us internal revenue service: p535--1997

8/14/2019 US Internal Revenue Service: p535--1997

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Contents1. Deducting Business Expenses .. 3

2. Employees' Pay ........................... 6

3. Meals and Lodging Furnished toEmployees ................................... 9

4. Fringe Benefits ............................ 11

5. Employee Benefit Programs ...... 19

6. Retirement Plans ......................... 27

7. Rent Expense .............................. 31

8. Interest ......................................... 33

9. Taxes ............................................ 39

10. Insurance ..................................... 40

11. Costs You Can Deduct orCapitalize ...................................... 43

12. Amortization ................................ 47

13. Depletion ...................................... 53

14. Business Bad Debts ................... 5815. Electric and Clean-Fuel Vehicles 60

16. Other Expenses ........................... 63

17. How To Get More Information ... 69

Index .................................................... 70

IntroductionThis publication discusses common businessexpenses and explains what is and is notdeductible. The general rules for deductingbusiness expenses are discussed in theopening chapter. The chapters that follow

cover specific expenses and list other publi-cations and forms you may need.

Help from the Problem Resolution Pro-gram. The Problem Resolution Program(administered by the Taxpayer Advocate) canoften help you with unresolved tax problems.It may be able to offer you special help if youhave a significant hardship as a result of a taxproblem. For more information, write to theTaxpayer Advocate at the district office orservice center where you have the problem,or call 18008291040 (18008294059for TTY/TDD users).

Important Changesfor 1997The following items highlight some changesin the tax law for 1997.

Standard mileage rate. The standard mile-age rate for the cost of operating your car,van, pickup, or panel truck in 1997 is 31.5cents per mile for all business miles.

Nondiscrimination rules. Nondiscriminationrules apply to the exclusion of certain fringebenefits from the income of highly compen-sated employees. For tax years beginningafter 1996, the definition of highly compen-

Departmentof theTreasury

InternalRevenueService

Publica tion 535Cat. No. 15065Z

BusinessExpenses

For use in preparing

1997 Returns

Get f orms and other informat ion faster and easier by:COMPUTER

World Wide Web www.irs.ustreas.gov FTP ftp.irs.ustreas.gov IRIS at FedWorld (703) 321-8020

FAX From your FAX machine, dial (703) 368-9694See How To Get More Information in this publication.


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sated employee has changed. For more in-formation, see Nondiscrimination rulesunderExclusion of Certain Fringe Benefits in chap-ter 4.

Adoption assistance. For tax years begin-ning after 1996, up to $5,000 ($6,000 for aspecial needs child) you pay or incur underan adoption assistance program for an em-ployee's qualified adoption expenses is ex-cluded from the employee's gross income.For more information, see Adoption Assist-ancein chapter 5.

Educational assistance. Each year, youcan exclude from an employee's wages up to$5,250 you pay or incur under an educationalassistance program. This exclusion, whichexpired for tax years beginning after May 31,1997, has been extended retroactively. It willnow expire for expenses paid with respect tocourses beginning after May 31, 2000. Formore information, see Educational Assistancein chapter 5.

Group health plan requirements. Generallyeffective for plan years beginning after June30, 1997, you (or the plan, if a multi-employerplan) may be subject to an excise tax if yourgroup health plan does not meet the new ac-

cessibility, portability, and renewability re-quirements. For more information, see OtherRequirements under Group Health Plans inchapter 5.

Medical savings accounts. For tax yearsbeginning after 1996, a new program for atax-exempt medical savings account (MSA)is available (for up to 4 years) to self-employed persons and employees of a smallbusiness. You can contribute (within limits) toan MSA for each employee you cover undera high deductible health plan. You can ex-clude from an employee's income amountsyou contribute to his or her MSA. For moreinformation, see Medical Savings Accountsunder Group Health Plansin chapter 5.

SIMPLE retirement plan. Beginning in 1997,you may be able to set up a savings incentivematch plan for employees (SIMPLE). You canset up a SIMPLE plan if you have 100 orfewer employees and meet other require-ments. For more information, see SIMPLERetirement Plansin chapter 6.

Repeal of salary reduction arrangementunder a SEP (SARSEP). Beginning in Jan-uary 1997, an employer is no longer allowedto establish a SARSEP. However, partic-ipants (including new participants hired after1996) in a SARSEP that was established be-fore 1997 can continue to elect to have theiremployer contribute part of their pay to theplan. For more information, see Salary Re-duction Arrangement under Simplified Em-ployee Pension (SEP) in chapter 6.

Minimum required distribution rule modi-fied. Beginning in 1997, the definition of therequired beginning date that is used to figurethe minimum required distribution from qual-ified retirement plans takes into accountwhether a plan participant has retired. Thisdoes not apply to a 5% owner, who must stillbegin to receive distributions on April 1 of theyear following the calendar year in which heor she reaches age 701/2. Also, the new lawdoes not apply to IRAs. For more information,see Required Distributions under KeoghPlansin Publication 560.

Interest on loans with respect to life in-surance policies. For tax years ending afterMay 31, 1997, you generally cannot deductinterest paid or accrued with respect to anylife insurance, annuity or endowment contractthat was issued or deemed issued after June8, 1997, and covers any individual, unlessthat individual is a key person. For partner-ships, corporations, and S corporations, thereare new proration rules that apply. For moreinformation, see Interest on loans with respectto life insurance policiesin chapter 8.

Self-employed health insurance de-duction. Beginning in 1997, the deductionfor health insurance of self-employed individ-uals increases from 30% to 40% of theamount paid for the insurance. The percent-age will further increase to 45% for tax years1998 and 1999. After 1999, the deduction in-creases even further. For more information,see Self-Employed Health Insurance De-ductionin chapter 10.

Long-term care insurance. A qualifiedlong-term care insurance contract issued after1996 will generally be treated as an accidentand health insurance contract. For more in-formation, see Long-term care insurance

deductionin chapter 10.

Life insurance and annuities. For contractsissued after June 8, 1997, you generallycannot deduct premiums on any life insurancepolicy, endowment contract, or annuity con-tract, if you are directly or indirectly a benefi-ciary. For contracts issued prior to June 9,1997, the deduction is denied only when youare directly or indirectly a beneficiary, and thelife insurance policy covers an officer, em-ployee, or other person financially interestedin your trade or business. For more informa-tion, see Nondeductible Premiumsin chapter10.

Important Changes for1998The following items highlight some changesin the tax law for 1998.

Deduction for meals furnished to employ-ees. For tax years beginning after 1997, yourannual revenue from meals you furnish toemployees both on your business premisesand for your convenience is considered toequal your direct operating costs of providingthese meals. A meal is considered providedfor your convenience if you provide it for asubstantial noncompensatory business rea-son. This legislative change may allow your

eating facility for employees to qualify as ade minimis fringe benefit. As a de minimisfringe benefit, your deduction for meals pro-vided in the facility is not limited to 50% of thecost of furnishing the meals. For more infor-mation, see chapters 3 and 4.

Qualified parking in place of pay. For taxyears beginning after 1997, you can excludequalified parking from an employee's wageseven if you provide it in place of pay. Youcannot exclude from an employee's wagesany other qualified transportation fringe ben-efit that you provide in place of pay. For moreinformation, see Qualified TransportationFringein chapter 4.

New group health plan requirements. Forplan years beginning on or after January 1,1998, you (or the plan, if a multi-employerplan) may be subject to an excise tax if yourplan does not meet certain new requirements.These requirements generally:

Obligate plans to pay for a minimumhospital stay following birth for mothersand newborns if the plan otherwise pro-vides maternity benefits, and

Prevent certain special limits from being

placed on mental health benefits.

For more information, see Other Require-mentsunder Group Health Plans in chapter5.

Temporary suspension of taxable incomelimit for certain percentage depletion. Fortax years beginning after 1997, percentagedepletion deductions on the marginal pro-duction of oil or natural gas will no longer belimited to the taxable income from the prop-erty figured without the depletion deduction.For more information, see Suspension oftaxable income limit for marginal productionin chapter 13.

Meal expense deduction increases forcertain individuals. Beginning in 1998, if anemployee is subject to the Department ofTransportation's hours of service limits, youmay be able to deduct 55% of the meal andbeverage expenses you reimburse for theirtravel away from their tax home. For moreinformation, get Publication 553, Highlightsof 1997 Tax Changes.

