Deducting Business Expenses

Business expenses are the cost of carrying on a trade or business. These expenses are usually deductible if the business is operated to make a profit.

What Can I Deduct?

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

It is important to separate business expenses from the following expenses:

  • The expenses used to figure the cost of goods sold,
  • Capital Expenses, and
  • Personal Expenses.

Cost of Goods Sold

If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your expenses may be included in figuring the cost of goods sold. Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.

The following are types of expenses that go into figuring the cost of goods sold.

  • The cost of products or raw materials, including freight
  • Storage
  • Direct labor costs (including contributions to pensions or annuity plans) for workers who produce the products
  • Factory overhead

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.

This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million.

For additional information, refer to the chapter on Cost of Goods Sold, Publication 334, Tax Guide for Small Businesses and the chapter on Inventories, Publication 538, Accounting Periods and Methods.

Capital Expenses

You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called capital expenses. Capital expenses are considered assets in your business. There are, in general, three types of costs you capitalize.

  • Business start-up cost (See the note below)
  • Business assets
  • Improvements

Note: You can elect to deduct or amortize certain business start-up costs. Refer to chapters 7 and 8 of Publication 535, Business Expenses.

Personal versus Business Expenses

Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part.

For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you can deduct 70% of the interest as a business expense. The remaining 30% is personal interest and is not deductible. Refer to chapter 4 of Publication 535, Business Expenses, for information on deducting interest and the allocation rules.

Business Use of Your Home

If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. Refer to Home Office Deduction and Publication 587, Business Use of Your Home, for more information.

Business Use of Your Car

If you use your car in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage. Refer to Publication 463, Travel, Entertainment, Gift, and Car Expenses. For a list of current and prior year mileage rates see the Standard Mileage Rates.

Other Types of Business Expenses

  • Employees’ Pay – You can generally deduct the pay you give your employees for the services they perform for your business.
  • Retirement Plans – Retirement plans are savings plans that offer you tax advantages to set aside money for your own, and your employees’ retirement.
  • Rent Expense – Rent is any amount you pay for the use of property you do not own. In general, you can deduct rent as an expense only if the rent is for property you use in your trade or business. If you have or will receive equity in or title to the property, the rent is not deductible.
  • Interest – Business interest expense is an amount charged for the use of money you borrowed for business activities.
  • Taxes – You can deduct various federal, state, local, and foreign taxes directly attributable to your trade or business as business expenses.
  • Insurance – Generally, you can deduct the ordinary and necessary cost of insurance as a business expense, if it is for your trade, business, or profession.

If you have a business and need help in completing your Income Tax Return, please contact us at 773-728-1500.  We, the Chicago Accountants, are here to help you.

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Can anyone qualify to own an S-Corporation?

Business Incorporation in Illinois is one of our Accountants in Chicago specialty. That’s why it is very important to know which are the tax savings from operating your ordinary income business under an S-Corp.  However, not everyone is a qualifying shareholder of an S-Corporation.  If you are from a foreign country living here in the U.S. with a ‘Visa’ or ‘Green Card’ it’s critical to know what the rules are.

Here are the two rules that would make you qualify to be a shareholder of an S-Corp.

  1. You need to be a “Resident Alien”, there are a few tests to determine that. 
    1. one is the “Green Card” test; this where the alien actually has to be a lawful permanent resident with a green card (Immigration Form I-551); if you have one of these documents it doesn’t matter how long you’ve been present in the country, you can qualify as an S-Corporation shareholder.  However, if your Visa is a non-immigrant visa, then that would not constitute lawful permanent residence, so you wouldn’t qualify under this test.
    2. b.      or you need to pass the  “Substantial Presence Test”, this test is essentially mathematical, it is satisfied if the alien individual is physically present in the United States for the requisite amount of time, either for the calendar year in question or for the three-year period that ends with the year in question. For purposes of the test, presence during any portion of a day is considered presence for a full day.
    3. The “Substantial Presence Test” is met in either of the following circumstances:
  • The alien is physically present in the United States for 183 days or more during the target calendar year, or
  • He is present in the United States for at least 31 days for the year in question and has been present for 183 days which are the sum of (a) days during the target year counted as full days, plus (b) days in the first preceding year counted as one-third days, plus (c) days in the second preceding year counted as one-sixth days.

In sum, if you have a ‘Green Card”, if you have been living in the U.S. for 183 days or more during the calendar year, then you would meet this test and be eligible to be a shareholder of an S-Corp.  Remember you need to continue to meet this test every year until you actually get the “Green Card”. Sounds easy right?

