Fun Asia Show Recording-November 14, 2013

Business Expenses Paid With Personal Funds – How to Avoid Tax Problems

 

Tax Issue

In an ideal situation, a business entity pays for all of its business expenses from its own funds, and business expenses are kept separate from personal expenses. However, sometimes employees, corporate shareholders, LLC members, partners, and sole proprietors pay for business expenses with personal funds as a matter of necessity or of convenience. Business expenses paid with personal funds might include vehicle expenses, overnight travel, business meals, and any expense that is an ordinary and necessary expense of a business entity, and, which for some reason, was paid by an individual taxpayer. Sometimes the business entity reimburses the individual, sometimes the individual could seek reimbursement but fails to do so, and sometimes there is no provision for reimbursement. Unreimbursed business expenses may or may not be deductible by the individual taxpayer, depending on the circumstances. The mixing of personal and business expenses or payments could also expose the business entity to loss of liability protection.

Applicable Tax Law

  • Employees are allowed a deduction on Schedule A, subject to the 2% AGI limitation, for reimbursement employee business expenses, the expenses must be ordinary and necessary and paid in connection with the taxpayer’s employment. If the employee could have been reimbursed for an expense, but did not seek reimbursement, no deduction is allowed.
  • For tax purposes, a corporation is treated as a separate entity from its shareholders, and a corporation’s trade or business is not attributed to its shareholders or employees. Thus, voluntary payments of a corporation’s expenses by officers, shareholders, or employees are generally not deductible on the taxpayer’s individual return, even if the expenses were incurred in furtherance of the corporation’s business. Such payments by shareholders are either contributions to capital or loans to the corporation and are deductible only on the corporate return, if at all. (T.C. Summary Opinion 2004-149)
  • For tax purposes, a partnership is treated as a separate entity from its partners. Thus, voluntary payments of a partnership’s expenses are generally not deductible on the taxpayer’s individual return, even if the expenses were incurred in furtherance of the partnership’s business. Such payments by partners are increases to partnership basis or loans to the partnership and are deductible only on the partnership return, if at all.

 

Tax Planning Strategies

Tax planning strategies for dealing with business expenses paid with personal funds can be separated into three general groups: use of accountable plans, strategies that allow the taxpayer to claim a deduction on his or her personal return, and strategies when a deduction on the personal return is not allowed or desired.

Strategy Group #1. Use of an accountable plan.

  • Employees, shareholders, and partners should seek reimbursement for business expenses whenever possible, either through an accountable plan or some other reimbursement system. Reimbursements through a properly administered accountable plan do not result in income to the employee, shareholder, or partner.
  • In an employee, shareholder, or partner could have sought reimbursement for a business expense, but for some reason did not, no deduction is allowed to the employee, shareholder, or partner, nor is a deduction for the expense allowed for the corporation or partnership.
  • When a corporation or partnership reimburses an employee, shareholder, or partner for ordinary and necessary business expenses paid by the individual, the corporation or partnership may deduct the reimbursed amount from gross income.

Strategy Group #2. Claiming deductions on the personal return instead of the corporate or partnership return.

  • Employee reimbursements that are paid in the form of a nonaccountable allowance are generally added to W-2 income as wages. The individual reports employee business expenses as miscellaneous expenses on Schedule A (or on Form 2106, which is carried to Schedule A), reduced by any reimbursement that has not been included in W-2 income and subject to the 2% AGI limitation. When only partial or no reimbursement is available, or when an allowance system is used, complete and accurate records will help the employee to maximize the tax benefits of employee business expenses.
  • When the business expense paid by a corporate officer or a partner in behalf of the corporation or partnership is actually a charitable contribution, the individual taxpayer deducts the payment on Schedule A with other charitable contributions. If the amount is more than $250, the individual obtains a proper acknowledgement in order to support the deduction.
  • When a corporate officer is also an employee, the corporation (including an LLC taxed as a corporation) can implement a resolution or policy requiring the corporate officer as an employee to assume certain expenses of the corporation. This converts the corporation’s expenses to the officer’s employee business expenses. Such expenses are deductible by the individual taxpayer on Schedule A and subject to the 2% AGI limitation.
  • Corporate officers or shareholders who are not also employees are not eligible to claim employee business expenses with respect to the corporation. Certain corporate expenses paid by nonemployee shareholders might qualify to be treated as investments expenses, deductible as miscellaneous expense on Schedule A and subject to the 2% AGI limitation. The shareholder must be able to show that the expenses were incurred in order to protect his or her investment in the corporation, restore stock value, protect some other business interest, etc.
  • Taxpayers who are partners can receive significantly more favorable tax treatment of unreimbursed business expenses, compared to employees and shareholders.  Partners are deemed to be engaged in the trade or business conducted by the partnership and unreimbursed expenses associated with earning partnership income can be treated as trade or business expenses of the partner. In order to take advantage of the differences between partners and employees, the following procedures can be used.