Important Change for1999

Business use of your home. One situationin which you currently can deduct home officeexpenses is if you use part of your home ex-clusively and regularly as your principal placeof business. Beginning in 1999, the definitionof principal place of business is expanded.Your home office generally will qualify as aprincipal place of business if:

1) You use it exclusively and regularly forthe administrative or management activ-ities of your trade or business, and

2) You have no other fixed location whereyou conduct substantial administrativeor management activities of your tradeor business.

For more information about this, get Pub-lication 553, Highlights of 1997 Tax Changes.For the current definition, get Publication 587,Business Use of Your Home (Including Useby Day-Care Providers).

Important Reminders

Business use of your home. For tax yearsbeginning after 1995, you may be able todeduct expenses for the part of your homeyou use to store product samples. For moreinformation, see chapter 1.

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Basis reduction for qualified electric vehi-cle. If you elect to claim a tax credit for aqualified electric vehicle you place in serviceduring the year, you must reduce your basisin that vehicle. For vehicles placed in serviceafter August 19, 1996, you must reduce yourbasis in that vehicle by the lesser of $4,000or 10% of the cost of the vehicle, even if thecredit allowed is less than that amount. Formore information on the electric vehicle credit,see chapter 15.

1.

DeductingBusinessExpenses

IntroductionThis chapter covers the general rules for de-ducting business expenses. Business ex-penses are the costs of carrying on a tradeor business. These expenses are usuallydeductible if the business is operated to makea profit.

TopicsThis chapter discusses:

What can be deducted

How much can be deducted

When to deduct

Not-for-profit activities

Useful ItemsYou may want to see:

Publication

334 Tax Guide for Small Business

463 Travel, Entertainment, Gift andCar Expenses

529 Miscellaneous Deductions

536 Net Operating Losses

538 Accounting Periods and Methods

547 Casualties, Disasters, and Thefts(Business and Nonbusiness)

551 Basis of Assets 587 Business Use of Your Home (In-

cluding Use by Day-Care Provid-ers)

925 Passive Activity and At-Risk Rules

936 Home Mortgage Interest De-duction

946 How To Depreciate Property

Form (and Instructions)

Sch A (Form 1040) Itemized Deductions

5213 Election To Postpone Determi-nation as To Whether the

Presumption Applies That an Ac-tivity Is Engaged in for Profit

See chapter 17 for information about get-ting these forms and publications.

What CanBe Deducted?To be deductible, a business expense mustbe both ordinary and necessary. An ordinaryexpense is one that is common and acceptedin your trade or business. A necessary ex-pense is one that is helpful and appropriatefor your trade or business. An expense doesnot have to be indispensable to be considerednecessary.

It is important to separate business ex-penses from:

1) The expenses used to figure the cost ofgoods sold,

2) Capital expenses, and

3) Personal expenses.

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If you have an expense that is partlyfor business and partly personal,

separate the personal part from thebusiness part.

Cost of Goods SoldIf your business manufactures products orpurchases them for resale, some of your ex-penses are for the products you sell. You usethese expenses to figure the cost of the goodsyou sold during the year. You deduct thesecosts from your gross receipts to figure yourgross profit for the year. You must maintaininventories to be able to determine your costof goods sold. If you use an expense to figurecost of goods sold, you cannot deduct it againas a business expense.

Among the expenses that go into figuringcost of goods sold are the following:

1) The cost of products or raw materials inyour inventory, including the cost ofhaving them shipped to you,

2) The cost of storing the products you sell,

3) Direct labor costs (including contribu-tions to pension or annuity plans) forworkers who produce the products,

4) Depreciation on machinery used toproduce the products, and

5) Factory overhead expenses.

Under the uniform capitalization rules, youmay have to include certain indirect costs ofproduction and resale in your cost of goods

sold. Indirect costs include rent, interest,taxes, storage, purchasing, processing, re-packaging, handling, and administrativecosts. This rule on indirect costs does notapply to personal property you acquire forresale if your average annual gross receipts(or those of your predecessor) for the pre-ceding 3 tax years are not more than $10million.

For more information, see the following.

Cost of goods soldchapter 6 of Publi-cation 334.

InventoriesPublication 538

Uniform capitalization rulessection1.263A or the Income Tax Regulations

Capital ExpensesYou must capitalize, rather than deduct, somecosts. These costs are a part of your invest-ment in your business and are called capitalexpenses. There are, in general, three typesof costs you capitalize:

1) Going into business,

2) Business assets, and

3) Improvements.

Recovery. Although you generally cannotdirectly deduct a capital expense, you maybe able to take deductions for the amount youspend through a method of depreciation,amortization, or depletion. These methodsallow you to deduct part of your cost eachyear over a number of years. In this way youare able to recover your capital expense.See Amortization(chapter 12) and Depletion(chapter 13) in this publication. For informa-tion on depreciation, see Publication 946.

Going Into BusinessThe costs of getting started in business, be-fore you actually begin business operations,are capital expenses. This may include ex-

penses for advertising, travel, utilities, repairs,or employees' wages.

If you go into business. When you go intobusiness, treat all costs you had to get itstarted as capital expenses.

Usually you recover costs for a particularasset through depreciation. Other start-upcosts can be recovered through amortization.If you do not choose to amortize these costs,you generally cannot recover them until yousell or otherwise go out of business.

See Going Into Businessin chapter 12 formore information on business start-up costs.

If you do not go into business. If your at-tempt to go into business is not successful,

the expenses you had in trying to establishyourself in business fall into two categories.

1) The costs you had before making a de-cision to acquire or begin a specificbusiness. These costs are personal andnondeductible. They include any costsincurred during a general search for, orpreliminary investigation of, a businessor investment possibility.

2) The costs you had in your attempt toacquire or begin a specific business.These costs are capital expenses andyou can deduct them as a capital loss.

The costs of any assets acquired duringyour unsuccessful attempt to go into business

are a part of your basis in the assets. Youcannot take a deduction for these costs. Youwill recover the costs of these assets whenyou dispose of them.

Business AssetsThe cost of any asset you use in your busi-ness is a capital expense. There are manydifferent kinds of business assets, such asland, buildings, machinery, furniture, trucks,patents, and franchise rights. You must capi-talize the full cost of the asset, includingfreight and installation charges.

If you produce certain property for use inyour trade or business, capitalize the pro-duction costs under the uniform capitalization

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rules. See section 1.263A of the Income TaxRegulations for information on those rules.

ImprovementsThe costs of making improvements to abusiness asset are capital expenses, if theimprovements add to the value of the asset,appreciably lengthen the time you can use it,or adapt it to a different use. You can deductrepairs that keep your property in a normalefficient operating condition as a business

expense.Improvements includenew electric wiring,a new roof, a new floor, new plumbing,bricking up windows to strengthen a wall, andlighting improvements.

Restoration plan. Capitalize the cost of re-conditioning, improving, or altering yourproperty as part of a general restoration planto make it suitable for your business. Thisapplies even if some of the work would byitself be classified as repairs.

Replacements. You cannot deduct the costof a replacement that stops deterioration andadds to the life of your property. Capitalize

that cost and depreciate it.Treat amounts paid to replace parts of amachine that only keep it in a normal operat-ing condition like repairs. However, if yourequipment has a major overhaul, capitalizeand depreciate the expense.

Capital or Deductible ExpensesTo help you distinguish between capital anddeductible expenses, several different itemsare discussed below.

Business motor vehicles. You usually capi-talize the cost of a motor vehicle you buy touse in your business. You can recover its costthrough annual deductions for depreciation.

There are dollar limits on the depreciationyou may claim each year on passenger au-tomobiles used in your business. See Publi-cation 463.

Repairs you make to your business vehi-cle are deductible expenses. However,amounts you pay to recondition and overhaula business vehicle are capital expenses.

Roads and driveways. The costs of buildinga private road on your business property andthe cost of replacing a gravel driveway witha concrete one are capital expenses you maybe able to depreciate. The cost of maintaininga private road on your business property is adeductible expense.

Tools. Unless the uniform capitalization rulesapply, amounts spent for tools used in yourbusiness are deductible expenses if the toolshave a life expectancy of less than one year.