For more questions regarding Business Incorporation in Illinois you can call us at 773-728-1500.

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Short Sale or Foreclosure – the Income Tax Consequences

We are CPAs in Chicago and provide the following summary for the benefit of Taxpayers in Chicago and surrounding suburbs.

These days a lot of home owners or real estate investors are encountering numerous questions about the tax consequences of these situations. That’s why it’s more important than ever for real estate owners to understand the basics of how the IRS views tax forgiveness.

How does the IRS view a short sale or foreclosure?

short sale is the discount a mortgage holder may allow in order to sell the property, even though doing so will short or discount the note. This generally results in a benefit to the debtor because the mortgage is reduced.

The process, of course, is different in a foreclosure, but the result is essentially the same.  The mortgage holder forecloses on the property, takes possession or sells the property on the courthouse steps, and will probably end up losing on the original mortgage. In effect, the borrower usually doesn’t have to pay the full mortgage, and whatever the lender can get for the property reduces the mortgage amount and the lender will often take a loss on the rest.

IRS frankly doesn’t care if a property is going through a short sale or foreclosure. The IRS is going to determine if Forgiveness of Debt took place and if it should be taxed to the taxpayer. Keep in mind though that the lender does not always forgive debt in a foreclosure or short sale. If the lender gets a deficiency judgment or comes after the homeowner for the unpaid amount, there is no debt forgiveness and thus no taxable income.

However, for situations where the lender does forgive the debt, determining what should be taxed can be a complicated question with lots of variations based on the facts and circumstances.

Keep in mind that, in almost every situation, the IRS boils the transaction down to the analysis of four questions:

.Question 1: Was the property sold for less than the mortgage or mortgages on the property?

Easy to calculate, simply add up all of the debt on the property (first and second mortgages included), and subtract it from the final sales price. If the result is a negative number, then there is a presumption the seller or prior owner is facing Forgiveness of Debt Income.

In case of foreclosure, it’s a little more difficult to determine the amounts in the equation above, because sometimes the bank/mortgage holder hasn’t sold the property yet; they simply took possession of the property in the foreclosure. Essentially, the calculation can’t be completed until the lender sells the property and their loss is determined.

Question 2: Was the mortgage or mortgages considered recourse or non-recourse debt?

If there is a presumption of debt forgiveness as determined in Question 1, the taxpayer next has to find out if the debt is recourse debt. This simply means the debtor signed personally guaranteeing the debt, or in other words, is personally obligated to pay the mortgage. This is actually an easy fact to determine.

A quick document review by an attorney can help the homeowner determine if the debt is recourse or not. The good news is if they aren’t personally liable, then they don’t have to pay the debt and they don’t have Forgiveness of Debt Income.

            Question 3: Is there Forgiveness of Debt Income after the basis on the property and any loss is calculated?

Often taxpayers overlook this aspect of the analysis.  Assuming there is recourse debt, and hence Forgiveness of Debt Income, taxpayers shouldn’t forget to calculate their loss on the property as a whole. This loss can offset any Forgiveness of Debt Income.

In this more complicated equation, the taxpayer would start with the sales price of the property and then subtract the adjusted basis on the property (i.e., the net cost for the property after adjusting for various items like depreciation or home improvements). This process will tell the homeowner if there is a gain or loss on the property. In sum, a loss would be deductible against the Forgiveness of Debt Income. Note, however, that a primary residence is going to be treated differently during this stage of the analysis (see below).

If there is Forgiveness of Debt Income from recourse debt and the loss on the sale doesn’t wipe out the gain, or it isn’t a primary residence, then the taxpayer’s only option to avoid being taxed on the forgiveness is to qualify under the insolvency or bankruptcy rules provided by the IRS. Essentially, these rules require the taxpayer’s total liabilities to exceed total assets, whether married or single (the details of which are discussed in IRS Publication 4681).

One final option that doesn’t allow the taxpayer to discharge the income but permits deferring the tax over time is to reduce the basis on other real estate owned by the taxpayer by using Form 982.

Question 4: Was the property in question the primary residence of the taxpayer?

The rules have been changed when it comes to principal or primary residences. Congress passed and President Bush signed into law the Mortgage Forgiveness Debt Relief Act of 2007 to provide relief to families who were going through a short sale or foreclosure on their primary residence through the end of 2012. This law essentially wipes out any acquisition indebtedness (not second mortgages unrelated to the purchase) and is a specific election made on a tax return. (Note there is a limit of $2 million of interest and debt for married couples and a lower limit for single individuals). Taxpayers should consult with their tax advisor regarding the specifics of this exception and they qualify.

