Small Business Taxes

Small Business: Avoiding Problems with the IRS

Publication Date: September 2020

Small Business:

Avoiding Problems with the IRS

Copyright © 2020 by

DeltaCPE LLC

All rights reserved. No part of this course may be reproduced in any form or by any means, without permission in

writing from the publisher.

The author is not engaged by this text or any accompanying lecture or electronic media in the rendering of legal,

tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this

material have been reviewed with sources believed to be reliable, concepts discussed can be affected by changes

in the law or in the interpretation of such laws since this text was printed. For that reason, the accuracy and

completeness of this information and the author's opinions based thereon cannot be guaranteed. In addition,

state or local tax laws and procedural rules may have a material impact on the general discussion. As a result, the

strategies suggested may not be suitable for every individual. Before taking any action, all references and citations

should be checked and updated accordingly.

This publication is designed to provide accurate and authoritative information in regard to the subject matter

covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other

professional service. If legal advice or other expert advice is required, the services of a competent professional

person should be sought.

—-From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a

Committee of Publishers and Associations.

Course Description

Small businesses must calculate the yearly income and expenses for their tax returns, and each return is unique,

ranging from the part-time teacher of trumpet lessons to the large law office operating as a single member LLC.

The books and records of these businesses can range from a disheveled box of receipts, to an Excel spreadsheet,

to a nice set of financials generated from QuickBooks. Certain issues or factors within a tax return are red flags,

or triggers, to the IRS that may increase the likelihood of an audit. Some of these triggers are newer, due to recent

changes in tax law while others have been around for so long that practitioners have grown bored with them and,

perhaps, become a bit careless in confirming that their clients are complying with the requirements of the law.

The Internal Revenue Service (IRS) has published auditing procedures in their Auditing Techniques Guides (ATGs),

which are available on its website. While these guides were designed for use by IRS examiners, they are also

valuable sources of information for small business owners and tax practitioners who can use them when

establishing their own procedures to ensure potential audit issues are addressed prior to filing tax returns.

Applying the ATGs benefits clients and also demonstrates practitioners’ due diligence in the preparation of tax

returns.

The Department of Labor (DOL) has recently taken an increasingly larger role in determining how businesses

should define their workers and how they should pay their workers. Many small businesses could run afoul of the

DOL rules and regulations with respect to their employee relations, and it is up to practitioners to educate them

about these requirements and issues. This course provides the most recent news out of the DOL.

This course takes an in-depth look at audit triggers for cash intensive businesses, the hobby loss rules, the proper

classification of independent contractors and employees, and the requirements of the recent Tangible Property

Regulations. This course also briefly reminds the practitioner of the requirements related to deductions for items

such as meals and entertainment, travel, and the office in the home. At the end of each chapter is an Action Plan,

which the practitioner can use to develop procedures that properly address these potential audit issues. By

following these procedures, practitioners can go a long way toward helping their clients stay out of trouble with

the IRS and the DOL.

Field of Study Taxes

Level of Knowledge Basic to Intermediate

Prerequisite Basic Taxation

Advanced Preparation None

Table of Contents

Section 1: Recordkeeping and Cash Intensive Businesses .......................................................................................1

Learning Objectives: ...............................................................................................................................................1

Overview .................................................................................................................................................................1

Audit Techniques Guides ........................................................................................................................................3

Careful Recordkeeping ...........................................................................................................................................4

1. Proof of income upon audit. ...........................................................................................................................5

2. IRS matching. ..................................................................................................................................................5

3. Documentation of all business expenses. ......................................................................................................6

Cash Intensive Businesses ......................................................................................................................................7

IRS Red Flags .......................................................................................................................................................8

Proper Accounting or Recordkeeping Procedures .............................................................................................9

Making Use of the ATGs in Developing Tax Season Procedures ..................................................................... 11

Summary and Action Plan ................................................................................................................................... 15

Review Questions - Section 1 .............................................................................................................................. 17

Section 2: Hobby Loss Rules ................................................................................................................................. 18

Learning Objectives: ............................................................................................................................................ 18

Is This Activity a Hobby? ...................................................................................................................................... 18

Hobby vs. Business: What’s the Big Deal? ........................................................................................................... 19

When an Activity Is Truly a Hobby ................................................................................................................... 20

Building an IRS-Proof Profit Motive ..................................................................................................................... 22

The Gullion Case .................................................................................................................................................. 27

The IRC §183(d) Safe Harbor ............................................................................................................................... 31

The IRC §183(e) Election: Is it a Good Idea? .................................................................................................... 31

Making the IRC §183(e) Election ..................................................................................................................... 32



Section 3: Independent Contractor vs. Employee ................................................................................................ 35


What’s the Big Deal? ........................................................................................................................................... 35

The DOL & the Fair Labor Standards Act: Coming Soon to a Business Near You ................................................ 37

Step One: Is the Individual a Corporate Officer or Statutory Employee? ........................................................... 41

Step Two: Is the Individual a Statutory Non-Employee? ..................................................................................... 43

Step Three: Can the Worker Qualify as an Independent Contractor Under Section 530? ................................. 44

Reasonable Basis Requirement ....................................................................................................................... 45

Consistency Requirement ................................................................................................................................ 46

Reporting Requirement ................................................................................................................................... 46

Step Four: How is the Worker Classified Under Common Law? ......................................................................... 47

Factors which Determine Behavioral Control ................................................................................................. 47

Factors which Determine Financial Control .................................................................................................... 48

Factors which Determine the Relationship of the Parties ............................................................................... 48


Voluntary Worker Classification Settlement Program (VCSP) ............................................................................. 52

Final Considerations ............................................................................................................................................ 54


Section 4: Capitalization and Repair Policies ........................................................................................................ 56


The Impact of the Tangible Property Regulations ............................................................................................... 56

The Tangible Property Regulations are All-Inclusive ........................................................................................... 57

A Systematic Approach to Complying with the Regs .......................................................................................... 57

Step One: Applying the De Minimis Safe Harbor ................................................................................................ 58

Making the De Minimis Safe Harbor Election .................................................................................................. 60

Step Two: Applying the Regs to Materials and Supplies ..................................................................................... 62

Rotable, Temporary, and Standby Emergency Spare Parts ............................................................................. 63

Step Three: Applying the Regs to Repairs and Maintenance .............................................................................. 64

1. Identify all expenditures that are related to a unit of property (UoP) ....................................................... 64

2. Determine which of these expenditures is an improvement to a UoP. ..................................................... 66

3. Determine which elections can be applied to the expenditures. ............................................................... 67

Tax Treatment of Removal and Demolition Costs ............................................................................................... 70

Partial Dispositions .............................................................................................................................................. 72

Cost Segregation Analysis .................................................................................................................................... 74



Section 5: Various Issues Impacting Practitioners and their Clients..................................................................... 80


Overview .............................................................................................................................................................. 80

New Issue: The DOL Overtime Pay Requirement ................................................................................................ 81

Issue: The Employer Mandate of the Affordable Care Act .................................................................................. 82

Renewed Issue: Meals and Entertainment ......................................................................................................... 83

Substantiation Requirements .......................................................................................................................... 84

Per Diem .......................................................................................................................................................... 85

Recurring Issue: Travel ........................................................................................................................................ 86

Tax Home ......................................................................................................................................................... 86

Substantiation Requirements .......................................................................................................................... 87

Reimbursed Expenses ................................................................................................................................... 87

Recurring Issue: Office in the Home Deduction .................................................................................................. 89

Checklist of Often Overlooked Deductions/Credits by Schedule C filers ............................................................ 91


Developing a Uniform Set of Procedures to Follow During Tax Season.............................................................. 95


References ............................................................................................................................................................... 98

Index ...................................................................................................................................................................... 100

Glossary ................................................................................................................................................................. 102

Appendix A: U.S. Department of Labor, Administrator’s Interpretation No. 2015-1 ........................................... 106

Appendix B: Comparison of Simplified Method and Regular Method of Computing the Office in the Home

Deduction .............................................................................................................................................................. 123

Answers to Review Questions ............................................................................................................................... 124

Section 1 ........................................................................................................................................................ 124

Section 2 ........................................................................................................................................................ 125

Section 3 ........................................................................................................................................................ 126

Section 4 ........................................................................................................................................................ 127

Section 5 ........................................................................................................................................................ 128

1

Section 1: Recordkeeping and Cash Intensive

Businesses

Learning Objectives:

After completing this section, you should be able to:

1. Identify taxpayers who are required to file a Schedule C.

2. Identify industries for which the IRS has published Audit Techniques Guides.

3. Recognize the important reasons for your clients’ careful recordkeeping.

4. Recognize the techniques the IRS uses in an audit to identify underreported income.

5. Recognize businesses the IRS considers cash intensive, along with businesses that are possible

opportunities for underground activities.

Overview

Schedule C, the form used by individuals to report profit or loss from their businesses, is filed with Form 1040.

Each Schedule C business is unique to a specific taxpayer. This lack of uniformity comes with its own set of

challenges due to the variety of businesses that are reported on Schedule C. Schedule C businesses can range

from small businesses, such as craft sale businesses, to very large sole-owner/single member LLC businesses such

as CPA firms. Some Schedule C businesses will have separate business bank accounts and an excellent set of

financial records generated from QuickBooks or other software; however, many Schedule C businesses will

deposit income into a personal checking account, with expenses paid from cash or personal credit cards with little

to no tracking or reporting. Sometimes clients will deliver their disorganized receipts to a practitioner in an old

shoebox. Each business reflects the personality of the owner, so if the owner is organized, then preparation of the

Schedule C will generally be easier. If the owner lives in a state of constant chaos and throws his or her receipts

to the floorboard of the car, preparation will be quite challenging! Practitioners know that of the total amount of

time it takes to prepare an individual’s return, a ridiculous amount of can attributed to preparation of a Schedule

C.

A Schedule C should be used to report the income and expenses of:

2

• Self-employed individuals (NOT farmers),

• Individuals who operate side-businesses, even if the taxpayers are employed in another line of work, and

• Single member LLCs that are treated as disregarded entities for tax purposes.

Treasury Regulation §1.183-1(d) requires that a separate Schedule C be filed for each business for which the

taxpayer is involved. Two businesses cannot be combined into one Schedule C. For example, income and expenses

from a welding business cannot be used to offset income and expenses from teaching private trumpet lessons.

These Regs do allow consolidation of multiple undertakings into one Schedule C if the businesses/activities are

sufficiently interconnected. Determining whether two businesses/activities are sufficiently interconnected is

based upon the facts and circumstances of the taxpayer; however, courts generally make their determinations

based on the answers to the following questions:

• Are the activities conducted at the same location?

• Are the activities performed as separate activities?

• Are the activities part of an effort to find sources of revenue from land?

• Do the activities have shared management?

• Do the activities have the same overseer?

• Do the activities share the same books and records?

• Does one activity benefit from the other?

• Does the taxpayer use one activity to advertise the other?

• Does the taxpayer use the same accountant for all the activities?

The activities reported on a Schedule C often trigger IRS audits for reasons discussed in this course. IRS audits are

inconvenient, costly and stressful. Audits frequently occur during tax season, causing firms to spend a significant

amount of time compiling documentation, sometimes for items that meet the definition of insignificant, into large

bound manuals to hand over to the IRS examiner while also ensuring they meet their tax filing deadlines.

ALERT!

Spouses who jointly own an unincorporated business are generally classified as a partnership for federal

tax purposes whether or not there is a formal partnership agreement. However, a husband and wife who

are the only owners and who each materially participate in the business can elect to be treated as a

qualified joint venture, and not as a partnership, by doing the following:

• Jointly file a Form 1040,

• Divide all items from the jointly-owned business in accordance with each spouse’s respective

interest, and

• File a Schedule C and Schedule SE for each spouse.

Additionally, in community property states, a husband and wife can treat the business as a sole

proprietorship rather than as a partnership. If only one spouse participates in the business, all of the

3

income is self-employment income of the spouse who carried on the business. If both spouses participate,

the income and deductions are allocated based on their distributive shares.

Statistically, the chances of being audited are quite low. But I’ve said a few times through the years that the chance

of being hit by a tornado is quite low, but if you are in its path, the chance is 100%. It is the same with audits--if

your client is selected for audit, his or her chance of audit just increased to 100%. Not to compare audits with

tornados…well, maybe just a little.

An excellent policy is to prepare every tax return as if it will be audited within three years. As tax preparers,

standard procedures should already be in place that require us –at the very least—to document in the client files

every position taken and why, and every meeting, telephone conversation and email. These procedures should

require follow-up on unusual items. But something happens in the heat of tax season when sometimes, in efforts

to move efficiently through mountains of work, practitioners become careless. They may not follow-up on an

unusually large expense listed in the client’s records, forget to get a signed engagement letter, or fail to document

the telephone call in which the client told us about his business mileage. This should never happen. Tax season

procedures should be established and followed on every single client every single time.

This course is a hearty attempt to remind tax practitioners (including me) to prepare for an audit before it ever

happens. It is designed to assist practitioners in establishing standard procedures that address the Schedule C

issues the IRS views as “hot.” This course can be viewed as sort of a storm shelter for when the tornado hits.

Audit Techniques Guides

The IRS makes available ATGs on its website for Small Businesses and Self-Employed. ATGs are used by IRS

examiners during audits to obtain an understanding of the issues and accounting methods unique to specific

industries. While ATGs cannot be cited as authority, they are quite useful to business owners and tax practitioners

because they identify the issues that matter most to the IRS. The IRS states that the ATGs are only current through

the publication date (several are > 10 years old) and as a result it provides no guarantee as to their technical

accuracy after that date. The guides set forth industry-specific auditing procedures, which provide guidance on

how examiners will audit income and other items, and including the questions taxpayers are typically asked upon

audit. Following is a list of some of the ATGs that are available:

Aerospace Industry Air Transportation

Architects and Landscape Architects Art Galleries

Attorneys Business Consultants

Capitalization of Tangible Property Cash Intensive Businesses

Child Care Provider Coal Excise Tax

Conservation Easement Construction Industry

4

Continuation of Health Care Coverage Cost Segregation

Credit for Increasing Research Activities Entertainment Industry

Excise Tax on Indoor Tanning Services Executive Compensation

Factoring of Receivables Farmers

Fishing Industry Foreign Insurance

Gold Parachute Hardware Timber Industry

IC-DISCs Inland Waterways

Low-Income Housing Credit §IRC 162(m) Salary Deduction Limitation

§IRC 183: Activities Not Engaged in For Profit Lawsuits, Awards, and Settlements

Ministers New Markets Tax Credit

New Vehicle Dealership Non-Qualified Deferred Compensation

Oil and Gas Industry Ozone Depleting Chemicals

Partnerships Passive Activity Losses

Place Mining The Port Project

Real Estate Property Foreclosure and Cancellation

of Debt

Reforestation Industry

Rehabilitation Tax Credit Retail Industry

Sections 48A and 48B - Advanced Coals and

Gasification Project Credits

Split Dollar Life Insurance

Structured Settlement Factoring Timber Casualty Loss

Veterinary Medicine Wine Industry

TIP

Another helpful aspect of the ATGs is the inclusion of Internal Revenue Code sections related to specific

topics or industries, as well as other authorities (court cases, Revenue Rulings and Procedures, etc.). If

codified law and judicial precedents regarding a specific issue or industry need to be researched, an ATG

is a great place to begin.

Practitioners should familiarize themselves with the ATGs that are representative of their clients’ respective

industries. Tax practitioners, are not required to audit their clients; however, these guides are extremely useful in

identifying potential issues and red flags, some of which may be addressed or eliminated prior to filing tax returns.

Careful Recordkeeping

Every Schedule C business should have a designated bank account into which all the income from the business is

deposited and from which all the business expenses are paid. There should be no commingling of the business

5

and personal expenses of the owner(s). Even though every Schedule C should have a designated bank account,

the reality is that many owners of Schedule C businesses run the income and expenses through the owner’s

personal bank account.

Schedule C businesses, no matter how large or small, should have a system of recordkeeping wherein all bank

statements, cancelled checks, deposit slips, sales contracts, invoices, purchase orders, receipts, and tax

information returns are kept. Three of the most important reasons for keeping such records are:

1. Proof of income upon audit.

Upon an audit, the client will likely be required to prove the income shown on Schedule C. The client should keep

all Forms 1099-MISC, 1099-NEC (beginning in 2020) and 1099-K, bank statements, deposit slips, and any other

documents that can be used to prove income. In the client work papers, the tax practitioner should always have

a detailed list of all the sources of gross income recognized on Schedule C.

2. IRS matching.

There aren’t many practitioners reading this course who haven’t received an IRS CP-2000 notice. An IRS CP-2000

notice is sent when the information on file with the IRS is different from what is reported on an income tax return.

This notice always begins with “the income and/or payment information we have on file doesn’t match the

information you reported on your tax return.” The IRS then explains specifically what doesn’t match. The client

receiving the notice has a set time to respond to the notice. Composing the response can be time consuming and

put additional stress on the practitioner when the client needs a response during the practitioner’s busy tax

season.

To avoid receiving such a notice, practitioners should check clients’ records carefully to ensure that all Forms 1099,

Schedules K-1, and Forms W-2 have been provided. For Schedule C, the practitioner will need Forms 1099-MISC

(Miscellaneous Income), 1099-NEC (Nonemployee Compensation, beginning in 2020) 1099-K (Payment Card and

Third Party Network Transactions), and any other forms reporting self-employment income to the client. The

practitioner should always review the prior year tax return for sources of income, and should always ask the client

whether new Forms 1099-MISC or 1099-NEC (beginning in 2020) have been received in the current year.

If any Form 1099 has erroneous information, whether incorrect social security number, incorrect name or address,

or incorrect amount (based on the client’s records), the issuer should be contacted to obtain a corrected form. If

a corrected 1099 form is not received and the information is reported differently on the tax return, a CP-2000 will

likely be generated.

Additionally, to make it easy for the IRS matching program, the tax preparer should list each Form 1099 on a

schedule attached to the client’s tax return. The IRS computers cannot match each separate information return

with the sum total reported on the tax return.

6

3. Documentation of all business expenses.

Upon an audit, the IRS will likely request documentation for all expenses claimed on Schedule C, especially

expenses related to business travel and meals. The perfect client records his or her business activity in QuickBooks

or other software and keeps all receipts, credit card statements, sales records, invoices, purchase records, payroll

records, bank statements and cancelled checks in labeled folders in a well-oiled file cabinet. Even more perfect is

the client who scans copies of source documents into electronic files that can be uploaded to the tax practitioner’s

secure website portal. As nice as that perfect world may be, the reality is that a host of disorganized self-employed

individuals are filing Schedules C. Their recordkeeping may be jumbled at best. In fact, their records just may be

kept in the dreaded shoebox. The topic of shoebox recordkeeping, which seems to be perfectly acceptable to

many clients, just happens to be on the “A” list of Tax Season Survival Tips.

TAX SEASON SURVIVAL TIP: JUST SAY “NO” TO THE SHOEBOX!

Most practitioners have been on the receiving end of a client’s shoebox full of receipts, some of

which are ripped, dirty, and some even smelling like cigarette smoke. The shoebox makes its way

down the hall to the practitioner’s newest staff member (as if there is anything to learn from

organizing a shoebox of receipts). This young staff member then sets out to organize the receipts,

and spends valuable tax season time on the phone with the client asking questions like, “What was

the business nature of the items you bought at Bed, Bath & Beyond on August 2?” This is a huge

waste of time and talent. The staff member is not a better accountant when finished, and precious

tax season time has slipped away performing unnecessary tasks. What can be done with the client

who has saved his or her tax receipts in shoeboxes? When the client comes in for his or her tax

season interview, would the following steps be a good idea for your firm?

1. Kindly hand the shoebox of receipts back to the client along with a very simple, easy to read—with bullet points—list of items that are tax deductible for businesses.

2. Inform the client that if he or she wishes your firm to organize the receipts, there will be an additional fee for this service on their invoice. (Be sure to state the amount of the fee, which should be commensurate with the size and organization of the shoebox. If it is a very large, disorganized shoebox containing everything from business expenses to charitable and medical receipts, the fee should be significant enough to cause a change in client behavior).

3. Tell the client that he or she can avoid the fee if he or she will organize the receipts and bring back an organized and categorized summation of the receipts.

The truth is, you were going to bill the client for the time spent with the shoebox anyway. BUT,

you presented your client an opportunity to receive a discount on their fee if they would organize

the shoebox. This action plan has solved the shoebox issue for many practitioners. Of course,

there will always be clients who would rather pay the extra fee; however, this action will generally

7

remove many shoeboxes from your office floor during tax season and reduce the number of hours

your staff spends on these tedious tasks.

If a client does not have a good recordkeeping system, the tax practitioner should be instrumental in developing

a good system for the client, which should include labeled files (paper or electronic) for receipts, credit card

statements, sales records, invoices, purchase records, payroll records, bank statements and cancelled checks. The

more organized the client, the more efficient the tax preparer. Additionally, if the client is audited, the client will

easily be able to locate the source documentation required by the IRS.

TIP

An excellent non-tax season service you can offer your clients is a training program about

document requirements and organization. Clients who implement a good organizational system

and apply it to their tax return documentation create valuable efficiencies for themselves and

your tax practice.

Cash Intensive Businesses

Your new client, Johnnie, is self-employed and his very successful business is called, “Johnnie’s Honey-Dos.” He is

in constant demand cleaning swimming pools, landscaping and maintaining yards, hanging Christmas lights,

power-washing houses and driveways, performing minor repair work, painting, and other odd jobs. He is paid

mostly in cash. He rarely deposits the cash and uses the cash to pay for his personal and business expenses. He

does, however, keep a well-used spiral notebook in his car where he writes down the date he is paid, the customer

who paid, and the amount paid. He also writes down business expenses when he incurs them but oftentimes

throws out the receipts when he cleans his truck. He is an honest fellow and doesn’t cheat. But how can you

convince him to keep better records?

A cash intensive business is a business that:

• receives a significant amount of receipts in cash and typically handles a high volume of small dollar

transactions (e.g. restaurants, grocery stores), and/or

• practices cash payments for services (e.g. construction or trucking companies where independent

contractors are generally paid in cash).

Client Tip

8

The IRS, in its Announcement 2015-23, stated that it will no longer accept check payments for $100 million

or more after January 1, 2016. Be sure and let all your clients know they can no longer write checks this

large to the IRS!

IRS Red Flags

If you have a client who has a cash intensive business, sit up and take notice! The IRS does not take breaks from

auditing cash intensive businesses. One of the most common issues of cash intensive businesses is underreporting

income. The IRS uses different methods to determine whether income has been underreported.

What exactly is the IRS looking for when selecting cash intensive businesses to audit? The Cash Intensive

Businesses ATG sets forth the frequent and unique issues or indicators, which raise red flags and trigger IRS

attention. The most significant indicator is a pattern of losses or consistently low profit percentages that seem

insufficient to sustain the business. Businesses that continue to operate for multiple years despite sustained

losses or low profits is a red flag.

Other factors to consider when looking for underreported income include whether the taxpayer’s occupation is

one which could have indirect sources of additional income (e.g. vending machines), and whether the income

reported can support the size of the taxpayer’s family. The IRS also looks at whether the individual lives in a high

value area that appears to be disproportionate to income reported, whether their itemized deductions such as

property taxes and mortgage interest indicate that other property is owned that may not be commensurate with

reported income, whether total deductions indicate expenditures greater than reported income, whether the

taxpayer has income from investments, and whether there are any unusual deductions such as large gambling

losses.

If you have a client in a mostly cash business who reports losses or low profits consistently on Schedule C, what

can you look for when determining whether your client has reported all income? If there is reason to believe that

income is underreported by our clients, we should take a closer look and consider the following:

• Does the client’s lifestyle seem to be consistent with the amount of income reported?

• Does the business continue to operate despite losses year after year?

• Do bank balances and other investments continue to grow even after reporting losses or low profits?

• Does the client continue to purchase assets even though losses or low profits are reported?

• Are debt balances decreasing in years that losses or low profits are reported?

• How does the client’s gross profit margin and annual sales align with other businesses in the same

industry? (Statistics such as these can be found on the IRS website under taxpayer Statistics of Income

(SOI) and at www.bizstats.com.)

Most tax preparers do not keep clients they don’t trust. But many clients, like Johnnie in the above example, are

trustworthy. They are just disorganized. And if practitioners do not make proper inquiries and show due diligence,

they could be assessed a nasty preparer penalty under Title 26 of the Internal Revenue Code.

9

Another important reason to ask these questions is to determine if the client has an employee who may be

embezzling. Cash intensive businesses should have sufficient internal controls in place that are enforced, including

cameras installed in locations where employees are handling cash. But many small businesses do not rely on a

system of internal controls.

Cases of embezzlement are interesting and shocking all at once. One case of great interest was the Collin Street

Bakery in Corsicana, Texas. The Collin Street Bakery is famous worldwide for its DeLuxe fruitcakes, which have

been purchased by Frank Sinatra, the queen of Spain, and my own mother, who used to ship a fruitcake to my

grandmother in Florida every year for Christmas. One of the fruitcakes also made its way onto the set of the

“Godfather” movie. A small business turned big business through mail-orders of fruit cakes now has at least four

locations, one of which sits on Interstate 45 in Corsicana, just south of Dallas. A delicious piece of pecan pie and

a cup of hot coffee await many a weary traveler. The now ex-controller, a man given to excessive life style, worked

for the bakery for years before he began embezzling. An accountant’s salary was just not enough to support the

lifestyle this man and his wife wanted to live. Through years of embezzlement, the controller ultimately skimmed

a mere $16 million from the bakery by fraudulent checks and an additional $114,000 from the petty cash fund.

The owners would look at their yearly financials, scratch their heads and wonder where the money was going.

But the bakery was building new locations and launching an aggressive Internet sales platform, so they chalked it

up to expansion. At long last, as most embezzlement cases are discovered, the controller was caught red-handed

by the new staff accountant who just couldn’t understand why certain transactions were recorded in an unusual

manner. This fascinating story is available in an online article published by Texas Monthly entitled, “A Strange

Tale of Fruitcakes and the Collin Street Bakery.” If you need a break from this course, for something much more

interesting, go read this article.

The lifestyle of the controller screamed embezzlement, and if anyone had made appropriate inquiries and

performed a financial ratio analysis of the financial statements, the inquiries and ratios themselves may have

revealed the malfeasance. This story is a great lesson to practitioners - our clients also rely on us to report back

to them things we find unusual. It might not be the owner skimming the cash; it might just be an employee.

So, our in-depth inquiries into our cash client’s affairs are not only our due diligence responsibilities, but also for

our client’s protection.

Proper Accounting or Recordkeeping Procedures

What procedures should clients have in place if they have a cash-based business? This is certainly not a course on

accounting procedures and internal control methods; however, there are many good courses available to help

businesses develop detailed procedures. At the very least, a client should have a system that tracks every item of

cash/income from the time it is received to the time it is deposited or spent. The basics:

• If a client uses cash registers, procedures should exist to ensure that the cash in the register drawers at

the end of the day agree to cash sales recorded on the register, less the amount of money in the cash

register drawer at the beginning of the day. A supervisor should make appropriate inquiries into any

discrepancies. The cash register receipts should be kept with deposit slips to verify that all cash was

deposited. Cash should be deposited regularly (preferably daily). There is always the risk that an individual

10

pockets cash prior to ringing up the sale on the cash register. To reduce this risk, clients should require

that a receipt be provided for every sale and, depending on the size and type of business, consider ways

to incentivize the customer to ask for a receipt if they did not receive one (e.g. offer a discount or a free

item if a receipt is not provided) as well as other controls.

• If a client does not use cash registers (like Johnnie’s Honey-Dos), the first thing the client should do is issue

sequentially numbered invoices or receipts to each customer at the time of sale to document the cash

received. At the end of the day, cash collected should agree to the total of these documents; all

invoice/receipt numbers in the sequence should be accounted for. Cash should be deposited on a regular

basis (preferably daily). The invoices or receipts should be kept with the deposit slips for proof that all

cash collected was deposited. Of course, an individual could pocket cash if he or she is paid for a job that

is not invoiced so the business would have to consider appropriate controls to limit and/or detect this

activity (see above also). For instance, Johnnie from the example above could detect this if he keeps a

record of all clients for whom he works in an appointment book or calendar showing bookings and agrees

them to the invoices/receipts issued. An invoice should exist for all clients who are booked on the

calendar, except for cancellations.

• In all cases, clients should have a working system of internal controls that includes procedures for

receiving, reconciling, and depositing cash, including segregation of duties wherever possible. The paper

trail generated by a working system of internal controls is excellent documentation in the event of an IRS

audit.

Sometimes, small business clients who have inventory and are not audited yearly by independent CPAs,

do not count physical inventory at year-end. Rather, they will give the tax practitioner a “guestimate”

rather than spending time taking an actual count. The problem with “guestimates” is that, year-after-

year, the inventory number isn’t even close to materially correct and the cost of goods sold expense for

the year is not accurate.

Practitioners can remind their less-than-diligent clients to take a physical count of inventory by sending

out a reminder letter or email a month or two before the client’s year end (which is December 31 for

businesses reported on Schedule C). This letter should explain the “why” of inventory counts. Oftentimes,

just educating the client on the importance of physical inventory counts and accurate cost of goods sold

numbers is enough to bring them into compliance.

The practitioner should also hold the client accountable for an inventory count. The client should have

purchase and sales records that indicate what ending inventory should be and the inventory count should

be reconciled back to these records; any significant differences should be explained.

11

Making Use of the ATGs in Developing Tax Season Procedures

If a client falls within an industry for which an ATG is published, the practitioner should review the ATG for specific

audit techniques related to that industry. Per the ATG, the IRS will request all bank statements, cancelled checks

and deposit slips, along with all documentation supporting transactions.

An IRS examiner is also instructed to perform comparative analysis and ratio analysis of a taxpayer’s financial

statements and other records to determine if any ratio is out of line with the average ratios within that taxpayer’s

industry. The premise for comparative and ratio analysis is that when someone is misappropriating funds, or

underreporting income, the ratios will reflect this imbalance. The examiner will compute ratios on gross profit

margin, inventory turnover, ending inventory balances, changes in net sales from year to year, and changes in cost

of sales from year to year, as applicable. The ratios will then be compared to businesses in similar industries. As

stated in a previous section, statistics such as these can be found on the IRS website under taxpayer Statistics of

Income (SOI) and at www.bizstats.com.