Machinery parts. Unless the uniform cap-italization rules apply, the cost of replacingshort-lived parts of a machine to keep it ingood working condition and not to add to itslife is a deductible expense.

Heating equipment. The cost of changingfrom one heating system to another is a cap-ital expense and not a deductible expense.

Personal ExpensesGenerally, you cannot deduct personal, livingor family expenses. However, if you have anexpense for something that is used partly forbusiness and partly for personal purposes,divide the total cost between the businessand personal parts. You can deduct as abusiness expense only the business part.

For example, if you borrow money anduse 70% of it for business and the other 30%for a family vacation, generally you can de-duct as a business expense only 70% of the

interest you pay on the loan. The remaining30% is personal interest that is not deductible.See chapter 8 for information on deductinginterest and the allocation rules.

Business use of your home. If you use yourhome in your business, you may be able toclaim part of the expenses of maintaining yourhome as a business expense. These ex-penses include mortgage interest, insurance,utilities, and repairs.

The business use of your home must meetstrict requirements before you can take anyof these expenses as business deductions.You can take a limited deduction for its busi-ness use if you use part of your home ex-clusivelyand regularly:

1) As the principal place of business for anytrade or business in which you engage.

2) As a place to meet or deal with patients,clients, or customers in the normalcourse of your trade or business, or

3) In connection with your trade or busi-ness, if you are using a separate struc-ture that is not attached to your home.

There are two exceptions to the exclusiveuse test:

1) The use of part of your home for thestorage of inventory or product samples,and

2) The use of part of your home as a day-care facility.

For more information, see Publication 587.

Business use of your car. If you use yourcar in your business, you can deduct car ex-penses. If you use your car for both businessand personal purposes, you must divide yourexpenses based on mileage. Only your ex-penses for the miles you drove it for businessare deductible as business expenses.

You can deduct actual car expenses,which include, depreciation, gas and oil, tires,repairs, tune-ups, insurance, and registrationfees. Instead of figuring the business part ofthese actual expenses, you may be able touse a standard mileage rate to figure yourdeduction. For 1997, the standard mileagerate for a car that you own is 31.5 cents foreach business mile.

If you are self-employed, you can deductthe business part of interest on your car loan,state and local personal property tax on thecar, parking fees, and tolls whether or not youclaim the standard mileage rate. You can usethe nonbusiness part of the personal propertytax to determine your deduction for taxes onSchedule A (Form 1040) if you itemize yourdeductions.

For more information on car expenses andthe standard mileage rate, see Publication463.

How MuchCan Be Deducted?You cannot deduct more for a business ex-pense than the amount you actually spend.There is usually no other limit on how muchyou can deduct if the amount is reasonable.However, if your deductions are large enoughto produce a net business loss for the year,the amount of tax loss may be limited.

Recovery of amount deducted. If you area cash method taxpayer who pays an ex-pense and then recovers part of the amountpaid in the same tax year, reduce your ex-pense deduction by the amount of the recov-ery. If you have a recovery in a later year,include the recovered amount in income.However, if part of the deduction for the ex-pense did not reduce your tax, you do nothave to include all the recovery in income.Exclude an amount equal to the part that didnot reduce your tax.

Limits on losses. If your deductions for aninvestment or business activity are more thanthe income it brings in, you have a net loss.

There may be limits on how much, if any, ofthe loss you can use to offset income fromother sources.

Not-for-profit limits. If you do not carryon your business activity with the intention ofmaking a profit, you cannot use a loss fromit to offset other income. The kinds of de-ductions you can take for a not-for-profit ac-tivity and the amounts you can deduct arelimited so that a deductible loss will not result.See Not-for-Profit Activities, later.

At-risk limits. Generally, a deductibleloss from a business or investment activity islimited to the investment you have at risk inthe activity. You are at risk in any activity for:

1) The money and adjusted basis of prop-

erty you contribute to the activity, and2) Amounts you borrow for use in the ac-

tivity if:

a) You are personally liable for repay-ment, or

b) You pledge property (other thanproperty used in the activity) as se-curity for the loan.

For more information, see Publication 925.Passive activities. Generally, you are in

a passive activity if you have a trade or busi-ness activity in which you do not materiallyparticipate during the year, or a rental activity.Deductions from passive activities generallycan only offset your income from passive ac-

tivities. You cannot deduct any excess de-ductions against your other income. In addi-tion, you can take passive activity credits onlyfrom tax on net passive income. Any excessloss or credits are carried over to later years.

For more information, see Publication 925.Net operating loss. If your deductions

are more than your income for the year, youmay have a net operating loss. You can usea net operating loss to lower your taxes inother years. See Publication 536 for more in-formation.

Payments in kind. If you provide services topay a business expense, the amount you candeduct is the amount you spend to provide

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the services. It is not what you would havepaid in cash.

Similarly, if you pay a business expensein goods or other property, you can deductonly the amount the property costs you. Ifthese costs are included in the cost of goodssold do not deduct them as a business ex-pense.

When Can anExpense BeDeducted?Under the cash method of accounting, youdeduct business expenses in the tax year youactually paid them, even if you incur them inan earlier year. Under an accrual method ofaccounting, you generally deduct businessexpenses when you become liable for them,whether or not you pay them in the sameyear. All events that set the amount of theliability must have happened, and you mustbe able to figure the amount of the expensewith reasonable accuracy.

For more information on accountingmethods, see Publication 538.

Economic performance rule. Under an ac-crual method, you generally do not deduct orcapitalize business expenses until economicperformance occurs. If your expense is forproperty or services provided to you, or foruse of property by you, economic perform-ance occurs as the property or services areprovided, or as the property is used. If yourexpense is for property or services you pro-vide to others, economic performance occursas you provide the property or service.

Example. Your tax year is the calendaryear. In December 1997, the Field PlumbingCompany did some repair work at your placeof business and sent you a bill for $150. You

paid it by check in January 1998. If you usean accrual method of accounting, deduct the$150 on your tax return for 1997 because allevents that set the amount of liability andeconomic performance occurred in that year.If you use the cash method of accounting,take the deduction on your 1998 return.

Prepayment. You cannot deduct expensesin advance, even if you pay them in advance.This rule applies to both the cash and accrualmethods. It applies to prepaid interest, pre-paid insurance premiums, and any other ex-pense paid far enough in advance to, in ef-fect, create an asset with a useful lifeextending substantially beyond the end of thecurrent tax year.

Example. In 1997, you sign a 10-yearlease and immediately pay your rent for thefirst three years. Even though you paid therent for 1997, 1998, and 1999, you can de-duct only the rent for 1997 on your current taxreturn. You can deduct on your 1998 and1999 tax returns the rent for those years.

Contested liabilities. Under the cashmethod, you deduct a disputed expense onlyin the year you pay the liability. Under an ac-crual method you can deduct contested li-abilities, such as taxes (except foreign or U.S.possession income, war profits, and excessprofits), in the tax year you pay the liability (ortransfer money or other property to satisfy the

obligation), or in the tax year you settle thecontest. However, to take the deduction in theyear of payment or transfer, you must meetcertain rules. See Contested Liability in Pub-lication 538 for more information.

Related parties. Under an accrual methodof accounting, you generally deduct expenseswhen you incur them, even if you have notpaid them. However, if you and the personyou owe are related parties and the personyou owe uses the cash method of accounting,you must pay the expense before you candeduct it. The deduction by an accrualmethod payer is allowed when the corre-sponding amount is includible in income bythe related cash method payee. See RelatedPersonsin Publication 538.

Not-for-ProfitActivitiesIf you do not carry on your business or in-vestment activity to make a profit, there is alimit on the deductions you can take. Youcannot use a loss from the activity to offsetother income. Activities you do as a hobby,

or mainly for sport or recreation, come underthis limit. So does an investment activity in-tended only to produce tax losses for the in-vestors.

The limit on not-for-profit losses applies toindividuals, partnerships, estates, trusts, andS corporations. It does not apply to corpo-rations other than S corporations.

In determining whether you are carryingon an activity for profit, all the facts are takeninto account. No one factor alone is decisive.Among the factors to be considered are:

1) Whether you carry on the activity in abusinesslike manner.

