Final 199A Regulations

The Section 199A deduction requires you to be a trade or business. Follow these rules to take advantage of this generous deduction on your rental properties.

The Section 199A deduction requires you to be a trade or business. Follow these rules to take advantage of this generous deduction on your rental properties.

The IRS released final regulations on 199A. The Kiplinger Tax Letter said it best: “Final regulations provide limited guidance, but IRS gives a safe harbor.”

In this post we will discuss the safe harbor as it relates to “trade or business” with special emphasis on application with rental properties. The safe harbor doesn’t apply to all taxpayers and the trade or business designation is still possible without meeting the safe harbor parameters.

The final regulations run 248 pages. I will follow this post with a detailed post on 199A tiers with several decision trees. Due to the length and complexity of the regulations we are forced to remain focused on one aspect of 199A. Taxpayers with a sole proprietorship, partnership, S corporation or investment property may wish to seek the services of a competent tax professional until more clarification is reached through more regulations or from the Tax Court.

Links are provided at the end of this post to the entire 248 pages of regulations released and Notice 2019-07 (only 10 pages!) dealing with the trade or business safe harbor for real estate issues for your further research.


Remaining Problems with the Final Regulations

The final regulations refer to Section 162 (as previous releases have). Section 162 generally governs the deductibility of expenses for a trade or business. But Section 162 is unclear when it comes to rental activities. 

The reason for the vagueness is because the facts and circumstances of each taxpayer differs. Whether the property is commercial or residential, the lease terms, services provided, how many properties owned  and day-to-day involvement in the activity all play a role. We will touch on each of these throughout this post. 

The biggest problem with the final regs is that they were issued after 2018 was in the books. Nobody knew they needed to keep track of time spent in the activity, nor did they know they were required to keep a separate bank account for the rental activity.

The IRS, aware of this, has granted some leeway for the 2018 tax return as it regards contemporaneous records.  However, for tax years beginning after December 31, 2018 you must follow the new regs for record keeping. Ignorance is not an excuse.

Once the IRS laid out the safe harbor for a “rental real estate enterprise” they state: 

Failure to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business for purposes of
section 199A.

This means the safe harbor isn’t the only way to take advantage of the generous 199A deduction. 

If you use the safe harbor you must include a statement to that effect with the tax return. Qualified pass-through entities (RPEs) can also use the safe harbor and provide the taxpayer with the required statement that application of the safe harbor was used as outlined by regulations. This is attached to your return.


Safe Harbor

The new deduction for rental property owners is no game. Get your deduction today.Rental Real Estate Enterprise: For purposes of the safe harbor the IRS uses the term rental real estate enterprise, defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. 

The individual or pass-through entity relying on this safe harbor must hold the interest directly or through a disregarded entity. This means you can only use the safe harbor if you hold the property personally or as an LLC treated as a disregarded entity. If you hold the property in an LLC electing to be treated as an S corporation (and there is no reason to ever hold real estate in an S corp) you cannot use the safe harbor.

The taxpayer must treat the property (or group of properties) held for the production of rents as a separate enterprise. This means you hold each property or group of properties as a single enterprise. Which means you have a separate bank account and name for the enterprise. Those with multiple LLCs could experience issues with qualifying for the safe harbor. 

Commercial and residential property cannot be part of the same enterprise. Yes, this can cause real confusion when you have mixed property under one LLC and/or business name. As I read this regulation you would need to qualify for the safe harbor for both the residential and commercial property.

Once you establish a treatment for your properties (which properties belong with each enterprise) you must continue with the same treatment unless there has been a significant change to the facts and circumstances (sale or purchase of property, for example).

Safe Harbor Defined: For the Qualified Business Income Deduction only, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:

  1. Separate accounting of income and expenses are maintained for the rental real estate enterprise.
  2. 250 or more hours of rental services are performed for taxable years beginning prior to January 1, 2023 with respect to the rental enterprise. 
  3. For taxable years beginning after December 31, 2022, 250 or more hours performed in respect to the rental real estate enterprise in any 3 of the 5 prior consecutive years.
  4. Contemporaneous records are required, including: time reports, logs and similar documents regarding the following:
    1. hours of all services performed
    2. description of all services performed
    3. dates services were performed, and
    4. who performed the services

Of course, contemporaneous records are a bit hard to produce when the rules were not in place until after the tax year concluded, and therefore the records do not need to be contemporaneous for tax year 2018. I recommend going over 2018 ASAP to create a log of all services performed.


What Counts for the Safe Harbor

Not all activities count toward the 250 hour requirement for the safe harbor. 

Rental services performed by the taxpayer or by employees, agents, and/or independent contractors of the taxpayer all count toward the 250 hour safe harbor requirement. 

Rental services for the rental real estate safe harbor include:

  1. advertising to rent or lease the property/s
  2. negotiating and executing leases
  3. verifying information from prospective tenants
  4. collection of rents
  5. daily operation, maintenance and repair of the property/s
  6. management of the property/s
  7. purchase of materials
  8. supervision of employees and independent contractors.

Keep in mind the time supervising employees and/or contractors only includes your time supervising. The hours performing services by employees and independent contractors do not count toward your hours.


Activities that Don’t Count as Rental Services

Several activities do not count as rental services as applied to the 250 hour requirement:

  1. travel to and from the property/s
  2. financing activities
  3. investment management activities (financial statement review; property search; and procuring and planning, managing or constructing long-term capital improvements)

Generally, things that are easily fudged are disallowed. Saying you spent many hours reviewing the books or driving to the property will not benefit you. Saying you spent x number of hours planning capital improvements to the properties also do not count toward the safe harbor.


Other Exclusions

Real estate is better than ever with the new tax laws. Discover the advantages to 199A. Get your tax break today.Several situations are excluded from using the safe harbor. 

Any personal use of the property during the year excludes use of the safe harbor.