In searching for information about a taxpayer, the IRS may check with U.S. banks, credit unions, check cashing

establishments, and currency exchanges to see if a Form 4789, Currency Transaction Report (CRT) was filed for

the taxpayer. This form reports the deposit, withdrawal, and exchange of currency exceeding $10,000. The IRS

may also check casino records, customs records, foreign bank account forms, criminal records, immigration files,

loan application files, and asset locator databases. The examiner may search for any Forms 8300, Report of Cash

Payments Over $10,000 Received in a Trade or Business, filed under a taxpayer’s name.

The IRS defines unidentified income (unreported income) as total cash expended exceeding total cash received.

To arrive at an amount of unreported income, the IRS employs different methods of reconstructing income. These

methods are necessary when taxpayers do not keep complete and accurate records.

The Bank Deposit and Cash Expenditures Method of reconstructing income is one of the methods used by the IRS.

Agents will compare total bank deposits plus cash expenditures less nontaxable sources of income (gifts, loans,

and transfers, etc.) for the year to total receipts reported on the return. Any excess of cash flow over the reported

receipts is additional income or inflated expenses. The burden of proof is on the taxpayer to show that the IRS is

incorrect in their reconstruction of income. Refer to the ATG for other methods the IRS uses to reconstruct income.

Regardless of the method used by the IRS to reconstruct income, the following questions, as listed in the ATG,

may be asked:

• Did the taxpayer withdraw goods from inventory for personal use without making an adjustment to

inventory?

• Did the taxpayer report the value of merchandise, trips or prizes earned from suppliers as income?

• How often does the taxpayer perform financial tasks (like reconciliations, deposits, bookkeeping, etc.)? If

these tasks are not performed regularly, a greater opportunity exists to skim cash or make errors.

• Do employees get freebies from the taxpayer without any record?

• Is there a side-line business that is operated “off the books”?

• Did the client have any bartering transactions?

12

• Did the client receive cash from other sources (family gift, loan, etc.)?

• Is there a stash of cash in a safe or other secure location? How was this cash received?

• What other sources of cash income are on site? This includes vending machines, newspaper stands, copy

or fax machines, phone cards, etc. Is cash from these sources accounted for?

• What is the taxpayer’s system of internal controls and is it enforced?

• How did the taxpayer obtain the funds to make purchases?

• Did the client have a set of financial statements prepared to obtain financing or to sell the business? Are

differences between these financial statements and the tax return explained?

• Are there angry family members or employees who claim mistreatment by the taxpayer?

• Are most expenses paid for by cash?

• How much petty cash does the taxpayer leave in the office or storefront?

• Is there any attempt by the taxpayer to delineate business and personal expenses?

• Can all loans of the taxpayer be verified?

• Was taxpayer paid in foreign currency?

• Is the taxpayer uncooperative, overly defensive, or aggressive toward the examiner?

• Does the taxpayer respond to inquiries in a timely manner?

• Does the taxpayer have sources of digital cash (EFTs, direct deposit, PayPal funds, bitcoin and other digital

currencies)?

TIP

If we know the IRS is going to ask these questions, wouldn’t it behoove us to ask our clients the same

questions? These are reasonable inquiries to make when preparing financial statements and/or tax

returns and should be included in our list of client service procedures.

The Cash Intensive Businesses ATG outlines specific examining procedures for the following cash intensive

businesses:

Bail bonds Beauty shops Car washes

Check cashing locations Coin operated amusements Convenience stores

Laundromats Scrap Metal Taxicabs

Retail liquor industry Video games Pizza pie sales

New auto dealerships Used auto dealerships Gasoline service stations

Auto body repair Retail gift shops Restaurants

Bars Grocery stores Boat and yacht sales

*If a tax practitioner has clients in these cash intensive businesses, he or she should review the IRS examination

procedures in the ATG and make every effort to answer the questions listed above. Then, document, document,

document in the client file the answers to the questions. And if the client does not have an acceptable answer to

a question, then steps should be taken to ensure the client is following reasonable practices with respect to its

cash.

13

ALERT

Please note that if the IRS discovers underreported income and finds sufficient evidence the client

intentionally understated income, the IRS will pursue civil or criminal fraud charges against the taxpayer,

and sometimes the practitioner as well. Fraud is defined as:

• Misrepresentation of material facts,

• Deception, which is the intent to conceal records, cheat, or mislead the examiner, and

• Silence when good faith requires expression.

According to the IRS, the underground economy represents income that is earned under the table and off the

books, which can be generated by legal and illegal activities. The primary goal of those involved is to avoid

reporting income and paying taxes. As practitioners, it goes without saying that we should not engage clients who

have businesses in the underground economy, especially those involved in illegal activities such as black market

goods, drug sales, money laundering and warehouse banking schemes. The ethics requirements for maintaining

a CPA license were enacted because a small number of CPAs were engaged in unethical and/or illegal behavior. It

just makes good sense to avoid clients in shady businesses.

The following business activities listed in the ATG are considered by the IRS as possible opportunities for

underground activities:

Used car sales Child care House cleaning

Pet sitting Tree trimming and hauling Construction workers

These seem to be rather innocuous professions; nevertheless, the IRS views them dimly. I hate to tell my son this

because he operated a pet sitting business from third to eighth grade. Such a young age to be on the shady side

of life.

Reporting Cash Payments Received Exceeding $10,000

In this discussion of cash intensive businesses, we should review the requirements of Form 8300, Report

of Cash Payments Over $10,000 Received in a Trade or Business. If our clients receive $10,000 in cash from

one buyer in a single transaction, or two or more transactions that are related, this form must be filed

with the IRS.

Form 8300 provides information to the IRS and the Financial Crimes Enforcement Network (FinCEN) for

use in busting money launderers. Information filed on this form has been used to identify tax evaders,

drug sellers, and terrorists.

14

The filer of the Form 8300 should mark Box 1b on the top line of the form if the transaction is “suspicious”,

defined as:

• The payer of the $10,000 is trying to prevent the business from filing Form 8300,

• The payer of the $10,000 is trying to cause the business to file a false or incomplete Form 8300,

or

• There is indication of possible illegal activity.

The form is due by the 15th day after the date the cash transaction occurs. The form can be filed either

electronically or mailed.

Our clients must also furnish a written statement to each buyer (the person who pays the cash) for whom

a Form 8300 was filed. The statement must include:

• the name, address, contact person, and telephone number of the business filing Form 8300,

• the aggregate amount of cash the business reported to the IRS,

• and notification that the business reported this information to the IRS.

The IRS assesses criminal and civil penalties for failing to file Form 8300 and the requisite statement to the

buyer. The penalty for failure to file a timely and correct Form 8300, and the penalty for failure to furnish

a written statement to the buyer, is $280 per instance. If the failure is corrected on or before 30 days after

the required filing date, the penalty is $50 per instance. Annual maximums also apply and are determined

based on whether average annual gross receipts are greater than $5 million.

If the IRS determines that there is an intentional disregard to file a timely and correct Form 8300, the

penalty is the greater of $28,260 (numbers provided are for returns filed in 2021; amount is adjusted

annually for inflation) or the amount of cash received in such transaction—not to exceed $113,000. If

there is intentional disregard of furnishing a statement to the buyer, the penalty is the greater of $560 per

statement or 10% of the aggregate amount of the items to be reported correctly.

For more information, see “Form 8300 and Reporting Cash Payments of Over $10,000” at www.irs.gov.

If an owner of a cash intensive business is hiding something, he or she will usually move on when the tax

practitioner begins to make in-depth inquiries. Here are two examples from real life:

1. A practitioner was preparing the financial statements for a new restaurant client who was using Point of

Sale software. The practitioner noticed that daily deposit slips never agreed to the cash recorded by the

POS system. When the practitioner made inquiries, the owner of the restaurant readily admitted that he

always took cash from the register for his personal needs. The practitioner then informed the owner that

she was going to include the cumulative difference between the daily deposits and the POS recorded cash

on a Form W-2 for the owner and have him pay payroll taxes on that amount. At that point, the client

informed the practitioner that he would take his business elsewhere (much to the relief of the

15

practitioner). Not long after, the restaurant closed, the owner moved to another state and filed

bankruptcy.

2. Another practitioner was preparing financial statements and the tax return for a new pawn shop/payday

lender client who had huge reserves of cash in a safe in the back of the store. The client had impeccable

records with respect to his pawn sales, eBay sales, and loans outstanding and repayments. However, the

practitioner could never reconcile the cash in the vault to the client’s records. When the practitioner

made inquiries, the client—without hesitation—fired the practitioner and moved on to another

accountant who did not make such inquiries.

TIP

As practitioners, we should be very wary of clients who regularly change accountants. We should always

ask during the initial client interview, “Why are you changing from your prior accountant?” Listen very

carefully to the answer. If they are too quick to blame the former accountant, you may want to send them

on down the road to another practitioner.

Summary and Action Plan

All taxpayers are required by law to maintain sufficiently-detailed records for the proper preparation of a tax

return. The IRS states in the Cash Intensive Businesses ATG that “poor books and records indicate reduced

credibility.” I believe that tax practitioners would agree with the IRS on this matter. Our experience generally

finds that the clients with the worst records are the worst clients.

In designing procedures for servicing cash-intensive business clients, practitioners should include inquiries into

their system of:

1. Accounting for all cash (and all income payments) from the time received to the time either deposited or

spent.

2. Accounting for all expenditures.

3. Internal controls, and whether the internal control actions are carried out by the employer and staff.

4. Organizing and compiling records for the preparation of financial statements and tax returns.

In developing these procedures, we should regularly review the ATGs with respect to our clients’ industries—not

so that we can become the auditor—but so that we can be prepared for an audit should it ever occur. Making

these inquiries of our clients protects us from due diligence preparer penalties, identifies possible embezzlement,

and serves as a system of weeding out potential clients who try to cheat the system.

Finally, for those clients who are just disorganized, practitioners should offer as an additional service a system to

help them become organized. This service could be in the form of online training or an evening class, possibly

preceded by a meal or social hour, that could be offered to clients as well as members of the community.

17

Review Questions - Section 1

1. Information that is excluded from an Audit Techniques Guide is:

A. Financial statistics pertaining to a specific industry.

B. A listing of all Internal Revenue Codes and judicial precedents related to a specific issue or industry.

C. A listing of questions an IRS examiner will ask a taxpayer upon audit.

D. Accounting methods unique to a specific industry.

2. Per the Cash Intensive Businesses ATG, which is the most significant indicator of possible underreported

income?

A. Taxpayer continues to purchase assets despite reporting consistent losses.

B. The taxpayer’s bank balances continue to grow even after reporting consistent losses.

C. The lifestyle of the taxpayer is inconsistent with the income reported on his or her tax return.

D. A pattern of losses or consistently low profit percentages.

3. Which cash intensive business is also a potential opportunity for underground activities per the Cash Intensive

Businesses ATG?

A. Used car sales

B. Bail bonds

C. Pizza pie sales

D. Check cashing locations

18

Section 2: Hobby Loss Rules



1. Recognize red flags on an individual tax return which can potentially alert the IRS to a hobby loss issue.

2. Recognize how to report hobby income and expenses on an individual income tax return.

3. Identify certain activities the IRS views as potential hobbies of taxpayers.

4. Identify an IRS-proof profit motive using the nine factors listed in Reg. §183-2(b).

5. Recognize when and how to make an IRC 183(e) election.

Is This Activity a Hobby?

As practitioners, we’ve probably all seen something like this: Steve Wakeboard is a very likeable fellow. He is

employed full-time as a manager of a retailer that sells outdoor and recreational clothing and supplies. He loves all

water sports: sailing, skiing, surfing, and scuba diving. On the weekends during the summers, he earns extra income

by using his boat to take individuals out in the bay to teach them how to scuba dive. He wants to write off his boat,

his scuba equipment, his lunches at the marina, even his swimsuits. While Steve may be living the dream, we are

left with the decision of whether his scuba instructing is a business or a hobby.

Resources for Further Study

• IRS Fact Sheet, “Is Your Hobby a For-Profit Endeavor?” at FS-2008-23, June 2008.

• Audit Technique Guide - IRC § 183: Activities Not Engaged in For Profit.

A wise tax practitioner should be well versed on how the IRS views the profit motive issue. The IRS Fact

Sheet and the ATG are excellent resources to study to gain insight into the IRS’s views.

Caution: Since this ATG was published in 2010, it has not been updated for various tax law changes

enacted since then, including those made by the Tax Cuts and Jobs Act of 2017 (TCJA) which impacted the

19

deductibility of hobby expenses. Practitioners and business owners need to be diligent when using the

ATGs to ensure they are applying the current law to their issues and circumstances.

Hobby vs. Business: What’s the Big Deal?

Well, it is generally only a big deal if an activity incurs losses year after year. A Schedule C that reflects net income

every year is not likely to be in danger of being reclassified as a hobby. Net income on a Schedule C is subject to

self-employment tax while hobby income is not subject to self-employment tax. The IRS likes net income on a

Schedule C for the obvious reason that a higher tax liability is generated.

Income Subject to Self-Employment Tax IRC §1401 imposes a self-employment tax on net earnings from self-employment. The definition of self-employment income is provided in IRC §1401 as “gross income derived by an individual from any trade or business carried on by such individual”. Gross income is reduced by allowable deductions to arrive at earnings from self-employment which are entered on Schedule SE, Self-Employment Tax. (Refer to Schedule SE and its instructions for details of the tax calculation.) Additionally, taxpayers are generally allowed a deduction equal to one half of the self-employment tax which is reported on Schedule 1 (Form 1040) (2019 form reference). The IRS defines a trade or business as an activity carried on for the livelihood or in good faith to make a profit, hence the term profit motive. Additional rulings have defined a trade or business as one that is regular, frequent, and continuous. Income from the following activities is not subject to self-employment tax:

• Investments

• Hobbies

• Employment

20

But what about activities incurring losses?

Exhibit 1. Governing Provisions of the Internal Revenue Code.

If the activity is…* Then…

A business. • Expenses are deductible under IRC §162.

Engaged in for the production or collection of

income or for the management, conservation or

maintenance of property held for the production of

income.

• Expenses are deductible under IRC §212.

A hobby (activity not engaged in for profit). • Treatment of expenses determined by IRC

§183.

A personal activity. • Per IRC §262, no expenses are deductible.

*Taxpayers bear the burden of proving their honest intention of making a profit.

The Treasury Inspector General for Tax Administration (TIGTA) issued a report on April 12, 2016, Reference

Number 2016-30-031, “Opportunities Exist to Identify and Examine Individual Taxpayers Who Deduct Potential

Hobby Losses to Offset Other Income.” TIGTA performed a review of the IRS’s success in auditing tax returns for

the hobby loss issues, and found that the “IRS can improve its methods of addressing taxpayers who offset their

income with hobby losses,” and recommends that the IRS 1) identify high-income individual returns with multi-

year Schedule C losses and other factors that indicate the taxpayer may not have a profit motive, and 2) emphasize

the importance of ensuring that hobby loss issues are pursued in an examination of a return. A bit alarming is the

fact that TIGTA also reported that it considers 88% of Schedule C losses as hobby losses! With that statistic, we

must take special efforts to ensure that our clients have legitimate profit motives for all of the Schedules C filed.

When an Activity Is Truly a Hobby

If the taxpayer’s facts and circumstances point undeniably to the fact that an activity is a hobby, then IRC §183

(the “hobby loss” rule) determines the treatment of expenses. Expenses related to a hobby cannot exceed income

received from the hobby. The income is reflected as other income on Form 1040 and is not subject to self-

employment tax. For 2019, hobby income was reported on line 8, Other income, of Schedule 1 (Form 1040) where

it was combined with additional income items. The total of all additional income from line 9 of Schedule 1 was

21

brought forward and reported on line 7a, Other income on Form 1040, If the hobby income is from the sale of

collectibles, the sales should be entered on Form 8949, Sales and Other Dispositions of Capital Assets.

Prior to the TCJA, expenses related to a hobby were deducted on Form 1040, Schedule A, Itemized Deductions, in

the following order:

1. Deduct expenses that are allowed regardless of the taxpayer’s profit motive related to the hobby, for

example home mortgage interest, taxes and casualty losses.

2. To the extent hobby income exceeds the items number 1, deduct expenses that would be allowed if the

activity was engaged in for profit (other than depreciation and amortization) as miscellaneous itemized

deductions on Schedule A.

3. To the extent hobby income exceeds expenses listed in points 1 and 2, depreciation and amortization

can be deducted, limited to the amount of the remaining hobby income, as miscellaneous itemized

deductions on Schedule A.

The TCJA suspended miscellaneous itemized deductions from 2018 through 2025 which means hobby losses are

generally not deductible during this time period.

Practically speaking, very few taxpayers will cede that their activity is a hobby, unless there are no expenses to

offset the income.

When there are expenses, most taxpayers will receive greater benefit by reflecting an activity’s income and

expenses on a Schedule C rather than treating it as a hobby because:

• Taxpayers who take the standard deduction will receive no benefit from hobby expenses on a Schedule

A.

• Taxpayers who itemize will likely receive no benefit from the activity’s expenses due to the 2% limitation

on miscellaneous itemized deductions, or to the overall limitation on itemized deductions for high

income taxpayers. (Note: TCJA suspended all miscellaneous itemized deductions and the overall

itemized deduction limitation from 2018-2025.)

Additionally, if the expenses exceed the income reported on Schedule C, the loss can be used to offset other

income (wages, interest, dividends, etc.) shown on the Form 1040.

A quick reminder that the IRS is less concerned when income is consistently reported from a hobby or Schedule C

activity than it is when a Schedule C reflects losses on a consistent basis. So, if you have clients who have been

reporting losses on a regular basis on their Schedule Cs, sit up and take notice! If you know what the IRS is looking

for in establishing a profit motive for an activity, you will want to have a discussion with your client about how to

survive a potential IRS audit.

22

Building an IRS-Proof Profit Motive

As stated in Section 1, the ATGs are one of the best resources for determining how the IRS views certain issues.

The ATG for the IRC §183 “hobby loss” rules instructs examiners to consider the following items on a tax return:

• Activities with large expenses and little or no income.

• Losses offsetting other income on the return.

• Activities that result in a large tax benefit to the taxpayer.

After identifying target activities, an examiner will study the history of the activity to determine whether it has

shown a profit in any year. The examiner will use taxpayer’s financial history, documentation of the activity

operations, and any accounting records.

PRACTICE TIP

Since we practitioners have this information available in IRC §183 ATG, we should apply it while

reviewing our clients’ files and prepare every future tax return as if it were to be audited by the IRS

within the next three years. This will help identify and resolve potential issues with our clients and

ensure that our work papers and our client’s documentation and accounting records adequately address

the questions and issues IRS examiners are likely to raise.

The IRS then applies nine relevant factors, set forth in IRC Reg. §183-2(b), to determine whether the taxpayer has

a profit motive. This determination is made on a case by case basis, considering all facts and circumstances of the

case. For further study, an excellent discussion of these nine factors is found in Appendix A of the Audit

Techniques Guide for IRC §183: Activities Not Engaged in For Profit. Appendix B of the same ATG lists questions

the IRS Examiner will ask when auditing whether a profit motive exists. A quick read of these questions is a

valuable use of time.

ALERT!

The ATG lists the following activities as possible hobbies. If you have a client engaged in an activity

listed (and we all do), sit up and take notice! A little planning on this side of an audit will surely assist

your client in establishing his or her business purpose for the activity.

Fishing Horse Racing Horse Breeding Farming Motorcross Racing Auto Racing Craft Sales Bowling Stamp Collecting Dog Breeding Yacht Charter Artists Gambling Photography Writing Direct Sales Airplane Charter Rentals Entertainers

23

The following checklist serves to alert you, the practitioner, to the nine relevant factors of establishing a profit

motive. From this list, you should be able to identify problems that may exist with certain client activities, and the

actions and documentation needed to support the client’s profit motive. At a minimum, you should consider

retaining this documentation in the client’s work papers to ensure it is available if and when an IRS examiner

requests it.

Reg. §183-2(b) Nine

Factors

Evidence of Motive

1. Manner in which the

taxpayer carries on the activity.

Does the taxpayer:

• carry on the activity in a businesslike manner?

• maintain complete and accurate books and records?

• maintain checking accounts for the activity which are separate from the accounts used for the taxpayer’s personal living expenses?

• rely upon these records to operate the activity and make decisions or changes?

• have a formal written business plan which demonstrates the taxpayer’s financial and economic forecast for the activity by showing a short range and long range forecast for the activity?

• follow the business plan?

The IRS examiner will:

• document the taxpayer’s daily operations, the history of the activity’s operations, and the efficiency of the taxpayer’s operations.

• obtain copies of any advertising.

• be alert for children’s activities being deducted on the parent’s tax return.

2. The expertise of the

taxpayer or his advisors.

Has the taxpayer:

• prepared for the activity by extensive study of its accepted business, economic, and scientific practices?

• consulted with those who are experts in the business?


• question the taxpayer’s expertise and the use of any experts in the business.

• compile the history of the taxpayer’s growth of knowledge within the activity and how this knowledge was obtained.

24

• document the names, position titles and address of advisors and how they were chosen by the taxpayer.

• document instances when the taxpayer was provided advice that was implemented in the activity.

• describe how this information affected the operation.

3. The time and effort

expended by the

taxpayer in carrying on

the activity.

Does the taxpayer:

• devote much of his or her personal time and effort to carrying on the activity? (including time spent for seminars, professional reading, and performing repairs and maintenance.)

• derive substantial personal or recreational aspects from the activity?

• withdraw from another occupation to devote much of his or her energies to the activity?


• establish precisely how much time the taxpayer devotes to this activity, as well as all other activities.

• consider whether the provisions of Sec 469 (passive activities) apply

to the taxpayer.

4. Expectation that assets

used in the activity

might appreciate in

value.

*This has been the most

difficult of the factors

for examiners to

correctly develop.

Does the taxpayer:

• use appreciated assets, such as land, in the activity?

• expect the appreciation in the value of the assets, even if no profit from current operations is derived?

• expect that income from the activity together with the appreciation of the assets will exceed expenses of operation?

*ALERT!: The success of Factor 4 is dependent upon whether the operation

of the taxpayer’s activity and the holding of appreciated assets, like land, are

considered to be a separate or single activity. If deemed separate activities,

taxpayers will often not meet this factor, and the potential gain from

appreciation of the assets will not be considered for overall profit and cannot

offset current operational losses.

*Warning to taxpayers using land purchased for future retirement purposes in

an activity: Because the Tax Court has ruled for both the IRS and taxpayers in

separate cases, it is wise to review the facts of these cases to determine how

to properly structure the activity’s use of retirement land in such a way that

the land will be included as part of the activity.

25

5. The success of the

taxpayer in carrying on

other similar or

dissimilar activities.

Has the taxpayer:

• engaged in similar other activities that were unprofitable and

converted them to profitable?


• document the taxpayer’s financial success in other activities.

• prepare a worksheet that details the history of these other activities.

• document any specific instances where the taxpayer has abandoned

certain activities proven to be unsuccessful.

Note.

The IRS does not take into account the success of the taxpayer in his or her

salaried job when considering the success of the taxpayer in other similar or

dissimilar activities.

6. The taxpayer’s history of

income or losses with

respect to the activity.

*According to the ATG,

this factor is one of the

most important factors

of the nine. This factor

supports the framework

of IRC §183 because the

history of losses triggers

the question of profit

motive.

Does the taxpayer have:

• sustained losses beyond the period which customarily is necessary to bring the operation to profitable status?

• an explanation for why there are sustained losses?


• prepare a worksheet showing a history of the activity’s profits and losses.

Reasons for losses that are beyond the taxpayer’s control and would not

indicate the lack of a profit motive as listed in the ATG:

drought, disease, theft, fire, weather damages, involuntary conversions, or

depressed market conditions.

7. The amount of

occasional profits, if

any, which are earned.

What are the taxpayer’s:

• amounts of profits in relation to the amount of losses incurred, in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity?

• amounts of substantial occasional profits, if any?

26

Does the taxpayer have:

• an opportunity to earn a substantial profit in a highly speculative venture?


• pinpoint the exact source of the gross receipts reported for the activity on the tax return.

Beware of misplacement of income!

Misplacement of income occurs when taxpayers report gross receipts on

Schedule C from sources other than the activity on Schedule C in error or

deliberately to report revenue where no revenue otherwise exists in an

effort to support a profit motive. Fabrication of income raises the examiner’s

consideration of potential fraud.

The examiner is told, in the ATG, to consider the implications of such

misplacement. If the two activities are closely related, then the two activities

can arguably be combined on the same form.

If the two activities cannot be combined or income was fabricated and the IRS determines that the taxpayers deliberately misplaced the revenue, civil

fraud charges may be filed against these taxpayers.

8. The financial status of

the taxpayer.

Does the taxpayer:

• have substantial income or capital from sources other than the activity?

CAUTION: If taxpayers have substantial income from sources other than the

activity, (particularly when the activity generates losses that provide

significant tax benefits) this may indicate that the activity is a hobby, especially

if there are personal or recreational aspects to the activity.


• determine whether taxpayers with substantial sources of income have the financial ability to sustain significant losses from activities that may be hobbies.

27

• determine why the taxpayer has not abandoned an unsuccessful activity when other taxpayers lacking the same financial ability would have likely abandoned the losing activity.

9. Elements of personal

pleasure or recreation.

Does the taxpayer:

• have personal motives in carrying on an activity that may indicate that the activity is not engaged in for profit?

• derive recreational or personal benefits from the activity?


• address the pleasurable and recreational aspects of the activity.

This is a relief! According to the ATG: the Courts do not require taxpayers to

hate their work in order to prove a profit motive.

After reviewing this checklist with your client, have you established whether your client has a clear profit motive?

If not, steps should be taken to ensure that your client is running this activity like a business. And these steps need

to be documented in the client’s work papers! Much is at stake.

Additionally, if the client has not bothered to keep a good set of records, documenting income and expenses,

there is no time like the present to train your client to keep good records. Remember, the IRS views good

recordkeeping as an indicator of credibility.

The Gullion Case

Not all Tax Court cases are interesting, but occasionally one comes along that is, and the facts of this case are

perfect for a real-life case study on the hobby loss rules. Plus, the taxpayer won representing himself. There are

many take-aways from this case, which are discussed after the facts are presented. A fascinating article detailing

the facts of the case and the outcome appeared in Forbes magazine.

Thomas Gullion is a gifted jazz saxophonist. He began playing saxophone at age 8 and by the time he was 16, he

was performing professionally. During his college years, he studied with the famed David N. Baker, a professor of

music at Indiana University, who founded the school’s Jazz Studies program (and whose passing in 2016 at the age

of 84 saddened the jazz community). At age 22, he began touring with J.J. Johnson, a trombonist who paved the

way for fellow trombonists in bebop music and who scored music for several movies and television series in the

70s, such as Starsky & Hutch, Mike Hammer, and the Six Million Dollar Man.

From 1988 to 1995, Gullion toured with different jazz groups, playing in New York, and moving for a time to Spain

where he performed with a Spanish jazz group. In 1995, Thomas Gullion moved to Chicago where he was a regular

performer in jazz clubs and recorded two CDs with other jazz greats. In 2002, Gullion removed himself from the

28

frenzied music scene and moved to rural Wisconsin and began working as a computer programmer. He developed

his skills as a composer, released a solo album, and worked at developing his playing style to include other music

genres. He also organized the Driftless Jazz Festival in Wisconsin, which occurs each year in July.

The IRS had no issue with his tax returns during the years he was performing solely as a musician. His trouble

began when he started his computer programming business. In 2008 and 2009, the years under audit, he and his

wife reported the following earnings:

2008 2009

Earnings attributable to Gullion’s wife $70,914 $1,348

Earnings attributable to Gullion $42,951 $131,897

Total earnings $113,865 $133,245

His Schedule C for his music business, however, was just a bit dismal:

Year Gross receipts Net loss

2004 $1,483 ($12,163)

2005 $530 ($11,842)

2006 $983 ($17,872)

2007 $1,615 ($20,315)

2008 $2,625 ($32,541)

2009 $2,931 ($26,003)

2010 $3,154 ($9,467)

Total $13,321 ($130,203)

In 2011, Gullion did show a small profit of $647 on his Schedule C. Gullion stated, in an interview with Forbes

contributor, Peter J. Reilly, that his accountant never advised him about the hobby loss rules. If his accountant

had, Gullion stated that he would have been “aggressive in capitalizing rather than expensing.” (Reilly, 2013)

Upon audit, the IRS maintained that Gullion was not engaged in the trade or business of being a musician;

therefore, all his Schedule C expenses were nondeductible as ordinary and necessary business expenses. The IRS

examiner further maintained that Gullion had no profit motive once he left Chicago. The additional tax liability, in

addition to penalties, was around $20,000.

Gullion stated that the “initial auditor mischaracterized almost all the facts in my case (stating that I moved to the

country in Wisconsin as part of an elaborate tax dodging scheme) and made wild, unsubstantiated judgments

(such as ‘it’s impossible to make a living as a musician in rural America’.)” (Reilly, 2013) Further, when Gullion

appealed the findings of the audit, the appeals officer wouldn’t even examine the facts in the case. So, to Tax

Court Gullion went.

29

Gullion hired a lawyer, to the tune of $7,000, to write a draft response to the IRS. “It turned out to be one of the

worst papers I’ve ever read. Completely unusable. So, I found myself in the unhappy position of having to go to

US Tax Court and represent myself.” (Reilly, 2013)

The Tax Court stated that Gullion provided sufficient evidence to prove that his musical activities were conducted

with continuity and regularity during the years in issue. However, the Court stated that Gullion had the burden

of proving that he conducted the activity with the requisite profit motive. The Court stated that a reasonable

expectation of profit is not required, but the profit objective must be actual and honest, which is determined by

the facts and circumstances of the case. (Thomas Allen Gullion, Petitioner v. Commissioner of Internal Revenue,

Respondent, 2013)

The Court referred to the nine relevant factors, as set forth in IRC Reg. §1.183-2(b), to determine whether the

activity is engaged in for profit or is a hobby, and concluded as follows on the analysis:

Expertise of the taxpayer. Considering the evidence presented, the Court concluded

that Gullion was certainly an expert saxophonist based on

his history, and that he was also knowledgeable of the

music industry.

Taxpayer’s time and effort. The IRS argued that, in his career as a full-time computer

programmer, Gullion did not have time for a music career.

The Court disagreed based upon his organization of the

jazz festival and the fact that he had recorded four CDs.

The Court stated, “We have recognized that a taxpayer

may be engaged in more than one trade or business at

any one time.” (Thomas Allen Gullion, Petitioner v.

Commissioner of Internal Revenue, Respondent, 2013)

The success of the taxpayer in carrying on

other activities.

The Court found that Gullion had earned a living from his

music career before moving to Wisconsin. The profit in

2011, although small, was consistent with Gullion’s

testimony that he intended to be profitable again.