2) Whether the time and effort you put intothe activity indicate you intend to make

it profitable.3) Whether you are depending on income

from the activity for your livelihood.

4) Whether your losses are due to circum-stances beyond your control (or arenormal in the start-up phase of your typeof business).

5) Whether you change your methods ofoperation in an attempt to improve prof-itability.

6) Whether you, or your advisors, have theknowledge needed to carry on the activ-ity as a successful business.

7) Whether you were successful in makinga profit in similar activities in the past.

8) Whether the activity makes a profit insome years, and how much profit itmakes.

9) Whether you can expect to make a fu-ture profit from the appreciation of theassets used in the activity.

Limit on Deductionsand LossesIf your activity is not carried on for profit, takedeductions only in the following order, only tothe extent stated in the three categories, and,if you are an individual, only if you itemizethem on Schedule A (Form 1040).

Category 1. Deductions you can take forpersonal as well as for business activities areallowed in full. For individuals, all nonbusi-ness deductions, such as those for homemortgage interest, taxes, and casualty losses,belong in this category. Deduct them on theappropriate lines of Schedule A (Form 1040).You can only deduct a nonbusiness casualtyloss to the extent it is more than $100 andall these losses exceed 10% of your adjustedgross income. See Publication 547 for moreinformation on casualty losses.

For the limits that apply to mortgage in-terest, see Publication 936.

Category 2. Deductions that do not result inan adjustment to the basis of property areallowed next, but only to the extent your grossincome from the activity is more than the de-ductions you take (or could take) for it underthe first category. Most business deductions,such as those for advertising, insurance pre-miums, interest, utilities, wages, etc., belongin this category.

Category 3. Business deductions that de-crease the basis of property are allowed last,but only to the extent the gross income fromthe activity is more than deductions you take

(or could take) for it under the first two cate-gories. The deductions for depreciation,amortization, and the part of a casualty lossan individual could not deduct in category (1)belong in this category. Where more than oneasset is involved, divide depreciation andthese other deductions proportionally amongthose assets.

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Individuals must claim the amounts incategories (2) and (3) as miscella-neous deductions on Schedule A

(Form 1040). They are subject to the 2% ofadjusted gross income limit. See Publication529 for information on this limit.

Example. Ida is engaged in a not-for-profit activity. The income and expenses of

the activity are as follows:

Ida must limit her deductions to $3,200,the gross income she earned from the activ-ity. The limit is reached in category (3), as

follows:

The $300 for depreciation is divided be-tween the automobile and machine, as fol-lows:$600

$300 = $225 depreciation for the automobile$800

$200 $300 = $75 depreciation for the machine

$800

Gross income ..................................... $3,200

Less expenses:Real estate taxes ........................... $700Home mortgage interest ................ 900Insurance ........................................ 400Utilities ............................................ 700Maintenance ................................... 200Depreciation on an automobile ...... 600Depreciation on a machine ............ 200

Total expenses ............................... 3,700

Loss $500

Limit on deduction ........................... $3,200

Category 1, Taxes and interest ...... $1,600Category 2, Insurance, utilities, andmaintenance .................................... 1,300 2,900

Available for Category 3 . ... ... .. ... ... .. $300

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The basis of each asset is reduced ac-cordingly.

The $1,600 for category (1) is deductiblein full on the appropriate lines for taxes andinterest on Schedule A (Form 1040). Ida addsthe remaining $1,600 (the total of categories(2) and (3)) to her other miscellaneous de-ductions on Schedule A (Form 1040) that aresubject to the 2% of adjusted gross incomelimit.

Partnerships and S corporations. If apartnership or S corporation carries on anot-for-profit activity, these limits apply at thepartnership or S corporation level. They arereflected in the individual shareholder's orpartner's distributive shares.

More than one activity. If you have severalundertakings, each may be a separate activ-ity, or several undertakings may be one ac-tivity. The most significant facts and circum-stances in making this determination are:

1) The degree of organizational and eco-nomic interrelationship of various under-takings,

2) The business purpose that is (or mightbe) served by carrying on the variousundertakings separately or together in abusiness or investment setting, and

3) The similarity of various undertakings.

The IRS will generally accept your character-ization of several undertakings as one activity,or more than one activity, if supported by factsand circumstances.

TIP

If you are carrying on two or moredifferent activities, keep the de-ductions and income from each one

separate. Figure separately whether each isa not-for-profit activity. Then figure the limiton deductions and losses separately for eachactivity that is not for profit.

Presumption of ProfitAn activity is presumed carried on for profit ifit produced a profit in at least 3 of the last 5tax years including the current year. Activitiesthat consist primarily of breeding, training,showing, or racing horses are presumed car-ried on for profit if they produced a profit inat least 2 of the last 7 tax years including thecurrent year. You have a profit when thegross income from an activity is more than thedeductions for it.

If a taxpayer dies before the end of the5-year (or 7-year) period, the period ends onthe date of the taxpayer's death.

If your business or investment activitypasses this 3- (or 2-) years-of-profit test, pre-sume it is carried on for profit. This means itwill not come under these limits. You can takeall your business deductions from the activity,even for the years that you have a loss. Youcan rely on this presumption in every case,unless the IRS shows it is not valid.

Using the presumption later. If you arestarting an activity and do not have 3 years(or 2 years) showing a profit, you may wantto take advantage of this presumption later,after you have the 5 (or 7) years of experi-ence allowed by the test.

You can choose to do this by filing Form5213. Filing this form postpones any deter-mination your activity is not carried on forprofit until 5 (or 7) years have passed sinceyou started the activity.

TIP

Form 5213 generally must be filedwithin 3 years of the due date of yourreturn for the year in which you first

carried on the activity.

The benefit gained by making this choiceis that the IRS will not immediately questionwhether your activity is engaged in for profit.Accordingly, it will not restrict your de-ductions. Rather, you will gain time to earn a

profit in 3 (or 2) out of the first 5 (or 7) yearsyou carry on the activity. If you show 3 (or 2)years of profit at the end of this period, yourdeductions are not limited under these rules.If you do not have 3 years (or 2 years) ofprofit, the limit can be applied retroactively toany year in the 5-year (or 7-year) period witha loss.

Filing Form 5213 automatically extendsthe period of limitations on any year in the5-year (or 7-year) period to 2 years after thedue date of the return for the last year of theperiod. The period is extended only for de-ductions of the activity and any related de-ductions that might be affected.

2.

Employees' Pay

IntroductionThis chapter is about deducting salaries,wages, and other forms of pay you make toyour employees. It discusses:

Common types of payments,

What you can deduct for each type, How to deduct each type on your tax re-

turn,

Whether you include the payment in youremployees' income as wages, and

If the payment is subject to employmenttaxes and income tax withholding.

You also may pay your employees indi-rectly through employee benefit programs.For example, you can deduct group term lifeinsurance premiums you pay or incur on apolicy covering an employee if you are not thedirect or indirect beneficiary of the policy. Youcan deduct the cost of providing coverage of$50,000 or less for an employee as an em-

ployee benefit. You must include the cost ofproviding coverage over $50,000 in the em-ployee's income, and you can deduct it aswages. For more information about employeebenefit programs, see chapter 5.

The rules discussed in this chapter canapply to sole proprietors, partnerships, cor-porations, estates, trusts, and any other entitythat carries on a trade or business and paysan employee for services.


Deductibility of pay

Kinds of payments


Publication

15 Circular E, Employer's Tax Guide

15A Employer's Supplemental TaxGuide

521 Moving Expenses

551 Basis of Assets

946 How To Depreciate Property

Form (and Instructions)

W2 Wage and Tax Statement

3800 General Business Credit

4782 Employee Moving Expense In-formation

See chapter 17 for information about get-ting publications and forms.

Deductibility of PayYou generally can deduct salaries, wages,and other forms of pay you make to employ-ees for personal services as a business ex-pense. However, you must reduce the de-duction by any current tax year employmentcredits. For more information about thesecredits, see Form 3800 and the related em-ployment credit forms.

Commissions. Generally, you can deduct acommission you pay to a salesperson or an-other person. However, you and the serviceprovider must agree on the service to beperformed and the amount to be paid beforethat person performs the service.

Employee-stockholder. A salary paid to anemployee who is also a stockholder mustmeet the same tests for deductibility as thesalary of any other executive or employee.SeeTests for Deductibility, later.