Triple-net leases are also excluded from the safe harbor. A triple-net lease is defined as a lease agreement that requires the tenant to pay for all or part of the taxes, fees and insurance, and the tenant is responsible for 

maintenance requirements in addition to rent and utilities. Since most commercial property is leased triple-net, the safe harbor option is unavailable, but may still qualify as a trade or business as shown next.


How to Still Claim as a Trade or Business

Since so many tax dollars are riding on the line it is important to determine if you qualify for the 199A deduction. The safe harbor is just that, a safe harbor. Just because you don’t qualify for the safe harbor does not mean you do not have a trade or business.

There are some similarities in this safe harbor with the material participation tests under the passive activity rules. While the numbers between this safe harbor and the material participation tests are different, we can still gather guidance by reviewing the facts and circumstances in determining if the activity is a trade or business.

Earlier last summer while waiting for the IRS to provide guidance on what a “trade or business” is, I decided to build a policy for my office. My conclusion was that investment property (reported on Schedule D when sold) was not a trade or business and property that is treated as a sale of business property when sold (reported on Form 4797) is a trade or business. With the recent IRS guidance I am forced to tighten my definition of a trade or business in situations not covered by the safe harbor.

The IRS actually uses the words “trade or business activities” in their material participation tests. In other words, they say:

You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests:

Whereas the safe harbor for 199A rental services say you need 250 hours, the first material participation test says 500 hours. I think it is safe to say we can use 250 hours when not using the safe harbor as well.

But you can still be a trade or business if you put in fewer than 250 hours if the material participation tests are a valid ancillary. 

Material participation test #3 says if you put in 100 hours, and is more than anyone else in the activity, you pass the test and materially participate.

According to test #2, if you put in substantially all the participation in the activity you pass.

There are additional tests to determine material participation. For trade or business issues I think it is reasonable to use the material participation guidelines, whether it be a small business or rental property. The safe harbor is a bit easier to pass for 199A based on hours, but if you meet the guidelines in any of the material participation tests you have substantial grounds for claiming you are a trade or business since the IRS already recognizes this in another area of tax application.


Final Considerations

Section 199A, the Qualified Business Income deduction is one of the most complex pieces of legislation to hit taxpayers in a long while. I dealt with one narrow subsection of the regulations. 

It might be a good idea to hire a tax professional for at least one year if you own a business and or rental property to deal with the litany of tax issues surrounding 199A. Even if an extension is required and your taxes are not filed until later in the year.

Here are a few issues not covered in this post that you will want to discuss with your tax professional:

  • Tier #1, #2 and #3 for small businesses
  • Specified service trades or businesses (SSTB)
  • Form 1099 (If a rental in not a trade or business then Form 1099 reporting can sometimes be avoided. However, you want to be a trade or business for 199A reasons so if you don’t file Form 1099 with contractors the IRS may disallow the deduction because you didn’t act like a trade or business)
  • Contributed property to an entity has special rules
  • Special rules apply to like-kind exchanges and involuntary conversions
  • Special considerations for basis of inherited property
  • Net operating losses affect 199A
  • Capital gains and losses may affect 199A
  • Amended returns are not allowed to initiate aggregation, but aggregation can be used in future years
  • SSBTs are better defined in the final regulations
  • and more. . . 


As promised, here are the reports from the IRS. You can read Notice 2019-07 as well as I. It is a short 10 page document and worth a read if you have rental properties. Less readable is the final regulations on 199A, coming in at 248 pages.

If you ever have trouble falling a sleep one evening just pick up the final regs. You’ll be out cold in minutes.



More Wealth Building Resources

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QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

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Dealing with Clients Who Want to Take Illegal Deductions

Tax professionals all have stories of clients who wanted to cheat on their taxes. It might be tempting to nudge the line a bit to the left to keep a client happy and collect a fee. But you need to think long and hard before you make your decision.

If you prepare your own return you can avoid all the pesky demands of tax professionals to file an accurate tax return. Just as a tax professionals face serious penalties, so does the taxpayer. If you talk a tax professional into an unreasonable position on your tax return you will be penalized a lot faster than the tax professional. Tax preparers are really just entering data. She may not be aware of the malfeasance. That leaves you blowing in the wind. And a cold wind it is.

Then we have those instances where the issues are not clear. You can take a questionable deduction, within reason. If you disclose the position you’re taking you should be secure from penalties from an overzealous IRS agent.

The Client Not Worth Having

Bring up the subject of the unreasonable client or client from hell with tax professionals and they all go into cataleptic shock.  A tax season isn’t complete without at least a dozen or three requests to do something industrial strength stupid.

A few years back my office had a client who included a receipt to deduct IMODIUM® and underwear. I pointed out the receipt and informed the client he hadn’t seen my bill yet so the deduction is not “regular and ordinary” and therefore not deductible. He is the good kind of client. He withdrew the deduction without complaint.

This tax season wasn’t as polite. As hard as I try to winnow down the client list somebody always comes up with a position that will not stand IRS scrutiny and has preparer penalty written all over it.

The client in question this year has been with my firm a few years. He always pushed the envelope too far and should have been shown the door a long time ago, but a certain accountant was a nice guy and listened to the BS.

In the past the client had us do his bookkeeping. That was too expensive so this year he threw everything in a box. I have employees who work exclusively bringing order to chaos. These employees are generally not tax professionals, but we do train them to sift the wheat from the chaff. Items in questions are reviewed by an accountant and added to the numbers if the deduction is allowed.

My friendly client likes to eat out. A lot! As in every meal. He threw every receipt into the box. Working on the road he filled the van with fuel often. Included on the receipt was always a bottle of water, gum or some other snack. The other items are NOT DEDUCTBLE!

If a few small items slip by I don’t lose sleep over it. I’m not auditing the return; I’m preparing it. Sorting wads of paper in a box isn’t bookkeeping. If you don’t care enough about your business to manage it correctly don’t expect me to work for free during the busiest time of the year bringing order to the mess. We separate receipts into piles based on our interpretation of type of expense (or if it is even a business expense) and run a z-tape on each pile.