­   A partnership (including an LLC taxed as a partnership) could include a provision in the partnership agreement requiring partners to pay certain business expenses of the partnership. The payment of partnership expenses may also be a routine partnership practice tantamount to a written agreement. The agreement should specify in detail which expenses are to be paid out of the partner’s personal funds.

­   Unreimbursed partnership expenses (UPE) are reported along with partnership income and Section 179 deductions on line 28, Part II, Schedule E, of the individual partner’s tax return, with “UPE” or “Unreimbursed Partnership Expenses” as the line item description. Each item being reported should be listed on a separate line 28.

­   UPE from passive activities is listed in column (f), line 28, unless Form 8582 is required. In that case report UPE from passive activities is treated like a passive loss and may be suspended.

­   UPE from nonpassive activities is listed in column (h), line 28, and directly reduces the partner’s gross income. Unlike reimbursed business expenses deducted by employees, there in no 2% AGI limitation for UPE deducted by partners.

­   General partners are viewed as self-employed. A general partner’s UPE from nonpassive activities reduces not only gross income, but also reduces net income subject to self-employment tax.

Strategy Group #3. Tax deduction on personal return not allowed or not desired.

  • Taxpayers who do not itemize on their personal returns get no benefit from deductions for unreimbursed employee business expenses, charitable contributions made in behalf of an employer, or unreimbursed business expenses being treated as investment expenses. These taxpayers should make use of accountable plans to provide for reimbursement of employee business expenses.
  • Shareholders who are not entitled to deduct corporate business expenses paid with personal funds (for example, the shareholder is not an employee or there is no corporate policy requiring shareholder-employees to assume certain expenses) and who are not entitled to reimbursement have two additional options. In both cases, the corporation deducts the business expenses.
  1. Shareholder payments of ordinary and necessary corporate business expenses may be treated as a capital contribution, increasing the shareholder’s stock basis.
  2. The payment may be treated as a loan to the corporation if proper procedures are followed. Direct shareholder loans to the corporation increase the shareholder’s loan basis. Proper procedures include the following.

­   Both the shareholder and the corporation intended the payment to be treated as a loan, and the corporation is obligated to repay the shareholder.

­   A written debt instrument should be issued, and interest on the outstanding loan amount should be paid at the appropriate rate to the shareholder at least annually.

­   Form 1099-INT should be issued by the corporation to the shareholder, if required.

  • Partners who are not entitled to deduct partnership business expenses paid with personal funds (for example, there is no policy or agreement regarding UPE) and who are not entitled to reimbursement also have two additional options. In both cases, the partnership deducts the business expenses.
  1. Partner payments of ordinary and necessary partnership expenses may be treated as a capital contribution, increasing the partner’s basis in the partnership.
  2. The payment may be treated as a loan to the partnership if proper procedures are followed. A loan from a partner to the partnership is generally treated as a recourse loan, increasing both the partner’s basis in the partnership and the partner’s at-risk basis.

­   Both the partner and the partnership intended the payment to be treated as a loan and the partnership is obligated to repay the partner.

­   A written debt instrument should be issued and interest on the outstanding loan amount should be paid at the appropriate rate to the partner at least annually.

­   Form 1099-INT should be issued by the partnership to the partner, if required.

 

Examples

Example #1: Margaret was a nonemployee shareholder in a corporation. She determined that Roger, the president of the corporation, had transferred money and other assets out of the corporation and had otherwise defrauded the other shareholders, causing corporate stock value to decline. Margaret incurred substantial legal fees in forcing the president to return the assets and funds to the corporation. The legal action did not add value to what had previously existed, but reinstated value that had been lost. As a result, the value of the stock was restored, and Margaret and other stockholders were able to sell their stock at a satisfactory price. Margaret was not an employee of the corporation so she cannot consider treating her legal fees an employee business expense. However, the legal fees were incurred for the management, conservation, or maintenance of property and thus are deductible on Margaret’s Schedule A as investment expenses, subject to the 2% AGI limitation.

