real estate ........................... 39
Money purchase pension ..... 28
Interest ................................. 35 Interest ................................. 37 Sales .................................... 40
Nonqualified ......................... 31
Moving expenses: Rent ...................................... 31 Unemployment fund ............. 40
Profit-sharing ........................ 28
Employees .............................. 9 Prepayment penalty .................. 35 Taxpayer Advocate ..................... 1
Qualified ......................... 26, 27
Machinery ............................. 69 Problem Resolution Program ...... 1 Telephone, deducting cost ........ 70
Salary reduction arrangement 29
Reimbursements .................. 19 Profit-sharing plans ................... 28 Timber ................................. 52, 58
Simplified employee pension
Publications (See More information) Trademark, trade name ....... 49, 67
(SEP) ............................... 29
Travel ......................................... 64
Small business owners ........ 28
TTY/TDD information ................ 70
Stock bonus ......................... 28
N R
Natural gas ................................ 57 Real estate taxes ...................... 39
Necessary expense ..................... 3 Recapture: U
Nonaccountable plan ................. 66 Amortization ......................... 51 S Unemployment fund taxes ........ 40
Nonqualifying intangibles .......... 49 Clean-fuel deductions .......... 62 Salaries and wages ..................... 6 Uniform capitalization rules ......... 6
Not-for-profit activities ................. 5 Electric vehicle credit ........... 63 Sales taxes ................................ 40 Unpaid expenses, related per-
Exploration expenses ........... 44 Self-employed, health insurance sons .................................. 5, 38
Timber property .................... 53 deduction .............................. 41 Unpaid salaries, related persons 8
Recordkeeping .................... 56, 57 Self-employment tax .................. 40 Utilities ....................................... 70
O Recovery of amount deducted .... 4 Self-insurance:
Office in home ............................. 4 Reforestation expenses ............. 52 Medical reimbursement plans 19
Oil and gas wells:
Depletion .............................. 55
Regulatory fees ......................... 68
Reimbursements:
Reserve for ........................... 42
SIMPLE plans ............................ 30
V
Vacation pay ................................ 8
Drilling costs ......................... 44 Accountable plan .................. 64 Simplified employee pension
Partnerships ......................... 56 Mileage ................................. 64 (SEP) .................................... 29
S corporation ........................ 57 Moving expense ................... 19 Standard mileage rate ............... 64
Ordinary expense ........................ 3 Nonaccountable plan ........... 66 Standby charges ....................... 36 W
Organization costs: Per diem ............................... 64 Start-up costs ............................ 51 Wages and salaries ..................... 6
Corporate ............................. 51 Qualifying requirements ....... 64 Stock bonus plan ....................... 28 Welfare benefit funds ................ 26
Partnership ........................... 51 Related persons: Stockholders as employees ........ 6 
Outplacement services .............. 69 Anti-churning rules ............... 50 Subscriptions ............................. 67

Page 72
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 1999 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 1999 Information for Members of the 908 Bankruptcy Tax Guide
553 Highlights of 1998 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 953 International Tax Information for
536 Net Operating Losses Businesses
15 Employer’s Tax Guide (Circular E) 537 Installment Sales 1544 Reporting Cash Payments of Over
15-A Employer’s Supplemental Tax Guide 538 Accounting Periods and Methods $10,000
51 Agricultural Employer’s Tax Guide 541 Partnerships 1546 The Problem Resolution Program
(Circular A) 542 Corporations of the Internal Revenue Service
80 Federal Tax Guide For Employers in 544 Sales and Other Dispositions of
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 Guía Contributiva Federal Para 579SP Cómo Preparar la Declaración de
Patronos Puertorriqueños 560 Retirement Plans for Small Business
(SEP, SIMPLE, and Keogh Plans) Impuesto Federal
(Circular PR)
561 Determining the Value of Donated 594SP Comprendiendo el Proceso de Cobro
926 Household Employer’s Tax Guide
Property 850 English-Spanish Glossary of Words
583 Starting a Business and Keeping and Phrases Used in Publications
Records Issued by the Internal Revenue
Specialized Publications Service
587 Business Use of Your Home
(Including Use by Day-Care 1544SP Informe de Pagos en Efectivo en
378 Fuel Tax Credits and Refunds Exceso de $10,000 (Recibidos en
Providers)
594 Understanding the Collection Process una Ocupación o Negocio)