Back to our client. All those meals and extra items on gas receipts were disallowed by my office. Dawn, a preparer in my office, separated out the questionable items and told the client she would not put those expenses on the return. The client was pissed. The only answer? Gotta talk to da boss.

The boss was having none of it. If you have a meal expense it is your responsibility to record the business purpose. You can NOT deduct everything you eat while on the road and dinner on the way home because that was related to work. NO IT’S NOT!

Smart tax preparers explain why the deduction is not allowed to the client. This is actually required by Treasury Circular 230, the publication regulating tax professionals practicing before the IRS. Section 10.21 clearly states a tax professional must inform the client of an unreasonable position. Nowhere in Circular 230 does it say you must fire the client, but Section 6694 of the Code is very clear: an unreasonable position by a preparer, even if disclosed, can result in penalty and even censure. Preparer penalties start at $1,000 for an unreasonable position and $5,000 for disregard of the rules.

The Most Important Number Every Tax Professional Must Know

For many years my office attended professional education classes taught by Jack Surgent. Jack is one of the smartest tax guys I’ve ever met.

During one of these training sessions we focused on ethics. When the topic of clients wanting to take illegal deductions came up Jack never stopped for comment. All he said was, “800. . . 799. Get it?”

The whole room better have. What Jack meant was if you have 800 clients and lose one you still have 799. Barely more than a tenth of one percent. No one client is worth it.

What Jack didn’t say, and I will, is, if you keep these clients it will hurt the profitability of your practice. Clients always pushing the envelope don’t want to pay for quality consulting. They want to cheat and if the boom is lowered will throw you under the bus before you open your mouth.


  1. Get it?

For the Folks Back Home Preparing Their Own Return

Nothing is more annoying than a highly trained and competent tax professional disallowing bogus deductions or not allowing unreported income. I see bloggers publishing some of the things they think are allowed. I quietly smile as I read knowing I’m not the one who will have to defend them in audit.

Treasury Circular 230 regulates most tax professionals. That doesn’t leave DIYers off the hook. The penalties can get large real fast for playing it fast and loose. Just failing to file a tax return by the due date (without a valid extension) subjects you to a 5% penalty per month up to five months (25%). If there is no balance due you at least avoid this one.

Section 6662 provides for a 20% accuracy penalty if you disregard the rules by failing to make a reasonable effort to comply with the tax code. The IRS automatically assumes you didn’t make a reasonable effort if they assess additional tax because if you did you wouldn’t owe the extra tax. You can fight this in appeals and might even win if you can substantiate you did make a reasonable effort.

Considering my ex-client above, he went to another preparer to get his return done. The other preparer has serious risk if she allows the deductions. The client is still on the hook for a Section 6662 penalty or even a $5,000 penalty for filing a frivolous return. If the numbers get big enough—I don’t think they were in this case, but then again I could be wrong—Section 7201 comes in to play. Section 7201 is the willful attempt to evade or defeat tax which is a felony, subject to a fine up to $100,000, up to a year in prison or both.

Don’t Be Scared

Now that I put the fear of god in you it’s time to take a deep breath and gain perspective. Honest mistakes are generally minor and the IRS rarely assesses a penalty or removes them relatively easily.

The discussion above isn’t about minor or honest mistakes. Small changes in an audit are usually disregarded by the IRS and treated as a “no change” audit. Most IRS auditors are pretty darn nice people. I’ve worked with them for several decades and one was an employee before she bed down with the enemy, ah, the IRS. Yes, there are a few knucklebusters out there, but even they don’t cause problems unless you invite them to.

Fear of an audit or penalties is unfounded unless you played fast and loose on your tax return.

If you do your own return you MUST take the time to educate yourself on the issues affecting your tax situation. Consulting with a tax professional doesn’t mean they must also prepare the return. I personally consult with many people who prepare their own taxes. I even consult other tax professionals. (It happens when you become the old guy on the block with three decades in the trenches.)

The takeaway from this post is thus: If you are a tax professional, do NOT relax your ethics for a fee. Educate your client, if they allow. If the client refuses to follow the rules remember Jack Surgent: 800; 799. No one client is worth your career, a fee or the headache. Move on. Life is better that way.

If you do your own tax return or hire a tax professional, insist on accuracy. Educate yourself on the issues affecting your taxes. There are so many ways to legally lower your taxes it is nothing short of insane to cheat on your taxes.

The only excuse is laziness and then you deserve what you get.

How to Deduct Unreimbursed Business Expenses Without Itemizing

Recent tax law changes have gutted many itemized deductions. State and local taxes are limited starting with tax year 2018. What many people are forgetting is that certain miscellaneous deductions and job expenses are also no longer deductible.

Schedule A has suffered many changes. Miscellaneous deductions, subject to 2%, are eliminated. Common deductions in this area include tax preparation fees, safe deposit box fee, legal expenses to protect income, certain job related expenses and unreimbursed employee business expenses.

Most people paid no attention to this area of their tax return because most of these deductions are small even when added together. Since these deductions only count when the total exceeds 2% of AGI, most people received no deduction.

Certain taxpayers made heavy use of these deductions. It’s common for sales people to have large out-of-pocket expenses. Mileage and other travel expenses can add up fast. The only option for these taxpayers is to have the employer reimburse the expenses. The income received from the employer for reimbursed expenses is not reportable income if paid under an accountable plan where the taxpayer provides the employer with evidence of the expense (mileage logs, receipts, et cetera).

Exceptions to the Rule

Unreimbursed business expenses aren’t always claimed on Schedule A. Sometimes the deduction can be reported on page two of Schedule E.

Whereas, the only option remaining for regular employees is to have the expenses reimbursed (or the deduction is lost), small business owners have unique opportunities to claim (and benefit from) all business related expenses.

