Volume 20, Number 5 July/August 2003
CAN THE RAINMAKER AND THE IRS BE BUSINESS PARTNERS?
By Dennis Jacknewitz and Patrick E. Stark
Dennis Jacknewitz formerly worked with the Internal Revenue Service and is a member of the General Practice, Solo and Small Firm Division of the American Bar Association and practices law in Belleville, Illinois; he can be reached at email@example.com.
Patrick E. Stark is a certified public accountant with Grace Advisors, Inc., in St. Louis, Missouri; he can be reached at firstname.lastname@example.org. The authors acknowledge the invaluable assistance of Sharon Yorker, CPA at Grace Advisors, Inc., in preparing this article.
Rainmakers: individual attorneys who, blessed with personality, expertise, or that certain pizzazz, have the uncanny ability to recruit and maintain business clients or obtain business client referrals for their law practice. Even when the reality of their wining and dining is more like a cup of coffee and a bagel, rainmakers incur a number of business expenses while keeping current clients happy, obtaining new clients, and mining contacts and referral sources. This inevitably leads to involvement with the Internal Revenue Service (IRS) and its complex guidelines regarding allowable deductions. Believe it or not, if a rainmaker doesn't overreach, the IRS can be the rainmaker's most productive business partner.
Although rainmakers can take clients to Hawaii or Las Vegas or wherever to develop business relationships, how the trips are structured will go far to determine whether the expenses are deductible on personal income tax returns or, preferably, business entity tax returns. By planning ahead, the rainmaker can enjoy entertainment or other activities and the IRS underwriting of such activities. Major categories of typical expenses are explored in this article.
Normal commuting expenses to and from home or office generally are not tax deductible. But a rainmaker who stops by a client's office en route renders the very same non-deductible commuting expense tax deductible. Both the mileage from your office to the client's business and the mileage from the client's office to your home are then deductible.
To compute such expenses, should you take actual expenses or standard mileage rates published by the IRS? Whichever you decide, be consistent. For actual expense deductions, keep track of gas expenses, oil, repairs, insurance, depreciation, car clean-up expenses, and so on; multiply the total of the expenses by the percentage of business use for the vehicle to obtain the proper deduction. For example, if you use your car strictly for business affairs 80 percent of the time, you can deduct 80 percent of all costs associated with maintaining the car. But you must keep track of the costs with receipts or a manual or computer log.
Most people will opt for the less cumbersome option of keeping track of business miles incurred. However, you still must document parking costs, tolls, and cleaning costs on a regular basis if you want the tax deduction. The IRS-approved mileage rate for tax year 2003 is 36 cents per mile for owned or leased vehicles.
Auto Lease vs. Purchase
Will you come out better tax-wise leasing or purchasing a company auto? This depends on a number of variables, including the residual value of the vehicle at the end of the lease period, the percentage of business and/or personal use for the vehicle, and the tax bracket of the lessor. You can use one of the financial calculators to help with this decision (one example is www.dinkytown.net). Leasing is probably easier than owning a vehicle in terms of record keeping, because you can deduct the business percentage of the lease payments and don't have to calculate depreciation and such on a leased vehicle. For luxury vehicles, the deduction for the actual lease payments is reduced to approximate the depreciation limits on purchased vehicles.
Want to get a faster write-off on that new vehicle? One way to get around the depreciation limits is to purchase a sport utility vehicle (SUV) rated at more than 6,000 pounds gross weight. These vehicles are often quite luxurious, and because they are not considered "luxury autos" under IRS regulations, these vehicles can be written off more quickly than can non-SUV vehicles. For example, if you purchased a $40,000 SUV in 2003 and used it 80 percent for business, you could expense $32,000 under section 179 of the Code the first year.
The 2003 tax act allows you to expense up to $100,000 of qualifying depreciable property, plus you can deduct first-year bonus depreciation of 50 percent on any other qualifying assests (generally machinery, office equipment, off-the-shelf computer software, and some leasehold improvements).
