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Travel and entertainment rules from a practice development point of view.

Deductions for travel and entertainment (T&E) tend to be taken for granted by most clients--until they get audited. Although most of the current rules have been in force for five years or more, many clients do not know (or do not want to know) what they should do to ensure the deductibility of T&E expenses. Therefore, it is both the responsibility of and an opportunity for the CPA to guide clients in this area.

While clients may consider their T&E deductions to be an inalienable right, Congress and the IRS have a somewhat different view. In the committee reports to the Tax Reform Act of 1986, the House of Representatives explained that it was proposing the 20% reduction for meals and entertainment because there is an inherent element of personal living expenses in such deductions. T&E is a favorite IRS target, because ignorance of the rules leads to inadequate documentation, which makes it easy for the Service to disallow otherwise valid deductions. A look at some of the areas of confusion and the basic recordkeeping requirements should be worthwhile.

* Business travel requires an overnight stay away from the taxpayer's "tax home" (generally the taxpayer's regular place of business) and allows deductions for meals and lodging in addition to the cost of the transportation. For the costs to be deductible at all, the trip must be primarily for business, which is a facts and circumstances test based in part on the amount of time spent on business versus the time spent on personal activities. A spouse's travel costs will be personal unless there is a bona fide business reason for the spouse to go along. Since any personal travel paid by a business must be reported as compensation to the employee, it will benefit both employee and employer to provide documentation that supports the highest business-related amount possible.

* Business meals and entertainment have to meet one of two basic tests to be deductible. They must be either "directly related to" the active conduct of the taxpayer's trade or business, or they can be "associated with" the active conduct of the business. "Directly related" is a tougher test to meet and requires (among other things) that the taxpayer usually transact or discuss business during the entertainment and expect to derive some business benefit beyond just goodwill. "Associated with" means the entertainment should immediately precede or follow a "substantial and bona fide" business discussion; business does not have to be discussed during the entertainment. Since clients tend to feel that almost everything they do is at least associated with their business, they should be made aware of what they must do to support these deductions.

* Entertainment facilities can be a major source of disallowed deductions if the client does not understand the rules. For example, a client may use his boat solely for legitimate business meetings and therefore feel its use is 100% business related. However, since a boat is considered an entertainment facility, the client can deduct only out-of-pocket costs (such as food consumed during the meetings). No deduction is allowed for depreciation of the boat itself or for any of its operating costs. One important exception to this rule limiting deductions for entertainment facilities is dues or fees paid to clubs used more than 50% for business purposes. Such dues are deductible only to the extent they are "directly related to" the taxpayer's trade or business.

With all these rules to face, the client needs the CPA's assistance to meet the recordkeeping requirements in order to preserve T&E deductions. The records should generally explain who what, when, where, why and how much it cost. Records should be made in writing near the time of the expenditure to provide the best support. Other methods can be used to support deductions after the fact, but they are more likely to be challenged by the IRS. Copies of receipts should be retained in addition to the written records.

When a taxpayer reimburses its employees for valid T&E expenses, the treatment for both will vary based on whether the taxpayer has an "accountable" or a "nonaccountable" plan. If the employee must substantiate all expenses to the taxpayer in accordance with the recordkeeping requirements, and any advances in excess of the substantiated expenses must be returned to the employer within a reasonable time, this will generally be considered an accountable plan. In this case, the taxpayer is subject to the 80% meals and entertainment limitation and there is no compensation to the employee. Otherwise, the plan is nonaccountable and all reimbursements must be reported as wages to the employee. Payroll taxes must be withheld and paid by the taxpayer as appropriate. The employee can then deduct the business expenses personally, subject to the 2% of adjusted gross income (AGI) limit. This generally results in more payroll taxes owed by the taxpayer and additional income tax owed by the employee.

CPA firms that have not already done so should take steps to see that their clients comply with the T&E rules. For smaller clients, the CPA may start by sending a memo explaining how problems might arise. The client can then decide whether he wants additional assistance. For larger clients, the CPA can offer to review their policies and procedures regarding T&E deductions. The CPA can make suggestions on how to improve the client's T&E record-keeping and provide logs and design forms that will allow the client to adequately substantiate expenses with a minimum of aggravation. An accountable reimbursement plan can be implemented. For the CPA, taking a practive stance rather than a reactive one can also generate additional chargeable hours for the firm. This is the type of work that can be done during slower times of the year, which will increase firm productivity.

Because the IRS has both more resources to conduct business audits and a desire for additional revenue, T&E could be an area of significant exposure for some clients. Such clients will not only be unhappy about the tax and penalties they owe, they will also be upset with the CPA who did not warn them of the risks attached to insufficient documentation of T&E expenditures.
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Author:Federanich, Charles E.
Publication:The Tax Adviser
Date:Mar 1, 1992
Words:1034
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