One-owner firms can easily deduct expenses on the business return since the single owner will want to have a policy of reimbursing all expenses paid for the business.

The problems begin when there are multiple owners.

Partnerships (or LLCs treated as partnerships for tax purposes) can have partners with an office in the home, phone expenses and mileage. These expenses are probably disproportionate among partners. One partner may work on the road in sales while another works from a home office and the remainder working at the company office building.

Partners can disagree as to the amount of deduction that should be reimbursed. One partner may feel the mileage rate is an added benefit to one particular partner since it could contain a non-cash deduction portion. The office in the home might cause friction between partners because the partner with the home office has a more expensive home.

In such situations the partner (if she is a general partner) can deduct unreimbursed expenses on page two of Schedule E. The deduction is reported and listed as “UPE”. Do NOT adjust the K-1. Report the K-1 information from the partner exactly as received. The UPE adjustment listed separately will reduce self-employment tax on Schedule SE automatically.

One final point. To deduct general partner unreimbursed expenses the partnership agreement MUST require these expenses be covered by the partner.

Confusion Accountant’s Sometimes Have with This

This summer a client came in off the street from another tax firm. They deducted expenses exactly as I outlined above with exception of the company reporting as an S corporation.

This does NOT work for regular or S corporations. Unreimbursed expenses, even from shareholders, are considered an unreimbursed “employee” business expense. This means no deduction for 2018 and after or until the tax code is changed allowing the deduction again.

The only way to solve this is to have the company reimburse the expense. The UPE adjustment outlined above is for partnerships ONLY!

For the new client the fix was easy since it was a sole-owner business.

What happened at the previous tax firm was the S corporation filed by the due date which is March 15th. The individual return was filed later, a normal occurrence since the business return has to filed first to file an accurate personal return. Additional expenses for the business were discovered after the S corporation was filed, but before the personal return was.

Rather than amend the S corporation return (the correct answer), the tax preparer took the deductions on page two of Schedule E. The IRS promptly disallowed the deduction. This brought the taxpayer to my office.

Since the company really reimbursed the expenses it was easily resolved with an amended return. If the error were discovered prior to the due date, plus valid extensions, a superseding return could have been filed. (I’ll have an article on superseding returns this tax season.)

My new client was lucky. He was able to deduct the entire amount through amended returns. However, it could have ended poorly if the circumstances were different.

Planning Tip

Over the years I’ve acquired several rock bands as clients. Once a reasonable level of profitability is reached it usually makes sense for the band to organize as an S corporation, replacing the self-employment tax with FICA taxes on only the reasonable compensation of the owners with the rest of the profits avoiding FICA and SE taxes.

Band members frequently have unreimbursed out-of-pocket expenses, such as: mileage, meal per diems, hotels and repairs and maintenance of their instruments. Guitar players need strings periodically and drummers need new sticks.

Each player is usually responsible for their own instrument purchases. Musical instruments aren’t cheap! And now they can’t deduct the expense on Schedule A as they have in the past.

For bands and similar types of businesses the S corporation may no longer be the preferred method of organization.

Regular corporations pay a flat 21% tax now, while S corporations pass all the profits through to the shareholders where income taxes can rape the shareholder of as much as 29.6%! With the loss of unreimbursed expenses, the S corporation structure may prove, ah, taxing.

Deducting Unreimbursed Employee Business Expenses or Unreimbursed Partnership Expenses.For more information to reduce your taxes:

Posted by The Wealthy Accountant on Friday, November 30, 2018

The partnership has its place among business structures. The big issue with partnerships is general partners pay SE tax on all their proration of profits, plus guaranteed payments to the partner.

Since general partners are NOT employees, they don’t get a deduction for unreimbursed employee business expenses. And good thing! That avenue evaporated faster than morning mist.

But they do get to deduct unreimbursed partner expenses in full on page two of Schedule E!

Tax professionals have a perfect opportunity this year to earn their keep. More than ever the tax professional must review business client’s data for restructuring of their businesses.

The default for many years was to encourage our business clients to become S corporations (or LLCs treated as such) when profits reached a level where the savings would justify the additional cost.

This is no longer the case. The choice is more than sole proprietor or S corporation. Partnerships and regular corporations are real possibilities for our clients.

My office prepared fewer than 25 regular corporation and partnership returns combined in recent years.  There is no doubt that will change this year!

An honest tax professional will review all the options and present them to her clients. We will prepare more partnership and C corporation returns in the next years than ever in my career.

To do any different would be malpractice.

It’s been a long time since we’ve seen such draconian tax changes. Tax professionals have become complacent in recent years with fewer new opportunities available to save clients money.

This all changed with the TAX CUTS AND JOBS ACT of 2017. This is our moment to shine, tax professionals. We can’t let the public down. We can, and must, do this.

Right, the first time.


When Claiming Fake Deductions is Legal

Fake deductions are sometimes legal! Many tax deductions don't require a receipt. Lost receipts and tax records are no problem when you know the rules. Claim every deduct due you even if you don't have substantiation to back it up. Made up deductions can be legal! #deductions #tax #fakedeductions #taxrecords #proofGoogle has a neat feature called Alerts. This feature allows you to get a daily update on any topic you desire. The setup process is so simple even an accountant like me can do it without a problem. Once set up Google scans the internet, news and social media for mentions of your selected topic/s.

I follow a few topics which rarely get an update. I also have an alert of my tax practice: Tax Prep & Accounting Services, Inc.

The name of my practice is generic for a reason. I wanted something simple like General Mills or General Electric or General Motors. While most accounting firms want to spray paint their names across the logo, I wanted a name a buyer would feel comfortable purchasing without changing the name. You see, I was thinking about my exit before I even opened the doors.

Thirty years later I’m still holding on without a sell date in sight. I also get a daily Google Alert on a dozen or so items Google thinks fits my criteria of interest relating to my business name.

Accounting Today is an industry newspaper with a Tax Fraud Blotter. It usually tops the list provided by Google when an alert is issued.