Finally, I would be remiss to not mention loan modifications and the impact they may have on a tax bill. Rest assured, most loan modifications don’t create taxable income as they simply modify the terms of a loan to help a debtor better make his or her payments. However, if a lender actually reduces the principal amount of the loan, sometimes called a cram down, then the debtor better expect a 1099 for Cancellation of Debt Income and speak with a tax advisor.

Make sure your Tax Advisor knows how to apply correctly the tax deductions that are allowed.

In summary, if you going through a loan modification, short-sale, foreclosure, or deed in lieu, please know that, we at TaxCutters can help you through the tax paperwork process.  Please give us a call at: 773-728-1500.

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Corporation Tax: How Business Website Expenses Are Deducted

With the explosion of online businesses, one would think that there would be a standard method of deducting the cost of your business website. But some questions still exist as to what part of a website is considered software, and to date, the IRS has not fully clarified that issue for tax purposes. As a Tax Accountant in Chicago, I’ve recently seen an explosion of questions regarding deductibility of assets in online businesses.

Purchased Websites – If the website is purchased from a contractor who is at economic risk should the software not perform, the design costs are amortized (ratably deducted) over the three-year period, beginning with the month in which the website is placed in service. For 2012, non-customized computer software placed in service during the year qualifies as Sec 179 property and can be written off in full up to the limits of this special expense deduction.

In-House Developed Websites – If, instead of being purchased, the website design is “developed” by the company or designed by an independent contractor who is not at risk should the software not perform, the company launching the website can choose among alternative treatments, one of which is deducting the costs in the year that the costs are paid, or accrued, depending on the taxpayer’s overall accounting method. Or, as an alternative, the costs may be amortized under the three-year rule.

Non-Software Expenses – Some website design costs, such as graphics, may not be classified as software and must be deducted over the useful life of the element. Non-software portions of the design with a useful life of no more than a year are currently deductible.

Advertising Content – Advertising costs are generally currently deductible. Thus, the costs of website content that is advertising are generally, currently deductible.

Cost Before Business Starts – Business expenses that are incurred or accrued prior to the actual activation of the business are generally not deductible until the business is terminated or sold. However, a taxpayer can elect to deduct up to $5,000 of the costs in the year that the business starts and amortize the costs in excess of $5,000 over a period of 180 months (15 years), beginning with the month that the business starts.

We provide bookkeeping and tax services for many businesses including online businesses.  If you have any questions regarding Corporation taxes, please call us at 773-728-1500.

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Tax analyse when you give your home to your children!!

We are accountants in Chicago and would like to give you our opinion regarding gifting you house to you children since many of my clients have asked me this question.

Giving / gifting you house to your children can have major tax consequences. Many people wonder if it is a good idea to give their home to their children, of course they can do that but this won’t dismiss the tax implication on such a transaction.

When you want to give a property as a gift (valued at more than $13,000 in any one year), you will have to file a gift tax form. And under current law you can gift a total of $5 million over your lifetime without incurring a gift tax. If your residence is worth less than $5 million, you likely won’t have to pay any gift taxes, but you will still have to file a gift tax form.  (And Congress may change the gift tax exemption, which is now scheduled to revert to $1 million at the end of 2012 unless Congress acts.)

You may not have to pay gift taxes on the gift, but if your children sell the house right away, they may be facing steep taxes. The reason is that when you give away your property, the tax basis (or the original cost) of the property for the giver becomes the tax basis for the recipient. For example, suppose you bought the house years ago for $250,000 and it is now worth $450,000. If you give your house to your children, the tax basis will be $250,000. If the children sell the house, they will have to pay capital gains taxes on the difference between $250,000 and the selling price. The only way for your children to avoid the taxes is for them to live in the house for at least two years before selling it. In that case, they can exclude up to $250,000 ($500,000 for a couple) of their capital gains from taxes.

Gifted property does not face the same taxes as inherited property. If the children were to inherit the property, the property’s tax basis would be “stepped up,” which means the basis would be the current value of the property. However, the home will remain in your estate, which may have estate tax consequences.

As a Tax Preparer, who has prepared thousands of tax returns, I can say that there are different consequences while gifting a house to your children and it can affect your eligibility for Medicaid coverage of long-term care.  There are other options for giving your house to your children, including putting it in a trust or selling it to them. Before you give away your home, consult your elder law attorney, who can advise you on the best method for passing on your home.

Please contact us at 773-728-1500 if you have any questions related to Income tax.

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