History of income or losses. The Court recognized that economic success in the arts

frequently takes longer to achieve than success in other

fields. Additionally, Gullion’s small profit in 2011 fortified

his testimony that he fully intended to be profitable again.

Financial status of the taxpayer. The Court did not consider Gullion’s income from the

computer software industry as considerable; therefore,

30

the income he earned from programming did not present

a problem.

Elements of personal pleasure or recreation. The Court stated, “The fact that the taxpayer derives

personal pleasure from engaging in the activity is not

sufficient to cause the activity to be classified as not

engaged in for profit. [Gullion] derives pleasure from his

music, but his goal is to make a profit.” (Thomas Allen

Gullion, Petitioner v. Commissioner of Internal Revenue,

Respondent, 2013)

The Tax Court ruled in favor of Gullion--that he was engaged in the trade or business of music during the years in

question. The only expenses disallowed were depreciation of his wife’s violin and mileage from his home to a

school where he taught a music class.

We can clearly see that Gullion is a professional musician with a profit motive, but how did he explain his huge

losses to the Court? He did so by thoroughly understanding the jazz music profession. Here are his arguments:

• The music industry has undergone significant changes over the years and it has become increasingly

difficult to make a profit,

• Many of the jazz clubs closed in Chicago and performing opportunities had dried up, and

• Less money is made when a musician plays another artist’s music.

Gullion told the Court that he had moved to Wisconsin where the cost of living was cheaper and that it was close

enough to travel back and forth to Chicago when necessary. He considered his time in Wisconsin as a time of

“rebuilding,” and that ultimately, he wanted to leave the software industry to pursue music full-time. Finally, he

was changing the course of his music career to composing, so that he could leave behind a legacy of work.

Very well presented and well argued, Mr. Gullion.

We practitioners have a few take-aways here:

1. We absolutely must warn our clients who have losses on Schedules C of activities that could be

construed as hobbies by the IRS. We need to sit down with them and assess whether they meet

most of the nine pertinent factors are present in their facts. Do they have a business plan? Do

they have business cards, a website? Can a profit motive be demonstrated?

2. We absolutely must document in our clients’ files the presence of these nine factors as they

pertain to the client and our conclusions related to the proper classification of the activity.

3. We absolutely must remember that a taxpayer won his case before the Tax Court representing

himself. He had already paid significant amounts to a CPA and a tax lawyer. But he received

inadequate service. Far be it from us that our clients would not receive excellent service for the

31

money they pay us! The lesson here is that--in our haste during tax season—we should never take

short-cuts with our clients. We should never be careless or lazy in addressing issues that are

potential IRS red flags for audit. Who wants to be mentioned, albeit anonymously, in Forbes

magazine as doing shoddy work for a client?

The IRC §183(d) Safe Harbor

For your clients who have recurring losses that could be targeted as hobby losses, IRC §183(d) provides a safe

harbor with the presumption that an activity is for profit if it makes a profit in at least three of the last five years,

including the current year. If the client is involved in horses (breeding, showing, training or racing), the

presumption is at least two of the last seven years. If these presumption periods are met, the IRS assumes the

taxpayer has a profit motive.

When does this safe harbor apply?

• For the breeding, showing, training or racing of horses: the safe harbor applies after the activity incurs a

second profitable year within the seven-year period that begins with the first profitable year.

• For all other activities: the safe harbor applies after the activity incurs a third profitable year within a

five-year presumption period that begins with the first profitable year.

Note. The burden of proof for showing lack of profit motive is shifted to the IRS when this safe harbor presumption

period is met.

PROBLEM!

What about loss years arising before the safe harbor is met? Are those years covered by the safe harbor

presumption? No. The only loss years protected by the safe harbor are those years arising after the safe

harbor is actually met. The safe harbor cannot be used for losses incurred during the start-up period and

the first few years of new activities, regardless of any future profits. This may present a problem for clients

who incurred large losses during the early years of an activity. All the more reason to review the nine

relevant factors in the checklist, and document, document, document those items that support a profit

motive.

The IRC §183(e) Election: Is it a Good Idea?

IRC §183(e) provides taxpayers an election to postpone the determination of whether the safe harbor

presumption applies until the fifth taxable year following the first year of activity. For horse activities, the

32

presumption is delayed until the seventh year following the first year of activity. This election permits an electing

taxpayer to file returns in the meantime under the assumption that the activity is conducted for profit.

The problem is that the taxpayer is essentially announcing to the IRS that he or she has not fully decided whether

this activity is a business with a profit motive. Also, when a taxpayer makes this election, he or she must agree to

waive the statute of limitations, which permits the IRS to assess any specific deficiency attributable to the activity

during all the years covered by the election. That could be very costly if the IRS proves that no profit motive existed

for the activity.

EXAMPLE

Adrienne’s Antique Sales began business in 2014. Adrienne has consistently recognized losses on her

prior year tax returns. She is concerned that the IRS may audit her, determine that her activity is a

hobby and disallow the losses. She wants to file Form 5213, Election to Postpone Determination as to

Whether the Presumption Applies That an Activity is Engaged in for Profit, so that the determination

of whether her activity is for profit is delayed. Is this a good idea for Adrienne? Probably not, because

filing the election will basically raise the red flag for the IRS, alerting them to a potential hobby issue.

Is there a good time to make the election? Yes, when the taxpayer is already under audit for the hobby loss issue.

Upon receiving the election, the examiner will suspend the audit and the determination of profit motive until the

end of the presumption period, when all returns of the presumption period have been filed.

Making the IRC §183(e) Election

• For taxpayers who have received no notice from the IRS regarding the hobby issue: The taxpayer should

file Form 5213 within 3 years after the due date of the return for the first year of the activity. Adrienne,

from the above example, should file the election by April 15, 2018 (three years after the due date of her

return for the first tax year of the activity, which was April 15, 2015).

• For taxpayers who have received an IRS notice disallowing the hobby losses: The taxpayer should file the

Form 5213 within 60 days after receiving the notice.


Every tax practitioner has clients who are at risk of an IRS audit because of the following items on their tax returns:

• Activities with large expenses and little or no income.

• Losses offsetting other income on the return.

• Activities that result in a large tax benefit to the taxpayer.

A great post-tax-season project for your newest staff member would be to compile a list of clients who are at risk

for audit on this issue. Most sophisticated tax preparation software packages contain a data-mining function

wherein you establish the search parameters to identify such clients.

33

Once these at-risk clients are targeted, communicate with them via letter, email or telephone regarding the issue.

The client should absolutely be informed of his or her risk of audit. Using the checklist on the nine relevant factors

provided in this section, create a plan for the client so that he or she can conduct the activity in a manner that

supports a profit motive.

And very important: document, document, document in the client work-papers your telephone conversations

(and dates of conversations) with the client, include any written communication, and include the steps the client

is taking to conform to the nine relevant factors.

At the very least, this will put you ahead in the game as you IRS-proof your client’s profit motive.

34


4. Which statement reflects the correct treatment of income and/or expenses from an activity that is definitely

a hobby?

A. If there are no expenses, the income should be reported on a Schedule C.

B. Hobby income from the sales of collectibles should be reported on a Schedule C.

C. The income is subject to self-employment tax.

D. If there are no expenses, the income should be reported on Schedule 1 (Form 1040) line 8.

5. Which statement is accurate with respect to the nine factors listed in IRC Reg. §183-2(b)?

A. If the appreciated land used in a potential hobby activity is considered separate from the activity, the

potential gain from appreciation of the asset can be offset by operational losses.

B. If the taxpayer has any elements of personal pleasure in an activity, it is usually considered a hobby by the

IRS.

C. When considering the success of the taxpayer in carrying on other activities, the IRS will take into

consideration a taxpayer’s success from a salaried job.

D. A depressed market condition is an acceptable reason for showing consistent losses in an activity.

6. Regarding the IRC 183(d) safe harbor:

A. For all activities, the safe harbor applies after the activity incurs a second profitable year within a seven-

year period that begins with the first profitable year.

B. The burden of proof for showing lack of profit motive is shifted to the IRS when the safe harbor is met.

C. The safe harbor applies to all years in which taxpayer incurred a net loss.

D. For all activities, the safe harbor applies after the activity incurs a third profitable year within a five-year

period that begins with the first profitable year.

35

Section 3: Independent Contractor vs. Employee



1. Identify the far-reaching consequences for clients who have misclassified workers as independent

contractors.

2. Distinguish between statutory employees and statutory non-employees.

3. Identify whether a worker can qualify for treatment as an independent contractor under Section 530.

4. Recognize the common-law factors of behavioral and financial control, as well as factors that determine

the relationship between the employer and the worker.

5. Recognize which of your clients are candidates for the Voluntary Worker Classification Settlement

Program.

What’s the Big Deal?

Your long-time client, Charlie, is the owner of ABC Widgets, a single member LLC that manufactures widgets. For

years, he has maintained that he cannot afford to pay payroll taxes, medical insurance, and retirement benefits

for his 52 full-time workers, so he pays them as independent contractors. The company does, however, make

contributions to Charlie’s retirement plan and reimburses him for his medical insurance premiums. Charlie is kind

and grosses up his workers’ hourly rate to help them pay their own taxes because they are required to pay self-

employment tax on what he pays them. He brings his financial statements in each spring and you prepare and

sign his tax return each year, crossing your fingers and hoping the IRS doesn’t catch on to his independent

contractor issue. One day, Charlie calls you in a panic. He has received notice from the IRS that he is being audited

on this issue. The realization sets in that Charlie’s decision to have independent contractors has cost him mightily.

How much is that cost?

After the reclassification of workers from independent contractors to employees is made, ABC Widgets is now

liable for years of:

• the employer’s portion of income and FICA taxes, along with substantial interest and penalties.

36

• (at the IRS’ discretion) three years of unremitted income tax withholding and employee FICA taxes,

along with substantial interest and penalties.

• FUTA and SUTA taxes, along with substantial penalties and interest.

Sadly, we aren’t finished with the cost list. To continue:

• Charlie’s retirement plan just became nonqualified because of lack of compliance with the

nondiscrimination requirements of retirement plans. Therefore, ABC’s contributions to his retirement

plan are now nondeductible. ABC must amend past returns to reclassify the deduction to

compensation, which results in additional payroll taxes for prior years, along with substantial penalties

and interest.

• The contributions to Charlie’s retirement plan, once considered deferred income, are now taxed as

compensation to Charlie. Charlie must amend his returns to pay back income tax, along with substantial

penalties and interest. This additional income may also lead to disallowance, or a reduction in the

amounts, of certain credits and deductions as well as additional taxes (e.g. net investment income tax)

that are calculated based on reported income.

• ABC now has 52 reclassified employees and for 2018, the company will be penalized for not offering

affordable health insurance coverage to these employees under the Affordable Care Act (ACA).

• ABC may now owe back wages for any overtime worked by the 52 if he did not comply with the pay

requirements under the Fair Labor Standards Act (FSLA). If any of these 52 goes to court over this issue

with ABC, ABC is also liable for the workers’ court costs and attorney fees.

• To add to the snowball, other laws are now applicable to ABC and Charlie is open to lawsuits by his 52

under COBRA, the Family Medical Leave Act, the Age Discrimination Act, the Americans with Disabilities

Act, other non-discrimination laws, ERISA and OSHA, just to name a few.

• Oh, and let’s not forget that 52 workers must amend past returns to reclassify their self-employment

income to salary. This will nullify any deductions they took against the income shown on Form 1099-

MISC. They, too, will owe back taxes with substantial penalties and interest.

And Charlie thought it was cheaper to classify the 52 as independent contractors!

And what about you, the preparer? What are your potential costs? For one, you are certainly a shining candidate

for any number of preparer penalties under Title 26 of the Internal Revenue Code. There are also violations of

ethics under Circular 230 and if you are a CPA, the AICPA and your state board. Granted, this example is extreme

(maybe), but the BIG take-away here: if you’ve got clients who don’t want to hassle with paying their workers as

employees, you will want to have a nitty-gritty face-to-face meeting with them about this issue and explain the

potential costs that could be incurred by them, their workers, and you.

Misclassification of workers is a big deal with the IRS; after all there is big money at stake if employers are

misclassifying workers as independent contractors. The IRS has defined what an employee is based on common-

law precedents. And recently, the DOL has become very involved in defining which workers are considered

employees.

In this section, we will look at recent activity from the DOL and the Business Consultants ATG which contains a

good discussion of the independent contractor/employee issue including how the IRS approaches it. This ATG

states that the IRS will look for large consulting or contract expenses, or expenses for “other services” in

37

identifying businesses to audit. (Remember that ATGs cannot be cited as authority and are only guaranteed to be

technically correct as of the publication date [which was 2011 for this one], but they are quite useful in

understanding how the IRS conducts an audit of the issue.)

When you encounter clients with such expenses, you should have an action plan, or procedure, for assuring that

the client is properly classifying the individuals to whom payment is made. This section of the course is designed

to assist you in developing that action plan. The stakes are becoming increasingly high to risk misclassifying

employees as independent contractors.

Note

For purposes of this issue, the IRS is generally concerned with payments made to individuals. Payments

made to corporations and other legal entities for services are typically not subject to the scrutiny of the

IRS on the independent contractor/employee issue. LLCs have become an issue as a company may

think it is paying a corporation due to the company name, etc. but then it turns out to be a single

member LLC which can be a disregarded entity for tax purposes. In this case, the company would be in

effect paying an individual. When in doubt, payers should request/ obtain a W-9 from domestic payees

prior to engaging them to determine the appropriate classification/treatment. (The IRS has suggested

this.) If the payee refuses to provide it, technically the payer should not engage them, but if they do,

backup withholding would apply.

TIP.

If your firm prepares the Forms 1099-MISC (or 1099-NEC beginning in 2020) for your clients in January of

each year, this is a perfect opportunity to collect the information you need to determine whether your

client has properly classified individuals receiving payment.

The DOL & the Fair Labor Standards Act: Coming Soon

to a Business Near You

Changes in the business environment over the last few years have created motivations for employers to reclassify

workers as independent contractors. For example, companies that have laid off workers will contract some of

those workers back for their expertise, or specialized skills, on demand rather than on a full-time basis.

Additionally, Uber and similar companies do not hire traditional employees, but contract individuals to meet their

needs. And finally, the requirements of the ACA on small businesses has motivated employers to hire part-time

employees and independent contractors.

38

In a move that the business community views as anti-business, the DOL issued an Administrator’s Interpretation

(AI) in July 2015 which stated that “most workers are employees under the FLSA’s broad definitions.” (Weil, 2015)

The AI seeks to clarify the definition of “employee” and specified that the definition is broader than what

employers believe and what court rulings have determined. The AI stated that the “economic realities” test

(discussed below) that is applied by courts in defining what is considered employment must be applied consistently

with the broad definition of “employ” found in the FLSA. (Weil, 2015)

The DOL is concerned that individuals classified as independent contractors are missing out on minimum wage

and overtime requirements, workers comp, unemployment insurance, the benefits of belonging to a union, and

other protections for employees. And since classifying workers as contractors also cuts down on state and federal

payroll tax collections, the DOL is concerned that the government is not getting its due share of taxes. The AI

states that the definition of employee is broad enough that, based on the language, everyone should be covered

as an employee. And it does not stop there: The DOL applies this analysis in determining employment under the

FLSA, the Migrant and Seasonal Agricultural Worker Protection Act, the Family and Medical Leave Act, and other

worker protection laws.

Primarily, the DOL asks whether the worker is truly in business for himself or herself. If not, well… the worker is

probably an employee per the DOL. If a worker is in business for himself or herself, he or she will not be

economically dependent on the employer. Conversely, if the worker is economically dependent on the employer,

and is “suffered or permitted to work” by the employer, he or she will be considered an employee. The DOL states

that the control factor will not be determinative, and rejects the common-law control test. The FSLA “suffer or

permit” standard significantly broadens the definition of employee.

The example of economic independence provided by the DOL is “a highly skilled carpenter who provides a

specialized service for a variety of area construction companies…[this carpenter] may be demonstrating the skill

and initiative of an independent contractor if the carpenter markets his services, determines when to order

materials and the quantity of materials to order, and determines which orders to fill.” (Smith, 2015; Weil, 2015)

There are six factors the DOL considers, which comprise the “economic realities” test. Under these six factors,

almost every worker could be considered an employee. These factors are:

1. Is the work an integral part of the employer’s business?

2. Does the worker’s managerial skill affect his or her opportunity for profit or loss?

3. How does the worker’s relative investment compare to the employer’s investment?

4. Does the work performed require special skill and initiative?

5. Is the relationship between the worker and the employer permanent or indefinite?

6. What is the nature and degree of the employer’s control?

Matthew Disbrow, an attorney with Honigman Business Law firm in Detroit, said, “The subjective nature of the

DOL’s interpretation, and its narrow focus on ‘economic dependence’ creates substantial challenges for

companies who wish to maintain their independent-contractor relationships.” (Smith, 2015) Allen Bloom, an

attorney with Proskauer in New York City is quoted as having said, “the DOL significantly downplays the ‘control

test,’ which has long been the guide many businesses consider when determining whether or not a worker is truly

an ‘employee’.” Bloom issued the warning that, “Businesses worried about staying under the DOL radar on this

39

issue should make sure that they are doing business with established independent service providers if they intend

to pay on a 1099 basis.” (Smith, 2015)

Tammy McCutchen, a former Labor Department lawyer who represents employers on labor issues believes the

DOL “essentially declares war on the use of independent contractors in certain industries,” such as call centers,

construction and janitorial services. (Trottman, 2015) The DOL also has recognized housekeeping, in-home care,

and trucking as industries that are common culprits of misclassification. (Hanrahan, 2015)

The DOL has a webpage for its misclassification initiative. This website is found at

https://www.dol.gov/whd/workers/misclassification/ . The website states, “Misclassified employees often are

denied access to critical benefits and protections they are entitled to by law, such as the minimum wage, overtime

compensation, family and medical leave, unemployment insurance, and safe workplaces. Employee

misclassification generates substantial losses to the federal government and state governments in the form of

lower tax revenues, as well as to state unemployment insurance and workers’ compensation funds.”

(Misclassification of Employees as Independent Contractors, 2018) This website lists additional resources to refer

to for more information about the DOL guidance on the misclassification of workers, including the following

articles:

• Myths about Misclassification

• Get the Facts on Misclassification Under the FLSA

• DOL Press Releases: Employee Misclassification as Independent Contractors

• Employment Relationship under the FLSA

Moreover, the DOL has entered a Memorandum of Understanding (MoU) with several states and the IRS to share

information and to collaborate to help reduce the incidence of misclassified employees. Per the DOL website, this

collaboration has resulted in more than $74 million in back wages for more than 102,000 workers in the janitorial,

temporary help, food service, day care, hospitality, and garment industries. The DOL states that, “Through this

[misclassification] initiative, the DOL will continue to strive to assure that workers in these industries receive a fair

day’s pay for a fair day’s work.” (Misclassification of Employees as Independent Contractors, 2018)

The states that have entered into this MoU are: Arkansas, California, Colorado, Connecticut, Florida, Hawaii, Idaho,

Illinois, Iowa, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Minnesota, Missouri, Montana, Nebraska,

North Carolina, New Hampshire, New Mexico, New York, Oklahoma, Oregon, Pennsylvania, Rhode Island, South

Dakota, Texas, Utah, Vermont, Virginia, Washington, Wisconsin, and Wyoming.

Labor attorneys have been quick to respond to the DOL Administrator’s Interpretation with some

recommendations for businesses who hire independent contractors. Michael Droke, who is with the law firm

Dorsey and Whitney in Palo Alto, California and in Seattle, advises, “Companies should make clear which

department within the organization is responsible to understand the law, know which contractors have been

engaged and monitor compliance. “ (Smith, 2015)

Steps that companies should take, per Matthew Disbrow, are: (Smith, 2015)

https://www.dol.gov/whd/workers/misclassification/

40

• Use independent contractors sparingly since the DOL believes most work should be performed by

employees.

• Remember that entering independent contractor agreements or hiring a business entity (rather than a

person) does not necessarily protect the employer from liability under the FLSA.

• Carefully review the type and scope of work being performed before engaging the services of any

nonemployee.

• Obtain appropriate indemnification provisions to protect the company from the wage and hour claims of

the service provider’s workers.

Michael Droke further advised that companies should not give contractors rights or access that “cut against”

contractor determination. “Contractors should not have internal e-mail accounts, should not be given server

access and should not be invited to employee functions.” Additionally, “The DOL guidance reminds employers to

periodically audit existing contractors to make sure they have not inadvertently slipped from contractors to

employees. If an otherwise-valid contractor arrangement becomes economically dependent on the work, then

the relationship may convert to an employee entitled to overtime.” (Smith, 2015)

Margaret Santen Hanrahan of Ogletree Deakins in Atlanta says that “now is the time to closely review any

independent contractor relationships you may have. The scrutiny must include review and revision of any

applicable independent contractor agreements, and, more importantly, actual practice with contractors, which

would be the overriding consideration in audits or litigation. If the factors weigh against independent contractor

status, employers should take appropriate steps such as enhancing the independent contractor mode, arbitration

agreements with class action waivers, or reclassification. The potential liability association with a misclassification

finding is too significant not to.” (Hanrahan, 2015)

The guidance administered in this AI is not a change in policy as no official regulatory steps have been taken to

make this law (yet). As such, the DOL says it is purely an attempt to provide a more detailed interpretation of how

the agency assesses employer compliance with existing law. However, if the courts sustain the AI’s interpretation,

businesses who have misclassified workers face a daunting liability, including federal and state laws, the Family

and Medical Leave Act, the ACA, and ERISA. (Doherty, 2015)

Consequently, the proper classification of our clients’ workers should be of primary importance to us as we

identify issues on their tax returns as potential audit items. It’s not just the IRS about which our clients must worry;

the real elephant in the room is the DOL. Each practitioner who has clients with independent contractors should

issue a letter to the clients advising them of the DOL’s guidance in the AI. And, because CPAs and other tax

practitioners are not permitted to practice law without a license, your letter should clearly refer them to a labor

law attorney.

Required reading for all of us is the DOL Administrator’s Interpretation 2015-1. The document can be found in

Appendix A of this course.

Keep in mind that worker classification is not a decision to be made by an agreement between the payer and

payee. Titles do not matter. The form of the contract does not matter. Rather, the substance of the relationship

between the employer and the worker is the overriding factor. And now, we must also view these steps in light of

the DOL MoU between the DOL, the IRS, and the states.

41

Below are four steps to follow in determining the proper classification.

Step One: Is the Individual a Corporate Officer or

Statutory Employee?

(The services rendered by these individuals have already been defined by law as employee services.)

IRC § 3121(d) classifies the following individuals as employees; therefore, no determination as to whether the

individual is an independent contractor is required.

(1) any officer of a corporation; or

(2) any statutory employee.

Corporate officers. In general, all corporate officers are considered employees by the IRS as per IRC §3121(d)(1).

Their payments are subject to FICA, FUTA, federal income tax withholding, and state unemployment. However, a

narrow exception is permitted by the regulations if both the following stipulations are met:

1. The officer does not perform any services or performs only minor services, and

2. The officer is not entitled to receive, directly or indirectly, any remuneration.

Revenue Ruling 74-390, 1974-2 C.B. 331 provides that in determining whether the officer has performed minor

services, the following may be considered:

• the character of the service,

• the frequency and duration of performance, and

• the actual or potential importance or necessity of the services in relation to the conduct of the

corporation’s business.

If both the stipulations are met, then the corporate officer is not considered an employee.

What about corporate directors? An individual serving on a corporation’s board of directors is not considered an

employee. Rather, he or she is considered an independent contractor.

What if an officer is also a director? Per Rev. Rul. 58-505, 1958-2 C.B. 728, the compensation paid to this individual

can be divided into two categories:

• services rendered as a board member should be paid as to an independent contractor (reported on a

Form 1099-MISC), and

• services rendered as a corporate officer should be paid as to an employee (reported on a Form W-2,

subject to FICA, FUTA, and federal income tax withholding).

42

ALERT!

The IRS examiner is instructed to examine all payments to a corporate officer to determine whether the

payments are potentially wages for FICA, FUTA, and income tax withholding purposes. Such payments

include those labeled as draws, loans, dividends, rents, royalties, or other distributions. For more

information, see Rev. Rul. 74–44, 1974–1 C.B. 287. If your client makes several types of cash payments

to a corporate officer, you will need to question the client as to the intent of the payments and

document the response in the client file. If the support for the intent is flimsy, address the risks of audit

with the client. If the payment is a loan, the client should have a loan document with an adequate, stated

interest rate. The interest rate should, at the very least, be the appropriate Applicable Federal Rate to

avoid a below-market-loan classification.

Statutory employees. All statutory employees are considered employees by the IRS as per IRC §3121(d)(3).

Statutory employees fall into four categories:

1. Agent-drivers or commission-drivers who distribute meat, vegetables, fruit products, bakery goods,

beverages other than milk, or laundry/dry-cleaning services.

2. Full-time life insurance salespersons, working for one company.

3. Home workers, working from home for one employer making clothing, bedspreads, quilts, gloves,

needlecrafts, buttons, etc. Includes individuals who perform typing or transcription services.

4. Traveling or city salespersons, selling for one principal employer.

Note. If you have an individual who performs any of the services listed above and may be classified as a

statutory employee, please review the specific code sections related to each of these four categories as

the specific details re: these categories are beyond the scope of this course.

For workers who fall into one of these four statutory employee categories, FICA taxes must be withheld from the

wages if all three of these conditions apply:

• the individual must be under contract to personally perform substantially all the services, and

• the individual’s only substantial investment used to perform the services is his or her vehicle for

transportation,

• the services are performed on a continuous basis for the same employer.

Employers are required to pay FICA taxes on wages paid, and employers of agent-drivers and traveling or city

salespersons are also liable for FUTA on the amount of the wages paid. However, the employer is not required to

withhold federal income tax.

43

A quick note about employee benefits and statutory employees. With the exception of full-time life insurance

salespersons, statutory employees are not eligible to participate in employee benefit plans sponsored by the

employer, including retirement plans and accident and health insurance plans. Full-time life insurance

salespersons, however, are permitted to participate in certain employee benefits, including group term life

insurance, accident and health insurance, and retirement plans.

INCOME TAX REPORTING REQUIREMENTS OF STATUTORY EMPLOYEES

An employer of a statutory employee will issue the individual a Form W-2 for each year indicating the

amount of wages paid and FICA withheld with Box 13 “Statutory Employee” checked.

The statutory employee reports his or her income from the W-2 (with Box 13 “Statutory Employee”

checked) as follows:

1. Report the wages as income on Schedule C.

2. Deduct unreimbursed expenses related to the W-2 income earned on the same Schedule C.

The net income from a statutory employee’s Schedule C is not subject to self-employment tax; therefore,

no Schedule SE needs to be completed with respect to this activity.

ALERT!

If a statutory employee has non-W-2 income from services performed in an activity wherein he or she is

not a statutory employee, he or she must report that income on a separate Schedule C. The individual is

not permitted to combine the income from two different activities on the same Schedule C. Further, the

individual should not offset income earned from other services with expenses incurred as a statutory

employee.

If the individual is not a corporate officer or statutory employee, then proceed to Step 2.

Step Two: Is the Individual a Statutory Non-Employee?

(These are services that have already been defined by law as non-employee services.)

Three occupations have been defined by the Internal Revenue Code to be statutory non-employees. As such, they

are treated as independent contractors. These occupations are:

1. Licensed real estate agents (IRC §3508(b)(1)),

2. Direct sellers (IRC §3508(b)(2)), and

3. Companion sitters (IRC §3506).

44

Note

If you have an individual in an occupation listed above, please review the referenced code sections related

to each of these occupations as the specifics related to statutory non-employees is beyond the scope of

this course.

INCOME TAX REPORTING REQUIREMENTS OF STATUTORY NON- EMPLOYEES

Statutory non-employees are considered independent contractors. Their pay is reported each year on a

Form 1099-MISC (Form 1099-NEC beginning in 2020). The payer does not pay FICA or FUTA and does

not withhold federal income tax or FICA from the compensation of the non-employee.

The non-employee reports the income on a Schedule C and deducts unreimbursed expenses on the

same Schedule C. Net income from the Schedule C is subject to self-employment tax, which is computed

on Schedule SE.

If the individual cannot be classified as a statutory employee or a statutory non-employee, proceed to Step 3.

Step Three: Can the Worker Qualify as an Independent

Contractor Under Section 530?

What is Section 530?

For employers who have treated workers as independent contractors and have had a reasonable basis for doing so, Section 530 terminates the employer’s payroll tax liabilities resulting from an employment status reclassification by the IRS. This includes FICA, FUTA, income tax withholding, and any interest and penalties attributable to the liability.

ALERT

Section 530 terminates only the employer's liability for payment of employment taxes, along with any resulting penalties and interest. The Section does not provide relief from any other laws that protect the rights of employees.

Therefore, make sure that your client understands that if the IRS reclassifies the independent contractors to employees, then Section 530 cannot be relied upon to terminate the employer’s liabilities

45

that may arise under any of the employee protection laws of the DOL or U.S. Equal Employment Opportunity Commission.

In order to qualify for relief under Section 530, the employer must meet all three of these conditions:

1. The employer had a reasonable basis for treating the workers as independent contractors.

2. The employer must have consistently treated the workers, and any similar workers, as independent

contractors.

3. The employer must have filed all required federal tax returns (including information returns)

consistent with the independent contractor treatment.

Reasonable Basis Requirement

An employer has reasonable basis for treating workers as independent contractors when he or she can show

reasonable reliance on any of the following:

• A court case or ruling involving the employer, or a technical advice (TAM), a private letter ruling, or a determination letter issued to the employer stating that the workers were independent contractors (a determination letter will be issued by the IRS to a business or worker in response to the filing of Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding);

• A prior IRS audit of the employer’s business in which similar workers were treated as independent contractors and the IRS did not reclassify those workers as employees.

ALERT

A prior audit can only be relied upon if it included an examination for employment tax

purposes of whether the workers—including those in substantially similar positions—

were properly classified.

• A long-standing, recognized practice of treating workers as independent contractors in a significant segment of the employer’s industry and the geographical area.

TIP

46

Statistically, very few clients will have appeared before Tax Court or received any

rulings, TAMs, or determination letters from the IRS on this issue. Therefore, the only

chance for most businesses to receive relief under Section 530 is the long-standing,

recognized practice throughout the industry. Therefore, you as the tax adviser should

research and understand fully how the industry classifies workers, and this

information should be well documented in your client files. A little effort to document

the position NOW should help stave off a reclassification by the IRS should they audit

this issue in the future.