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
Sch D Capital Gains and Losses* 11338 3800 General Business Credit 12392
Sch E Supplemental Income and Loss* 11344 3903 Moving Expenses* 12490
Sch F Profit or Loss From Farming* 11346 4562 Depreciation and Amortization* 12906
Sch H Household Employment Taxes* 12187 4797 Sales of Business Property* 13086
4868 Application for Automatic Extension of Time To 13141
Sch J Farm Income Averaging* 25513 File U.S. Individual Income Tax Return*
Sch R Credit for the Elderly or the Disabled* 11359
5329 Additional Taxes Attributable to IRAs, Other 13329
Sch SE Self-Employment Tax* 11358 Qualified Retirement Plans, Annuities, Modified
1040-ES Estimated Tax for Individuals* 11340 Endowment Contracts, and MSAs*
1040X Amended U.S. Individual Income Tax Return* 11360 6252 Installment Sale Income* 13601
1065 U.S. Partnership Return of Income 11390 8283 Noncash Charitable Contributions* 62299
Sch D Capital Gains and Losses 11393 8300 Report of Cash Payments Over $10,000 62133
Sch K-1 Partner’s Share of Income, 11394 Received in a Trade or Business*
Credits, Deductions, etc. 8582 Passive Activity Loss Limitations* 63704
1120 U.S. Corporation Income Tax Return 11450 8606 Nondeductible IRAs* 63966
1120-A U.S. Corporation Short-Form 11456 8822 Change of Address* 12081
Income Tax Return 8829 Expenses for Business Use of Your Home* 13232

Page 73
See How To Get More Information for a variety of ways to get publications,
Tax Publications for Individual Taxpayers including by computer, phone, and mail.

General Guides 530 Tax Information for First-Time 901 U.S. Tax Treaties
Homeowners 907 Tax Highlights for Persons with
1 Your Rights as a Taxpayer 531 Reporting Tip Income Disabilities
17 Your Federal Income Tax (For 533 Self-Employment Tax 908 Bankruptcy Tax Guide
Individuals) 534 Depreciating Property Placed in 911 Direct Sellers
225 Farmer’s Tax Guide Service Before 1987 915 Social Security and Equivalent
334 Tax Guide for Small Business 537 Installment Sales Railroad Retirement Benefits
509 Tax Calendars for 1999 541 Partnerships 919 Is My Withholding Correct for 1999?
553 Highlights of 1998 Tax Changes 544 Sales and Other Dispositions of 925 Passive Activity and At-Risk Rules
595 Tax Highlights for Commercial Assets 926 Household Employer’s Tax Guide
Fishermen 547 Casualties, Disasters, and Thefts 929 Tax Rules for Children and
910 Guide to Free Tax Services (Business and Nonbusiness) Dependents
550 Investment Income and Expenses 936 Home Mortgage Interest Deduction
Specialized Publications 551 Basis of Assets 946 How To Depreciate Property
552 Recordkeeping for Individuals 947 Practice Before the IRS and Power
3 Armed Forces’ Tax Guide 554 Older Americans’ Tax Guide of Attorney
378 Fuel Tax Credits and Refunds 555 Community Property 950 Introduction to Estate and Gift Taxes
463 Travel, Entertainment, Gift, and Car 556 Examination of Returns, Appeal 967 IRS Will Figure Your Tax
Expenses Rights, and Claims for Refund 968 Tax Benefits for Adoption
501 Exemptions, Standard Deduction, 559 Survivors, Executors, and
and Filing Information 970 Tax Benefits for Higher Education
Administrators 971 Innocent Spouse Relief
502 Medical and Dental Expenses 561 Determining the Value of Donated
503 Child and Dependent Care Expenses 1542 Per Diem Rates
Property 1544 Reporting Cash Payments of Over
504 Divorced or Separated Individuals 564 Mutual Fund Distributions $10,000
505 Tax Withholding and Estimated Tax 570 Tax Guide for Individuals With 1546 The Problem Resolution Program
508 Educational Expenses Income From U.S. Possessions of the Internal Revenue Service
514 Foreign Tax Credit for Individuals 575 Pension and Annuity Income
516 U.S. Government Civilian Employees 584 Nonbusiness Disaster, Casualty, and
Stationed Abroad Theft Loss Workbook Spanish Language Publications
517 Social Security and Other 587 Business Use of Your Home
Information for Members of the (Including Use by Day-Care 1SP Derechos del Contribuyente
Clergy and Religious Workers Providers) 579SP Cómo Preparar la Declaración de
519 U.S. Tax Guide for Aliens 590 Individual Retirement Arrangements Impuesto Federal
520 Scholarships and Fellowships (IRAs) (Including Roth IRAs and 594SP Comprendiendo el Proceso de Cobro
521 Moving Expenses Education IRAs) 596SP Crédito por Ingreso del Trabajo
523 Selling Your Home 593 Tax Highlights for U.S. Citizens and 850 English-Spanish Glossary of Words
524 Credit for the Elderly or the Disabled Residents Going Abroad and Phrases Used in Publications
525 Taxable and Nontaxable Income 594 Understanding the Collection Process Issued by the Internal Revenue
526 Charitable Contributions 596 Earned Income Credit Service
527 Residential Rental Property 721 Tax Guide to U.S. Civil Service 1544SP Informe de Pagos en Efectivo en
529 Miscellaneous Deductions Retirement Benefits Exceso de $10,000 (Recibidos en
una Ocupación o Negocio)
See How To Get More Information for a variety of ways to get forms, including by computer,
Commonly Used Tax Forms fax, phone, and mail. For fax orders only, use the catalog numbers when ordering.