You cannot deduct a payment to anemployee-stockholder that is not for servicesperformed. The payment may be a distribu-tion of dividends on stock. This is most likelyto occur in a corporation with few sharehold-ers, practically all of whom draw salaries. Asalary paid to an employee-stockholder thatis more than the salary ordinarily paid forsimilar services and that bears a close re-lationship to the employee's stock holdingsprobably is not paid wholly for services per-formed. This salary may include a distributionof earnings on the stock.

If the payment to an employee-stockholder of a closely held corporation isreasonable and for services performed, thepayment will not be denied as a deductionmerely because the corporation has a poorhistory of paying dividends on its outstandingstock.

If your corporation uses an accrualmethod of accounting and the salary is unpaidat the end of the tax year, see Unpaid Sala-ries, later.

Relative. You can deduct the salary orwages paid to a relative who is an employee,including your minor child, if the paymentmeets the four tests for deductibility, dis-

Page 6 Chapter 2 Employees' Pay


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cussed later. However, also see Unpaid Sal-aries, later.

Payment to beneficiary of deceased em-ployee. You can deduct a payment youmake to an employee's beneficiary becauseof the employee's death if the payment isreasonable in relation to past services per-formed by the employee. The payment alsomust meet the other tests for deductibility,discussed later.

Uniform capitalization rules. Generally,you must capitalize or include in inventory thewages and salaries you pay employees toproduce real or tangible personal property orto acquire property for resale. If the propertyis inventory, add the wages to inventory.Capitalize the costs for any other property.

Personal property you acquire for resaleis not subject to these rules if your averageannual gross receipts for the 3 preceding taxyears are $10 million or less. You can deductthese costs as a current business expense.For more information, see Publication 551.

Construction of capital asset. You cannotdeduct salaries and other wages incurred forconstructing a capital asset. You must includethem in the basis of the asset and recover

your cost through depreciation deductions.See Publication 946 for information aboutdepreciation.

Tests for DeductibilityTo be deductible, salaries or wages you payyour employees must meet all the followingtests.

Ordinary and necessary

Reasonable

For services performed

Paid or incurred

Test 1 Ordinary and necessary. You

must be able to show that the salary, wage,or other payment for services an employeeperforms for you is an ordinary and necessaryexpense. You also must be able to show thatit is directly connected with your trade orbusiness. For more information, seen WhatCan Be Deducted?in chapter 1.

That you pay your employee for a legiti-mate business purpose is not sufficient, byitself, for you to deduct the amount as abusiness expense. You can deduct a pay-ment for your employee's services only if thepayment is ordinary and necessary to carryon your trade or business.

Expenses (including salaries and otherpayments for services) incurred to completea merger, recapitalization, consolidation, orother reorganization are not expenses ofcarrying on a business; they are capital ex-penditures. You cannot deduct them as ordi-nary and necessary business expenses.However, if you later abandon your plan toreorganize, etc., you can deduct the ex-penses for the plan in the tax year youabandon it.

Test 2 Reasonable. Determine the rea-sonableness of pay by the facts. Generally,reasonable pay is the amount that like enter-prises ordinarily would pay for the servicesby like enterprises under similar circum-stances.

You must be able to prove the pay isreasonable. Base this test on the circum-

stances that exist at the time you contract forthe services, not those existing when thereasonableness is questioned. If the pay isexcessive, you can deduct only the part thatis reasonable.

Factors to consider. To determine if payis reasonable, consider the following itemsand any other pertinent facts.

The duties performed by the employee.

The volume of business handled.

The character and amount of responsi-

bility. The complexities of your business.

The amount of time required.

The general cost of living in the locality.

The ability and achievements of the indi-vidual employee performing the service.

The pay compared with the amount ofgross and net income of the business,as well as with distributions to share-holders, if the business is a corporation.

Your policy regarding pay for all of youremployees.

The history of pay for each employee.

Individual salaries. You must base thetest of whether a salary is reasonable on eachindividual's salary and the service performed,not on the total salaries paid to all officers orall employees. For example, even if the totalamount you pay to your officers is reason-able, you cannot deduct an individual officer'sentire salary if it is not reasonable based onthe items listed above.

Test 3 For services performed. Youmust be able to prove the payment was madefor services actually performed.

Test 4 Paid or incurred. You must haveactually made the payment or incurred theexpense in the tax year.

If you use the cash method of accounting,

deduct the salary or wages paid to an em-ployee in the year you pay it to theemployee.

If you use an accrual method of account-ing, deduct your expense for the salary orwage when you establish your obligation tomake the payment and when economic per-formance occurs. Economic performancegenerally occurs as an employee performsthe services for you. The economic perform-ance rule is discussed in When Can an Ex-pense Be Deducted? in chapter 1. Your pay-ment need not be made in the year theobligation exists. You can defer it to a laterdate, but special rules apply. See UnpaidSalaries, later.

Kinds of PaymentsSome of the ways you may provide pay toyour employees are discussed next.

Bonuses and AwardsYou can deduct bonuses and awards to youremployees if they meet certain conditions.

Bonuses. You can deduct a bonus paid toan employee if you intended the bonus asadditional pay for services, not as a gift, andthe services were actually performed. How-ever, to deduct the amount as wages the total

bonuses, salaries, and other pay must bereasonable for the services performed. In-clude the bonus in the employee's income.You can pay a bonus in cash, property, or acombination of both.

Gifts of nominal value. If, to promote em-ployee goodwill, you distribute turkeys, hams,or other merchandise of nominal value to youremployees at holidays, the value of theseitems is not salary or wages. You can deductthe cost of these items as a business expenseeven though the employees do not includethe items in income.

If you distribute cash, gift certificates, orsimilar items readily convertible to cash, thevalue of these items is additional wages orsalaries, regardless of the amount or value.

Employee achievement awards. You candeduct the cost of an employee achievementaward, subject to certain limits. An employeeachievement award is tangible personalpropertythat is:

Given for length of service or safetyachievement,

Awarded as part of a meaningful pres-entation, and

Awarded under conditions and circum-stances that do not create a significantlikelihood of disguised pay.

Length-of-service award. An award willnot qualify as a length-of-service award if:

The employee receives the award duringhis or her first 5 years of employment, or

The employee received a length-of-service award (other than one of verysmall value) during that year or in any ofthe prior 4 years.

Safety achievement award. An awardwill not qualify as a safety achievement awardif it is:

1) Awarded to a manager, administrator,clerical employee, or other professionalemployee, or

2) Given to more than 10% of the employ-ees during the year, excluding thoselisted in (1).

Qualified or nonqualified plan awards.You must give a qualified plan award as partof an established written plan that does notdiscriminate in favor of highly compensatedemployees as to eligibility or benefits. SeeExclusion of Certain Fringe Benefits in chap-ter 4 for the definition of a highly compen-sated employee.

An award is not a qualified plan award ifthe average cost of all the employeeachievement awards given during the tax year(that would be qualified plan awards exceptfor this limit) exceeds $400. To determine thisaverage cost, do not take into account awardsof very small value.

Limits on deductible awards. Deduct-ible nonqualified plan awards made to anyone employee cannot be more than $400during the tax year. The total deductibleawards, including both qualified and non-qualified plan awards, made to any one em-ployee cannot be more than $1,600 duringthe tax year.

If the employee achievement awards donot exceed the limits, you can exclude themfrom the employee's income and you can

Chapter 2 Employees' Pay Page 7


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deduct them on the Other deductions lineof your tax return or business schedule.

If the award costs more than the amountyou can deduct, include in the employee'sincome the largerof:

1) The part of the cost of the award youcannot deduct (up to the award's fairmarket value), or

2) The amount by which the fair marketvalue of the award is more than theamount you can deduct.

Do not include the remaining value of theaward in the employee's income.

Loans or AdvancesYou generally can deduct as wages a loanor advance you make to an employee thatyou do not expect the employee to repay if itis for personal services actually performed.The total must be reasonable when you addthe loan or advance to the employee's otherpay, and it must meet the tests for deduct-ibility, discussed earlier. However, if the em-ployee performs no services, treat the amountyou advanced to the employee as a loan,which you cannot deduct.