Consistency Requirement

An employer meets the consistency requirement of Section 530 when he or she has historically treated all

individuals holding substantially similar positions as independent contractors. The relief afforded by Section 530

is not available when the employer has treated similar workers as employees.

Reporting Requirement

An employer meets the reporting requirement of Section 530 when he or she files yearly tax and information

returns consistent with the treatment of workers as independent contractors.

EXAMPLE

An employer with independent contractors should file income tax returns with a deduction for

“contract labor” and Forms 1099-MISC to report the payments and provide the required copy to the

contractors. An employer would be inconsistent in reporting if he or she provided Forms W-2 to

independent contractors and reported their wages as a deduction for “contract labor.”

ALERT

Section 530(d) provides that no relief is available for businesses who provide workers to a client in the

following services:

Engineers Designers Drafters

Computer programmers Systems analysts Other similarly skilled workers

47

Example. Your client is an engineering consulting firm that provides engineers to businesses for special

projects. Your client—the engineering consulting firm—cannot obtain relief under Section 530 if the

engineers were treated as independent contractors.

Please note that Section 530(d) does not change the classification of an independent contractor to an

employee. The common-law rules will determine whether such an individual is an employee or contractor.

These are discussed in Step 4.

If the employer cannot meet all three of the requirements under Section 530, then the determination of whether

a worker is an employee or independent contractor is subject to interpretation under common law. Proceed to

Step 4.

Step Four: How is the Worker Classified Under

Common Law?

When the three steps listed above do not clearly classify a worker, then IRC §3121(d)(2) requires the application

of common law in determining whether an employer-employee relationship exists. Under common law, the

degree to which a business has behavioral and financial control over a worker, as well as the relationship that

exists between the two parties, determines the classification of the worker. Twenty factors have been identified

in Revenue Ruling 87-41, 1987-1 C.B. 296 as indicating whether sufficient control is present to establish an

employer-employee relationship.

If we practitioners know the questions the IRS examiners ask when auditing this issue, we should work with our

clients to document the answers and address any issues before they are audited. These questions, which consider

the twenty factors, are included in Exhibit D of the Business Consultants ATG, which instructs examiners to

consider several factors in determining the 1) degree of behavioral and financial control the business has over the

worker, and 2) the relationship that exists between the two parties.

Factors which Determine Behavioral Control

1. To what degree does the business hiring the worker instruct the worker on the following?

• When to do the work,

• Where to do the work,

• What tools or equipment to use,

• What workers to hire to assist with the work,

• Where to purchase supplies or services,

48

• What work must be performed by a specific individual (including ability to hire assistants),

• What routines or patterns must be used, and

• What order or sequence to follow.

2. Is the worker required to seek approval from the business before taking certain actions?

3. To what degree does the business provide instructions to the worker? What happens if the worker does

not follow the business’s instructions?

4. Were these instructions in compliance with a governmental or other regulating entity, or were the

instructions in compliance with the business’s standards?

5. How did the business respond to any instructions provided by the customer?

6. Did the business require the worker to wear a uniform with the business name to provide customer

assurance of security?

7. Was the worker required to place the business name on his or her vehicle to provide customer

assurance or for security purposes?

8. Does the business or the worker incur the expense of the uniform or signage for the vehicle?

9. What is the occupation of the worker?

10. What degree of direction (or oversight) does the business provide for the worker as the work is

completed?

11. Is the worker required to submit regular written or oral reports to the business?

12. How is worker performance and compliance measured?

13. Are the worker’s services an integral part of the business operations?

14. How is the worker trained to perform the work? What business procedures is the worker required to

perform?

15. How is the worker updated on company policies or governmental rules and regulations?

16. Is the worker required to attend training sessions?

17. Is the worker compensated for attending training sessions?

Factors which Determine Financial Control

1. Who has incurred the cost for the assets normally used in the performance of services or provision of products?

2. Does the business reimburse the costs incurred by the worker? 3. Where does the worker perform the services? 4. Does the worker advertise his or her services to other customers? 5. Is the worker available to work for other customers? 6. What is the worker’s method of payment? 7. Is the worker permitted the freedom to make decisions that will impact whether he or she makes a

profit or loss?

Factors which Determine the Relationship of the Parties

1. What is the nature of the contract that exists between the worker and the business? Is the contract in

writing?

2. What is the substance of the relationship? Does the contract support the actual substance of the

relationship (substance over form)?

49

3. What type of information returns have been filed historically?

4. Is the worker incorporated?

5. Does the worker receive any benefits, such as a) paid vacation and/or sick days, b) health, life, and/or

disability insurance, c) qualified retirement plans, d) cafeteria plan?

6. What is the status of the worker determined by state or federal agencies for purposes of providing

benefits?

7. Are there any limitations on the business’s ability to terminate the worker?

8. Are there any limitations on the worker’s ability to terminate the working relationship with the business?

9. What is the worker’s liability if he or she doesn’t complete the work?

10. What rights does the business have if the worker does not complete the work?

11. What is the term of the relationship? Long-term, temporary? Does the contract state the term?

12. Does the worker work part-time, full-time, or as needed? Are there set hours in which the worker must

work?

Updates for Information Returns Filed for Tax Years 2016 and Later New due date for filing Forms W-2. The Social Security Administration (SSA) website and the instructions to Forms W-2 and W-3 state that the new due date for filing Forms W-2 with the SSA is now January 31. This due date applies regardless of whether you file paper forms or file electronically. If the employer does not want to file Forms W-2 electronically, a waiver can be requested by filing Form 8508, Request for Waiver From Filing Information Returns Electronically. This form must be submitted to the IRS at least 45 days before the due date of Form W-2. See the instructions to Form 8508 for more information. Extensions for filing Forms W-2 with SSA. If an employer is not able to file Forms W-2 with the SSA by January 31, the employer can request one 30-day extension. This extension request is made on a Form 8809, Application for Extension of Time to File Information Returns. The employer will need to include a detailed explanation of why additional time is needed and sign the form under penalties of perjury. This extension will be granted only when there are extraordinary circumstances or catastrophes. The instructions to Form W-2 give the examples of a natural disaster or fire destroying the books and records needed for filing the forms. Extensions of time for furnishing Forms W-2 to employees. An employer can request an extension of time to furnish Forms W-2 by sending a letter to the IRS stating the reason for the delay. For more information, see instructions to Forms W-2. New due date for filings Forms 1099. From 2016-2019, the General Instructions for Certain Information Returns stated that Form 1099-MISC must be filed on or before January 31 when reporting nonemployee compensation in box 7 for both paper and electronic filing methods. All other payments reported in other boxes on Form 1099-MISC are due by February 28 (if filing paper returns) or by March 31 (if filing electronically). The due date for furnishing payee statements is generally February 15. Beginning with tax year 2020, filers will use a new form, Form 1099-NEC, to report nonemployee compensation by January 31 (February 1 in 2021). The IRS created this new form in an effort to eliminate the burden of filers having to separately report nonemployee compensation by January 31 and

50

other payments by February 28 (paper filings) or March 31 (electronic filings). As a result, the IRS removed nonemployee compensation from Form 1099-MISC and redesigned the form, which will continue to be used for other payments; due dates remain the same. Higher penalties related to filing Forms W-2 and Forms 1099. The following penalties were increased for tax years beginning in 2016 and later for:

• Failure to file correct Forms W-2 or Forms 1099 by the due date.

• Intentional disregard of filing requirements.

• Failure to furnish employees with Forms W-2 or Forms 1099.

• Intentional disregard of payee statement requirements. Failure to file correct Forms W-2 and Forms 1099 by the due date and failure to furnish correct payee statements (two separate penalties). Note: these penalties are generally adjusted for inflation annually, effective for returns or statements required to be filed after December 31 of a certain year. If filed correctly:

• Within 30 days of the due date, the penalty is $50 per W-2 or 1099, not to exceed $197,500 (2020) for small businesses.

• More than 30 days after the due date but by August 1 of same year, the penalty is $110 per W-02 or 1099, not to exceed $565,500 (2020) for small businesses.

• After August 1, or do not file corrected W-2s or 1099s, the penalty is $280 per W-2 or 1099, not to exceed $1,130,500 (2020) for small businesses.

Intentional disregard of filing requirements and intentional disregard of payee statement requirements (two separate penalties). The penalty is at least $560 (2020) per W-2 or 1099 with no maximum penalty. *Exceptions to these penalties can be found in the instructions for Forms W-2 and the General Instructions for Certain Information Returns. Safe Harbor for de minimis dollar amount errors on information returns and payee statements. No correction is needed if

• The difference between the amount filed and the correct amount is no more than $100, and

• The different between reported amount for tax withheld and the correct amount of withholding is $25 or less.

51

The following table summarizes all four steps in determining proper worker classification.

Table 1. Summarization of Steps to Determine Proper Worker Classification

Is the worker any of the following?

• A corporate officer.

• An agent- or commission-driver distributing meat, vegetables, fruit products, bakery goods, beverages other than milk, or laundry/dry-cleaning services.

• A full-time life insurance salesperson working for one company.

• Certain home workers, working from home for one employer.

• A traveling or city salesperson, selling for one principal employer.

If yes, the corporate officer is an employee. The

other four occupations are considered statutory

employees.

Is the worker any of the following?

• A licensed real estate agent.

• A direct seller.

• A companion sitter.

If yes, these occupations are considered statutory

non-employees and will be treated as

independent contractors.

Can the business meet the three requirements of

Section 530?

If yes, then the business is relieved of the payroll

tax liability that would result from reclassification

from independent contractor to employee.

It does not, however, relieve the business from

other laws promulgated by the DOL, and other

employee-rights legislation.

Was “No” the response to all three questions

above?

If yes, then a facts and circumstances test, based

on common law, is applied to determine whether

an employer-employee relationship exists.

Relevant questions asked by the IRS are listed in

Exhibit D of the Business Consultants ATG.

52


Every tax practitioner has a client (or clients) who will push the boundaries on this issue. It is your responsibility

to communicate the ramifications of being audited by the IRS and the implications of the DOL’s AI to them.

If you or your firm prepares Forms 1099 for your clients each January, you should collect the information needed

to ensure that the independent contractors are properly classified. Also, as you prepare tax returns for businesses,

pay close attention to expenses labeled “contract labor” or “other services” and make inquiries based on the four

steps of worker classification to determine whether the workers are indeed properly classified. Document,

document, document your actions and findings.

What if you need help in determining the proper classification? If a business needs assistance in making a proper

classification of its workers, or if a worker thinks that he or she has been misclassified as an independent

contractor, Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax

Withholding should be filed with the IRS. In response, the IRS will issue a determination letter stating the proper

classification based upon the facts and circumstances provided on the form.

What if you find that the client has incorrectly classified true employees as independent contractors? Well, you

and your client should quickly remedy this situation so that your client doesn’t end up like poor Charlie in the

example at the beginning of this section. If eligible, the client should seriously consider participating in the

Voluntary Worker Classification Settlement Program (VCSP) which is discussed below. VCSP is the cheapest and

easiest method for reclassifying independent contractors as employees. If your client has years of improperly

classified independent contractors, this is a very attractive alternative to crossing your fingers and hoping the IRS

doesn’t audit.

Voluntary Worker Classification Settlement Program

(VCSP)

Worker misclassification has been a hot topic with the IRS for years. Now that the DOL has thrown their hat into

the ring, taxpayers need to ask if the independent contractor status for their workers is worth the cost of being

reclassified by either agency.

The IRS offers a program, VCSP, for taxpayers to voluntarily reclassify workers with relatively low cost. In fact,

when you consider the cost of an audit and the daunting consequences suffered by Charlie, in the example at the

beginning of this section, the program is a downright bargain. This program may become widely popular in view

of the DOL’s AI.

If your client needs to reclassify his or her workers as employees for employment tax purposes for future tax

periods, they may do so and receive partial relief from federal employment taxes using the VCSP. All taxpayers,

exempt organizations, and government entities may participate in VCSP if these eligibility requirements are met:

53

• The taxpayer (including exempt organizations and government entities) must have consistently treated

the workers as independent contractors and filed all required Forms 1099 for the previous three years.

• The taxpayer must not currently be under an employment tax audit by the IRS or a worker classification

audit by the DOL or a state agency. An affiliated group is not eligible for VCSP if any member of the

affiliated group is under an employment tax audit or worker classification audit.

• If the taxpayer was previously audited by the IRS or the DOL on the classification of workers, the taxpayer

must have complied with the results of the audit. The taxpayer will not be eligible for the VCSP is he or

she is currently contesting the classification in court.

Under VCSP, the participating employer will:

• pay 10% of the employment tax liability computed on compensation paid to the workers for the most

recent tax year. This is computed using reduced rates as provided in IRC §3509(a);

• not be liable for interest and penalties on the computed amount; and

• be protected from an employment tax audit related to the workers reclassified under VCSP for prior years.

To apply to VCSP, your client must use Form 8952, Application for Voluntary Classification Settlement Program.

The application should be filed at least 60 days prior to the date your client wants to begin treating its workers as

employees. For example, if your client wants to begin treating workers as employees on January 1, the application

should be filed no later than November 2 of the preceding year. Form 2848, Power of Attorney, will also need to

be filed if your client wants you to designate you as their authorized representative.

*As part of the agreement, the IRS agrees not share the VCSP participant’s information with the DOL.

VCSP is a welcome relief for taxpayers who have misclassified employees as independent contractors. The IRS has

made it cheap and easy to reclassify and begin afresh with the current year. And to top it off, the taxpayer will

not be audited for prior years on the employment tax issue nor have their information handed over to the DOL.

Very much worth considering.

54

Tip

Have you sent your clients who pay independent contractors a letter about the VCSP? You probably should. First and foremost, because it is in the best interest of our clients. And secondly, because the last thing any practitioner wants to hear is, “Well, you never told me about this.”

Final Considerations

Reclassifying independent contractors to employees takes quite a bit of paper shuffling. It requires creating

employment contracts, setting up the workers for federal and state payroll deductions and federal income tax

withholding, setting up the workers for employee benefits and qualified retirement plans, and ensuring proper

health care coverage, if required. Consider the ACA requirement of providing medical insurance to employees

when a business has 50 or more full-time employees. Reclassifying independent contractors to employees will

increase the number of full-time employees and may result in an ACA requirement when none existed previously.

For the worker who knows he or she is improperly classified as an independent contractor, the worker should not

use Schedule SE when filing a personal income tax return because his or her earnings are not subject to the

employer’s half of FICA tax. Rather, the worker should file Form 8919, Uncollected Social Security and Medicare

Tax on Wages, to pay his or her share of the FICA tax.

For further reading:

• Revenue Ruling 87-41, 1987-1 C.B. 296

• IRS Training Manual: Independent Contractor or Employee?

• Audit Techniques Guide: Business Consultants

55


7. Which of the following is an indication that a worker is truly an independent contractor per the Administrator’s

Interpretation issued by the DOL on July 15, 2015?

A. The independent contractor splits his time between two companies because he has contracts with both.

B. The independent contractor has an internal e-mail account with the company for whom he works.

C. The independent contractor has access to the company server.

D. The independent contractor is invited to the company’s weekly happy hours.

8. Which statement is correct regarding the income tax reporting of statutory employees?

A. The employer of a statutory employee will issue the individual a Form 1099-MISC for compensation paid.

B. The statutory employee will compute self-employment tax on the compensation received.

C. The employer is not required to withhold federal income tax from the statutory employee’s

compensation.

D. The statutory employee can combine his or her income as a statutory employee with the income from

other activities on the same Schedule C.

9. Which question would an IRS examiner ask to determine the level of behavioral control?

A. Is the worker available to work for other customers?

B. What is the business’s ability to terminate the worker?

C. Does the worker advertise his or her services to other customers?

D. Are the worker’s services an integral part of the business operations?

56

Section 4: Capitalization and Repair Policies



1. Recognize the de minimis safe harbor to expense asset purchases under the safe harbor amount.

2. Identify expenses as materials and supplies, and understand the tax treatment of materials and supplies,

as defined by the Tangible Property Regulations.

3. Differentiate the building systems that are separate from the building structure in identifying units or

property.

4. Distinguish between improvements (betterments, restorations, and adaptations) and repair and routine

maintenance expenses.

5. Identify tax savings for your client using the partial disposition election.

The Impact of the Tangible Property Regulations

Chaotic, to put it mildly, have been recent tax seasons. We preparers were tasked for the first time with ensuring

that our clients were complying with the ACA regarding health insurance coverage and determining whether

exemptions or penalties apply if not covered. Additionally, very few clients had, in prior tax years, voluntarily

implemented the requirements of the final Tangible Property Regulations (the Regs)—regardless of our wise

counsel to do otherwise. Now that compliance with the Regs is mandatory, even the experts did not fully agree

on the mechanics of compliance. The early days found us computing any necessary §481(a) adjustments and

preparing a Form 3115 for each tax return in which the Regs applied. That was just a bit burdensome, to say the

least. Thankfully, Rev. Proc. 2015-20 was issued mid-February permitting small businesses to make the required

accounting changes without filing a Form 3115. CPAs everywhere breathed a collective sigh of relief on the release

of that welcome news.

The dust has settled quite a bit since, and a few years of tax returns have now been filed under these new laws.

Even though practitioners have a much better understanding of how to apply the requirements, there is still quite

a bit of confusion, which is leading to a host of incorrectly-filed tax returns. The Regs have many taxpayer-friendly

provisions and provide uniformity and simplification of the treatment of certain expenditures. However, that is a

57

bit hard to see when sifting through the lengthy and wordy Regs with head-scratching detail. This section will

revisit the requirements of the Tangible Property Regs, provide a systematic approach to applying the rules, and

discuss the traps and benefits of cost segregation analysis.

Since the Regs are fairly new, there are no new interesting court cases to examine or amusing anecdotal stories

about clients complying with the Regs. But, we do know that the IRS recently issued an ATG on this topic, which

means the Service is gearing up for audits of taxpayers. So let’s grit our teeth and get down to the nitty gritty

details of these Regs!

Required Reading! In September of 2016, the IRS released an ATG on the Capitalization of Tangible

Property. We can assume, then, that the IRS considers this an area of potential noncompliance for many

taxpayers. The ATG is 202 pages of not-so-thrilling information, but is a must-read for every tax

practitioner.

The Tangible Property Regulations are All-Inclusive

The Tangible Property Regulations apply to all taxpayers (both for-profit and non-profit), regardless of legal entity

of operation, if the taxpayer paid or incurred amounts to acquire, produce, or improve tangible real or personal

property. This includes:

• Individuals filing a Form 1040 with a Schedule C, Schedule E, or Schedule F

• Corporations

• S corporations

• Partnerships

• Limited Liability Companies

A Systematic Approach to Complying with the Regs

Applying the Regs requires a careful examination of the year-long activity in the following accounts of a business:

Fixed Asset Accounts Expense Accounts

Building and improvements Repairs and maintenance

Plant and equipment Materials and supplies

Machinery and equipment Office supplies and expenses

Furniture and fixtures Other supplies

Other fixed asset accounts Other repairs

58

Step One: Applying the De Minimis Safe Harbor

What is the de minimis safe harbor election? The de minimis safe harbor election permits a taxpayer to expense

certain amounts paid to acquire or produce tangible property to the extent such amounts are also deducted for

financial accounting purposes. Tangible property includes real or personal property, including leasehold

improvements, land and land improvements, buildings, machinery and equipment, and furniture and fixtures.

When a taxpayer elects this safe harbor provision, he or she must also apply the election to amounts considered

materials and supplies. This is discussed later in this section.

The amount of the safe harbor is:

For businesses with applicable financial

statements*

For businesses without applicable financial

statements*

$5,000 per item or per invoice $2,500 per item or invoice

*Applicable financial statements (AFS) are financial statements filed with the SEC, audited financial statements,

or financial statements that are required by a federal or state government agency (other than the IRS or SEC).

Most small businesses will fall under the $2,500 safe harbor amount because they are not publicly-traded, audited,

or required to file financial statements with any federal or state agency. And for many individuals who file

Schedules C, E, or F, no financial statements exist at all.

The effect of the election is that any amount paid (for a single item or for a single invoice) to acquire or produce

tangible property can be expensed if it falls at or below the safe harbor amount. These amounts paid are usually

recorded in the client’s fixed asset accounts (listed above).

EXAMPLE

A small business purchases three printers for $1,600 each. Because each item is below the safe harbor

amount, the printers can be expensed.

Note

Amounts paid for single items exceeding the safe harbor in the fixed asset accounts should generally be

capitalized, subject to depreciation, to minimize questions and potential disallowance of deductions by

IRS examiners. Of course, these amounts can be expensed for tax purposes under Section 179 or bonus

depreciation, if qualifying property and all limitations are observed.

59

The IRS states in its Tangible Property Regs FAQs that this election “eliminates the burden of determining whether

every small-dollar expenditure for the acquisition or production of property is properly deductible or capitalizable.

If you elect to use the de minimis safe harbor, you don’t have to capitalize the cost of qualifying de minimis

acquisitions or improvements.” (Tangible Property Regulations--Frequently Asked Questions, 2016)

ALERT

Make sure your clients have an accounting procedure and/or capitalization policy in place on or before

the beginning of the year that addresses expensing the following in its books and records:

• all amounts paid for property costing less than a specific dollar amount, or

• all amounts paid for property that has a useful life of 12 months or less.

You should require that your clients put accounting policies and procedures in writing* even though the

Regs do not require written procedures for taxpayers who do not have AFS. (Written procedures are

required for those with AFS.) Upon audit, IRS examiners are instructed to review all capitalization policies

and accounting procedures, so it would be most helpful for your clients to have written policies and

procedures. And, it’s always best if clients follow the policies and procedures they have set!

The tax treatment of such costs under the Regs must mirror the treatment of these same costs in the

financial statements or books and records.

*Note: It is certainly worth nagging clients to obtain copies of their policies and procedures, which you

should retain in your client files. If your client doesn’t have accounting procedures (as many businesses

do not), offer to assist in creating them as quickly as possible. The client should store all accounting

policies and procedures in permanent files, paper or electronic.

----------------------------------------------------------------------------------------------------------------------------------------

Sample Accounting Procedure Establishing a Capitalization Policy

Client Name

The accounting capitalization policy of (client name) treats as an expense for non-tax purposes:

(i) Any amount paid for property that does not exceed $ ________________* per invoice (or per item

as stated on invoice); or

(ii) Any amount paid for property with an economic useful life of 12 months or less.

In accordance with this procedure, all amounts described above will be expensed on the books and

records of (client name).

This procedure is effective as of: ___________________________ (date)

60

_____________________________________________ ______________________

Taxpayer Representative (officer, partner, member, etc.) Date

A Word About Transaction Costs

Any transaction costs incurred in the acquisition of capitalized tangible real or personal property must be

capitalized as part of the cost of the property unless a safe harbor applies. Transaction costs are amounts

paid in the investigation of, or pursuing of, the acquisition of tangible property other than real property.

For real property, such pre-decision or investigative costs are deductible when paid or incurred. Additional

transactions costs include:

• Shipping fees, moving costs, or other costs incurred in transporting the property

• Appraisal fees

• Professional fees (including tax advice) on negotiating the terms of the acquisition

• Application fees, bidding costs, and other such costs

• Costs incurred for document preparation and review

• Costs incurred in the examining and evaluating the title of property

• Permit fees or other costs to obtain regulatory approval

• Sales tax and title registration costs

• Brokers’ commissions and finders’ fees

• Costs incurred for architectural, geological, survey, engineering, environmental, or inspection

services

• Costs for a qualified intermediary for a like-kind exchange under IRC §1031

*In the ATG, the examiner is instructed to review the accounts that may include such transaction costs,

such as legal fees, professional expenses, transaction costs, engineering costs, design costs, accounting

fees, and investment advice fees. In view of this, ensure that all transaction costs are properly capitalized

when required.

Making the De Minimis Safe Harbor Election

To make the de minimis safe harbor election, review the following accounts for expenditures that are equal to the

safe harbor amount or less ($5,000 with AFS; $2,500 without AFS). These are the amounts that can be expensed

under the de minimis safe harbor election.

Accounts to Review:

Building and improvements, plant equipment, machinery and other equipment, furniture and fixtures, and other

fixed asset accounts. Additionally, non-inventory materials and supplies, office supplies, and other supplies.

61

Below is an example of an election statement, which must be attached to a timely filed original federal tax return

(including extensions) for the taxable year in which the amounts are paid. This is not a one-time election; rather,

the election should be filed each year that the safe harbor de minimis is used by the client. Most tax preparation

software programs prepare this election statement.

Making the De Minimis Safe Harbor Election

Client’s Name

Address

Tax I.D. Number

Section 1.263(a)-1(f) De Minimis Safe Harbor Election

The taxpayer is hereby making the de minimis safe harbor election under Reg. Sec. 1.263(a)-1(f).

Other Important Considerations

• When the election is made, the taxpayer must consistently apply the safe harbor to all amounts paid

during the year. In other words, the taxpayer cannot pick and choose the items to which the safe

harbor applies.

• A taxpayer cannot file an amended return to either make or revoke the election.

• The safe harbor does not include amounts paid for land, or amounts paid for rotable or temporary

spare parts.

• When the election is made, the safe harbor rules apply also to items that are considered materials

and supplies.

• The safe harbor election does not override the UNICAP rules under IRC §263A; i.e., if an expense

must be capitalized for UNICAP purposes, it is not eligible for the de minimis safe harbor election.

• IRS examiners have been instructed to be on the lookout for manipulated transactions to achieve

the tax benefits under this safe harbor, most notably the manipulation of invoices or issuance of

multiple invoices to make transactions appear to fall below the safe harbor amounts.

62

Step Two: Applying the Regs to Materials and Supplies

The following accounts should be analyzed to ensure that amounts paid agree with the definition of materials and

supplies per the Regs.

Materials and supplies Other supplies

Office supplies Repairs and maintenance

What is defined as materials and supplies? Materials and supplies are non-inventory, tangible property used

and consumed in operations including:

Type of materials and supplies: Defined as:

Acquired components Components acquired to maintain, repair, or

improve tangible property owned, leased or

serviced; and is not a part of a larger item of

tangible property.

Consumables Fuel, lubricants, water, similar items that are

expected to be consumed in 12 months or less.

12-month property Tangible property that has an economic useful life

of 12 months or less.

$200 property Tangible property that costs $200 or less.

What materials and supplies are deductible? This table provides the definition and deductibility of materials and

supplies.

Incidental materials and supplies Items that are of minor or secondary importance,

for which no record is kept of items on hand, no

beginning or ending inventories are maintained.

Examples per IRS FAQs: pens, paper, staplers,

toner, trash baskets.

*Deductible in the year paid.

63

Non-incidental materials and supplies Any item that is not incidental, i.e. items that are

of importance, for which records are kept of

consumption.

*Deductible in the year first used or consumed.

ALERT!

*If the de minimis safe harbor is used, any materials and supplies falling at or below the amount of the

safe harbor must be deducted in the year the amounts are paid or incurred. Amounts paid above the safe

harbor amount should be analyzed to ensure the definition of deductible materials and supplies is met.

Otherwise, these items may be subject to capitalization.

* The Tangible Property Regs treatment of materials and supplies does not override the UNICAP

capitalization requirements of §263A.

Rotable, Temporary, and Standby Emergency Spare Parts

The following is a brief discussion of the definition and tax treatment of rotable, temporary or standby emergency

spare parts for operating equipment. For additional details, please consult the ATG, Capitalization of Tangible

Property, Chapter 10, Materials and Supplies.

Rotable spare part A part that can be removed from a Unit of Property (UoP), repaired

or improved, and then reinstalled on the same UoP or other

property, or stored for later installation.

Temporary spare part A part that is used temporarily until a new or repaired part is

installed.

Standby emergency spare part A part that is set aside to use in the event of an emergency to avoid

equipment shut downs. (Refer to ATG for additional definitional

details.)

64

Election to Capitalize Rotable and Temporary Parts

Expenditures for rotable, temporary, and standby emergency spare parts are deductible in the year used,

consumed, or otherwise disposed of unless the taxpayer uses the optional method of accounting. The optional

method of accounting is complicated and requires the taxpayer to deduct the cost of the item in the year it is first

installed. When the part is removed, the part’s fair market value is included in income and any removal costs are

capitalized. The tax basis for the part is the amount of income recognized plus capitalized costs. A taxpayer who

uses this method of accounting can elect to capitalize and depreciate the parts on a timely (including extensions)

originally filed tax return. The election is made by capitalizing and depreciating the parts; there is no requirement

to attach an election statement to the tax return.

Page 98 of the ATG provides an excellent summary chart for the treatment of materials and supplies.

Step Three: Applying the Regs to Repairs and

Maintenance

Determining the deductibility of repairs is on a case by case basis, using a facts and circumstances analysis. This

analysis includes the following:

1. Identify all expenditures that are related to a unit of property (UoP)

DESCRIPTION UNIT OF PROPERTY (UOP)

Buildings--used in the business The building structure (foundation, roof, walls, partitions, floors,

windows, ceilings and permanent coverings, like panel or tile)

The plumbing system (pipes, drains, valves, sinks, bathtubs, toilets,

water and sanitary sewer collection equipment, and site utility

equipment used to distribute water and waste to and from the

property line and between buildings and other permanent

structures)

The electrical system (wiring, outlets, junction boxes, lighting

fixtures and associated connectors, and site utility equipment used

to distribute electricity from property line to and between buildings

and other permanent structures)

The HVAC system (motors, compressors, boilers, furnace, chillers,

pipes, ducts, radiators)

65

The elevator system

The escalator system

The fire protection and alarm system (sensing devices, computer

controls, sprinkler heads, sprinkler mains, associated piping or

plumbing, pumps, visual and audible alarms, alarm control panels,

heat and smoke detection devices, fire escapes, fire doors,

emergency exit lighting and signage, and firefighting equipment,

such as extinguishers, hoses)

The gas distribution system (associated pipes and equipment used

to distribute gas to and from property line and between buildings or

permanent structures)

The security system (window and door locks, security cameras,

recorders, monitors, motion detectors, security lighting, alarm

systems, entry and access systems, related junction boxes,

associated wiring and conduit)

Buildings – as a lessee Apply the above analysis to the portion of the building that is leased

Buildings—as a lessor Apply the above analysis to the entire building

Applies to all components that are functionally interdependent,

comprising one UoP (if the component cannot be placed into service

without placing in service another component of property). The

example from the ATG is a locomotive, which is made up of the

following functionally interdependent parts: the engine, generators,

batteries and trucks.

Plant Property (e.g.

manufacturing or generation

plant property, etc.)

UoP is defined as each component or group of components that

performs a discrete and major function or operation, and is

triggered when the UoP is placed into service.