On an alert received Saturday was the clickbait title: Look Ma—Phony Deductions!

The title bothered me because phony deductions, or more to the point, unsubstantiated deductions, are not always illegal!

I clicked to the Tax Fraud Blotter and discovered, as I knew I would, there was more to the story than the headline. The phony deductions were illegal. But the topic of legally claiming unsubstantiated deductions is real.

A Story from the Underground

If you were a tax professional, what would you do in a case like this? A regular client starts a business and has questionable recordkeeping from Day 1. Then he expands his business and has almost no records at all.

There are only a few things you can do. First, you can fire the client.

Remember, as a tax professional you sign the tax return under oath that the return is “true and accurate to the best of your knowledge” under penalty of perjury. If you sign a tax return as the paid preparer and the return doesn’t pass the sniff test you can face some serious fines, some as high as $25,000 a swing!

Second, you can throw up your hands and tell your client, “You can’t file an inaccurate return so I guess you don’t have to file at all.”

This is another really bad idea.

Third, you can prepare the return with the information at hand and hope for the best.

Each of these choices has issues. Firing a client because they’re stupid they didn’t keep accurate records doesn’t solve the problem.

It’s illegal NOT TO FILE your tax return by the due date, plus extensions. You are required to file even if you can’t pay. Lack of funds is not illegal; non-filing is!

If you refuse to touch the return somebody else will have to or the client is out in the cold. So if you don’t do it, somebody will or your client is heading for the hoosegow.

Telling a client they don’t have to file their tax return if they didn’t keep pertinent documents is also a bad idea.  I don’t know the IRS penalty off the top of my head, but it includes a baseball bat and something about “behind the woodshed.”

And last, hoping for the best is not sound tax advice.

Super Accountant to the Rescue

If you’re a taxpayer reading this you might want to put your fingers in your ears for a few sentences.

There is an easy way to file the above mentioned tax return for a disordered client and you get to charge extra for the service. A lot extra!

Last summer I wrote about the Cohan Rule. Now with tax season racing straight for us at warp speed, it’s a good time to review an extreme case which will allow you to file an accurate return “to the best of your knowledge” and avoid preparer penalties.

The example client we used above for our thought experiment is a real client. He runs a liquor store. His records are a mess to be polite. When we ask for more documentation we get an annoyed, “We gave you everything. It’s in there.”

No it’s not!

Last tax season it was so bad I had to junk the entire return except for three things: the bank statements showing deposits and checks written, supplier printouts for cost of goods sold and property taxes paid by going to the county to get proof of what was paid and when. From these few items I had to reconstruct a tax return, avoid preparer penalties and stay out of jail.

What would you do in a case like this? The client is a good guy, just a bit light when it comes to recording business income and expenses. Dumping him on the street would almost certainly end in the return never getting filed for years until the IRS lowered the boom. Then it would hurt him really bad and certainly end his business, putting him and his employees on the unemployment line.

You already have a good idea what I’m going to do. I’m going to make up numbers. But how?

You can read the Cohan Rule post I wrote back in August. The Reader’s Digest version states you can deduct reasonable expenses ordinary and necessary to a business (Section 162(a)) with the exception of meals, entertainment, recreation, amusement, gifts and certain listed property (Section 274(d)) for unsubstantiated expenses.

In the case of our friendly client, we also had to reconstruct income!

Building an Elegant Tax Return

I will show you how I built this client’s tax return without triggering an audit. The odds of the client getting audited are slim as I told the IRS exactly what I did. Past experience leads me to this conclusion because I’ve never had a client audited when I disclosed what I am about to show you.

Our victim, ahem, client had a box of stuff to go through. I added the whole thing up once his retainer cleared the bank.

The numbers were well outside the expected norm. (Remember, a tax professional can’t just file a return based on client provided information. If the numbers are unusual the tax professional MUST quiz the client further to ascertain if the data is correct. Unusual items remaining on a tax return should be disclosed with the original return. The disclosure should include the item in question and how the number claimed was arrived at.)

I pay special attention to local clients. If they have a business I make a note when driving past their establishment if I’m in the area. Clients miss a lot of serious tax benefits I find from a simple drive-by.

Our client in question had a small shop. I expected that since it was a liquor store. The footprint of such establishments is generally small compared to sales.

Almost every deduction available can be fake and still legal. Fake deductions are okay with the IRS if you know the law. Lost records? Missing receipts? No problem. You can use a guesstimate when filing your taxes. #law #irs #legal #illegal #fakeI also had his prior year return to build from. The numbers were substantially different.

I plugged the numbers I had as a starting point. My software compares the current year to the prior year. It was a crazy mess.

To construct a return I’d be willing to sign off on I started with known variables. The client was slow to get me bank statements so I had him sign a power of attorney allowing me to pull his bank records.

With the whole year of bank transactions in hand I added all the deposits for the year to arrive at Gross Revenue. I asked the client if he had ever deposited personal cash or checks to fund company expenses. He said, “No, well, maybe once. Okay, but, yes. No! Now that I think of it, maybe.”

There is a price for bad records. It’s called double taxation. If you can’t prove any of those deposits aren’t business income you have to report it as income! My disclosure to the IRS will list my position as such for good reason. The IRS uses the same formula!

I also asked if any income wasn’t deposited. I got an answer identical to the last question. Facepalm.

The revenue looked reasonable compared to the growth in his company.

Next I used the power of attorney to get a printout of the cost of goods sold from his main supplier. This was another number I could hang my hat on with reasonable comfort.

The COGS allowed me to back out an expected revenue number. It was close so we will stick to what we originally calculated by adding all deposits.

Property tax records are easy to find online so that was one expense I was also comfortable with.

Now came the hard part. I had three months of rent receipts and the landlord wasn’t kicking him out so I multiplied one payment by twelve.