Below-market interest rate loans. On cer-tain loans you make to an employee orstockholder, you are treated as having re-ceived interest income and as having paidcompensation or dividends equal to that in-terest. See Below-Market Interest Rate Loansin chapter 8 for more information.

Vacation PayVacation pay is an amount you pay or will payto an employee while the employee is on va-cation. It includes an amount you pay anemployee even if the employee chooses notto take a vacation. Vacation pay does not in-clude any amount for sick pay or holiday pay.

Cash method. If you use the cash methodof accounting, deduct vacation pay as wageswhen you pay it to an employee.

Accrual method. If you use an accrualmethod of accounting, you can deduct vaca-tion pay earned by an employee as wages inthe year earned only if you pay it:

By the close of your tax year, or

If the amount is vested, within 21/2 monthsafter the end of the tax year.

Deduct vacation pay in the year paid if youpay it later than this.

Unpaid SalariesIf you have a definite, fixed, and unconditionalagreement to pay an employee a certain sal-ary for the year, but you defer paying part ofit until the next tax year, figure your deductionfor the salary using the following rules.

If you use an accrual method of ac-counting, you can deduct the entire salaryin the first year if economic performanceoccurs (the employee performed the ser-vices in that year).

If you use the cash method of accounting,you can deduct each year only theamount actually paid that year.

If you made no definite prior arrangement,no fixed obligation exists to make the laterpayments and you can deduct in the first yearonly the amount paid in that year. This rule isthe same for the cash method and for anyaccrual method of accounting.

Special rule for accrual method payer. Ifyou use an accrual method of accounting, youcannot deduct salaries, wages, and other ex-penses owed to a related taxpayer (definednext) until:

1) The tax year you make the payment, and

2) The amount is includible in the incomeof the person paid.

This rule applies even if you and that personcease to be related taxpayers before theamount is includible in that person's grossincome.

Related taxpayers. For this special rule,related taxpayers include:

1) Members of a family, but only:

a) Brothers and sisters (either whole-or half-blood).

b) Spouses.

c) Ancestors (parents, grandparents,etc.).

d) Lineal descendants (children,grandchildren, etc.).

2) An individual and a corporation in whichmore than 50% of the value of the out-standing stock is owned directly or indi-rectly by or for that individual.

Indirect ownership of stock. To decideif a person indirectly owns any of the out-standing stock of a corporation, use the fol-lowing rules.

Stock owned directly or indirectly by or fora corporation, partnership, estate, or trust

is considered owned proportionately byor for its shareholders, partners, or ben-eficiaries.

Stock owned directly or indirectly by or foran individual's family is consideredowned by the individual. See Relatedtaxpayers, earlier, for persons consideredmembers of a family.

Stock in a corporation owned by an indi-vidual (other than because of rule (2)above) is considered owned by or for theindividual's partner.

Stock considered owned by a personbecause of rule (1) is treated, for applyingrules (1), (2), or (3), as actually ownedby that person. But stock considered

owned by an individual because of rules(2) or (3) is not treated as owned by thatindividual for applying either rule (2) or (3)again to consider another the owner ofthat stock.

Example 1. Tom Green runs a retail storeas a sole proprietor. He uses the calendaryear as his tax year and an accrual methodof accounting. Tom's brother Bob works forhim, and he pays Bob $1,000 a month. Bobuses the calendar year as his tax year and thecash method of accounting. At the end of theyear, Tom accrues Bob's December salary.

Because of a temporary cash shortage,Tom pays Bob $600 in January of the nextyear and the $400 balance in April. Tom

cannot deduct the $1,000 until the year inwhich he pays it, the year Bob must includethe amount in his income.

Example 2. The Lomar Corporation usesthe calendar year as its tax year and an ac-crual method of accounting. Frank Wilson, anofficer of the corporation, also uses the cal-endar year and the cash method of account-ing. At the end of the calendar year, Frankowns 50% of the outstanding stock of thecorporation. In March of the next year, hebuys additional shares that bring his holdings

to 51%. At the end of the first year, the cor-poration accrues salary of $1,000 payable toFrank.

The Lomar Corporation pays Frank $600in January of the second year, and the bal-ance that March. The corporation can deductthe salary of $1,000 in the first year. Frankand the Lomar Corporation are not relatedtaxpayers at the end of Lomar's first tax year.

Guaranteed Annual WageIf you guarantee to pay certain employees fullpay during the year (determined by the num-ber of hours in the normal work year) underterms of a collective bargaining agreement,you can deduct the pay as wages. You must

include the payments in the employees' in-come, and they are subject to FICA andFUTA taxes and income tax withholding.

Pay forSickness and InjuryYou can deduct amounts you pay to youremployees for sickness and injury, includinglump-sum amounts, as compensation. How-ever, your deduction is limited to amounts notcompensated by insurance or other means.

Meals and LodgingYou usually can deduct the cost of furnishingmeals and lodging to your employees if the

expense is an ordinary and necessary busi-ness expense. Do not deduct the cost asemployees' pay, but as an expense of oper-ating your business. For example, if you owna restaurant or operate a cafeteria for youremployees, include in the cost of goods soldthe cost of food your employees eat. Simi-larly, if you rent or buy a house for an em-ployee, you deduct the cost of insurance,utilities, rent, and/or depreciation in each ofthose categories on your return.

You may have to include the value ofmeals or lodging in an employee's income.For meals, this depends on whether you fur-nished them on your premises for your con-venience. For lodging, it depends on whetheryou required it as a condition of employment.See chapter 3 for more information.

Payment ofEmployee ExpensesThere generally are two different ways youcan deduct the amount you pay or reimburseemployees for business expenses they incurfor you for items such as travel and enter-tainment.

1) You deduct the payment under an ac-countable planin the category of theexpense paid. For example, if you payan employee for travel expenses in-curred on your behalf, deduct this pay-ment as a travel expense on your return.

Page 8 Chapter 2 Employees' Pay


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See the instructions for the form you filefor information on which lines to use.

2) Include the payment under a nonac-countable planin the compensation youpay your employees and deduct it aswages on your return.

See Travel, Meals, and Entertainment inchapter 16 for more information about reim-bursing employees and an explanation of ac-countable and nonaccountable plans.

Education ExpensesIf you pay or reimburse education expensesfor an employee enrolled in a course not re-quired for the job or not otherwise related tothe job, deduct the payment as wages. Youmust include the payment in the employee'sincome, and it is subject to FICA and FUTAtaxes and income tax withholding. However,if the payment is part of a qualified educa-tional assistance program, these rules maynot apply. See chapter 5.

If you pay or reimburse education ex-penses for an employee enrolled in a job-related course, you can deduct the paymentas a noncompensatory business expense.

Since this expense would be deductible ifpaid by the employee, it is called a workingcondition fringe benefit. Do not include aworking condition fringe benefit in an em-ployee's income. Working condition fringebenefits are discussed in more detail inchapter 4.

Moving ExpensesDeduct as a qualified fringe benefit amountsyou pay employees or pay for them for qual-ified moving expenses. Qualified moving ex-penses are those the employee could deductif he or she paid or incurred them directly.They include only the reasonable expensesof:

Moving household goods and personaleffects from the former home to the newhome, and

Travel (including lodging) from the formerhome to the new home.

Qualified moving expenses do not includeany expenses for meals.

Deduct as wages any payment you makeas an allowance or payment for a nonqualifiedmoving expense (that is, an expense theemployee cannot deduct). You must includethe payment of nonqualified moving expensesin the employee's income. The payment iswages for income tax withholding and FICA

and FUTA taxes. Treat the payment to theemployee as payment for services. You candeduct the amount if it meets the deductibilitytests discussed earlier.

Statement to employee. You must give theemployee a statement describing the pay-ments made to the employee, or on his or herbehalf, for moving expenses. The statementmust contain sufficient information so theemployee can properly figure the allowablemoving expense deduction.

You may use Form 4782 for this purpose.You must give this information to your em-ployee by January 31 of the year following theyear in which you make the payments.

Form W2. You must also show any re-imbursement for moving expenses on theemployee's Form W2. However, report anyamount considered a qualified fringe benefitin box 13, not as wages in box 1.

More information. For more informationabout moving expenses, see Publication 521.For information about excluding fringe bene-fits, see chapter 4.