Network assets (e.g. railroad

track, oil and gas pipelines,

etc.)

Guidance from the IRS and Treasury Department determines the

UoP based upon the facts and circumstances, and is triggered when

the UoP is placed into service.

All expenditures related to a specific UoP can be classified as routine maintenance, a repair, or an improvement. The next steps are a systematic approach to this classification.

66

2. Determine which of these expenditures is an improvement to a UoP.

An improvement is considered a betterment, a restoration, or an adaptation. The IRS uses many words to define

these terms. The table below contains a simplified version of the terms—if you would like to read the IRS’s

detailed definitions and see examples, please see the IRS FAQs at https://www.irs.gov/businesses/small-

businesses-self-employed/tangible-property-final-regulations). Also, as mentioned previously, a reading of the

ATG for Capitalization of Tangible Property is an excellent way to learn about the many details of the Regs.

Type of Improvement Definition

Betterment to a UoP • Expenditures to ameliorate a material condition or material defect

that existed before the acquisition or arose during production; or

• Expenditures for a material addition or for a material increase in capacity; or

• Expenditures that materially increase productivity, efficiency, strength, quality, or output.

• ALERT! Any amount paid for a betterment does not qualify for the safe harbor for routine maintenance (discussed later).

Restoration of a UoP • Expenditures for the replacement of a part(s) of a major

component or a substantial structural part.

• ALERT! Amounts paid for a replacement of a component in which the taxpayer 1) incurred a loss on disposition or 2) was required to take a basis adjustment for a casualty loss, do not qualify for the safe harbor for routine maintenance.

• However, if the replacement was of a major component or a substantial structural part of a UoP, then the expenditure may fall within the safe harbor. This is a facts and circumstances determination.

• Expenditures to a deteriorated or non-functioning UoP to restore it to efficient operating condition.

• ALERT! These amounts do not qualify for the routine maintenance safe harbor.

• Expenditures for rebuilding the UoP to like-new condition after the end of its class life. These amounts may fall within the safe harbor for routine maintenance. This is a facts and circumstances determination.

• *When a disposition of a component of a UoP occurs, a loss may be taken on the disposition equal to the adjusted basis of the component (See Partial Dispositions later). If the component is replaced, then the replacement is treated as a restoration.

https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations


67

Adaptation • Expenditures to adapt a UoP to a new or different use.

• ALERT! Amounts paid for adaptations do not qualify for the routine maintenance safe harbor.

Any expenditure that is not an improvement is either routine maintenance or a repair. After you have classified

all expenditures related to a UoP as 1) improvements, 2) routine maintenance, or 3) repairs, the next step is to

determine how to expense or capitalize these expenditures.

3. Determine which elections can be applied to the expenditures.

Three elections are available which will, if elected, determine the treatment of expenditures for improvements,

routine maintenance and repairs. These elections are:

• Safe Harbor Election for Small Taxpayers

• Safe Harbor for Routine Maintenance

• Election to Capitalize Repair and Maintenance Costs

Safe Harbor Election for Small Taxpayers

A qualifying small taxpayer may deduct all expenditures paid or incurred for a betterment, restoration, or

adaptation of a unit of eligible building property if the taxpayer:

1. Has average annual gross receipts of $10 million or less (that includes most, if not all, of our clients), and

2. Owns or leases a building property with an unadjusted basis of $1 million or less, and

3. The total amount paid during the year for repairs, maintenance, improvements, or similar activities

performed on the building property don’t exceed the lesser of:

• 2% of the unadjusted basis of the eligible building property, or

• $10,000.

and,

4. Makes the proper election.

The limit is applied on a building-by-building basis. For this safe harbor election, there is no limit to the total

number of eligible buildings that a taxpayer can own.

Note

In most cases, the unadjusted basis is considered cost. However, see “Figuring the Unadjusted Basis of

Your Property” in IRS Publication 946 if the building was acquired by a method other than purchase.

68

For a lessee, the unadjusted basis is the total undiscounted rent paid or to be paid over the life of the

lease, including renewals.

Below is an example of an election statement, which each electing entity must attach to a timely filed original

federal tax return (including extensions) for the taxable year in which the amounts are paid. This is not a one-time

election; rather, the election should be filed each year that the safe harbor is used by the client. This election is

irrevocable. Most tax preparation software programs prepare this election statement.

Making the Safe Harbor Election for Small Taxpayers

Client’s Name

Address

Tax I.D. Number

Section 1.263(a)-3(h) Small Taxpayer Safe Harbor Election for Building Property

The taxpayer is hereby making the safe harbor election for small taxpayers under Reg. Sec. 1.263(a)-3(h).

This election applies to the following eligible building property(ies):

[Provide a description of each eligible building property to which the election applies]

Other Considerations When Making this Election

• Make sure to use the unadjusted basis of the building. Do not subtract accumulated depreciation.

• Make sure to add up all expenses for each building property for the year, including all repairs,

maintenance, improvements, etc. If the total of all expenses exceed the threshold for any building,

the taxpayer cannot apply this safe harbor to that building.

• Amounts deducted under the de minimis safe harbor or the safe harbor for routine maintenance (see

below) are counted toward the $10,000 limit.

Safe Harbor for Routine Maintenance

The taxpayer may deduct all amounts paid or incurred, regardless of dollar value, for expected recurring activities

intended to maintain business property in its efficient operating condition. The expenditures must be expected

to occur:

69

• For building structures and any of the building systems, more than once during the 10-year period

beginning when placed in service.

• For non-building property, more than once during its class life (the alterative depreciation system class

life).

Routine maintenance does not improve property, but rather maintains a property’s operational efficiency.

Examples of routine maintenance include cleaning, oiling, replacing parts, inspecting, and testing.

No attachment or election is generally needed by a taxpayer to utilize this safe harbor.

ALERT!

This safe harbor for routine maintenance does not apply to expenditures paid or incurred for betterments,

adaptations and certain restorations. The safe harbor also does not apply to repairs, maintenance or

improvement of:

• Railroad track

• Oil and gas pipelines

• Water and sewage pipelines

• Power transmission and distribution lines

• Telephone and cable lines

• Rotable and temporary spare parts if the taxpayer uses the optional method of accounting to

account for them

Election to Capitalize Repair and Maintenance Costs

The taxpayer may capitalize repair and maintenance costs that would otherwise be deductible in the current year

by electing to capitalize these costs. To make this election, the taxpayer must capitalize the same costs in its books

and records.

The capitalized repairs will be depreciated over the class life of the property to which the repairs correspond.

NOTE

A taxpayer can still use the de minimis safe harbor, safe harbor for small taxpayers, and routine

maintenance safe harbor to deduct repair and maintenance costs that are not capitalized using this

election.

A taxpayer may want to make the election to capitalize repair and maintenance costs if he or she is currently in a

net operating loss (NOL) position or has very little taxable income.

70

Below is an example of an election statement, which an electing entity must attach to a timely filed original federal

tax return (including extensions) for the taxable year in which the amounts are paid. This is not a one-time election;

rather, the election should be filed each year the election is made. Most tax preparation software programs

prepare this election statement.

Making the Election to Capitalize Repair and Maintenance Costs

Client’s Name

Address

Tax I.D. Number

Section 1.263(a)-3(n) Election to Capitalize Repair and Maintenance Costs

The taxpayer is hereby making the election to capitalize repair and maintenance costs under Reg. Sec.

1.263(a)-3(n).

Tax Treatment of Removal and Demolition Costs

Removal/Demolition Costs Related to Disposals

of Components that are Not Considered

Dispositions or Partial Dispositions for Federal

Income Tax Purposes

Removal/Demolition Costs Related to

Disposition or Partial Disposition of the Asset

• Costs are capitalized if they are incurred by reason of an improvement to the UoP.

• Costs may be deducted as repair costs if they are not incurred by reason of an improvement to the UoP.

• If taxpayer fully or partially disposes of a depreciable asset and has taken the adjusted basis into account when realizing a gain or loss on the asset or component, then the removal costs are not required to be capitalized.*

*Casualty loss rule. Taxpayers who make required basis adjustments as a result of casualty losses or events and pay to restore the damage to a UoP must capitalize the casualty-related restoration costs as improvements, subject to limitation. Generally, the limitation requires capitalization of casualty-related restoration costs up to the amount of the basis reduction and any excess restoration costs to be analyzed under the improvement rules to determine whether the excess costs should be expensed (e.g. as a repair) or capitalized as an improvement.

71

Scenario Treatment of Removal/Demolition Costs

Gain or loss is recognized on the sale,

exchange or involuntary conversion of a UoP

or component of UoP

Expensed

Gain only is recognized on the conversion of

a business UoP (or component) to personal

use.

Expensed

Loss is recognized on the physical

abandonment of the whole UoP.

Expensed

Loss is recognized on a transfer of a UoP (or

component) to supplies or scrap account.

Expensed

Loss is recognized on a partial asset

retirement (disposition) with partial

disposition election.

Expensed

If the loss is equal to zero for removal costs

purposes on a General Asset Account (GAA)

asset disposition and no GAA-terminating

event has occurred.

Expensed

No gain or loss realized on a partial

retirement or disposition with no partial

disposition election.

If incurred by reason of an improvement,

capitalize.

If not related to an improvement, expense

as repair.

Demolition of entire building structure. Capitalize to land.

72

Partial Dispositions

A partial disposition is best described through use of examples. Your client owns a building which houses a

manufacturing facility. The building was built in 2002. In 2016, the client replaces the roof. The taxpayer can elect

to write the adjusted basis of the old roof off using the partial disposition election. If this election is made, the

cost of the new roof must be capitalized and not deducted under the routine maintenance election. It is also

important to note that while the partial disposition rule is generally elective, there are cases when its application

is required (e.g. disposition of a portion of an asset as a result of a casualty event) regardless of whether the

taxpayer makes the election.

This election has endless possibilities, even for something as small as remodeling a bathroom in an office building

or a leasehold. If new fixtures are installed, the partial disposition election permits writing off the adjusted basis

of the old fixtures and capitalizing the new fixtures. However, be aware that the IRS stated, in a Memorandum on

September 2, 2015, that if a taxpayer claims a loss from a partial disposition, the taxpayer should be able to prove

that the portion of the building or building system disposed of was replaced with a new similar asset. The IRS must

foresee that this will be an area that may be prone to abuse by taxpayers. So, if your client has a loss from a partial

disposition, collect this proof now for your client files.

ALERT!

If the election is made, the de minimis safe harbor election is not applicable.

This election is made by reflecting the loss from the partial disposition on Form 4797, or other appropriate form,

on a timely (including extensions) filed original tax return. No election statement is required and the election

cannot be revoked without IRS consent.

If the asset is in a GAA, no partial disposition election can be made.

Making this election is easy. Determining the adjusted basis of the partial disposition component is not so easy.

To continue with the roof example above, the adjusted basis of the roof must somehow be broken out of the cost

of the building, which was built in 2002. The Regs permit any reasonable method to calculate the amount to write

off as a partial disposition. The following steps can be taken with respect to determining the adjusted basis, which

is the amount to write off for the old roof:

1. Refer to existing records and source documents. Does the taxpayer still have the contract from the

construction of the building? Was the contract (or bid) broken out into costs for foundation, roof,

plumbing, electrical, etc.? If any such source documents reflect the cost of the roof, then the adjusted

basis is the original cost less the pro rata amount of accumulated depreciation. This, of course, is the

best method of determining the amount to write off because it reflects the actual cost of the

component.

73

2. Refer to a cost segregation analysis. A cost segregation analysis is a study which allocates the cost of

an asset to its individual components. The amount of cost allocated to the roof, less the pro rata

amount of accumulated depreciation, is the roof’s adjusted basis.

3. Use the Producer Price Index discounting method. Under this method, the adjusted basis, amount of

the write-off, is computed by discounting the cost of the new replacement roof to its placed-in-service

year cost using the Producer Price Index (PPI) for Finished Goods and its successor, the PPI for Final

Demand. PPI tables are located on the Bureau of Labor Statistics website at www.bls.gov/ppi.

THREE ALERTS!

* If you choose this as a valuation for your client’s partial disposition, please research on the use of

a condition factor further to achieve the most accurate valuation. Without a condition factor, the

PPI discount may result in a grossly overstated write off for a building component that is replaced

within the first ten years of its acquisition or construction.

** If the original asset was purchased at a significant discount, (i.e., upon foreclosure) or had basis

adjustments (i.e., casualty loss or Sec. 1031 exchange), this discount method may result in an over-

valuation of the original cost of the roof. If using the PPI discount method, please consider whether

the resulting valuation is reasonable based upon all the facts and circumstances. Document the

process, facts and assumptions in the client’s files.

*** The PPI discount method can only be used if the replacement is a restoration. If the

replacement is a betterment or an adaptation, the PPI discount method cannot be used. This makes

sense, because if a betterment or an adaptation is made to the building, then essentially no

replacement of a component has occurred. The key word here is “replacement.”

The PPI discounting method cannot be used for any of the following:

• An expansion or an upgrade to a facility

• Renovations to a recently purchased assisted living facility incurred over two years while

facility is operating

• Extensive remodeling of the interior of a retail store

• An addition of a mezzanine and a stairway in a retail store

• An addition of a drive-through service area in a restaurant

• The conversion of a manufacturing building to a showroom

• Reconfiguring a pharmacy to create a clinical area

• The installation by a landlord of leasehold improvements for new tenant business activity

• Improvements to a building where items were replaced with components of a higher

quality, strength, or efficiency

If you keep in mind that the PPI discount is available only for true replacements, then you will realize

that the above list is representative of additions, adaptations, and betterments. The last bullet point

74

can be troubling, however. For example, is the replacement of an ordinary HVAC system with one

that has the highest efficiency rating a replacement or a betterment? In similar situations, you’d

better do some research to determine if this is a restoration, betterment or adaptation. Only then

can you choose the right valuation method.

4. Use the pro rata allocation method. If there were basis adjustments or the asset was purchased at a

significant discount, this method may result in a more reasonable valuation than the PPI Discount

method. Under this method, the unadjusted depreciable basis of the disposed portion of the asset is

equal to the pro rata allocation of replacement cost of the disposed portion of the asset to the

replacement cost of the entire asset (in other words, divide the replacement cost of the disposed

asset by the replacement cost of the entire asset and multiply the result times the total unadjusted

basis of the entire asset). Adjusted basis is then determined by reducing the unadjusted basis of the

disposed portion by the greater of allowed or allowable depreciation on that portion. If your client

has an asset that was purchased at a significant discount or had basis adjustments from a Section

1031 exchange, casualty loss, etc., please research how to compute the write-off amount using this

method. There are examples in the Regs and in the ATG that will assist you. Estimates of replacement

cost of buildings provided by realtors or contractors may be sufficient for this calculation.

One last word, the ATG discusses specific rules related to Single Asset Accounts (SAAs), Multiple Asset Accounts

(MAAs), and GAAs. As very few Schedule C filers have MAAs and GAAs, these details are not discussed in this

course. If you have a Schedule C filer with assets in MAAs or GAAs, please refer to the ATG, Chapters 12-15.

Cost Segregation Analysis

The Tangible Property Regulations redefined asset purchases for all taxpayers for future years. In years prior to

the Regs, assets were depreciated on the books without being broken into smaller components. For example, if

a building cost $750,000 in 2002 to construct, the total amount was put on the books and depreciated over a 39-

year class life for tax purposes. Since the advent of the Regs and the partial disposition election, the cost of a

building should be separated into its structural components and each of its building systems, which are

depreciated using a shorter class life than 39 years.

Ideally, valuation of a building’s separate systems should be determined based on actual costs as identified in

construction bids, contractors’ invoices, and other source documents that establish cost. If these documents are

not available (as with buildings that are purchased instead of constructed), the next best valuation method is a

cost segregation analysis.

A taxpayer can hire a cost segregation specialist to perform an analysis on buildings purchased or constructed

prior to the effective date of the Regulations. This analysis will split out the building components and assign

75

respective values based on the specifications of the buildings, locale, and industry. The IRS will not question a

reasonable cost segregation analysis if the taxpayer uses the assigned values in a partial disposition election.

For buildings purchased and capitalized as a single asset after the effective date of the Regulations, taxpayers

should consider having a cost segregation analysis performed to separate the building into its different

components for depreciation purposes. The resulting components will generally include building structure itself

and the following nine building systems:

1. Heating, ventilation, and air conditioning systems

2. Plumbing systems

3. Electrical systems

4. All escalators

5. All elevators

6. Fire protection and alarm systems

7. Security systems

8. Gas distribution systems

9. Any other systems identified in published guidance

The details of these systems were listed earlier in this section.

In the landmark Hospital Corp. of America & Subs. V. Commissioner, 109 T. C. 21 (1997), the Tax Court permitted

the use of cost segregation techniques for building improvements. In this Case, these improvements were broken

out into the following class lives: (Hospital Corp. of America & Subs. v. Commissioner, 1997)

• Primary and secondary electrical distribution systems

• Wiring and related property in the laboratory and maintenance

shop

• Other wiring and related property

• Wiring to television equipment

• Conduit, floor boxes and power boxes

• Electrical wiring related to internal communications

• Carpeting

• Vinyl wall and floor covering

• Kitchen water piping and steam lines

• Special plumbing to X-ray machines

• Kitchen hoods and exhaust systems

• Patient corridor handrails

• Accordion doors and partitions

5 -year class life

• Branch electrical wiring and connections special equipment

• Overhead lighting

• Acoustical tile ceilings

39-year class life

76

• Steam boilers

Given the precedent of this case, cost segregation studies will generally break out the building structure and

systems into the following class lives for deprecation purposes:

Building Components with 5-year Class Life

• Cabinets and millwork

• Moldings

• Flooring and carpeting

• Decorative flooring

• Wall coverings

• Window treatments

• Specialty electrical equipment

• Communications and data equipment

• Specialty plumbing (steam systems, compressed air, refrigeration)

• Security equipment and lighting

• Exterior lighting

• Awnings

• Interior windows

• Surveillance systems


• Refrigeration equipment

• Dock equipment


• Parking lot

• Exterior signage

• Parking lot striping

• Sidewalks

• Curbs

• Landscaping

• Security Lighting Poles

77

Building Structure with 39-year Class Life

• Structural components

• Roofing systems

• Foundation

• HVAC

• Electrical

• Plumbing

• Suspended ceiling systems

• Elevators

The Tangible Property Regulations have caused the demand for cost segregation analyses to skyrocket. Some CPA

firms are adding specialists to their staff so that the studies can be performed in-house. Cost segregation studies

are expensive and the taxpayer will need to determine if the savings from accelerated depreciation deductions

and partial disposition write-offs exceed the cost of the analysis.

For taxpayers who are constructing buildings, they should keep all construction bids, contractor invoices, and

other documents that support the valuation of each building component recorded in its books and records. This

will eliminate the need for a costly cost segregation analysis and provide good evidence to the IRS should they

request support for the valuation; the IRS does not generally challenge values that are based upon original source

documents.

Taxpayers should also keep all source documents from remodeling and other improvements that include assets

that can be divided into separate class lives.


The Tangible Property Regulations are taxpayer-friendly, and once the broader concepts are fished out of a sea of

detail, the Regs make sense.

So, to sum up a section that has way too much detail: To ensure that you are taking advantage of every taxpayer-

friendly provision in the Tangible Property Regulations, follow these steps:

1. Review the activity for the year in the following accounts of your client:

Fixed Asset Accounts Expense Accounts

Building and improvements Repairs and maintenance

Plant and equipment Materials and supplies

Machinery and equipment Office supplies and expenses

78

Furniture and fixtures Other supplies

Other fixed asset accounts Other repairs

2. Determine which expenditures meet the de minimis safe harbor requirements, including materials and

supplies. Expense all items that fall within the safe harbor amounts.

3. Identify all expenditures that are either repairs, maintenance, or improvement costs to specific Units of

Property.

4. Identify the treatment of all expenditures (to expense as repairs or capitalize) in 3 above based upon the

following safe harbors/elections.

• Safe Harbor Election for Small Taxpayers

• Safe Harbor for Routine Maintenance

• Election to Capitalize Repair and Maintenance Costs

5. If there are removal or demolition costs, determine whether the costs can be deducted as a repair or

capitalized as an improvement.

6. Determine whether purchases of new tangible properties can be considered replacements of existing

Units of Property, or components thereof. If so, apply the partial asset disposition election in writing off

the adjusted basis of the existing UoP.

7. Ensure all elections are made timely and include the required information.

8. Consider if your client would benefit from a cost segregation analysis on existing building structures.

79


10. Expenses incurred for the restoration of a Unit of Property:

A. Qualify for the routine maintenance safe harbor.

B. Ameliorate a material condition or defect that existed before the acquisition.

C. Adapt a Unit of Property to a new or different use.

D. Permit the partial disposition election, allowing a loss to be taken equal to the adjusted basis of the

component replaced.

11. Which statement is accurate regarding the election to capitalize repair and maintenance costs?

A. A taxpayer would want to make this election if he or she currently has a large NOL carryover.

B. If the taxpayer makes this election, then he or she cannot use the de minimis safe harbor.

C. The taxpayer can have a book-tax difference on their books for items capitalized under this election.

D. To make this election, no election statement is required to be attached to the tax return.

12. Which statement is accurate regarding the PPI discounting method?

A. This method should be used when the asset was purchased at a significant discount.

B. This method can be used on replacements that are considered betterments and adaptations.

C. Without a condition factor, the PPI discount may result in an overstated amount for a write-off.

D. This method can be used to value an addition of a stairway in a retail store.

80

Section 5: Various Issues Impacting Practitioners and

their Clients



1. Recognize the importance of the new DOL’s overtime rule.

2. Identify correct attributes of an accountable plan.

3. Recognize the office in the home deduction requirements.

Overview

Many issues can cause trouble for our clients. The first four sections of this course discussed issues that create the

biggest problems. This section will briefly highlight five more issues that have the potential to cause our clients

some grief. Two of these issues are relatively new. The other three issues have been around for years. In fact,

these three issues are so old and commonplace they are rarely discussed at seminars or in self-study courses. In

fact, these issues make us yawn. But, we shouldn’t go to sleep yet.

We typically are very aware of newer issues, especially if they are complex issues like the ACA requirements or

the Tangible Property Regulations. The problem with old issues, however, is that we can easily gloss over them on

our clients’ tax returns with a “been there, done that” mentality. But, when was the last time we really discussed

issues like proper documentation of meals and travel? When was the last time we questioned our clients about

their office in the home deduction? Do you know that these issues are still the top issues for which the IRS audits

small business taxpayers?

This section will bring you up to date on yet another pronouncement by the DOL and will also briefly review the

requirements for the deductions of business meals and travel, and the office in the home deduction.

81

For further reading:

The discussion of the issues in this section will be brief. If you need greater detail, this reading list contains

excellent sources of information:

• DOL final rule on overtime: https://www.dol.gov/agencies/whd/overtime/2019/index

• Business Consultants Audit Techniques Guide

• IRS Publications on Travel, Meal, Gift, and Car Expenses.

New Issue: The DOL Overtime Pay Requirement

The DOL issued a final rule on September 24, 2019, effective January 1, 2020 (2019 final rule), that increased the

earnings thresholds used to determine overtime eligibility for exempted “white collar” employees, making an

estimated 1.3 million American workers newly eligible for overtime pay. It is important to note that the DOL had

issued a similar final rule on May 18, 2016 that was to become effective December 1, 2016 (2016 rule); however,

it was highly contested and eventually invalidated in August, 2017. The earnings thresholds announced under the

2016 rule, which were significantly higher than those in the 2019 final rule, created a general panic among small

businesses as they pondered how they would pay for these significant estimated cost increases. Many tax

practitioners met with worried clients to discuss the implications of this DOL requirement.

Prior to the final rule, the FLSA had mandated time-and-a-half overtime pay for employees who worked more

than 40 hours in a week, except for certain exempted “white collar” employees. These exempted employees were

individuals who performed executive, administrative, professional, or outside sales duties, and who were paid at

least the amount of the stated salary threshold, set in 2004, which was $23,660, or $455 per week.

The 2019 final rule included the following changes:

• For employees falling under the administrative, professional or executive exemption from overtime pay,

the former salary requirement of $23,660 annually ($455 per week) was increased to $35,568 annually

($684 per week).

• For employees falling under the highly compensated employee exemption from overtime pay, the former

salary requirement of $100,000 was increased to $107,432.

• Employers will be able to use nondiscretionary bonuses and incentive payments to satisfy up to a cap of

10% of the salary threshold.

As stated previously, the 2016 rule was highly contested and never became effective. For informational purposes,

following are some of the opposing arguments and actions that occurred prior to the invalidation of the 2016 rule

in August 2017. More than 21 state and local governments, along with several business organizations and trade

groups, were led by Nevada Attorney General, Adam Laxalt to file suit against the DOL based on the premise that

https://www.dol.gov/agencies/whd/overtime/2019/index

82

the 2016 DOL rule violated the 10th Amendment by removing control from the states to set pay levels. (States of

Nevada, et al. v. United States Department of Labor, et al., 2016)

On November 22, 2016, Texas District Court Judge, Amos L. Mazzant, issued a nationwide injunction blocking the

DOL from “implementing and enforcing” the rule, noting that the DOL had exceeded its delegated authority and

thus, the rule was “unlawful.” (States of Nevada, et al. v. United States Department of Labor, et al., 2016). The

Nevada Attorney General, Adam Laxalt, stated, “Left unchecked by the Court, this latest example of federal

overreach would have imposed millions of dollars of unfunded liabilities on the States, a loss of private sector

jobs, huge financial and regulatory burdens on small businesses, and undoubtedly caused great difficulty across

the country in implementing this oppressive rule. Businesses and state and local governments across the country

can breathe a sigh of relief now that this rule has been halted.” (Nevada Attorney General, 2016)

The DOL had responded, in a 2016 press release, that the department “strongly disagree[s] with the decision by

the court, which has the effect of delaying a fair day’s pay for a long day’s work for millions of hardworking

Americans…The Department’s Overtime Final Rule is the result of a comprehensive, inclusive rulemaking process,

and we remain confident in the legality of all aspects of the rule. We are currently considering all of our legal

options.” (Department of Labor, 2016)

Issue: The Employer Mandate of the Affordable Care

Act

For years beginning in 2016 and later, the following mandate applies:

• All businesses with 50 or more full-time equivalent employees must offer health insurance to at least 95%

of their full-time employees and dependents up to age 26.

• Businesses with 49 or fewer employees are not required to provide health insurance to employees.

The health care insurance offered must provide minimum essential coverage and must be affordable. If a

qualifying business does not offer such health care insurance, the business is subject to a hefty penalty.

Very few Schedule C filers will be subject to this mandate because most businesses with 50 or more full-time

equivalent employees operate under a legal entity other than a sole proprietorship or single member LLC. Because

of this, the details of this topic will be left to other courses that are written specifically on the employer mandate.

However, the practitioner who has that rare Schedule C filer who is required to offer health insurance should hold

a meeting with the client to discuss how the ACA requirements are being implemented.

83

Renewed Issue: Meals and Entertainment

History: The IRS limited most taxpayers to a deduction of 50% of meals and entertainment, with certain

exceptions, years ago because many taxpayers were taking great liberties in this area. Even with this limitation,

the IRS still considers the deduction of meals and entertainment to be one of their top audit issues of self-

employed individuals.

New: The 2017 TCJA changed the rules in that, effective for 2018 and later, no deduction is allowed for:

1. An activity generally considered to be entertainment, amusement or recreation,

2. Membership dues with respect to any club organized for business, pleasure, recreation or other social

purposes, or

3. A facility or any portion of it used in connection with the above items.

The TCJA also repealed the provision that allowed employers operating employee eating facilities to fully deduct

meals provided to employees if the de minimis fringe benefit and “for the convenience of the employer”

requirements were met; therefore, the 50% limitation currently applies to these meals as well.

Additionally, Notice 2018-76 (Notice) and proposed regulations (publication date January 26, 2020) were issued

to address the deductibility of certain business meals. Notice 2018-76 states that taxpayers may deduct 50% of

an otherwise allowable business meal expense if:

1. The expense is an ordinary and necessary expense under §162(a) paid or incurred during the taxable year

in carrying on any trade or business;

2. The expense is not lavish or extravagant under the circumstances;

3. The taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages;

4. The food and beverages are provided to a current or potential business customer, client, consultant, or

similar business contact; and

5. In the case of food and beverages provided during or at an entertainment activity, the food and beverages

are purchased separately from the entertainment, or the cost of the food and beverages is stated

separately from the cost of the entertainment on one or more bills, invoices, or receipts. The

entertainment disallowance rule may not be circumvented through inflating the amount charged for food

and beverages.

The proposed regulations generally incorporate the guidance in Notice 2018-76 with some modifications. For

example, one proposed change is to use the term, and follow the definition of, business associate [item 4 above]

to more closely conform to the trade or business requirement in Section 162, as currently provided in 1.274-

2(b)(2)(iii) and apply the standard to the deduction of meals generally, making the standard applicable to employer

provided meals as well. Further, the proposed regulations describe, clarify and illustrate (with specific examples

and scenarios) certain statutory requirements as well as the applicability of certain exceptions. The proposed

regulations had not been finalized as of this writing; however, the IRS stated that taxpayers may rely on the Notice

and proposed regulations until final regulations are issued and become effective. The IRS and the Treasury

Department also indicated that they will continue to study comments on issues that were beyond the scope of

84

the proposed regulations and that they may incorporate some of those items in the final regulations or in future

guidance.

The proposed regulations can be found at: https://www.federalregister.gov/documents/2020/02/26/2020-

03723/meals-and-entertainment-expenses.

A review of the meals deduction is a good use of time.

Keep in mind that when the IRS performs an audit of this area, the IRS examiner will mostly be looking for 1) the

deduction of personal expenses, 2) whether the taxpayer is deducting expenses that have been reimbursed, 3)

whether the appropriate limitations were applied, and 4) whether expenses are substantiated by adequate

records or sufficient evidence. Remember, IRS examiners form an opinion about the credibility of a taxpayer

based on the existence and condition of his or her records; the more organized and comprehensive the

documentation, the higher the credibility of the taxpayer in the eyes of the IRS.

Note

With a normal Schedule C, the IRS expects some deduction for meals. Therefore, if a Schedule C has no

such deduction, the IRS may think that the taxpayer has possibly misclassified the expense on another line

of Schedule C, potentially resulting in a deduction of 100% of the meal amount. This may cause the IRS

examiner to review other expenses more closely in an effort to identify potential meal expenses that

should be limited.

Meals expenses meeting the criteria under the Notice above are generally deductible for most taxpayers or their

employees when incurred while:

• Traveling away from home on business,

• Meeting with customers, or

• Attending a business convention or reception, business meeting, or business luncheon at a club.