Travel and Lodging
You do not have to be away from home for more than 24 hours for a business trip to be considered out of town. However, you do have to be away overnight, or long enough to require securing lodging to sleep or rest. Your travel agent may advise you that staying over Saturday night can save on airfare. If the additional cost of staying Saturday night is less than the original plane fare, lodging and meal expenses for the extra day are tax deductible. For example, if you can save $400 on airfare by staying Saturday night, and your additional lodging and meals cost $325, you can deduct the $325 in expenses even if the business part of your trip ended on Friday-courtesy of your business partner the IRS. (Unfortunately, the IRS will not let you deduct travel expenses for investment seminars or stockholders' meetings.)
The IRS believes abuses in the area of entertainment expenses do occur and therefore has set limits on allowable deductions. The result is that entertainment is deductible only if the expense passes either the "directly-related" or "associated-with" tests established by the IRS.
The directly-related test requires more than a general expectation of receiving income or a business benefit at some point in the future from the expense. The main purpose of the entertainment expense must be the active conduct of business-you must initiate a business discussion with the entertained party during the entertainment period. To meet the associated-with test, the entertainment must be associated with the active conduct of your trade or business (the business of practicing law) and take place either before or after a substantial business discussion.
Many types of entertainment expenses are allowable, including visits to nightclubs, theaters, and sporting events, if the circumstances meet the above tests. Additional restrictions are imposed by the IRS for activities such as entertaining on a yacht, during a fishing or hunting trip, or at a vacation spot. For these types of activities, the cost of renting or maintaining an entertainment facility such as a hunting lodge is not deductible under IRS regulations, but the out-of-pocket expenses like beverages, food, and so forth are deductible.
Recreational or social activities for employees, including holiday parties or golf outings, do not have to meet the directly-related or associated-with tests to be tax deductible. The deduction includes the expense for renting a facility such as a ballroom or swimming pool. Expenses for employees of the law firm also are not subject to the 50 percent reduction in meals and entertainment deduction that usually applies, so long as the entertainment is primarily for rank-and-file employees, although it may also include highly compensated employees.
Country club dues and similar membership fees for venues for recreational or other social purposes no longer are deductible under current IRS guidelines. Only civic or professional association dues are exempt from the above disallowance. If you entertain clients at home, however, costs associated with meals, drinks, a pianist or string quartet, and similar types of entertainment are deductible if the primary purpose is business and not social.
When purchasing tickets for a sporting event or stadium concert, only the face value of the ticket is tax deductible, not the fees paid to a ticket agent or scalper. If a skybox is involved, the IRS imposes even more restrictions: The skybox must be leased for more than one event to be deductible. In order to determine the deduction, the face value of the highest priced non-luxury box ticket is used and multiplied by the number of seats in the rented space. For example, if there are 12 seats in the luxury box and the most expensive regular box seat costs $40, the deduction is limited to $480, even if the box cost $2,500. Food and beverage costs are deductible if they are separately stated on the bill.
The IRS disallows expenses it determines to be lavish or extravagant. But that doesn't mean you can't stay in a first-class hotel or entertain at a five-star restaurant; to qualify as a deduction, the expense must be reasonable considering the facts and circumstances, such as the position of the person claiming the deduction and the person being entertained. A luxury suite at a hotel may be reasonable when used to meet with or entertain clients or prospects for business.
Combining business with pleasure will cause the IRS to examine your expenses very closely. If the primary purpose of the trip is business, the entire cost of transportation to and from the destination is deductible, even if you add a short personal side trip (of course your personal expenses are not deductible). On the other hand, if the primary purpose of the trip is deemed personal, no transportation expenses are deductible, and only expenses directly related to the business once you are at your destination, such as meals and lodging, should be claimed.
If the primary purpose of your trip is business but you want to take your spouse along, your spouse's expenses may be deducted only if the spouse serves a bona fide business purpose and is an employee or officer of the corporation, LLC, LLP, or other law business entity. Participating in social functions generally is not considered a business purpose, although the tax courts have allowed such expenses in certain circumstances.1 If the law firm pays for your spouse but the expenses ultimately do not qualify for a business deduction, the amount expended on the spouse will be included in your gross income for that particular year and taxed accordingly.