Catalog Catalog
Form Number and Title Number Form Number and Title Number
1040 U.S. Individual Income Tax Return 11320 2106 Employee Business Expenses 11700
Sch A & B Itemized Deductions & Interest and 11330 2106-EZ Unreimbursed Employee Business 20604
Ordinary Dividends Expenses
Sch C Profit or Loss From Business 11334 2210 Underpayment of Estimated Tax by 11744
Sch C-EZ Net Profit From Business 14374 Individuals, Estates and Trusts
Sch D Capital Gains and Losses 11338 2441 Child and Dependent Care Expenses 11862
Sch E Supplemental Income and Loss 11344 2848 Power of Attorney and Declaration 11980
Sch EIC Earned Income Credit 11339 of Representative
Sch F Profit or Loss From Farming 11346 3903 Moving Expenses 12490
Sch H Household Employment Taxes 12187 4562 Depreciation and Amortization 12906
Sch J Farm Income Averaging 25513 4868 Application for Automatic Extension of Time 13141
Sch R Credit for the Elderly or the Disabled 11359 To File U.S. Individual Income Tax Return
4952 Investment Interest Expense Deduction 13177
Sch SE Self-Employment Tax 11358
1040A U.S. Individual Income Tax Return 11327 5329 Additional Taxes Attributable to IRAs, Other 13329
Qualified Retirement Plans, Annuities,
Sch 1 Interest and Ordinary Dividends for 12075 Modified Endowment Contracts, and MSAs
Form 1040A Filers
Sch 2 Child and Dependent Care 10749 6251 Alternative Minimum Tax–Individuals 13600
Expenses for Form 1040A Filers 8283 Noncash Charitable Contributions 62294
Sch 3 Credit for the Elderly or the 12064 8582 Passive Activity Loss Limitations 63704
Disabled for Form 1040A Filers 8606 Nondeductible IRAs 63966
1040EZ Income Tax Return for Single and 11329 8812 Additional Child Tax Credit 10644
Joint Filers With No Dependents 8822 Change of Address 12081
1040-ES Estimated Tax for Individuals 11340 8829 Expenses for Business Use of Your Home 13232
1040X Amended U.S. Individual Income Tax 11360 8863 Education Credits 25379
Return

Page 74
Notes

Page 75

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