Deductible amounts include the taxes and tips on the meal. The meal should be an event in which business is

discussed. If the meal has both personal and business elements, the personal element must be separated and

not deducted. Additionally, if the meal is provided during or at an entertainment activity, the meal must be

purchased separately from the entertainment or the invoice, bill or receipt must specifically identify the meal

charges separately from the entertainment charges in order for the meal expense to be deductible. While the IRC

states that lavish and extravagant meals may not be deductible, this is a highly subjective determination and the

final determination will be based on the specific facts and circumstances.

Substantiation Requirements

If a taxpayer is audited and does not have records and receipts substantiating business meals, these expenses

will generally be disallowed.

https://www.federalregister.gov/documents/2020/02/26/2020-03723/meals-and-entertainment-expenses

https://www.federalregister.gov/documents/2020/02/26/2020-03723/meals-and-entertainment-expenses

85

For EACH expense, the taxpayer must record the following “at or near the time” when the expense was incurred:

• The amount and description of the expense;

• The date, time and place the meal was provided; and

• The business purpose of the activity, including a description of any benefit derived or expected nature of

the business discussion.

This is as easy as writing on the back of receipts. If the date, place, and total amount are already on the receipt,

the following can quickly be written on the back:

• Time of event

• Business purpose

• Name of individual(s)

• Relationship of individual(s) to client

If the receipt does not show the date, place, and total amount, these must be added to the receipt or other

supporting records such as a diary or log.

The client should be in the habit of writing this information on receipts and filing the receipts in a file (paper or

electronic) or envelope that is retained to support the expenses. Taxpayers may store receipts electronically as

well; there are even cell phone apps that track receipts.

Additionally,

• The client should maintain records (paper or electronic) such as a diary, travel log or calendar that show

the business purpose and dates of the meals as well as other relevant information. The diary, or log,

should agree with the receipts. (As an alternative to maintaining a file or envelope for the receipts, clients

can staple them into the diary or calendar).

• If the client hosts an event in which many business associates attend, he or she should have a sign-in log,

or guest registry, documenting the names and business relationships of the persons attending. If non-

business individuals are also in attendance (spouses, significant others, children, etc.), this also should be

indicated in the log or registry. The log should also contain all the substantiation requirements listed above

for receipts.

Per Diem

If the meals occur while the taxpayer is traveling for business purposes, the amounts are considered substantiated

(i.e. receipts not required) if he or she uses the per diem rate, which is the amount computed at the Meals &

Incidental Expense (M&IE) rate for the locality for such day provided any applicable “adequate accounting

requirements” are met. The source of per diem rates is found at www.gsa .gov . While traveling, the per diem

method is administratively easier than trying to keep track of receipts.

A question for practitioners: How many of your clients are actually complying with the substantiation

requirements?

86

Many practitioners provide (or should provide if they aren’t) their clients with a yearly statement which specifies

the substantiation requirements for meals and travel. The clients sign the statement (while signing many other

documents, like engagement letters and privacy disclosures), agreeing that they have complied with the

substantiation requirements. But, does the client actually read the statement? Does the client actually comply

with the substantiation requirements? How many of your clients would pass an audit on this issue? And, how will

it impact your client relations if you say, “Well, I’m sorry you are being audited, but you did sign our statement

that you were complying with the substantiation requirements.” So, in addition to having our clients sign a

statement that they are complying with the substantiation requirements, we should also have a face-to-face

meeting with them during the year to discuss their actual procedures for compliance. The best time to have this

discussion is before the clients bring in their data for tax preparation.

And yet another question: Are you, the practitioner, adhering to the documentation requirements for your own

expenses? Many tax practitioners do not comply with the requirements for their own expenses!

Recurring Issue: Travel

Travel for business purposes is generally deductible. Personal travel is obviously not deductible, including travel

expenses for a spouse or family members, and costs for personal vacations which are tacked onto the business

travel. Travel expenses are deductible for a spouse or family members who are employees traveling with a bona

fide business purpose. For non-U.S. travel only, if the portion of travel for non-business purposes is less than 25%,

then no allocation between personal and business is required.

Travel is defined as expenses that are:

• Ordinary and necessary,

• Incurred in the pursuit of a trade or business, profession or job and

• Incurred while away from home.

Travel expenses are deductible only if:

• The business duties require the taxpayer to be away from his or her tax home substantially longer than

an ordinary day’s work and the taxpayer needs to rest or sleep to meet the work demands.

• The business travel is temporary. An assignment that is expected to last for one year or less is considered

temporary.

• The expenses are not reimbursed.

Travel expenses include transportation, lodging, meals, taxis, fees, tips, and other incidentals.

Tax Home

To determine whether a taxpayer is away from home, the taxpayer must first define the location of his or her tax

home, which is generally the taxpayer’s regular place of business (regardless of where their personal home is

maintained). The tax home includes the entire city or general area where the taxpayer’s place of business is

located.

87

Two special rules.

Itinerant workers. A taxpayer is itinerant if he or she has neither a principal place of business nor a place

where they regularly live; therefore, their tax home is wherever they work. For such workers, no costs for

travel are deductible because the taxpayer is never considered to be away home.

Taxpayers with more than one regular place of work. If a taxpayer has two or more regular places of

business, his or her tax home is the location of their principal place of business.

Substantiation Requirements

If a taxpayer is audited and does not have receipts substantiating business travel expenses, these expenses will

be disallowed.

The following information for each expense must be detailed:

• Cost

• Dates taxpayer left and returned for each trip and number of days spent on business

• Location/destination of travel

• Business purpose of the travel, along with any benefit gained or expected to be gained

As with meals, this information can be easily documented by writing on the receipts. Additionally, the taxpayer

should maintain a diary, travel log, calendar, or other written record that shows the dates and reasons of business

travel. The receipts should support the entries in the written records.

Commuting expenses

Typically, traveling between an individual’s residence and his or her regular places of business is

considered by the IRS to be personal expense and is therefore, nondeductible. However, there are

exceptions to this rule. For example, deductions are allowed for daily transportation expenses incurred

while traveling from home to a temporary work location outside the metropolitan area where the

taxpayer lives. Additionally, if a taxpayer’s residence is their principal place of business, regardless of

whether they take the office in the home deduction (discussed below), the taxpayer may deduct travel

expenses incurred in going between his or her residence and work locations in the same trade or business.

See Revenue Ruling 99-7, 26 CFR 1.162-2 for further discussion.

Reimbursed Expenses

Employee reimbursements - If an employer reimburses employees for qualifying business expenses, including

non-entertainment meals and travel expenses, the tax treatment generally depends on whether the employer has

88

an accountable plan. To qualify as an accountable plan, the reimbursement or allowance arrangement must

include the following three rules: 1) Expenses must have a business connection—that is, deductible expenses

must have been paid or incurred while employees were performing services for an employer, 2) Employees must

adequately account to an employer for these expenses within a reasonable period of time, and 3) Employees must

return any excess reimbursement or allowance to their employers within a reasonable period of time.

Reimbursements for qualifying expenses made under an accountable plan are generally not reported as wages on

an employee’s W-2 and the 50% non-entertainment meal deduction limitation applies to the employer. If

expenses are reimbursed under an accountable plan but the expenses themselves do not meet the three rules

stated above, the reimbursement will generally be treated as if it were made under a nonaccountable plan.

Under a nonaccountable plan (i.e. a plan that does not meet the accountable plan rules), an employer classifies

reimbursements to employees as wages subject to withholding, reports them on an employee’s W-2 and deducts

100% of the reimbursements as compensation expense on their tax return. Thus, the employee, not the employer,

is subject to the meal deduction limitations. Since the TCJA’s repeal of miscellaneous itemized deductions for

individuals and the limitations imposed on the use of IRS Form 2106, fewer employees will be able to claim a

deduction for these expenses.

Independent contractor (IC) reimbursements - If a customer or client reimburses an IC for costs the IC incurred

for qualified business expenses, including travel and non-entertainment meals, under a qualifying reimbursement

or other expense allowance arrangement, the tax treatment depends on whether the IC adequately accounted

for their expenses to their client/customer. Generally, ICs who do not adequately account to their customers for

their expenses must include any reimbursements or allowances received in their income. In this case, customers

generally deduct the reimbursements or allowances as payments for services (provided they qualify as ordinary

and necessary business expenses) and file information returns as required to report amounts paid to ICs (e.g.

1099s when fees plus reimbursements exceed $600).

The non-entertainment meal limitations apply to the party identified in the reimbursement or allowance

agreement. If the agreement does not expressly identify the party that is subject to the 50% non-entertainment

meal limitation, it will be applied as follows:

If IC and customer: Then, the 50% non-entertainment meal limitation is:

Have a qualifying written

reimbursement/allowance arrangement and the IC

adequately accounts to the customer for his or her

meals,

Applied by the customer.

Have a qualifying reimbursement/allowance

arrangement but the IC does not adequately

account to the customer for his or her meals,

Applied by the IC.

89

Do not have a qualifying written

reimbursement/allowance arrangement regardless

of whether or not the IC adequately accounts to

the customer for his or her meals,

Applied by the IC.

Recurring Issue: Office in the Home Deduction

The IRS still considers the office in the home deduction a top audit item when reviewing Schedule Cs. Clients

should always be made aware that no home office deduction is allowed for a space in the home that is used for

personal purposes, even if business is conducted in the same location. For example, your client is the sole user of

a desk in the living room of his home which he uses to conduct his consulting business. He works at this location

when he is not at customers’ locations. He even meets his customers in the living room of his home. However,

the living room is used by the rest of the family to watch television and play video games. Your client cannot claim

a home office deduction for the entire living room, but he can claim a deduction for the space occupied by his

desk. A bit ludicrous, but not far from reality for many taxpayers.

With changes in technology and the workplace, more and more taxpayers are working from home. Tax

practitioners should ask every client who wants to claim an office in the home deduction the following two

questions:

1. Does the taxpayer regularly use a section of his or her home exclusively for conducting business?

2. Can the taxpayer show that the home is his or her principal place of business?

Taxpayers can have multiple business locations; however the home office must be used exclusively and regularly

to conduct business in order to claim the home office deduction.

Exceptions to the Exclusive-Use Test for Certain Taxpayers:

Taxpayers are not required to meet the exclusive-use requirement for areas in their homes used:

• As a state-licensed day care facility for children, handicapped individuals, or adults age 65 or older,

or

• As storage for business inventory or product.

However, these taxpayers are still required to be in a trade or business and use the portion of the home

attributable to these activities on a regular basis.

90

Tip

Advise your clients to:

• Have all business mail sent to the home office.

• Use the home office address on stationery, business cards and advertising.

• Avoid using the home phone for business. Use a separate business line or cell phone for business.

• Maintain a log of the time the taxpayer spends in the home office working.

For tax years of 2013 and later, taxpayers may opt to use the simplified method rather than using actual expenses

(also known as the regular method) to compute the office in the home deduction. Regardless of the method used,

the above requirements for claiming an office in the home deduction must be met. The simplified method

provides a safe harbor amount of $5 per square footage of office space, not to exceed 300 square feet, resulting

in a maximum deduction of $1,500. The election to use the simplified method can be made annually just by taking

the appropriately calculated deduction on a timely filed tax return.

The IRS has a table comparing the Simplified Method with the Regular Method on its website. This table is

reproduced in Appendix B of this course.

91

Checklist of Often Overlooked Deductions/Credits by

Schedule C filers

The following is a checklist of deductions and credits that are often overlooked by Schedule C filers:

Checklist of Often Overlooked Deductions/Credits by Schedule C Filers

Self-Employed Health Insurance Deduction

What is deductible? Medical insurance premiums paid for the:

• the self-employed taxpayer,

• the taxpayer’s spouse,

• the taxpayer’s dependents, and

• any child of the taxpayer who is not 27 by the end of the year.

100% of the premiums paid are deductible before AGI, with the following limitations and considerations:

• The deduction is limited to the business’s net profit or earnings from self-employment, less the

deductible portion of self-employment tax and self-employed SEP, SIMPLE and qualified plan

reported on lines 14 and 15, respectively, on Schedule 1 Form 1040 (2019)

• The deduction is limited when the taxpayer is eligible to participate in a subsidized health plan

maintained by his or her employer, the spouse’s employer, a dependent’s employer or a child’s

(who is under 27) employer,

• The deduction does not reduce self-employment income for self-employment tax computation

purposes,

• If a self-employed taxpayer receives a premium assistance credit through the Marketplace, he or

she can only deduct the net premiums paid.

*Medicare insurance premiums voluntarily paid to obtain insurance that is similar to qualifying private

health insurance can be included in the deduction of self-employed health insurance premiums.

Wages Paid to Minor Children Working in the Business

A taxpayer may hire his or her minor children (under the age of 18) to work in their Schedule C business

and deduct the amount paid as wages. The wages paid to the minor are not subject to Social Security and

Medicare taxes, nor federal unemployment (FUTA) tax. The taxpayer must issue Forms W-2 to his or her

minor children, and file all required payroll tax returns. And, the children should actually do work for their

wages! The taxpayer should have a system that documents the hours worked by the minor child and the

92

work performed. And it goes without saying that the wages should be reasonable, based upon the work

that is performed by the minor child.

Start-Up Expenses

Start-up expenses are defined in IRC §195 as any amounts

A) paid or incurred in connection with:

i) investigating the creation or acquisition of an active trade or business, or

ii) creating an active trade or business, or

iii) any activity engaged in for profit and for the production of income before the day on

which the business begins, in anticipation of such activity becoming an active trade or

business, and

B) which would be deductible if paid or incurred in connection with the operation of an existing active

trade or business in the year it was paid or incurred.

While start-up costs are generally capitalized, the taxpayer can elect to deduct up to the greater of 1) the

cumulative costs for start-up expenses or 2) $5,000 in the first year. Keep in mind that the $5,000

deduction is reduced dollar for dollar, but not below zero, by the amount the taxpayer’s total start-up

costs exceed $50,000.

The remaining start-up costs can be amortized over a 180 month period (15 years), beginning with the

month the business began.

Identity Theft

Identity theft is a significant issue. Following is some information regarding this important topic as well

as some ways the IRS and tax practitioners can identify potential identity theft.

It’s All About…Identity Theft

The Treasury Inspector General for Tax Administration (TIGTA) issued a report on August 10, 2016,

Reference Number 2016-40-065, “Processes Are Not Sufficient to Assist Victims of Employment-Related

Identity Theft.” In this report, TIGTA defined employment-related identity theft as when an identity thief

uses the identity of an innocent taxpayer to gain employment. During a 4 ½ year period from February

2011 to December 2015, the IRS identified almost 1.1 million taxpayers who were the victims of

employment-related identity theft. TIGTA’s findings concluded that the “IRS has not established an

93

effective process to ensure that notice of identity theft is sent to the SSA to alert it of earnings not

associated with a victim of employment-related identity theft”. TIGTA further recommended that the IRS

“develop procedures to notify all individuals identified as victims of employment-related identify theft;

develop a tracking process to ensure that notices are completed and sent to the SSA.” (Treasury Inspector

General for Tax Administration (TIGTA), August 10, 2016). Since identity theft has remained a high priority

for the IRS each year from 2017-2020, ranked as second or third within the top 10 challenges, TIGTA

continues to audit this topic and has issued reports that include its findings, its recommendations and the

IRS’s responses. The reports and other information are available on TIGTA’s website.

Following are some of the ways the IRS is trying to deal with identity theft and assist taxpayers and tax

practitioners in identifying and reporting potential identity theft:

Monitoring PTIN and EFIN accounts

More and more practitioners are being targeted by identify thieves. These thieves are after our client

data and our PTINs, EFINs and e-Service passwords. The IRS has collaborated with state tax agencies and

tax professionals in a campaign entitled, “Protect Your Clients; Protect Yourself.” This campaign was

designed to create awareness among practitioners about the rampant identify theft.

The IRS consistently reminds practitioners that they need to maintain, monitor and protect their PTINs

and EFINs. All tax preparers (effective 2/22/2019) who have filed at least 50 tax returns from the 1040

series in the current year can check their PTIN accounts to ensure the number of returns filed agrees to

IRS records. Prior to February 22, 2019 the IRS only made this information available to PTIN holders with

professional credentials (i.e. Enrolled Agents, CPAs, attorneys, Enrolled Retirement Plan Agents or

Enrolled Actuaries) or who were an Annual Filing Season Program participant and who met the 50 returns

criteria.

Preparers can access “Returns Filed Per PTIN” by following these steps:

1. Go to http://www.irs.gov/ptin and log into your PTIN account

2. Choose “Additional Activities” from the Main Menu

3. Select “View My Summary of Returns Filed”

4. You will be provided with a count of individual income tax returns filed and processed in the

current year

The information is updated weekly, so it is important that you check in regularly. The IRS advises PTIN

holders whose number of returns processed is significantly more than the number of tax returns they’ve

prepared and who suspect that their PTIN has been stolen, to complete and submit Form 14157,

Complaint: Tax Return Preparer.

EFIN holders can also track EFIN usage to ensure the number of returns e-filed agrees to the IRS’s records.

Similar to PTIN information, the IRS posts EFIN information weekly. To obtain the number of e-filed

returns, log into the EFIN application, enter the EFIN holder’s name and select EFIN status. If the number

http://www.irs.gov/ptin

94

of e-filings per the IRS is significantly higher than the number of returns the EFIN holder transmitted, the

EFIN holder should contact the IRS e-help Desk.

IP PINs

The IRS assigns victims of identity theft and other eligible taxpayers an Identity Protection Personal

Identification Number (IP PIN), a 6-digit number, to help prevent the misuse of their SSNs on fraudulent

tax returns. A taxpayer is eligible for an IP PIN if:

• The taxpayer is a victim of identity theft and the IRS has resolved the case, and placed an identity

theft indicator on the taxpayer’s account. The IRS will generally send the taxpayer a CP01A Notice

with the IP PIN in December or January; or

• For 2020, taxpayers are eligible for the online IP PIN Opt-In Program if they filed their prior year

tax returns as residents of Arizona, California, Colorado, Connecticut, Delaware, District of

Columbia, Florida, Georgia, Illinois, Maryland, Michigan, Nevada, New Jersey, New Mexico, New

York, North Carolina, Pennsylvania, Rhode Island, Texas or Washington; (Note: States are being

added to the Opt-In Program in phases until the program becomes nationwide.) or

• The IRS sent the taxpayer a letter of invitation to “opt-in” to get an IP PIN.

The IRS will use the IP PIN to verify the eligible taxpayer’s identity and accept their electronically-filed or

paper-filed tax return. When a taxpayer has an IP PIN, no one else can file a tax return using their SSN.

ALERT! Once a taxpayer has an IP PIN, he or she must use the IP PIN on all federal income tax returns. This

is critical since electronically filed returns without IP PINs will be rejected and paper filed tax returns

without IP PINs will be subject to additional screenings to validate the taxpayer’s identity, delaying any

refunds that may be due.

What to do when tax practitioners suspect a fraudulent tax return has been filed

Most of us have had this happen: we finish our client’s tax return and submit it electronically to the IRS.

We then receive a rejection notice from the IRS stating that the return has been rejected because it is a

duplicate filing which could be a sign of identity theft. This commonly happens when a taxpayer has

passed away and a return was erroneously or fraudulently filed using the deceased’s SSN.

When we receive these IRS rejection notices that cannot be properly resolved, we should file a paper Form

1040 for our client, with both Form 14039, the Identity Theft Affidavit, and Form 8948, Preparer

Explanation for Not Filing Electronically. The error reject code must be entered on Form 8948, section 4.

The IRS will generally resolve the case within 6 months.

A very valuable resource about identity theft, Taxpayer Guide to Identity Theft, can be found on the IRS

website at www.irs.gov.

95


Now, more than ever, tax practitioners are required to stay current on laws that are regulated by agencies other

than the IRS. The DOL has had an active year, not only with the new overtime rule, but also with its guidance that

provides that most workers can be considered employees. To avoid making errors on returns, tax practitioners

must develop procedures and checklists to correctly handle not only the new issues, but also the recurring issues,

especially those issues that continue to be hot audit issues for the IRS.

We should consider reminding our clients about the DOL’s overtime rule effective January 1, 2020 to ensure they

are complying with its requirements.

And, year after year, we must continue to question our clients about their home offices, and their procedures for

substantiation of their business meals and travel expenses. The IRS does not sleep on these issues, and an audit

can be costly for our clients and us.

Developing a Uniform Set of Procedures to Follow

During Tax Season

This course has been all about developing procedures to ensure that tax issues are addressed properly. If your

tax practice does not have written procedures, now is the time to develop them. The procedures should be saved

to your server so that each staff member has electronic access to them. Additionally, a copy of it could be printed,

bound, and available for your staff. All staff persons should be required to abide by these procedures. Procedures

are necessary because they provide uniformity of actions by all staff people, thereby increasing efficiency which

increases billable hours and reducing the risk of errors. Plus, it is also evidence of due diligence on the part of the

firm, which could prove invaluable if you are ever assessed with a preparer penalty by the IRS. Procedures, by

themselves, are useless unless they are followed.

What type of procedures should you have? This is a sample list, but it is by no means exhaustive.

1. How client tax information is brought into the firm. A staff member (preferably an administrative

assistant) should interview each client as they bring in their tax information. Clients should be given a

packet of documents to sign, which includes: engagement letter, disclosure agreements and other legally

required disclosure forms, a thorough checklist to be completed by the client that will bring to attention

any major issues with his or her tax return, a statement as to substantiation of meal, travel and auto

expenses, electronic filing permissions, and any other forms you find necessary for the client to sign. No

client should be allowed to just drop his or her information off at the front desk. This creates more time

for the tax preparer later. These forms should be made available through your website so that clients can

print and prepare them before bringing them to your office or mailing them to you. Even better are forms

that can be completed online.

96

2. How the client file is developed. All staff preparers should have a uniform way of creating and organizing

files for each client. There should be a routing sheet, lead sheets, notes on the client, documentation of

communications with the client, etc. This procedure applies regardless of whether the work-papers are

electronically stored or in paper files.

3. How the return travels through the office. A routing sheet should accompany each client file, and it

should identify the staff performing the following actions and dates:

• when the client brings in his or her data

• when the preparer starts and finishes preparation

• when the reviewer starts and finishes review

• when the return is processed

• when the return is signed

• when a copy of the return is delivered to the client (and whether hand delivered, mailed, or emailed

to the client)

• when the return is electronically filed

• when payment for services is due and received

4. How communications with the client are documented. All communications with the client should be

documented in the client file including notes related to a telephone call or an in person conversation and

copies of emails sent and received.

5. How certain hot issues with the IRS will be addressed. Certain issues that are high risk for audit should

be included in the procedures so that all tax staff will know how to treat the issue on the tax return. Many

preparers do not know how to treat an item because they do not understand the law regarding that item.

Having access to a set of procedures about complicated issues will go a long way to help new staff

understand how such issues should be treated on a tax return. (This course has been about establishing

procedures for some of the hot audit issues.)

If you do not have a set of standardized procedures, you can initiate a post-tax-season project, requiring input

from everyone on your staff, to develop them. Scheduling time during the off-season for a fun team-building

activity will provide many benefits—both monetary and nonmonetary--during your next tax season.

97


13. Which statement is accurate regarding the deductibility of meals expense?

A. A meal that has both business and personal elements is deductible, subject to the 50% limitation.

B. If an independent contractor is reimbursed by his customer under a qualifying reimbursement

arrangement that does not specify which party is subject to the limitation and he adequately accounts to

the customer, the 50% limitation is applied by the customer.

C. The actual cost of a business meal is always deductible, subject to the 50% limitation.

D. If a taxpayer claims the per diem rate as a deduction, she must keep the receipts from her meals and

travel.

14. A taxpayer can deduct the following travel expenses:

A. Travel expenses for U.S. travel if the personal element is less than 25%.

B. Travel expenses incurred by a self-employed individual who has no tax home.

C. Travel expenses incurred during a business assignment that is less than one year in duration.

D. Travel expenses incurred by a non-employed spouse who is accompanying a self-employed individual.

15. Which taxpayer would be ineligible for an IP PIN?

A. A taxpayer who received a letter from the IRS to get an IP PIN.

B. A taxpayer whose return was rejected by the IRS and subsequently filed a Form 14039, the Identity Theft

Affidavit

C. A victim of identity theft for whom the IRS placed an identity theft indicator on the victim’s account.

D. An individual who filed her prior year tax return as a resident of the District of Columbia.

98

References Department of Labor. (2016, November 22). Department of Labor Press Release. Retrieved from United States

Department of Labor: https://www.dol.gov/featured/overtime/

Doherty, S. K. (2015, July 27). New DOL Opinion Seeks to Classify Most Independent Contractors as Employees.

Retrieved from Insight + Analysis for the Independent Agent:

http://www.iamagazine.com/news/read/2015/07/27/new-dol-opinion-seeks-to-classify-most-

independent-contractors-as-employees

Hanrahan, M. S. (2015, July 16). Independent Contractor or Employee: DOLs Lates Guidance on Employee Status.

Retrieved from Ogletree Deakins: http://www.ogletreedeakins.com/shared-

content/content/blog/2015/july/independent-contractor-or-employee-dols-latest-guidance-on-

employee-status

Hospital Corp. of America & Subs. v. Commissioner, 109 (United States Tax Court July 24, 1997).

Memorandum of understanding. (2016, November 21). Retrieved from Wikipedia:

https://en.wikipedia.org/wiki/Memorandum_of_understanding

Misclassification of Employees as Independent Contractors. (2016, November). Retrieved from Wage and Hour

Division of the Department of Labor: https://www.dol.gov/whd/workers/misclassification/

Nevada Attorney General. (2016, November 22). Nevada Attorney General Adam P. Laxalt Applauds Ruling Halting

US Department of Labor Overtime Rule. Retrieved from Press Release Point:

http://www.pressreleasepoint.com/nevada-attorney-general-adam-p-laxalt-applauds-ruling-halting-us-

department-labor-overtime-rule

Reilly, P. J. (2013, September 23). Musician Wins Hobby Loss Case. Retrieved from Forbes.com:

http://www.forbes.com/sites/peterjreilly/2013/09/23/musician-wins-hobby-loss-case/#986ee7143f95

Smith, A. (2015, July 16). DOL Narrows Independent Contractor Classification. Retrieved from Society for Human

Resource Management: https://www.shrm.org/ResourcesAndTools/legal-and-compliance/employment-

law/Pages/administrator-interpretation-independent-contractors.aspx

States of Nevada, et al. v. United States Department of Labor, et al., 4:16-CV-00731-ALM (U.S. District Court,

Eastern District of Texas November 22, 2016).

Tangible Property Regulations--Frequently Asked Questions. (2016, June 17). Retrieved from IRS.gov:


Thomas Allen Gullion, Petitioner v. Commissioner of Internal Revenue, Respondent, 15560-12S (United States Tax

Court August 14, 2013).

99

Treasury Inspector General For Tax Administration (TIGTA). (April 12, 2016). Opportunities Exist to Identify and

Examine Individual Taxpayers Who Deduct Potential Hobby Losses to Offset Other Income, Reference

Number 2016-30-031. TIGTA.

Treasury Inspector General for Tax Administration (TIGTA). (August 10, 2016). Processes Are Not Sufficient to Assist

Victims of Employment-Related Identity Theft, Reference Number 2016-40-065.

Trottman, M. (2015, July 15). Employees vs. Indpendent Contractors: U.S. Weighs In on Debate Over How to Classify

Workers. Retrieved from Wall Street Journal: http://www.wsj.com/articles/labor-department-releases-

guidance-on-classification-of-workers-1436954401

Weil, A. D. (2015, July 15). Administrator's Interpretation No. 2015-1. Retrieved from U.S. Department of Labor:

https://www.dol.gov/whd/workers/Misclassification/AI-2015_1.pdf

100

Index

Accountable plan, 88 Adaptation, 67 Affordable Care Act, 82 Alert!, 84 ALERT!, 22, 42, 43, 44, 59, 63, 66, 67, 72 Audit Techniques Guides (ATGs), 3 Behavioral Control, 47 Betterment, 66 Building an IRS-Proof Profit Motive, 22 Careful Recordkeeping, 5 Cash Intensive Businesses, 1, 3, 7, 8, 15, 17, 125 Consistency Requirement, 46 Corporate Officer, 41 Cost Segregation Analysis, 74 De Minimis Safe Harbor, 58 Documentation of all business expenses., 6 DOL & the Fair Labor Standards Act, 37 DOL Overtime Pay Requirement, 81 Election to Capitalize Repair and Maintenance Costs,

69 Elements of personal pleasure or recreation, 27 Employer Mandate, 82 Expectation that assets used in the activity might

appreciate in value., 24 Fair Labor Standards Act (FLSA), 81 Financial Control, 48 Hobby vs. Business: What’s the Big Deal?, 19 Incidental materials and supplies, 63 INCOME TAX REPORTING REQUIREMENTS OF

STATUTORY EMPLOYEES, 43 INCOME TAX REPORTING REQUIREMENTS OF

STATUTORY NON- EMPLOYEES, 44 IRC §183(d) SAFE HARBOR, 31 IRC §183(e) Election: Is it a Good Idea?, 32 IRS matching, 5 IRS Red Flags, 8 Is This Activity a Hobby?, 18 Itinerant workers, 87, 103 Making the De Minimis Safe Harbor Election, 61 Making the IRC §183(e) Election, 32 Making Use of the ATGs in Developing Tax Season

Procedures, 11

Manner in which the taxpayer carries on the activity., 23

Materials and Supplies, 62 Meals and Entertainment, 83 misplacement of income, 26 Non-incidental materials and supplies, 63 Partial Dispositions, 72 Per Diem, 85 PRACTICE TIP, 22 pro rata allocation method., 74 Producer Price Index discounting method, 73 Proof of income upon audit, 5 Proper Accounting or Record-Keeping Procedures, 9 Reasonable Basis Requirement, 45 Reasons for losses listed in ATG:, 25 Reimbursed Expenses, 87 Relationship of the Parties, 48 Removal and Demolition Costs, 70 Repairs and Maintenance, 64 Reporting Requirement, 46 Restoration, 66 Rotable spare part, 63 Safe Harbor Election for Small Taxpayers, 67 Safe Harbor for Routine Maintenance, 69 Section 530, 44 Standby emergency spare part, 64 Statutory, 43 Statutory Employee, 41 Substantiation Requirements, 84, 87 Summarization of Steps to Determine Proper Worker

Classification, 51 Tangible Property Regulations, 56 Tax Home, 86 TAX SEASON SURVIVAL TIP:, 6 Temporary spare part, 64 The amount of occasional profits, if any, which are

earned., 25 The expertise of the taxpayer or his advisors, 23 The financial status of the taxpayer, 26 The Gullion Case, 27 The success of the taxpayer in carrying on other

similar or dissimilar activities, 25

101

The taxpayer’s history of income or losses with respect to the activity., 25

The time and effort expended by the taxpayer in carrying on the activity., 24

Tip, 7, 12, 37, 54 Transaction Costs, 60

Travel, 86 unit of property (UoP), 64 Voluntary Worker Classification Settlement Program

(VCSP), 52 Worker Classified Under Common Law, 47

102

Glossary Adaptation. Expenditures to adapt a unit of property to a new or different use.