Capital AssetsIf you transfer a capital asset or an asset usedin your business to one of your employeesas payment for services, you can deduct itas wages. The amount you can deduct is itsfair market value on the date of the transferminus any amount the employee paid for theproperty. You treat the deductible amount asreceived in exchange for the asset, and youmust recognize any gain or loss realized onthe transfer. Your gain or loss is the differencebetween the fair market value of the assetand its adjusted basis on the date of transfer.

Payment in

Restricted PropertyRestricted property is property subject to acondition that significantly affects its value.

If you transfer property, including stock inyour company, as payment for services andthe property is considered substantiallyvested in the recipient, you generally have adeductible ordinary and necessary businessexpense.

Substantially vested means the propertyis not subject to a substantial risk of forfeiture.The recipient is not likely to have to give uphis or her rights in the property in the future.

The amount and the year in which you candeduct the payment will vary, depending inpart on the kind of property interest youtransfer. The amount you can deduct de-

pends on the amount included in the recipi-ent's income. You must report the amount ona timely filed Form W2 or Form 1099MISC(even if the recipient is a corporation) to takethe deduction. However, You do not have toreport if the transfer:

Is exempt from reporting because thepayment is less than the $600 reportingrequirement for Form 1099MISC, or

Meets any other reporting exception thatapplies to a recipient other than a corpo-ration.

3.

Meals andLodgingFurnished toEmployees

Important Changefor 1998

Deduction for meals. For tax years begin-ning after 1997, your annual revenue frommeals you furnish to employees both on yourbusiness premises and for your convenienceis considered to equal your direct operatingcosts of providing these meals. This change

makes it easier for these meals to qualify asa de minimis fringe benefit. As a de minimisfringe benefit, your deduction for these mealsis not limited to 50% of the costs of furnishingthem. For more information, see chapter 4and Deduction limit on meals, later.

IntroductionThis chapter discusses the deduction formeals and lodging you furnish to your em-ployees. It also describes the tests you mustmeet to exclude the value of meals andlodging from your employees' wages.

For information on the requirements that

all business expenses must meet, see chap-ter 1. If you include the value of the meals andlodging in an employee's wages, that value,when added to all other compensation youpay to that employee, must meet all the testsdescribed under Tests for Deductibility inchapter 2. See chapter 4 for rules you mustuse to value any meals or lodging you mustinclude in your employees' wages.


Deduction for meals and lodging

Exclusion from employee wages


Publication


See chapter 17 for information about get-ting this publication.

Deduction for

Meals and LodgingYou can usually deduct the cost of furnishingmeals and lodging to your employees. How-ever, you can generally deduct only 50% ofyour costs of furnishing meals. For more in-formation, see Deduction limit on meals, next.

Deduct the cost on your business incometax return in whatever category the expensefalls. For example, if you operate a restaurant,deduct the cost of the meals you furnish toyour employees as part of the cost of goodssold. If you operate a nursing home, motel,or rental property, deduct the costs of fur-nishing lodging to an employee as expensesfor utilities, linen service, salaries, depreci-ation, etc.

Chapter 3 Meals and Lodging Furnished to Employees Page 9


10/74

CAUTION

!If you must include the value of themeals and lodging in your employees'wages, do not deduct as wages the

amount you claimed elsewhere on your re-turn.

Deduction limit on meals. You can gener-ally deduct only 50% of the costs of furnishingmeals to your employees. However, you candeduct the full costs of the following meals.

1) Meals that qualify as a de minimis fringe

benefit as discussed in chapter 4.2) Meals where you include their value in

an employee's wages. For more infor-mation, see Exclusion From EmployeeWages, later.

3) Meals you furnish to your employees atthe work site when you operate a res-taurant or catering service.

4) Meals you furnish to your employees aspart of the expense of providing recre-ational or social activities, such as acompany picnic.

5) Meals you must furnish to crew membersof a commercial vessel under a federallaw. This includes crew members of

commercial vessels operating on theGreat Lakes, the Saint LawrenceSeaway, or any U.S. inland waterway ifmeals would be required under federallaw had the vessel been operated at sea.This does not include meals you furnishon vessels primarily providing luxurywater transportation.

6) Meals you furnish on an oil or gas plat-form or drilling rig located offshore or inAlaska. This includes meals you furnishat a support camp that is near and inte-gral to an oil or gas drilling rig located inAlaska.

Exclusion FromEmployee WagesGenerally, you must include in an employee'swages the value of meals and lodging youfurnish to the employee or the employee'sspouse or dependents. Use the general val-uation rule, discussed in chapter 4, to deter-mine the amount to include in the employee'swages. However, if you provide meals at anemployer-operated eating facility, you may beable to use the employer-operated-eating-facility rule to value the meals. For more in-formation, see chapter 4.

You can exclude from an employee'swages the value of meals you furnish to theemployee if the meals qualify as a de minimisfringe benefit (see chapter 4). Also, if youmeet the following tests, you can excludefrom an employee's wages the value of mealsand lodging you, or a third party on your be-half, furnish to the employee or the employ-ee's spouse or dependents.

Test 1. You furnish the meals or lodgingon your business premises.

Test 2. You furnish the meals or lodgingfor your convenience.

Test 3. In the case of lodging (but notmeals), your employees must accept thelodging on your business premises as a

condition of their employment. Thismeans they must accept the lodging toallow them to properly perform their du-ties.

However, if an employee can choose toreceive additional pay instead of meals orlodging, you must include the value of themeals or lodging in the employee's wages.The examples at the end of this chapter willhelp you apply these tests.

Test 1On Your BusinessPremisesThis generally means the place of employ-ment. For example, meals and lodging youfurnish to a household employee in your pri-vate home are furnished on your businesspremises. Similarly, meals you furnish tocowhands while herding cattle on land youlease or own are furnished on your businesspremises.

Test 2For YourConvenienceWhether you furnish meals or lodging for yourconvenience as an employer depends on allthe facts and circumstances. You furnish themeals or lodging to your employee for yourconvenience if you do this for a substantialbusiness reason other than to provide theemployee with additional pay. This is trueeven if a law or an employment contract pro-vides that they are furnished as pay. A writtenstatement that the meals or lodging are foryour convenience is not sufficient.

Substantial nonpay reasons. The followingmeals are furnished for a substantial nonpaybusiness reason.

1) Meals you furnish during working hoursso your employee will be available foremergency calls during the meal period.

However, you must be able to show thatemergencies have occurred or can rea-sonably be expected to occur.

2) Meals you furnish during working hoursbecause the nature of your business re-stricts your employee to a short mealperiod (such as 30 or 45 minutes), andthe employee cannot be expected to eatelsewhere in such a short time. For ex-ample, meals can qualify if the peakworkload occurs during the normal lunchhour. But if the reason for the short mealperiod is to allow the employee to leaveearlier in the day, the meal will not qual-ify.

3) Meals you furnish during work hours

because your employee could not oth-erwise eat proper meals within a rea-sonable period of time. For example,meals can qualify if there are insufficienteating facilities near the place of em-ployment.

4) Meals you furnish to restaurant or otherfood service employees, for each mealperiod in which they work, if you furnishthe meals during, immediately before,or immediately after work hours. For ex-ample, if a waitress works through thebreakfast and lunch periods, you canexclude from her wages the value of thebreakfast and lunch you furnish in yourrestaurant for each day she works.

5) Meals you furnish immediately afterworking hours that you would have fur-nished during working hours for a sub-stantial nonpay business reason, butbecause of the work duties were noteaten during working hours.

6) Meals you furnish to all employees atyour place of business if substantially allof your employees are furnished mealsfor a substantial nonpay business rea-son.

Meals you furnish to promote goodwill,boost morale, or attract prospective em-ployees. These meals are considered fur-nished in your business for pay reasons.

Meals furnished on nonworkdays or withlodging. The value of meals you furnish onany nonworkday is normally not furnished foryour convenience. However, if your employ-ees must occupy lodging on your businesspremises as a condition of employment, asdiscussed later under Test 3Lodging Re-quired As a Condition of Employment, do nottreat the value of any meal you furnish on thebusiness premises as wages.

Meals with a charge. The fact that youcharge for the meals and that the employeemay accept or decline the meals, is not takeninto account in determining whether mealsare furnished for your convenience.