I asked the client if he ever took money from the business account for something other than a business expense. By the way his mouth was catching flies I took it as a “no”. I couldn’t add all the checks cleared and allocate between expenses. (Since some items are not allowed under the Cohan Rule I don’t use the bank statement for a total of deductible expenses when I have no substantiation unless I have no choice. That and I know how small business owners like to take cash here and there for personal expenses even if they say they don’t.)

Deep Science

Now we are going to get extremely scientific; we’re going to guess.

Advertising, utilities, office supplies, and other expenses still are allowed under the Cohan Rule.

For our client today I took his information from prior returns and compared the expenses as a percentage of revenue and COGS. Example: If in the past three years he has advertizing expenses of 12% of revenue and 27% of COGS, I will use the percentage that gives the lower number as a deduction.

I want two reference points whenever possible. I use the lower deduction because it’s not my job to put my neck on the line if you don’t care enough to keep good records.

I move to each deduction normal for the type of business involved.

As I work through the return I keep detailed records of how I arrived at the numbers I report and attach it to the tax return and keep a copy in our permanent file.

I’ve used the same process for clients who get audited but lose their documents between filing and the audit. A home or business fire or theft is an understandable reason for a client to lose their documentation, hence the need for the Cohan Rule.

We scan a lot of stuff in when preparing a return, but time is limited so we don’t copy every receipt for our records. That is the client’s obligation.

However, if we see documentation we note this fact in our records. Our contemporaneous record acknowledging we saw the paperwork and actual receipts are frequently enough for the taxing authorities to accept the numbers we report. Must be my honest face.

The Flower Girl

Virtually every number on the above client’s tax return is a guess. The IRS would have to use the same methodology to come to an estimated return. We just beat the IRS to the punch and documented each step we took.

And that is how claiming fake deductions is legal.

Now before you say a word, I can hear you thinking.

For any client willing to pay me a bit extra to see if my guess is a better result than the actual numbers, NO!

My guess will always be conservative and probably overstates your tax liability. The Tax Court has clarified what they allow and don’t when invoking the Cohan Rule. And they always lean in favor of the government. So do I in such instances.

But good try. I like the way you think.


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Meet Mister Cohan: The Client Who Never Keeps Tax Records

George M. Cohan

Today I have a very special guest I would like you to meet: George M. Cohan. George has been a regular fixture of my practice from nearly the first day. But he has one serious problem; he hates keeping business records.

There is a very good reason why Cohan doesn’t keep good records of his business expenses. He is a very famous Broadway actor. He also likes to enjoy his fame.

Well, the IRS came knocking and since most of his receipts were missing the expenses were disallowed. Cohan might be lax when it comes to keeping business records, but he can fight like a pit bull in the hot sun after a pair of double espressos. Our good friend was headed to court.

The IRS felt they had it in the bag. Unfortunately, the IRS had an education coming. The 2nd Circuit US Court of Appeals settled the case in our good friend’s favor. The court said when receipts are absent it would be impossible to get a perfectly accurate number. However, the court continued, allowing nothing is inconsistent when it is obvious there were expenses.

This court ruling happened March 3, 1930 and my office has never been the same.

Close Enough for Government Work

Paid tax preparers sign tax returns under threat of perjury that the return they are signing is true and accurate to the best of their knowledge. Too many tax professionals forget this as they quickly scribble their signature for the eighteen thousandth time this tax season.

The shoot from the hip response from most tax professionals is if you don’t have the receipt you don’t get the deduction. Sometimes, as we shall shortly see, this is true. Many times it is not.

Even when a client has records it may be necessary to make adjustments to reflect the facts and circumstances. A handful of returns grace my desk every year I wish never showed up in the office because I need to apply more art than science to the return. There is no other option.

Before we talk about adjusting deductions we need to set a few ground rules. The Cohan Rule doesn’t apply to every area of the tax return. The court ruled an approximation of business expenses, based on credible evidence other than actual documentation, was enough to sustain a deduction.

The Cohan Rule can be applied to most deductions or business expenses with the exception of travel, meals, entertainment and listed property (Section 274). Airfare and hotels need a receipt or the deduction is lost. Mileage records need to be contiguous. This means you need to record the information in your logbook near the time of the event and certainly before the tax return is filed. Meals under $75 don’t need a receipt, but you need to record the expense in your logbooks along with the business purpose of the meal and who you were talking with. Receipts for entertainment are required to qualify for the deduction.

What about that listed property thingy? Listed property consists of computers (and related peripherals) not used exclusively at a regular business establishment or qualified home office; vehicles susceptible to personal use; and property used for entertainment, recreation or amusement (i.e. video recorder). Cell phones are not considered listed property. No deduction/depreciation is allowed on listed property unless you can substantiate the expense (have a receipt). [IRC Sec. 274(d)(4)]

The Tax Court has provided plenty of help over the years in determining which instances we can use the Cohan Rule. There are also areas of inconsistency. A few years back the IRS started requiring charitable deduction receipts must be in your hand prior to filing the return. However, the Court has applied the Cohan Rule in some cases involving small charitable donations while disallowing the deduction if the amount donated involved $250 or more in any one donation.

To make it even more interesting, the Tax Court used the Cohan Rule when determining gambling losses in a 1991 case. Who would have thought?

Time to Get Creative

Now that the basics are out we can apply the Cohan Rule for more obvious cases to more creative uses of the rule.

A fire or theft could cost you your substantiation of deductions and the Cohan Rule would apply. A computer systems failure is a modern version of “the house burnt down” excuse.

Recreating deductions might not always be as hard as first thought. Bank statements are not technically receipts or allowable substantiation, but the IRS uses them all the time. Check stubs and statements from a vendor after the fact can get you reasonably accurate numbers the IRS should accept.

Certain tax forms like a 1099 can also do the trick as the IRS will already have that information. You can request a transcript from the IRS to see what they have on file as a good starting point to reconstruct a substantial or complete loss of documentation.

Mr. Cohan makes the cover of Time Magazine.