Applicable financial statements (AFS). Financial statements, defined by the Tangible Property Regulations, that

are filed with the SEC, or audited financial statements, or financial statements that are required by a federal or

state government agency.

Audit Techniques Guides (ATGs). Manuals used by IRS examiners during audits to provide understanding into

issues and accounting methods used by specific industries. ATGs are also used by business owners and tax

practitioners because they identify the issues that matter most to the IRS. The guides set forth industry-specific

auditing procedures.

Betterment. Expenditures : a) to ameliorate a material condition or material defect; or b) for a material addition

or for a material increase in capacity; or c) that materially increase productivity, efficiency, strength, quality, or

output.

Capitalization policy. An accounting procedure wherein a taxpayer establishes that all amounts paid for property

costing under a certain amount, and all amounts paid for property that has a useful life of 12 months or less, are

expensed. Any other amounts paid for property will be capitalized.

Cash intensive business. A business that receives a significant amount of receipts in cash and that typically handles

a high volume of small dollar transactions. It can also be an industry that practices cash payments for services (e.g.

construction or trucking companies where independent contractors are generally paid in cash).

Condition factor. A factor used in Producer Price Index discounting method that impacts the valuation of an asset

or component based upon the condition of the asset.

Cost segregation analysis. A study which allocates the cost of an asset to its individual components.

De minimis safe harbor election. This election permits a taxpayer to expense certain amounts paid to acquire or

produce tangible property to the extent such amounts are also deducted for financial accounting purposes.

Election to capitalize repair and maintenance costs. An election wherein a taxpayer opts to capitalize repair and

maintenance costs that would otherwise have been deductible in the current year.

Eligible building property. A building property with an unadjusted basis of $1 million or less.

Employment-related identity theft. When an identity thief uses the identity of an innocent taxpayer to gain

employment.

Form 8508, Request for Waiver From Filing Information Returns Electronically. A form used by an employer to

request a waiver from filing information returns electronically with the SSA.

103

Form 8809, Application for Extension of Time to File Information Returns. If an employer is not able to file the

Forms W-2 with the SSA by January 31, the employer can request one 30-day extension to file Form W-2 on Form

8809.

Form 8919, Uncollected Social Security and Medicare Tax on Wages. A form which is to be filed by a worker who

knows that he or she is improperly classified as an independent contractor. This form is filed to pay his or her

share of the FICA tax.

Form 8952, Application for Voluntary Classification Settlement Program (VCSP). This application is filed by

employers who wish to enter the VCSP to reclassify workers from independent contractor to employees. There

are many benefits to entering such an agreement.

Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax

Withholding. A form filed with the IRS by an employer to receive a determination letter stating the proper

classification of its workers.

Fraud. The IRS defines fraud as 1) misrepresentation of material facts, 2) deception, which is the intent to conceal

records, cheat, or mislead the examiner, and 3) silence when good faith requires expression.

Hobby. An activity not engaged in for profit.

Incidental materials and supplies. Items that are of minor or secondary importance, for which no record is kept

of items on hand, no beginning or ending inventories are maintained.

Independent contractor. Defined by the IRS as an individual whose payer has the right to control or direct only

the result of the work and not what will be done and how it will be done.

IRC §183(d) safe harbor. A safe harbor for taxpayers with the presumption that an activity is for profit if it makes

a profit in at least three of the last five years, including the current year. If the taxpayer is involved in horses

(breeding, showing, training or racing) the presumption is at least two of the last seven years.

IRC §183(e) election. An election to postpone the determination of whether the safe harbor presumption applies

until the fifth taxable year following the first year of an activity. For horse activities, the presumption is delayed

until the seventh year following the first year of the activity.

IRS CP-2000 notice. This notice is sent by the IRS to a taxpayer when the information on file with the IRS is different

from what is reported on an income tax return. This notice always begins with “the income and/or payment

information we have on file doesn’t match the information you reported on your tax return.” The IRS then explains

specifically what does not match.

Itinerant workers. A taxpayer is itinerant if he or she has neither a principal place of business nor an abode; in

other words, the worker has no tax home.

Materials and supplies. Supplies that are non-inventory, tangible property including 1) components acquired to

maintain, repair, or improve tangible property owned, leased or serviced; and is not a part of a larger item of

tangible property, 2) fuel, lubricants, water, or similar items that are expected to be consumed in 12 months or

104

less, 3) tangible property that has an economic useful life of 12 months or less, and 4) tangible property costly

$200 or less.

Memorandum of understanding (MoU). Describes a bilateral or multilateral agreement between two or more

parties. It expresses a convergence of will between the parties, indicating an intended common line of action. It

is often used in cases where parties either do not imply a legal commitment or in situations where the parties

cannot create a legally enforceable agreement. (Memorandum of understanding, 2016)

Misplacement of income. When taxpayers have reported gross receipts on Schedule C from sources other than

the activity on Schedule C.

Non-business “for profit” activity. Activities that are for the collection of income, or for the management,

conservation or maintenance of property held for the production of income.

Non-incidental materials and supplies. Any items that are not incidental material and supplies; items that are of

importance and for which records are kept of consumption.

Optional method of accounting. This accounting method requires the cost of rotable, temporary, and standby

emergency parts to be deducted in the year the item is installed. When that part is subsequently removed, the

part’s fair market value is included in income and any removal costs are capitalized. The tax basis for the part is

then the amount of income recognized plus any capitalized costs.

Partial disposition. A disposition of a component that makes up a unit of property.

Per diem. A rate found at www.gsa.gov that provides an average amount of meals and lodging per day for specific

locales. If a taxpayer uses the per diem rate when traveling, the amounts deducted on his or her return are

considered substantiated (receipts not required) provided any applicable “adequate accounting” requirements

are met.

Pro rata allocation method. A valuation method used when an asset is purchased at a significant discount,

wherein the unadjusted depreciable basis of the asset is based upon the replacement cost of the disposed portion

of the asset and the replacement cost of the entire asset.

Producer Price Index discounting method. A method of valuation wherein the adjusted basis of a partial asset

disposition is computed by discounting the cost of the new replacement to its placed-in-service cost using the

Producer Price Index for Finished Goods or Final Demand.

Qualifying small taxpayer. A taxpayer who has average annual gross receipts of $10 million or less.

Restoration. Expenditures for the replacement of a part of a major component or a substantial structural part, or

for the rebuilding the unit of property to like-new condition.

Rotable spare parts. A part that can be removed from a unit of property to have repaired or improved, and then

the same part is reinstalled on the same unit of property or other property, or stored for later installation.

Routine maintenance. Activities that do not improve property, but maintain a property’s operational efficiency.

105

Safe harbor election for small taxpayers. An election whereby a qualifying small taxpayer may deduct all

expenditures paid or incurred for a betterment, restoration, or adaptation to a unit of eligible building property

provided certain criteria are met.

Safe harbor for routine maintenance. A safe harbor provision wherein a taxpayer may deduct all amounts paid

or incurred, regardless of dollar value, for expected recurring activities intended to maintain business property in

its efficient operation condition.

Schedule C, Profit or Loss from Business. The form for reporting profit or loss from businesses on a Form 1040.

Section 530 relief. Section 530 terminates the employer’s liability for payment of employment taxes, along with

any resulting penalties and interest resulting from an employment status reclassification by the IRS if the employer

meets all three of the conditions required to receive such relief.

Standby emergency spare parts. A part that is set aside to use in the event of an emergency to avoid equipment

shut downs.

Statutory employee. Independent contractors under the common-law rules, but defined by statute to be treated

as employees if they fall within one of the four categories of statutory employees and they 1) are contracted to

perform the services personally, 2) do not have a substantial investment in the equipment and property used to

perform the services, and 3) perform the services on a continuing basis for the same payer.

Statutory non-employee. Individuals who have been defined by statute to be non-employees; specifically, direct

sellers, licensed real estate agents, and certain companion sitters.

Tax home: The location where a taxpayer conducts business, and is generally located at or near the taxpayer’s

regular place of business. The tax home includes the entire city or general area where the taxpayer’s place of

business is located.

Temporary spare part. A part that is used temporarily until a new or repaired part is installed.

Transaction costs. Costs paid in the investigation of, or pursuing of, the acquisition of tangible property other than

real property.

Unadjusted basis. The cost, or other original basis, of an asset prior to any subtraction for depreciation or

amortization deductions or other adjustments to basis from like-kind exchanges, casualties, or other events.

Underground economy: According to the IRS, the underground economy represents income that is earned under

the table and off the books, which can be generated by legal and illegal activities including businesses that sell

black market goods, drugs and other illegal commodities as well as money laundering and warehouse banking

schemes.

Unidentified income: The IRS defines unidentified income as total cash expended exceeding total cash received.

106

Appendix A: U.S. Department of Labor,

Administrator’s Interpretation No. 2015-1 U.S. Department of Labor

Wage and Hour Division

Washington, D.C. 20210

_____________________________________________________________________________

Administrator’s Interpretation No. 2015-1

July 15, 2015

Issued by ADMINISTRATOR DAVID WEIL

SUBJECT: The Application of the Fair Labor Standards Act’s “Suffer or Permit” Standard in the

Identification of Employees Who Are Misclassified as Independent Contractors.

Misclassification of employees as independent contractors is found in an increasing number of workplaces

in the United States, in part reflecting larger restructuring of business organizations. When employers

improperly classify employees as independent contractors, the employees may not receive important

workplace protections such as the minimum wage, overtime compensation, unemployment insurance, and

workers’ compensation. Misclassification also results in lower tax revenues for government and an

uneven playing field for employers who properly classify their workers. Although independent

contracting relationships can be advantageous for workers and businesses, some employees may be

intentionally misclassified as a means to cut costs and avoid compliance with labor laws.

The Department of Labor’s Wage and Hour Division (WHD) continues to receive numerous complaints

from workers alleging misclassification, and the Department continues to bring successful enforcement

actions against employers who misclassify workers. In addition, many states have acknowledged this

problematic trend and have responded with legislation and misclassification task forces. Understanding

that combating misclassification requires a multipronged approach, WHD has entered into memoranda of

understanding with many of these states, as well as the Internal Revenue Service.1 In conjunction with

1 Information about the Department’s Misclassification Initiative and related memoranda of understanding is available at

http://www.dol.gov/whd/workers/misclassification/.

107

these efforts, the Administrator believes that additional guidance regarding the application of the standards

for determining who is an employee under the Fair Labor Standards Act (FLSA or “the Act”) may be

helpful to the regulated community in classifying workers and ultimately in curtailing misclassification.

The FLSA’s definition of employ as “to suffer or permit to work” and the later-developed “economic

realities” test provide a broader scope of employment than the common law control test. Indeed, although

the common law control test was the prevalent test for determining whether an employment relationship

existed at the time that the FLSA was enacted, Congress rejected the common law control test in drafting

the FLSA. See Walling v. Portland Terminal Co., 330 U.S. 148, 150-51 (1947). Instead, the FLSA defines

“employ” broadly as including “to suffer or permit to work,” 29 U.S.C. 203(g), which clearly covers more

workers as employees, see U.S. v. Rosenwasser, 323 U.S. 360, 362-63 (1945).

In order to make the determination whether a worker is an employee or an independent contractor under

the FLSA, courts use the multi-factorial “economic realities” test, which focuses on whether the worker

is economically dependent on the employer or in business for him or herself.2 A worker who is

economically dependent on an employer is suffered or permitted to work by the employer. Thus, applying

the economic realities test in view of the expansive definition of “employ” under the Act, most workers

are employees under the FLSA. The application of the economic realities factors must be consistent with

the broad “suffer or permit to work” standard of the FLSA.

This Administrator’s Interpretation first discusses the pertinent FLSA definitions and the breadth of

employment relationships covered by the FLSA. When determining whether a worker is an employee or

independent contractor, the application of the economic realities factors should be guided by the FLSA’s

statutory directive that the scope of the employment relationship is very broad. This Administrator’s

Interpretation then addresses each of the factors, providing citations to case law and examples. All of the

factors must be considered in each case, and no one factor (particularly the control factor) is determinative

of whether a worker is an employee. Moreover, the factors themselves should not be applied in a

mechanical fashion, but with an understanding that the factors are indicators of the broader concept of

economic dependence. Ultimately, the goal is not simply to tally which factors are met, but to determine

whether the worker is economically dependent on the employer (and thus its employee) or is really in

business for him or herself (and thus its independent

2 While most misclassified employees are labeled “independent contractors,” the Department has seen an increasing number

of instances where employees are labeled something else, such as

“owners,” “partners,” or “members of a limited liability company.” In these instances, the determination of whether the

workers are in fact FLSA covered employees is also made by applying an economic realities analysis.

108

contractor). The factors are a guide to make this ultimate determination of economic dependence or

independence.34

I. The Economic Realities Factors Should Be Applied in View of the FLSA’s Broad

Scope of Employment and “Suffer or Permit” Standard

The FLSA’s definitions establish the scope of the employment relationship under the Act and provide the

basis for distinguishing between employees and independent contractors. The FLSA defines “employee”

as “any individual employed by an employer,” 29 U.S.C. 203(e)(1), and “employer” as including “any

person acting directly or indirectly in the interest of an employer in relation to an employee,” 29 U.S.C.

203(d). The FLSA’s definition of “‘employ’ includes to suffer or permit to work.” 29 U.S.C. 203(g).

This “suffer or permit” concept has broad applicability and is critical to determining whether a worker is

an employee and thus entitled to the Act’s protections.

The “suffer or permit” standard was specifically designed to ensure as broad of a scope of statutory

coverage as possible. See Rosenwasser, 323 U.S. at 362-63 (“A broader or more comprehensive coverage

of employees . . . would be difficult to frame.”); Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 326

(1992) (“employ” is defined with “striking breadth”). The Supreme Court “has consistently construed the

Act ‘liberally to apply to the furthest reaches consistent with congressional direction,’ recognizing that

broad coverage is essential to accomplish the [Act’s] goal . . . .” Tony & Susan Alamo Found. v. Sec’y of

Labor, 471 U.S. 290, 296 (1985) (quoting Mitchell v. Lublin, McGaughy & Assocs., 358 U.S. 207, 211

(1959)) (internal citation omitted).

The history of the “suffer or permit” standard highlights its broad applicability. Prior to the FLSA’s

enactment, the phrase “suffer or permit” (or variations of the phrase) was commonly used in state laws

regulating child labor and was “designed to reach businesses that used middlemen to illegally hire and

supervise children.” Antenor v. D & S Farms, 88 F.3d 925, 929 n.5 (11th Cir. 1996). A key rationale

underlying the “suffer or permit” standard in child labor laws was that the employer’s opportunity to detect

work being performed illegally and the ability to prevent it from occurring was sufficient to impose

3 The analysis in this Administrator’s Interpretation should also be applied in determining whether a

worker is an employee or an independent contractor in cases arising under the Migrant and Seasonal

Agricultural Worker Protection Act (MSPA) and the Family and Medical Leave Act (FMLA). MSPA

expressly adopts the FLSA’s definition of “employ” as MSPA’s definition of “employ” and thus

incorporates the broad “suffer or permit” standard for determining the scope of employment

relationships. See 29 U.S.C. 1802(5) (“The term ‘employ’ has the meaning given such term under [the

FLSA, 29 U.S.C. 203(g)].”); see also 29 C.F.R. 4 .20(h)(1)-(4). The FMLA also adopts the FLSA’s definition of “employ” for employer coverage and

employee eligibility purposes (subject to additional eligibility requirements). See 29 U.S.C. 2611(3); 29

C.F.R. 825.105.

109

liability on the employer. See, e.g., People ex rel. Price v. Sheffield Farms-Slawson-Decker Co., 225 N.Y.

25, 29-31 (N.Y. 1918). Thus, extending coverage of child labor laws to those who suffered or permitted

the work was designed to expand child labor laws’ coverage beyond those who controlled the child laborer,

counter an employer’s argument that it was unaware that children were working, and prevent employers

from using agents to evade requirements.

Unlike the common law control test, which analyzes whether a worker is an employee based on the

employer’s control over the worker and not the broader economic realities of the working relationship,

the “suffer or permit” standard broadens the scope of employment relationships covered by the FLSA.

Indeed, the FLSA’s statutory definitions (including “suffer or permit”) rejected the common law control

test that was prevalent at the time. As the Supreme Court explained:

[I]n determining who are “employees” under the Act, common law employee categories or

employer-employee classifications under other statutes are not of controlling significance. This

Act contains its own definitions, comprehensive enough to require its application to many persons

and working relationships, which prior to this Act, were not deemed to fall within an employer-

employee category.

Walling, 330 U.S. at 150-51 (internal citation omitted); see also Darden, 503 U.S. at 326 (FLSA’s “suffer

or permit” standard for employment “stretches the meaning of ‘employee’ to cover some parties who

might not qualify as such under a strict application of traditional agency law principles.”); Antenor, 88

F.3d at 933 (“Indeed, the ‘suffer or permit to work’ standard was developed to assign responsibility to

businesses that did not directly supervise putative employees.”). Thus, the scope of employment under

the FLSA is the “‘broadest definition that has ever been included in any one act.’” Rosenwasser, 323 U.S.

at 363 n.3 (quoting from statement of Senator Black on Senate floor).

An “entity ‘suffers or permits’ an individual to work if, as a matter of economic reality, the individual is

dependent on the entity.” Antenor, 88 F.3d at 929. The Supreme Court and Circuit Courts of Appeals

have developed a multi-factor “economic realities” test to determine whether a worker is an employee or

an independent contractor under the FLSA. See, e.g., Tony & Susan Alamo, 471 U.S. at 301 (noting that

the test of employment under the FLSA is economic reality); Goldberg v. Whitaker House Co-op, Inc.,

366 U.S. 28, 33 (1961) (the economic realities of the worker’s relationship with the employer control,

rather than any technical concepts used to characterize that relationship). The factors typically include:

(A) the extent to which the work performed is an integral part of the employer’s business; (B) the worker’s

opportunity for profit or loss depending on his or her managerial skill; (C) the extent of the relative

investments of the employer and the worker; (D) whether the work performed requires special skills and

110

initiative; (E) the permanency of the relationship; and (F) the degree of control exercised or retained by

the employer.5

In undertaking this analysis, each factor is examined and analyzed in relation to one another, and no single

factor is determinative. The “control” factor, for example, should not be given undue weight. The factors

should be considered in totality to determine whether a worker is economically dependent on the

employer, and thus an employee. The factors should not be applied as a checklist, but rather the outcome

must be determined by a qualitative rather than a quantitative analysis. The application of the economic

realities factors is guided by the overarching principle that the FLSA should be liberally construed to

provide broad coverage for workers, as evidenced by the Act’s defining “employ” as “to suffer or permit

to work.”

In applying the economic realities factors, courts have described independent contractors as those workers

with economic independence who are operating a business of their own. On the other hand, workers who

are economically dependent on the employer, regardless of skill level, are employees covered by the

FLSA. See, e.g., Hopkins v. Cornerstone Am., 545 F.3d 338, 343 (5th Cir. 2008) (“To determine if a

worker qualifies as an employee, we focus on whether, as a matter of economic reality, the worker is

economically dependent upon the alleged employer or is instead in business for himself.”); Baker v. Flint

Eng’g & Constr. Co., 137 F.3d 1436, 1440 (10th Cir. 1998) (the economic realities of the relationship

govern, and the focal point is whether the individual is economically dependent on the business to which

he renders service or is, as a matter of economic fact, in business for himself); Brock v. Superior Care,

Inc., 840 F.2d 1054, 1059 (2d Cir. 1988) (“The ultimate concern is whether, as a matter of economic

reality, the workers depend on someone else’s business . . . or are in business for themselves.”).

“Ultimately, in considering economic dependence, the court focuses on whether an individual is ‘in

business for himself’ or is ‘dependent upon finding employment in the business of others.’” Scantland v.

Jeffry Knight, Inc., 721 F.3d 1308, 1312 (11th Cir. 2013) (quoting Mednick v. Albert Enters., Inc., 508

F.2d 297, 301-02 (5th Cir. 1975)).

Moreover, the economic realities of the relationship, and not the label an employer gives it, are

determinative. Thus, an agreement between an employer and a worker designating or labeling the worker

as an independent contractor is not indicative of the economic realities of the working relationship and is

not relevant to the analysis of the worker’s status. See, e.g., Scantland, 721 F.3d at 1311 (“This inquiry

is not governed by the ‘label’ put on the relationship by the parties or the contract controlling that

relationship, but rather focuses on whether ‘the work done, in its essence, follows the usual path of an

employee.’”) (quoting Rutherford Food Corp. v. McComb, 331 U.S. 722, 729 (1947)); Superior Care, 840

F.2d at 1059 (“[E]mployer’s self-serving label of workers as independent contractors is not controlling.”);

Robicheaux v. Radcliff Material, Inc.,

5 The number of factors and the exact articulation of the factors may vary some depending on the court.

Courts routinely note that they may consider additional factors depending on the circumstances and that

no one factor is determinative.

111

697 F.2d 662, 667 (5th Cir. 1983) (explaining that “[a]n employee is not permitted to waive employee

status,” and affirming that welders were employees despite having signed independent contractor

agreements). Likewise, workers who are classified as independent contractors may receive a Form 1099-

MISC from their employers. This form simply indicates that the employer engaged the worker as an

independent contractor, not that the worker is actually an independent contractor under the FLSA. See

Olson v. Star Lift Inc., 709 F. Supp. 2d 1351, 1356 (S.D. Fla. 2010) (worker’s receipt of Form 1099-MISC

from employer does not weigh in favor of independent contractor status). “Economic realities, not

contractual labels, determine employment status for the remedial purposes of the FLSA.” Real v. Driscoll

Strawberry Assocs., Inc., 603 F.2d 748, 755 (9th Cir. 1979).

The ultimate inquiry under the FLSA is whether the worker is economically dependent on the employer

or truly in business for him or herself. If the worker is economically dependent on the employer, then the

worker is an employee. If the worker is in business for him or herself (i.e., economically independent

from the employer), then the worker is an independent contractor.

II. The Economic Realities Factors Guide the Determination Whether the Worker Is

Truly an Independent Business or Is Economically Dependent on the Employer

To help illustrate how the economic realities factors should be properly used to determine whether a

worker is truly in business for him or herself, each factor is discussed in detail below. The distinction

between workers who are economically dependent on employers and the narrower subset of workers who

are truly independent businesspersons must not be eclipsed by a mechanical application of the economic

realities test. The analysis whether the factors are met must focus on whether the worker is economically

dependent on the employer or truly in business for him or herself. As a district court held in an

enforcement action by the Department:

These factors are to be considered and weighed against one another in each situation, but there is

no mechanical formula for using them to arrive at the correct result. Rather, the factors are simply

a tool to assist in understanding individual cases, with the ultimate goal of deciding whether it is

economically realistic to view a relationship as one of employment or not.

Solis v. Cascom, Inc., 2011 WL 10501391, at *4 (S.D. Ohio Sept. 21, 2011); see also Scantland, 721 F.3d

at 1312 (the economic realities factors “serve as guides, [and] the overarching focus of the inquiry is

economic dependence”); Usery v. Pilgrim Equip. Co., Inc., 527 F.2d 1308, 1311 (5th Cir. 1976) (The

economic realities factors “are aids—tools to be used to gauge the degree of dependence of alleged

employees on the business with which they are connected. It is dependence that indicates employee status.

Each test must be applied with that ultimate notion in mind.”).

112

Each factor of the economic realities test is discussed below in order to highlight, using case law and

examples, relevant considerations for each factor and how each suggests whether or not there is an

employment relationship.

A. Is the Work an Integral Part of the Employer’s Business?

The policy behind the “suffer or permit” statutory language was to bring within the scope of employment

workers integrated into an employer’s business. If the work performed by a worker is integral to the

employer’s business, it is more likely that the worker is economically dependent on the employer. See

Rutherford, 331 U.S. at 729 (workers were employees in part because work was “part of the integrated

unit of production”); Donovan v. DialAmerica Mktg., Inc., 757 F.2d 1376, 1385 (3d Cir. 1985) (“workers

are more likely to be ‘employees’ under the FLSA if they perform the primary work of the alleged

employer”). A true independent contractor’s work, on the other hand, is unlikely to be integral to the

employer’s business.6

Courts have found the “integral” factor to be compelling. See, e.g., Dole v. Snell, 875 F.2d 802, 811 (10th

Cir. 1989) (holding that work performed by cake decorators “is obviously integral” to the business of

selling cakes which are custom decorated); Sec’y of Labor v. Lauritzen, 835 F.2d 1529, 1537-38 (7th Cir.

1987) (“It does not take much of a record to demonstrate that picking the pickles is a necessary and integral

part of the pickle business . . . .”). Work can be integral to a business even if the work is just one component

of the business and/or is performed by hundreds or thousands of other workers. For example, a worker

answering calls at a call center along with hundreds of others is performing work that is integral to the call

center’s business even if that worker’s work is the same as and interchangeable with many others’ work.

Moreover (and especially considering developments such as telework and flexible work schedules, for

example), work can be integral to an employer’s business even if it is performed away from the employer’s

premises, at the worker’s home, or on the premises of the employer’s customers.

6 Given that the “integral” factor particularly encompasses the “suffer or permit” standard and that the

Supreme Court in Rutherford found the workers in that case to be employees, in part because they were

“part of the integrated unit of production,” whether the worker’s work is an integral part of the

employer’s business should always be analyzed in misclassification cases. Although a few courts, such

as the Fifth Circuit, do not include the “integral” factor in their recitation of the factors that comprise the

economic realities test, they nonetheless recognize that the factors comprising the test are not exclusive.

See, e.g., Cromwell v. Driftwood Elec. Contractors, Inc., 348 Fed. App’x 57, 59 (5th Cir. 2009)

(describing the five factors it identifies as “non-exhaustive”); Brock v. Mr. W Fireworks, Inc., 814 F.2d

1042, 1043 (5th Cir. 1987) (same).

113

Example:7 For a construction company that frames residential homes, carpenters are integral to the

employer’s business because the company is in business to frame homes, and carpentry is

an integral part of providing that service.

In contrast, the same construction company may contract with a software developer to

create software that, among other things, assists the company in tracking its bids,

scheduling projects and crews, and tracking material orders. The software developer is

performing work that is not integral to the construction company’s business, which is

indicative of an independent contractor.

B. Does the Worker’s Managerial Skill Affect the Worker’s Opportunity for Profit or Loss?

In considering whether a worker has an opportunity for profit or loss, the focus is whether the worker’s

managerial skill can affect his or her profit and loss.8 A worker in business for him or herself faces the

possibility to not only make a profit, but also to experience a loss. The worker’s managerial skill will

often affect opportunity for profit or loss beyond the current job, such as by leading to additional business

from other parties or by reducing the opportunity for future work. For example, a worker’s decisions to

hire others, purchase materials and equipment, advertise, rent space, and manage time tables may reflect

managerial skills that will affect his or her opportunity for profit or loss beyond a current job.

On the other hand, the worker’s ability to work more hours and the amount of work available from the

employer have nothing to do with the worker’s managerial skill and do little to separate employees from

independent contractors—both of whom are likely to earn more if they work more and if there is more

work available. See Scantland, 721 F.3d at 1316-17 (“Plaintiffs’ opportunity for profit was largely limited

to their ability to complete more jobs than assigned, which is analogous to an employee’s ability to take

on overtime work or an efficient piece-rate worker’s ability to produce more pieces.”). The effect on one’s

earnings of doing one’s job well or working more hours is no different for an independent contractor than

it is for an employee.

7 The addition or alteration of any of the facts in any of the examples could change the resulting

analysis. Additionally, while the examples help illustrate the discussion of several common factors of

the economic realities test, no one factor is determinative of whether a worker is an employee or

independent contractor.

8 This factor is sometimes articulated as “the degree to which the worker’s opportunity for profit and

loss is determined by the alleged employer,” Herman v. Express Sixty-Minutes Delivery Serv., Inc., 161

F.3d 299, 303 (5th Cir. 1998), or simply as “the worker’s opportunity for profit or loss,” Baker, 137 F.3d

at 1440. This factor should not focus, however, just on whether there is opportunity for profit or loss,

but rather on whether the worker has the ability to make decisions and use his or her managerial skill

and initiative to affect opportunity for profit or loss.

114

Those considerations are not the product of exercising managerial skill and do not demonstrate that the

worker is an independent contractor. As one court said:

There was no opportunity for increased profit or loss depending upon an alleged employee’s

managerial skill. While the alleged employees were free to work additional hours to increase their

income, they had no decisions to make regarding routes, or acquisition of materials, or any facet

normally associated with the operation of an independent business.

Cascom, 2011 WL 10501391, at *6; see also Scantland, 721 F.3d at 1317 (“An individual’s ability to earn

more by being more technically proficient is unrelated to an individual’s ability to earn or lose profit via

his managerial skill, and it does not indicate that he operates his own business.”); Martin v. Selker Bros.,

Inc., 949 F.2d 1286, 1294 (3d Cir. 1991) (opportunity for profit or loss must depend on managerial skills

to indicate independent contractor status); Snell, 875 F.2d at 810 (cake decorators’ “earnings did not

depend upon their judgment or initiative, but on the [employer’s] need for their work”).9

Consistent with determining whether the worker is in business for him or herself, it is important not to

overlook whether there is an opportunity for loss, as a worker truly in business for him or herself faces the

possibility of experiencing a loss. See, e.g., Snell, 875 F.2d at 810 (possibility of loss is a risk usually

associated with independent contractor status, but there was no way for cake decorators to experience a

loss, and possible reduction in earnings was not the same as a loss); Lauritzen, 835 F.2d at 1536 (migrant

farm workers had no possibility for loss of investment, only loss of wages, indicating that they were

employees). In sum, in order to inform the determination of whether the worker is in business for him or

herself, this factor should not focus on the worker’s ability to work more hours, but rather on whether the

worker exercises managerial skills and whether those skills affect the worker’s opportunity for both profit

and loss.