Suppose you find yourself in one of those situations where your client only now remembers some "other" information she should have shared before you accepted the case. You lease a jet to fly cross-country to converse with your client rather than use a commercial flight. Is this a legitimate deduction? Possibly-the rule is that the business portion of the cost is deductible if the airplane is used primarily for business and if commercial flights are inconvenient or unavailable. If the costs associated with the private plane are unreasonable, the IRS may limit the expense to the price of a first-class commercial airline ticket.
You want to attend that convention in London, and you want the IRS to pay all or part of the bill. Will it work? Generally you can deduct travel expenses for attending a convention if you can show that your attendance benefits your trade or business. In order to take a deduction for a convention held outside North America, you must be able to prove that it is as reasonable for the meeting to be held outside the United States as it is to hold the meeting here. For example, the convention was held in England so attendees could study the British court system firsthand and discuss it with barristers.
What about that really great CLE course given on the Mediterranean cruise ship? If you meet the very strict IRS reporting requirements, including a statement from the seminar sponsor verifying days and hours of business meetings, up to $2,000 per year of expenses for attending conventions, seminars, or similar meetings on cruise ships can be deducted. Forget the Mediterranean, however-the ship must be registered in the United States and visit ports of calls only in the United States or its possessions.
Good Deals That Still Exist
Despite IRS limitations on business deductions, some deductions you might have thought obsolete may still exist:
-Travel from home to a temporary work site (such as a client's office).
-Total cost of traveling to and from a foreign location, if the trip is primarily for business and lasts one week or less (even if more than 25 percent of your time is spent on personal activities).
-Total cost of noncommercial employer-provided vacation flights for employees, as long as the employees include the value of the flight under the Standard Industry Fare Level rates as part of their income, even if the actual cost was higher. (Standard Industry fares generally equal the cost of a first-class commercial airline ticket.)
-A noncommercial flight taken by an employee not flying primarily for business can be valued at zero if at least half the regular seating capacity is occupied by employees whose flights primarily are for business. This applies to both current and retired employees, but not to directors or independent contractors.
-New 401(k) rules allow a self-employed individual or single-employee law firm to create an individual retirement plan and defer up to $12,000 of income for the year. For individuals over age 50, that deferral increases to $14,000. Additionally, the law firm can contribute to the plan and deduct 25 percent of the individual's salary for that year. The two amounts combined cannot exceed $40,000 per year.
Employer vs. Employee Expenses
Is it better for the company law firm or the employee personally to claim the business-related tax deduction? Generally it makes more sense for the company to take the deduction, especially under a "non-accountable plan." A non-accountable plan requires employees to include reimbursements in wages and payroll taxes. The employee can claim the expense only as an itemized deduction, but the deductions are reduced by 2 percent of the employee's adjusted gross income and are further reduced as the employee's income increases. Not such a good deal for the employee.
An "accountable plan" makes much more sense for the company and the employee but does require that the employee substantiate expenses to the employer. The employee also must return to the business any funds in excess of substantiated expenses.
The company can pay a fixed amount per day (per diem) instead of reimbursing actual expenses. A list of allowable per diems based on locality and date is available at www.policyworks.gov/perdiem. You could also use optional high/low per-diem rates based on high or low expense areas. For example, the high rate for lodging, meals, and incidentals for 2003 is $204, and the low rate is $125. Even when using per diems, the employee must still substantiate the business purpose of the meeting, time, and place to the employer.
Rainmaking can be expensive, but by making the IRS into a partner, the rainmaker can benefit the business by entertaining clients in a nontraditional luxury environment and save tax dollars while making a great impression on clients and prospects.
1. See, e.g., Disney v. United States (CA9 1969), 24 AFTR 2d 69-5123, 69-2, USTC 9494.
Serving on the board of directors of a nonprofit or community organization such as the local symphony or art museum board can be a great way for a rainmaker to network with wealthy and influential contacts and receive applicable tax deductions for the activity. Mileage and out-of-pocket expenses are deductible as charitable expenses on itemized tax returns. Underwriting a fund-raising event may be deductible as a public relations expense-in addition to being a great advertisement for the lawyer or firm.