Now things get harder. You think you have all your receipts but they don’t make sense. I’ll use an example from a real client. Names and certain facts are changed to protect the guilt.

The client in question has a retail store. He expanded to a second store this last year. His paperwork was a mess. Some records were there, a lot was missing. When I added what appeared to be income it amounted to a massive increase over the prior year even adjusting for the new location.

After a dozen or so rounds with the client we were able to get a reasonably clean revenue number for the business. Reminder, the number I used was reasonably accurate. There was no way to guarantee it was absolutely accurate. As I sign the return, it was “true and accurate to the best of my knowledge”.

Now came the hard part. Major expenses were missing. Anything unsubstantiated under Section 274 was automatically lost per the Code. What we had, we used. No more, no less.

The other expenses were also obviously off and to make matters worse the client paid for many items, including inventory, with cash. (Please god, be kind to an accountant. Don’t use cash for business expenses with the exception of a few minor items from petty cash.)

Some receipts were illegible and the bookkeeping was incomplete and a mess. We had to reconstruct. I’ll save you the boring details and give you the important information. I used a model based on prior year data and expected ratios for the business at hand to determine reasonable numbers. It sounds easy, but it took a lot of time as I kept working the numbers until it all looked acceptable. In this case we had at least a few numbers to establish a baseline.

Whenever I rely on the Cohan Rule on a tax return I attach a statement clearly outlining what we did and how we arrived at the numbers we did. Whenever I have attached such a statement to a return the IRS has never, I said never, audited any of those returns. Maybe I am lucky or maybe the IRS figures if I went to that much trouble to get it right they would come to a similar conclusion.

The same applies in an audit. I take a lot of IRS audits from off the street. These people usually have a mess on their hands and missing receipts. When I bring up the Cohan Rule auditors have always been receptive once I outline how I will determine a reasonable number. I think they like my methodology because I am intense instead of guessing. I really devise a method to arrive at relatively clean numbers in pretty much any case. Auditors are usually impressed and if they aren’t their supervisor is. A few cases went to appeals over the years, but none to Tax Court and we always had end results within a nickel’s throw of where I said we would land.

Having your books and substantiation of deductions in order is the best policy. If disaster strikes you can rest assured there are alternatives for fixing most of the problem. Any additional tax liability should be small unless major Section 274 issues are involved.

Even bad bookkeeping has a solution. If a client brings in books that defy logic I must, as a tax professional, dig deeper. Sometimes the client has more material to clear up the issues. Sometimes I have to make adjustments. I disclose any adjustments to the IRS as an attachment to the return.

I sign my name attesting to the accuracy of a return to the IRS. I take that attestation seriously. When you sign your tax return you are making the same attestation I am. You can’t just file a return because that is what your books read or what a tax document or statement says. Statements can be wrong; books can be wrong.

Adjust obvious errors where allowed to reflect a more accurate return. Keep a record of the changes and the method used to reach the final numbers. I recommend attaching a statement to the return as well.

From now on you can sleep better knowing a lost receipt isn’t the end of the world. Make a note of it and take the deduction. The IRS (and the Tax Court) have your back on this one.

The Sweet Spot of Non-Cash Deductions

There is an old Looney Tunes cartoon where Daffy Duck is portraying Sherlock Holmes. Daffy is seated at a desk stacked with papers vigorously working the calculator. Porky Pig, portraying Watson, walks in and asks, “Whatever are you doing, Holmes.” “Deducting, my dear Watson. Deducting,” came the frantic reply.

Deductions come in a variety of flavors. We are all familiar with deductions matched with an expense. Donations to charity are deductible on Schedule A. Business owners deduct marketing expenses dollar for dollar.

There is another elusive deduction taxpayers only dream about: the non-cash deduction. The appeal of the non-cash deduction is the large write-off without a matching real world expense. Capitalizing on non-cash deductions can supercharge your retirement or debt reduction plans. The list of non-cash deductions is long. We will explore several ways you can reduce your taxes without spending a penny or taking a deduction significantly higher than the actual expense and stay out of jail in the process.

It’s All Legal

Accountants mentioning non-cash deductions frequently mean things like depreciation. We are not. Depreciation is a non-cash deduction, but it required the full cash investment at some time in the past to achieve the deduction. What we mean here by non-cash deductions are those expenses claimed on a tax return where the deduction allowed is greater than the cash outlay.

The weak of heart sometimes get nervous about these deductions, worried they might not be legal. I assure you they are. The IRS has even codified many of these strategies.

Most non-cash deductions affect business owners and folks with a side gig. Individuals sometimes think they are getting a special deduction when they have non-cash charitable deductions, but once again, there is a greater cash outlay at some time in the past to get the deduction. The exception is donations of highly appreciated assets. Individuals get special tax treatment when they donate artwork, property, stocks, et cetera, to a qualified nonprofit organization. If the asset has increased in value, the non-cash donation fits our description of non-cash deduction for this post. Therefore, your friendly accountant likes it.

Taking Care of Business

Business owners and those with a side gig have ample opportunity to deduct things they never spent money on. A required receipt is not the deciding factor. For example: A receipt is not needed for a meal expense if the expense is under $75. You still need a record of the expense and that makes it deductible, but an actual receipt is unnecessary. That said, you still only deduct the actual cost of the meal unless you are cheating. And there is no reason to be here if you are cheating. We only use legal methods around these parts to lower our tax liability.

Miles: Talking about receipts, mileage is a non-cash deduction worth more than the actual expense unless you are driving a big-ass, gas-guzzling SUV. The 2017 mileage rates for deductions are as follows:

53.5 cents per mile for business miles driven;

17 cents for medical or moving miles; and,

14 cents a mile driven for nonprofit organizations.

A few qualifiers are required. Business miles are straight forward. If you drive for business (or for your employer) you can deduct 53.5 cents per mile. Sole proprietors deduct on Schedule C, landlords on Schedule E and farmers on Schedule F. Employees claim non-reimbursed business miles for an employer on Form 2106 which flows to Schedule A. There are additional limitations on the deduction for individuals.