Example: A worker provides cleaning services for corporate clients. The worker performs

assignments only as determined by a cleaning company; he does not independently

schedule assignments, solicit additional work from other clients, advertise his services, or

9 In Chao v. Mid-Atlantic Installation Servs., Inc., 16 Fed. App’x 104, 106-07 (4th Cir. 2001), the Fourth

Circuit identified “the business acumen with which the Installer makes his required capital investments

in tools, equipment, and a truck” and the “decision whether to hire his own employees or to work alone”

as indicative of the managerial skill that suggests independent contractor status. The court also

identified the workers’ skill in meeting technical specifications and their ability to control earnings by

working more or fewer hours as indicative of managerial skill. Id.; see also Express Sixty-Minutes, 161

F.3d at 304 (relying on workers’ “ability to choose how much they wanted to work” as indicative of

managerial skill). These latter considerations do not helpfully distinguish between workers who are in

business for themselves and those who are economically dependent on the employer.

115

endeavor to reduce costs. The worker regularly agrees to work additional hours at any time

in order to earn more. In this scenario, the worker does not exercise managerial skill that

affects his profit or loss. Rather,

his earnings may fluctuate based on the work available and his willingness to work more.

This lack of managerial skill is indicative of an employment relationship between the

worker and the cleaning company.

In contrast, a worker provides cleaning services for corporate clients, produces advertising,

negotiates contracts, decides which jobs to perform and when to perform them, decides to

hire helpers to assist with the work, and recruits new clients. This worker exercises

managerial skill that affects his opportunity for profit and loss, which is indicative of an

independent contractor.

C. How Does the Worker’s Relative Investment Compare to the Employer’s Investment?

Courts also consider the nature and extent of the relative investments of the employer and the worker in

determining whether the worker is an independent contractor in business for him or herself. The worker

should make some investment (and therefore undertake at least some risk for a loss) in order for there to

be an indication that he or she is an independent business. An independent contractor typically makes

investments that support a business as a business beyond any particular job. The investment of a true

independent contractor might, for example, further the business’s capacity to expand, reduce its cost

structure, or extend the reach of the independent contractor’s market.

Even if the worker has made an investment, it should not be considered in isolation; it is the relative

investments that matter. Looking not just to the nature of the investment, but also comparing the worker’s

investment to the employer’s investment helps determine whether the worker is an independent business.

If so, the worker’s investment should not be relatively minor compared with that of the employer. If the

worker’s investment is relatively minor, that suggests that the worker and the employer are not on similar

footings and that the worker may be economically dependent on the employer.

For example, investing in tools and equipment is not necessarily a business investment or a capital

expenditure that indicates that the worker is an independent contractor. See Snell, 875 F.2d at 810 (citing

cases); Lauritzen, 835 F.2d at 1537. Instead, the tools and equipment may simply be necessary to perform

the specific work for the employer. Even if the investment is possibly a business investment, the worker’s

investment must be significant in nature and magnitude relative to the employer’s investment in its overall

business to indicate that the worker is an independent businessperson. The Tenth Circuit determined, for

example, that rig welders’ investments in equipped trucks costing between $35,000 and $40,000 did not

indicate that the rig welders were independent contractors when compared to the employer’s investment

in its business. See Baker, 137 F.3d at 1442 (comparing rig welders’ investment to employer’s “hundreds

of thousands of dollars of equipment at each work site”); see also Snell, 875 F.2d at

116

810-11 (comparing cake decorators’ $400 investment in their tools to employers’ business investments,

including paying for rent, advertising, operating expenses, and labor, in addition to supplies and decorating

equipment); Lauritzen, 835 F.2d at 1537 (reasoning that where workers provided their own gloves, and

the employer provided the farm equipment, land, seed, fertilizers, and living quarters, their work was not

independent of the employer); Hopkins, 545 F.3d at 344

(comparing each worker’s individual investment to employer’s overall investment in the business); Real

v. Driscoll Strawberry Assocs., Inc., 603 F.2d 748, 755 (9th Cir. 1979) (strawberry growers’ investment

in light equipment, including hoes, shovels, and picking carts was “minimal in comparison” with

employer’s total investment in land and heavy machinery).

An analysis of the workers’ investment, even if that investment is substantial, without comparing it to the

employer’s investment is not faithful to the ultimate determination of whether the worker is truly an

independent business.10 Moreover, an analysis that compares the worker’s investment to the employer’s

investment—but only to the employer’s investment in the particular job performed by the worker—

likewise disregards the ultimate determination by examining only a piece of the employer’s business for

the comparison.

Example: A worker providing cleaning services for a cleaning company is issued a Form 1099-MISC

each year and signs a contract stating that she is an independent contractor. The company

provides insurance, a vehicle to use, and all equipment and supplies for the worker. The

company invests in advertising and finding clients. The worker occasionally brings her

own preferred cleaning supplies to certain jobs. In this scenario, the relative investment of

the worker as compared to the employer’s investment is indicative of an employment

relationship between the worker and the cleaning company. The worker’s investment in

cleaning supplies does little to further a business beyond that particular job.

A worker providing cleaning services receives referrals and sometimes works for a local

cleaning company. The worker invests in a vehicle that is not suitable for personal use and

uses it to travel to various worksites. The worker rents her own space to store the vehicle

and materials. The worker also advertises and markets her services and hires a helper for

larger jobs. She regularly (as opposed to on a job-by-job basis) purchases material and

equipment to provide cleaning services and brings her own equipment (vacuum, mop,

10 Cf. Mid-Atlantic Installation, 16 Fed. App’x at 107 (analyzing workers’ investment without

comparing it to employer’s investment); Freund v. Hi-Tech Satellite, Inc., 185 Fed. App’x 782, 783-84

(11th Cir. 2006) (same).

117

broom, etc.) and cleaning supplies to each worksite. Her level of investments is similar to

the investments of the local cleaning company for whom she sometimes works. These

types of investments may be indicative of an independent contractor.

D. Does the Work Performed Require Special Skill and Initiative?

A worker’s business skills, judgment, and initiative, not his or her technical skills, will aid in determining

whether the worker is economically independent. “[T]he fact that workers are skilled is not itself

indicative of independent contractor status.” Superior Care, 840 F.2d at 1060. Even specialized skills do

not indicate that workers are in business for themselves, especially if those skills are technical and used to

perform the work. See id. Accordingly, the conclusion that the skills of installing cable are indicative of

independent contractor status because the skills are “akin to those of carpenters, construction workers, and

electricians, who are usually considered independent contractors,” Mid-Atlantic Installation, 16 Fed.

App’x at 107, overlooks whether the worker is exercising business skills, judgment, or initiative. The

technical skills of cable installers, carpenters, construction workers, and electricians, for example, even

assuming that they are special,11 are not themselves indicative of any independence or business initiative.

See Selker Bros., 949 F.2d at 1295 (“the use of special skills is not itself indicative of independent

contractor status, especially if the workers do not use those skills in any independent way”); Superior

Care, 840 F.2d at 1060 (for skills to be indicative of independent contractor status, they should be used in

some independent way, such as demonstrating business-like initiative); Express Sixty-Minutes, 161 F.3d

at 305 (efficiency in performing work is not initiative indicative of independent contractor status);

Lauritzen, 835 F.2d at 1537 (“Skills are not the monopoly of independent contractors.”). Only carpenters,

construction workers, electricians, and other workers who operate as independent businesses, as opposed

to being economically dependent on their employer, are independent contractors.

Example: A highly skilled carpenter provides carpentry services for a construction firm; however,

such skills are not exercised in an independent manner. For example, the carpenter does

not make any independent judgments at the job site beyond the work that he is doing for

that job; he does not determine the sequence of work, order additional materials, or think

11 A district court determined that the cable installation at issue in that case “did not require a special

skill” and could be learned by workers with no experience in the field after six weeks of training.

Cascom, 2011 WL 10501391, at *6; see also Scantland, 721 F.3d at 1318 (cable installers admitted that

they were skilled workers; however, “[t]he meaningfulness of this skill as indicating that [they] were in

business for themselves or economically independent . . . is undermined by the fact that [the employer]

provided most [of them] with their skills”); Keller v. Miri Microsystems LLC, 781 F.3d 799, 809-810

(6th Cir. 2015) (denying summary judgment and contrasting carpenters, who have “unique skill,

craftsmanship, and artistic flourish,” with cable technicians who do not need “unique skills” but rather

are selected on the basis of availability and location).

118

about bidding the next job, but rather is told what work to perform where. In this scenario,

the carpenter, although highly skilled technically, is not demonstrating the skill and

initiative of an independent contractor (such as managerial and business skills). He is

simply providing his skilled labor.

In contrast, a highly skilled carpenter who provides a specialized service for a variety of

area construction companies, for example, custom, handcrafted cabinets that are made-to-

order, may be demonstrating the skill and initiative of an independent contractor if the

carpenter markets his services, determines when to order materials and the quantity of

materials to order, and determines which orders to fill.

E. Is the Relationship between the Worker and the Employer Permanent or Indefinite?

Permanency or indefiniteness in the worker’s relationship with the employer suggests that the worker is

an employee. After all, a worker who is truly in business for him or herself will eschew a permanent or

indefinite relationship with an employer and the dependence that comes with such permanence or

indefiniteness. Most workers are engaged on a permanent or indefinite basis (for example, the typical at-

will employee). Even if the working relationship lasts weeks or months instead of years, there is likely

some permanence or indefiniteness to it as compared to an independent contractor, who typically works

one project for an employer and does not necessarily work continuously or repeatedly for an employer.

See, e.g., DialAmerica Mktg., 757 F.2d at 1384-85 (correcting district court for ignoring fact that workers

worked continuously for the employer and that such evidence indicates that workers were employees);

Cascom, 2011 WL 10501391, at *6 (workers who “worked until they quit or were terminated” had

relationship “similar to an at-will employment arrangement”).

However, a lack of permanence or indefiniteness does not automatically suggest an independent contractor

relationship, and the reason for the lack of permanence or indefiniteness should be carefully reviewed to

determine if the reason is indicative of the worker’s running an independent business. As the Second

Circuit noted, neither working for other employers nor not relying on the employer as his or her primary

source of income transform the worker into the employer’s independent contractor. See Superior Care,

840 F.2d at 1060. The key is whether the lack of permanence or indefiniteness is due to “operational

characteristics intrinsic to the industry” (for example, employers who hire part-time workers or use

staffing agencies12) or the worker’s “own business initiative.” Id. at 1060-61 (“the fact that these nurses

12 See, e.g., Solis v. A+ Nursetemps, Inc., 2013 WL 1395863, at *7 (M.D. Fla. Apr. 5, 2013)

(holding that nurses were employees of a temporary health care staffing agency; although nurses

“enjoy[ed] a degree of flexibility . . . not shared by many in the work force,” had “an enhanced ability to

‘moonlight’ by working for more than one [staffing] agency at a time,” and had some flexibility in

choosing “when and where to make themselves available for work,” the court concluded that when the

119

are a transient work force reflects the nature of their profession and not their success in marketing their

skills independently”); see also Mr. W Fireworks, 814 F.2d at 1054 (“We thus hold that when an industry

is seasonal, the proper test for determining permanency of the relationship is not whether the alleged

employees returned from season to season, but whether the alleged employees worked for the entire

operative period of a particular season.”). A worker’s lack of a permanent or indefinite relationship with

an employer is indicative of independent contractor status if it results from the worker’s own independent

business initiative. See Superior Care, 840 F.2d at 1060-61.

Example:13 An editor has worked for an established publishing house for several years. Her edits are

completed in accordance with the publishing house’s specifications, using its software. She

only edits books provided by the publishing house. This

scenario indicates a permanence to the relationship between the editor and the publishing

house that is indicative of an employment relationship.

Another editor has worked intermittently with fifteen different publishing houses over the

past several years. She markets her services to numerous publishing houses. She

negotiates rates for each editing job and turns down work for any reason, including because

she is too busy with other editing jobs. This lack of permanence with one publishing house

is indicative of an independent contractor relationship.

F. What is the Nature and Degree of the Employer’s Control?

As with the other economic realities factors, the employer’s control should be analyzed in light of the

ultimate determination whether the worker is economically dependent on the employer or truly an

independent businessperson. The worker must control meaningful aspects of the work performed such

that it is possible to view the worker as a person conducting his or her own business. See Scantland, 721

F.3d at 1313 (“‘Control is only significant when it shows an individual exerts such a control over a

meaningful part of the business that she stands as a separate economic entity.’”) (quoting Pilgrim Equip.,

527 F.2d at 1312-13); Baker, 137 F.3d at 1441. And the worker’s control over meaningful aspects of the

nurses were working on assignment for the staffing agency they were, during those work weeks, its

employees).

13 This factor helps illustrate how no one factor alone is determinative of the economic realities of the

relationship between a worker and an employer and how it can be difficult to isolate one factor. Here,

the example necessarily includes relevant facts beyond just the permanence or indefiniteness of the

editors’ relationships with the publishing houses to illustrate the existence, or not, of an employment

relationship.

120

work must be more than theoretical—the worker must actually exercise it. See, e.g., Snell, 875 F.2d at

808; Mr. W

Fireworks, 814 F.2d at 1047 (“it is not what the operators could have done that counts, but as a matter of

economic reality what they actually do that is dispositive”) (emphases in original).

For example, an employer’s lack of control over workers is not particularly telling if the workers work

from home or offsite. As the Third Circuit explained in DialAmerica Marketing, the fact that the workers

could control the hours during which they worked and that they were subject to little direct supervision

was unsurprising given that such facts are typical of homeworkers and thus largely insignificant in

determining their status. See 757 F.2d at 1384 (“The district court therefore misapplied and

overemphasized the right-to-control factor in its analysis.”); see also Superior Care, 840 F.2d at 1060

(“An employer does not need to look over his workers’ shoulders every day in order to exercise control.”);

Antenor, 88 F.3d at 933 (The “courts have found economic dependence under a multitude of circumstances

where the alleged employer exercised little or no control or supervision over the putative employees.”).

Moreover, workers’ control over the hours when they work is not indicative of independent contractor

status. See, e.g., Snell, 875 F.2d at 806 (“Of course, flexibility in work schedules is common to many

businesses and is not significant in and of itself.”); Doty v. Elias, 733 F.2d 720, 723 (10th Cir. 1984) (“A

relatively flexible work schedule alone, however, does not make an individual an independent contractor

rather than an employee.”).

Technological advances and enhanced monitoring mechanisms may encourage companies to engage

workers not as employees yet maintain stringent control over aspects of the workers’ jobs, from their

schedules, to the way that they dress, to the tasks that they carry out. Some employers assert that the

control that they exercise over workers is due to the nature of their business, regulatory requirements, or

the desire to ensure that their customers are satisfied.

However, control exercised over a worker, even for any or all of those reasons, still indicates that the

worker is an employee. As the Eleventh Circuit explained:

[The employer] also argues that its quality control measures and regulation of schedules stemmed

from “the nature of the business” and are therefore not the type of control that is relevant to the

economic dependence inquiry. We disagree. The economic reality inquiry requires us to examine

the nature and degree of the alleged employer’s control, not why the alleged employer exercised

such control. Business needs cannot immunize employers from the FLSA’s requirements. If the

nature of a business requires a company to exert control over workers to the extent that [the

employer] has allegedly done, then that company must hire employees, not independent

contractors.

Scantland, 721 F.3d at 1316. Thus, the nature and degree of the employer’s control must be examined as

part of determining the ultimate question whether the worker is economically dependent on the employer.

121

Finally, the “control” factor should not play an oversized role in the analysis of whether a worker is an

employee or an independent contractor. All possibly relevant factors should be considered, and cases

must not be evaluated based on the control factor alone. See, e.g., Superior Care, Inc., 840 F.2d at 1059

(“No one of these factors is dispositive; rather, the test is based on a totality of the circumstances.”). As

discussed above, the FLSA’s statutory definitions (including “suffer or permit”) rejected the common law

control test for determining employment that was prevalent at the time. See Walling, 330 U.S. at 150-51;

Darden, 503 U.S. at 326. Indeed, the FLSA covers workers of an employer even if the employer does not

exercise the requisite control over the workers, assuming the workers are economically dependent on the

employer. The control factor should not overtake the other factors of the economic realities test, and like

the other factors, it should be analyzed in the context of ultimately determining whether the worker is

economically dependent on the employer or an independent business.

Example: A registered nurse who provides skilled nursing care in nursing homes is listed with Beta

Nurse Registry in order to be matched with clients. The registry interviewed the nurse prior

to her joining the registry, and also required the nurse to undergo a multi-day training

presented by Beta. Beta sends the nurse a listing each week with potential clients and

requires the nurse to fill out a form with Beta prior to contacting any clients. Beta also

requires that the nurse adhere to a certain wage range and the nurse cannot provide care

during any weekend hours. The nurse must inform Beta if she is hired by a client and must

contact Beta if she will miss scheduled work with any client. In this scenario, the degree

of control exercised by the registry is indicative of an employment relationship.

Another registered nurse who provides skilled nursing care in nursing homes is listed with

Jones Nurse Registry in order to be matched with clients. The registry sends the nurse a

listing each week with potential clients. The nurse is free to call as many or as few potential

clients as she wishes and to work for as many or as few as she wishes; the nurse also

negotiates her own wage rate and schedule with

the client. In this scenario, the degree of control exercised by the registry is not indicative

of an employment relationship.

III. Conclusion

In sum, most workers are employees under the FLSA’s broad definitions. The very broad definition of

employment under the FLSA as “to suffer or permit to work” and the Act’s intended expansive coverage

for workers must be considered when applying the economic realities factors to determine whether a

worker is an employee or an independent contractor. The factors should not be analyzed mechanically or

in a vacuum, and no single factor, including control, should be over-emphasized. Instead, each factor

should be considered in light of the ultimate determination of whether the worker is really in business for

him or herself (and thus is an independent contractor) or is economically dependent on the employer (and

thus is its employee). The factors should be used as guides to answer that ultimate question of economic

dependence. The correct classification of workers as employees or independent contractors has critical

122

implications for the legal protections that workers receive, particularly when misclassification occurs in

industries employing low wage workers.

123

Appendix B: Comparison of Simplified

Method and Regular Method of Computing

the Office in the Home Deduction

Simplified Option Regular Method

Deduction for home office use of a portion of a residence allowed only if that portion is exclusively used on a regular basis for business purposes

Same

Allowable square footage of home use for business (not to exceed 300 square feet)

Percentage of home used for business

Standard $5 per square foot used to determine home business deduction

Actual expenses determined and records maintained

Home-related itemized deductions claimed in full on Schedule A

Home-related itemized deductions apportioned between Schedule A and business schedule (Sch. C or Sch. F)

No depreciation deduction Depreciation deduction for portion of home used for business

No recapture of depreciation upon sale of home Recapture of depreciation on gain upon sale of home

Deduction cannot exceed gross income from business use of home less business expenses

Same

Amount in excess of gross income limitation may not be carried over

Amount in excess of gross income limitation may be carried over

Loss carryover from use of regular method in prior year may not be claimed

Loss carryover from use of regular method in prior year may be claimed if gross income test is met in current year

Source: Simplified Option for Home Office Deduction https://www.irs.gov/businesses/small-businesses-self-employed/simplified-option-for-home-office-deduction

124

Answers to Review Questions

Section 1

1. Information that is excluded from an Audit Techniques Guide is:

A. Correct. Because statistics such as these are constantly changing, they are not included in an ATG. These

statistics can be found on the IRS website under taxpayer Statistics of Income (SOI) and at

www.bizstats.com.

B. Incorrect. A very thorough listing of Internal Revenue Code sections and judicial precedents related to a

specific issue or industry are included in ATGs.

C. Incorrect. Each ATG lists specific audit procedures to follow, along with appendices listing questions an

IRS examiner should ask a taxpayer upon audit.

D. Incorrect. Each ATG discusses industry specific practices, including accounting methods that are unique

to that specific industry.

2. Per the Cash Intensive Businesses ATG, which is the most significant indicator of possible underreported

income?

A. Incorrect. While a taxpayer who continues to purchase assets despite reporting consistent losses is one

of the factors, it is not the most significant. Many times the IRS examiner will make inquiries and find out

about the purchases after the tax return has been flagged for examination as a result of the pattern of

losses and/or consistently low profit percentages.

B. Incorrect. This situation is an indicator; however, it is not the most significant. The IRS will generally learn

about a taxpayer’s growing bank balances while reporting consistent losses after the return was flagged

for an audit based on the pattern of losses or consistently low profit percentages.

C. Incorrect. The lifestyle of the taxpayer, when inconsistent with the income reported on his or her tax

return, is certainly suspicious and is an indicator or underreported income, it is not the most significant

one. This issue will usually be found after the return has been flagged for audit due to the pattern of

reported losses or consistently low profit percentages.

D. Correct. The most significant indicator of possible underreported income is a pattern of losses or

consistently low profit percentages that seem insufficient to sustain the business. Typically, businesses

cannot sustain a pattern of losses for a prolonged period of time. A business that continues to open its

doors year after year while reporting consistent losses may indicate underreported income.

125

3. Which cash intensive business is also a potential opportunity for underground activities per the Cash Intensive

Businesses ATG?

A. Correct. Used auto dealerships and other businesses that sell used cars are considered as possible

opportunities for underground activities.

B. Incorrect. Businesses that sell bail bonds are a cash intensive business, per the ATG, but such businesses

are not listed as an example of possible underground activities.

C. Incorrect. Businesses that sell pizza pies are cash intensive businesses with a unique set of auditing

procedures; however, the IRS has not listed such businesses as an example of possible underground

activities.

D. Incorrect. Check cashing locations are indeed cash intensive businesses with a unique set of auditing

procedures. Such businesses, however, are not listed by the IRS as an example of possible underground

activities.

Section 2

4. Which statement reflects the correct treatment of income and/or expenses from an activity that is definitely

a hobby?

A. Incorrect. Schedule C is used to report the income and expenses of a trade or business. In instances when

the activity is definitely a hobby and there are no expenses, the income should be included as Other

Income on line 8 of Schedule 1 (Form 1040). The income is not subject to self-employment tax.

B. Incorrect. Schedule C is used to report the income and expenses of a trade or business. If the hobby

income is from the sale of collectibles, the sales should be entered on Form 8949, Sales and Other

Dispositions of Capital Assets.

C. Incorrect. Hobby income is not subject to self-employment tax. Only income from self-employment and

activities engaged in for profit is subject to self-employment tax.

D. Correct. When an activity is determined to be definitely a hobby and there are no expenses, the income

should be reported as Other income on line of 8 of Schedule 1 (Form 1040). The income is not subject to

self-employment tax.

126

5. Which statement is accurate with respect to the nine factors listed in IRC Reg. §183-2(b)?

A. Incorrect. The potential gain from appreciation of the assets can be offset by operational losses only if

the asset and the operations are a single activity.

B. Incorrect. Fortunately, the Courts do not require taxpayers to hate their work to prove a profit motive.

Therefore, even activities that contain elements of personal pleasure can be considered activities with a

profit motive.

C. Incorrect. The income from a salaried position is not taken into account when considering the success of

the taxpayer in carrying on other activities.

D. Correct. The IRS considers drought, disease, theft, fire, weather damages, involuntary conversions, and

depressed market conditions as acceptable reasons for sustaining losses beyond the period which is

customarily necessary to bring an operation to profitable status.

6. Regarding the IRC 183(d) safe harbor:

A. Incorrect. For activities where a taxpayer is involved in horses (breeding, showing, training, or racing), the

safe harbor period is at least two of the last seven years. For all other activities, the safe harbor period is

at least three of the last five years.

B. Correct. The burden of proof for showing lack of profit motive is shifted to the IRS when the safe harbor

presumption period is met.

C. Incorrect. The safe harbor protects only the loss years arising after the safe harbor is met. The loss years

arising before the safe harbor is met are not covered by the safe harbor protections.

D. Incorrect. For all activities, other than the breeding, showing, training, or racing of horses, the safe harbor

applies after the third profitable year within a five-year period. For horse-related activities, the safe harbor

applies after the second profitable year within a seven-year period.

Section 3

7. Which of the following is an indication that a worker is truly an independent contractor per the Administrator’s

Interpretation issued by the DOL on July 15, 2015?

A. Correct. The DOL Administrative Interpretation primarily is looking to see if the individual is in business

for himself or herself. If an individual is offering services to several customers, this is a strong indication

that the individual is indeed an independent contractor.

B. Incorrect. A worker with an internal e-mail account with the company for whom he works is indicative

that the worker is an employee. An independent contractor should not have a company email; rather, he

should have an email address that is independent of any company for whom he offers services.

C. Incorrect. An independent contractor should not have access to the company server. If the worker has

access to the company server, he may be considered an employee by the DOL unless facts and

circumstances prove otherwise.

127

D. Incorrect. Typically, independent contractors are not invited to weekly happy hours that are held strictly

for employees. This may be indicative of an employer/employee relationship by the DOL.

8. Which statement is correct regarding the income tax reporting of statutory employees?

A. Incorrect. The employer of a statutory employee will issue the individual a Form W-2 for each year

indicating the amount of wages paid, FICA withheld, and with the Box 13 “Statutory Employee” checked.

B. Incorrect. The net income from a statutory employee’s Schedule C is not subject to self-employment tax.

C. Correct. The employer is only required to withhold FICA tax; the statutory employee is responsible for

paying his or her federal income tax.

D. Incorrect. A statutory employee is not permitted to combine the income from two different activities on

the same Schedule C. Further, the individual should not offset income earned from other services with

expenses incurred as a statutory employee.

9. Which question would an IRS examiner ask to determine the level of behavioral control?

A. Incorrect. Whether a worker is available to work for other customers is a determinant of the level of

financial control a payer has over the worker.

B. Incorrect. The business’s ability to terminate a worker is a factor in defining the relationship between the

payer and the worker.

C. Incorrect. A worker who can advertise his or her services to other customers is indicative of a low level of

financial control a payer has over the worker.

D. Correct. If the worker’s services are an integral part of the business operation, the level of behavioral

control the payer has over the worker is high.

Section 4

10. Expenses incurred for the restoration of a Unit of Property:

A. Incorrect. The routine maintenance safe harbor cannot be used to expense amounts considered

restorations to a UoP.

B. Incorrect. An expense that ameliorates a material condition or defect that existed before the acquisition

is considered a betterment. Betterment expenditures do not qualify for the safe harbor for routine

maintenance.

C. Incorrect. Amounts paid for adaptations do not qualify for the routine maintenance safe harbor.

D. Correct. When a disposition of a component of a UoP occurs, a loss may be taken on the disposition equal

to the adjusted basis of the component replaced.

11. Which statement is accurate regarding the election to capitalize repair and maintenance costs?

128

A. Correct. A taxpayer would make the election to capitalize repair and maintenance costs if he or she is

currently in a net operating loss (NOL) position, or if the client has very little taxable income.

B. Incorrect. The taxpayer can still use the de minimis safe harbor, the safe harbor for small taxpayers, and

the routine maintenance safe harbor to deduct repair and maintenance costs that are not capitalized

using this election.

C. Incorrect. The taxpayer may capitalize repair and maintenance costs that would otherwise be deductible

in the current year by electing to capitalize these costs. To make this election, the taxpayer must capitalize

the same costs on its books and records.

D. Incorrect. The electing entity must attach a statement to a timely filed original federal tax return (including

extensions) for the taxable year in which the amounts are paid.

12. Which statement is accurate regarding the PPI discounting method?

A. Incorrect. If the original asset was purchased at a significant discount, (i.e., upon foreclosure) or had basis

adjustments (i.e., casualty loss or Sec. 1031 exchange), the PPI discount method may result in an over-

valuation of the original cost of a building component.

B. Incorrect. The PPI discount method can only be used if the replacement is a restoration. If the

replacement is a betterment or an adaptation, the PPI discount method cannot be used.

C. Correct. Without a condition factor, the PPI discount may result in a grossly overstated write off for a

building component that is replaced within the first ten years of the acquisition or construction of a

building.

D. Incorrect. The PPI discounting method cannot be used for an addition of a stairway in a retail store. The

PPI discounting method cannot be used for any adaptations or betterments.

Section 5

13. Which statement is accurate regarding the deductibility of meals expense?

A. Incorrect. If the meal has both personal and business elements, the personal element must be separated

and not deducted.

B. Correct. Independent contractors (IC) who account to, and are reimbursed by, their customers for costs

incurred for meals under a qualifying reimbursement agreement that does not specify which party is

subject to the limitation, are not subject to the limitation; the 50% limitation is applied by the customer.

C. Incorrect. Business meals that are determined to be lavish or extravagant based on the facts and

circumstances are not deductible.

D. Incorrect. If the meals occur while the taxpayer is traveling for business purposes, the amounts are

considered substantiated and receipts are not required if he or she uses the per diem rate, which is the

amount computed at the M&IE rate for the locality for such day provided any applicable “adequate

accounting” requirements are met.

129

14. A taxpayer can deduct the following travel expenses:

A. Incorrect. For non-U.S. travel only, if the portion of travel for non-business purposes is less than 25%,

then no allocation between personal and business is required. However, if the travel is within the U.S.,

then the personal portion of the expense is nondeductible.

B. Incorrect. A taxpayer is itinerant if he or she has neither a principal place of business nor an abode; in

other words, the worker has no tax home. For such workers, no costs for travel are deductible because

the taxpayer is never considered to be away from his or her tax home.

C. Correct. Travel expenses are deductible only if the business travel is related to a temporary assignment.

An assignment that is expected to last for one year or less is considered temporary.

D. Incorrect. Expenses for personal travel are not deductible, including travel expenses for a spouse or family

members, and costs that are for personal vacations which are tacked onto the business travel. Travel

expenses are deductible for a spouse or family members who are employees traveling with a bona fide

business purpose.

15. Which taxpayer would be ineligible for an IP PIN?

A. Incorrect. A taxpayer who receives a letter of invitation form the IRS to “opt in” for an IP PIN is eligible for

an IP PIN from the IRS.

B. Correct. The taxpayer has only recently become a victim of identity theft and notified the IRS via Form

14039. In order to be eligible for an IP PIN, the IRS will have to resolve the case and place an identity theft

indicator on the taxpayer’s account.

C. Incorrect. A taxpayer who has been a victim of identity theft is eligible for an IP PIN when the IRS resolves

the case and places an identity theft indicator on the taxpayer’s account.

D. A taxpayer is eligible for an IP PIN if he or she filed a prior year tax return as a resident of the District of

Columbia or any of the following states: Arizona, California, Colorado, Connecticut, Delaware, Florida,

Georgia, Illinois, Maryland, Michigan, Nevada, New Jersey, New Mexico, New York, North Carolina,

Pennsylvania, Rhode Island, Texas or Washington.

Small Business Taxes

Documents

Transcript of Small Business Taxes