 

Possible Risks

  • Taxpayers often try to claim an employee business expense deduction for amounts that could have been reimbursed. No deduction is allowed in this case.
  • Despite the best and most thorough recordkeeping, the value of the employee business expense deduction is diluted by the Schedule A 2% AGI limitation, phase-outs, and AMT.
  • When a nonemployee shareholder claims an investment expense deduction for an amount paid in behalf of the corporation, the IRS could determine that the payment was really a contribution to capital, a loan to the corporation, or a nondeductible personal expense.
  • A partnership may rely on verbal agreements and routine practice among the partners regarding which partnership expenses are to be reimbursed. While a written agreement is not specifically required, the IRS may disallow the deduction of unreimbursed partnership expenses that arise from verbal agreements, understandings, or routine practice. It is best to have a written policy that specifies which ordinary and necessary partnership expenses will not be reimbursed by the partnership even though paid by the partners. The IRS generally will not allow retroactive agreements for unreimbursed expenses. The same holds true for corporations.
  • Reimbursement plans might be implemented without the consent of all, or a sufficient number of, the partners or shareholders. The partnership agreement or articles of incorporation should specify whether or not unanimous consent is required for partnership or corporate policies.
  • Partners who claim deductions for UPE are subject to the same recordkeeping standards as anyone who claims deductions. If a proper mileage log is not kept, for example, vehicle expenses could be disallowed.
  • Partnership agreements and articles of incorporation that don’t specify what is to be reimbursed or not reimbursed open the door to disputes between partners and shareholders.
  • Shareholder loans to corporations that are not properly structured may cause interest payments by the corporation to be recharacterized as return of capital, eliminating the corporation’s interest deduction. Care should be taken to properly structure shareholder loans to a corporation. The same holds true for partner loans to partnerships.
  • Related party rules may create unintended reallocations of partnership debt when a partner who owns more than 50% of the capital interests or profits interests makes a loan to the partnership.
  • A shareholder or partner may pay for the corporation or partnership’s business expenses with borrowed money. Interest on that borrowed money would be deductible only as investment interest, if at all. If the taxpayer does not itemize or has little or no investment income, any deduction for the interest would be lost.
  • A corporation or partnership may have a loan fro a shareholder or partner on the books. If the loan is unsecured, and the business entity goes bankrupt, repayment will not occur. The shareholder or partner may be able to claim a bad debt deduction in some cases, but only if it can be established that an actual and properly documented debt existed.

 

Court Cases

Court Case: a taxpayer was a minority shareholder and uncompensated director in a corporation. He rented an airplane at his own expense in order to attend meetings of the corporation’s board of directors. Since he also received no compensation as a director, he could not claim an employee business expense for the airplane rentals. Instead, he deducted his airplane rental expenses as ordinary and necessary expenses incurred for the conservation of income, i.e., as investment expenses. The IRS initially claimed that when attending these meetings, the taxpayer was conducting corporate business, not personal business.  Any unreimbursed expenses had to be viewed as incurred in behalf of the corporation. The IRS disallowed his deductions for two tax years and said that the airplane rental expenses had to be treated as contributions to capital. In Tax Court, the taxpayer was able to show that his attendance at the meetings was part on a concentrated effort to maintain the value of his investment in the corporation.  The board of directors meeting included viewing reports, budgets, and financial statements and other routine administrative matters. But the main issue of the meetings was an ongoing dispute between the minority shareholders and the majority shareholder on how the company should be run. Through his attendance at the meetings, the taxpayer attempted to influence the dispute, and eventually prevented the majority shareholder and other board members form taking actions that would have decreased the value of his stock. As a result, he realized a significant profit when the company was sold. The Tax Court agreed that the taxpayer’s airplane rental expenses were incurred primarily to protect his investments. He was allowed to claim the investment expense deduction for the airplane rental costs for the tax years in question. (Stranahan, T.C. Memo 1982-151)