Business miles can be paid to the employee by the employer even if it is your own company. The employer takes the deduction and the employee does NOT claim the reimbursement.

Medical miles are claimed on Schedule A, but are also allowed for Health Savings Accounts. Schedule A has serious medical deduction limitations. But your employers Health Reimbursement Arrangement might allow the expense, putting additional tax-free cash in your pocket. Medical travel is an allowed distribution from Health Savings Accounts.

Moving miles only apply to those claimed on Form 3903. This means the move must be work related and of a greater distance. A move down the street does not count; a move across country probably does if it is for a new job.

The mileage rate for nonprofit driven miles is smaller, but does add up if you enjoy helping out. Miles driven to church do NOT count, even if you are a Sunday School teacher or an usher. Similar, miles to council meetings are not deductible. What miles ARE deductible? If you drive to church to do maintenance work or repairs. Miles driven to a work site for Habitat for Humanity. Miles driven to a national conference for your church would also count. Only the routine miles probably driven anyway do not count.

Office in the Home: The office in the home for your business, side gig, or even your employer can turn into a nice non-cash deduction. The home office must be regular and exclusive for the business/side gig. That means a spare bedroom used as the office and for nothing else counts; a corner of the living room does not. The home office for an employer must be for the convenience of the employer in addition to the regular and exclusive rule.

I consider the home office a non-cash deduction because you get to deduct something you were spending on anyway. And there is a way for certain taxpayers to get a real non-cash deduction above actual expense too!

For easy figuring we will assume a 1,000 square foot home with a 100 square foot qualified office. In this scenario 10% of the home is office. You use Form 8829 to claim home office expenses. Ten percent of mortgage interest, property taxes, utilities, homeowners insurance, et cetera count toward the home office expense. Additional deductions are allowed for expensed directly related to the home office. Office furniture and office remodeling are fully included in the amount allowed for the home office expense.

A few years ago the IRS offered a simple way to claim the home office by providing a safe harbor or $5 per square foot up to 300 square feet, a $1,500 maximum home office deduction. Your personal circumstances will determine if the safe harbor is a better deal than actual expenses.

The home office is complicated. Daycares, for example have significant additional rules. A short blog post only provides the concept. I have added links where I feel additional reading is required. The links allow this post to remain modest in size while retaining flow. You can research deeper into subjects affecting you.

Meals & Incidental Expenses: Meals and incidental expenses are deductions for businesses and for employees in limited circumstances.

Normally you claim the actual meal expense. But when you are traveling the rules change and for the better in most cases. Rather than keep loads of receipts while traveling, you can use a per diem instead. The per diem is allowed if your travel includes an overnight stay.

There are two methods available when using the per diem instead of actual expenses: High-Low and CONUS/OCONUS rates. The high-low method is easiest. Except for a few high costs areas of the U.S., the meal per diem is $52 with an additional $5 added for incidentals, for a $57 per diem.

If you love keeping perfect records you can use the CONUS (continental U.S.) table for U.S. travel and the OCONUS (outside continental U.S.) rates set by the Department of Defense based on each city traveled to. You can use only one method on your tax return. No cherry picking between methods. You can change the method from a prior year if desired. I included several links so you fully understand this non-cash deduction, including calculators for finding your per diem rate.

This is not a full non-cash deduction, but for people reading blogs like The Wealthy Accountant it is a way to receive a larger deduction than the actual expense. Frugality pays when the IRS has a per diem.

Renting Your Home to Your Business: There was a time I thought I was the only guy doing this. Then reality set in. I was in a continuing education class a few years back when the presenter talked about this. Now I will share it with you.

There is a little section of the Internal Revenue Code which says you don’t claim rental income if you rented the property less than 15 days in the year and you used the property personally at least 15 days per year (IRC Sec. 280A(g).) There is a planning tip in there.

A vacation home can be a powerful tax-free cash generator in these instances. I’ll let you research that subject with the links. What we are talking about today is non-cash deductions and I have a whopper for you.

Business owners frequently have a summer picnic for clients or employees, Christmas parties, et cetera. You can always have the event at the workplace, but it still feels like going to work when it should be a time to unwind from work. You can also rent a banquet hall. Or, better still, have the event at your home!

As an example, assume you decide to have the Christmas party this year at your home rather than at a local hotel or banquet hall. You can do a quick search of rates around town of what it would cost if you did use the outside venue. Now you decide to have the event at your home. Here is what happens:

The cost of the event is still a business expense. Let’s say a reasonable fee for such an event is $1,500 in your area. Your business writes you a check for $1,500 and takes the deduction along with the cost of the food and any other related expense. YOU DO NOT CLAIM THE $1,500 AS INCOME! Since you rented your home less than 15 days during the year you do not claim the rent income, but the business does deduct the expense.

Before you salivate too much, let me remind you reasonable rent is required. You can’t say rent for one day is $20,000 unless you have a mansion and a large enough company to justify such a rent rate. In my business I make a few calls to get an idea of rates around town and use that as my guide. I keep a record in case the IRS comes a knockin’. I want to keep my tax-free income and deduction!

As we finish up I want to make one more point. When I write tax posts I usually get plenty of email telling me I am wrong. I know I am wrong! I can’t possibly include all possibilities so I provide concepts here with plenty of links for deeper research. It also keeps tax posts moving forward at a reasonable clip. (Of course, you are more than welcome to expand on these topics in the comments section below.)

There are plenty a juicy non-cash deductions out there. The ones I included here should give a majority of readers at least one way to line their pocket at IRS expense. Use this as a starting point. Don’t stretch the rules; it isn’t necessary. Follow the rules and you will enjoy the fruits of non-cash tax deduction loopholes.

Here are a few books worth investing in: 1001 Tax Breaks, 475 Tax Deductions, and Landlord Deduction Guide.