If you furnish meals for which you chargethe employees a flat amount, do not includethe flat amount you charge in your employees'wages. This does not depend on the em-ployees' acceptance of the meals. You haveto include the actual value of the meals inyour employees' wages if Test 1 and Test 2are not met.

If you charge your employees a flatamount for meals and you have to include thevalue in your employees' wages, include thevalue whether it is more or less than theamount you charged. If no evidence indicatesotherwise, the value of the meals is theamount you charged for them.

Test 3Lodging RequiredAs a Condition ofEmploymentThis means that you require your employeesto accept the lodging because they need tolive on your business premises to be able toproperly perform their duties. Examples in-clude employees who must be available atall times and employees who could not per-form their required duties without being fur-nished the lodging.

It does not matter whether you must fur-nish the lodging as pay under the terms ofan employment contract, or a law fixing theterms of employment.

You may furnish the lodging to your em-ployees with or without a charge. If youcharge a flat amount for lodging whether ornot the employee accepts it, do not includethe flat charge in the employee's wages.Whether the value of the lodging is wagesdepends on whether Tests 1, 2, and 3 are allmet. If any one of these tests is not met, youmust include the value of the lodging in youremployees' wages whether it is more or lessthan the amount you charged for it. If no evi-dence indicates otherwise, the value of thelodging is the amount you charged for it.

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Employment TaxesThe value of meals and lodging you excludefrom an employee's wages is not subject tosocial security, Medicare, and federal unem-ployment taxes, or income tax withholding.

ExamplesThese examples will help you determinewhether to include in your employees' wages

the value of meals or lodging you furnish tothem.

Example 1 (Meals). You operate a res-taurant business. You furnish your employee,Carol, who is a waitress working 7 a.m. to 4p.m., two meals during each workday. Youencourage but do not require Carol to haveher breakfast on the business premises be-fore starting work. She must have her lunchon the premises. Since Carol is a food serviceemployee and works during the normalbreakfast and lunch periods, do not includethe value of her breakfast and lunch in herwages.

Example 2 (Meals on nonworkdays).

You also allow Carol to have meals on yourbusiness premises without charge on herdays off. You must include the value of thesemeals in her wages.

Example 3 (Meals). Frank is a bank tellerwho works from 9 a.m. to 5 p.m. The bankfurnishes his lunch without charge in a cafe-teria the bank maintains on its premises. Thebank furnishes these meals to Frank to limithis lunch period to 30 minutes, since thebank's peak workload occurs during thenormal lunch period. If Frank got his lunchelsewhere, it would take him much longerthan 30 minutes, and the bank strictly en-forces the time limit. The bank does not in-clude the value of these meals in Frank's

wages.

Example 4 (Meals). A hospital maintainsa cafeteria on its premises where all of its 230employees may get meals at no charge dur-ing their working hours. The hospital furnishesmeals to have 210 employees available foremergencies. Each of these employees isat times called upon to perform services dur-ing the meal period. Although the hospitaldoes not require these employees to remainon the premises, they rarely leave the hospitalduring their meal period. Since the hospitalfurnishes meals to most of its employees tohave each of them available for emergencycall during their meal periods, the hospitaldoes not include the value of these meals in

the wages of any of its employees.

Example 5 (Lodging). A hospital givesJoan, an employee of the hospital, the choiceof living at the hospital free of charge or livingelsewhere and receiving a cash allowance inaddition to her regular salary. If Joan choosesto live at the hospital, the hospital must in-clude the value of the lodging in her wagesbecause she is not required to live at thehospital to properly perform the duties of heremployment.

4.

Fringe Benefits

Important Change

for 1997Nondiscrimination rules. Nondiscriminationrules apply to the exclusion of certain fringebenefits from the income of highly compen-sated employees. For tax years beginningafter 1996, the definition of highly compen-sated employee has changed. For more in-formation, see Nondiscrimination rulesunderExclusion of Certain Fringe Benefits, later.

Important Changesfor 1998

Meals furnished to employees. For taxyears beginning after 1997, your annual rev-enue from meals you furnish to employeesboth on your business premises and for yourconvenience is considered to equal your di-rect operating costs of providing these meals.A meal is considered provided for your con-venience if you provide it for a substantialnoncompensatory business reason. This leg-islative change may allow your eating facilityfor employees to qualify as a de minimisfringe benefit. As a de minimis fringe benefit,your deduction for meals provided in the fa-cility is not limited to 50% of the cost of fur-nishing the meals. For more information, seechapter 3 and De Minimis (Minimal) Fringe,

later.

Qualified parking in place of pay. For taxyears beginning after 1997, you can excludequalified parking from an employee's wageseven if you provide it in place of pay. Youcannot exclude from an employee's wagesany other qualified transportation fringe ben-efit that you provide in place of pay. For moreinformation, see Qualified TransportationFringe, later.

IntroductionThis chapter gives general information onfringe benefits and fringe benefit valuationrules. However, it does not cover all the ex-ceptions to these rules, or the rules that applyto the use of an aircraft. For more information,see section 1.6121 of the Income Tax Reg-ulations.


General information

The general valuation rule

Special valuation rules

Exclusion of certain fringe benefits fromemployee income


Publication


521 Moving Expenses

See chapter 17 for information about get-ting these publications.

General InformationA fringe benefit is a form of pay provided toany person for the performance of servicesby that person. For these rules, treat a personwho agrees not to perform services (such asunder a covenant not to compete) as per-forming services.

Examples of fringe benefits you may pro-vide include:

The use of a car.

Flights on airplanes.

Discounts on property or services.

Memberships in country clubs or othersocial clubs.

Tickets to entertainment or sportingevents.

Provider of fringe benefit. You are theprovider of a fringe benefit if it is provided forservices performed for you. You may be theprovider of the benefit even if it was providedby another person. For example, you are theprovider of a fringe benefit your client or cus-tomer provides to your employee for servicesthe employee performs for you.

Nonemployer provider. You do not haveto be the employer of the recipient to be theprovider of a fringe benefit. For example, you

may provide fringe benefits to an independentcontractor as a client or customer of the con-tractor.

Recipient of benefit. Your employee orsome other person who performs services foryou is the recipient of a fringe benefit providedfor those services. Your employee may be therecipient of the benefit even if it is providedto someone who did not perform services foryou. For example, your employee is the re-cipient of a fringe benefit you provide to amember of the employee's family.

The recipient does not have to be youremployee. For example, the recipient may bea partner, director, or independent contractor.In this chapter, the term employee includes

any recipient of a fringe benefit unless statedotherwise.

Including benefits in pay. Unless the lawsays otherwise, you must include fringe ben-efits in an employee's gross income aswages. The benefits are subject to incomeand employment taxes.

You and your employees will generallyuse the general valuation rule, discussedlater, to figure the amount of a fringe benefitto include in your employees' income. How-ever, you and your employees can use spe-cial rules to value certain fringe benefits. Formore information, see Special ValuationRules, later.

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Deducting the cost. Even though youinclude an amount for noncash fringe benefitsin an employee's gross income as wages, youcannot deduct that amount as wages. But youcan deduct the costs you incurred to providethe benefit. You may be able to take an ex-pense or depreciation deduction. For exam-ple, if a noncash fringe benefit you provide toyour employee is property you lease, youmust include the amount (value) of the benefitin the employee's wages, but you cannot de-duct that amount as wages. However, youmay be able to deduct the rent as a businessexpense.

When fringe benefits are treated as paid.You may choose to treat certain noncashfringe benefits as paid by the pay period, orby the quarter, or on any other basis youchoose as long as you treat the benefits aspaid at least as often as once a year. How-ever, this choice does not apply to fringebenefits that involve the transfer of personalproperty normally held for investment or thetransfer of real property.

You do not have to make a formal choiceof payment dates or notify the IRS of thedates you choose. You do not have to use thesame time period for all employees. You maychange methods as often as you like, as long

as you treat all benefits provided in a calendaryear as paid by December 31 of that year.However, you may be able to use the specialaccounting period rule, discussed later, forfringe benefits you actually provide duringNovember and December.

Multiple dates for one benefit. You cantreat a taxable noncash fringe benefit as paidon one or more dates in the same calendaryear even if the employee receives the entirebenefit at one time. For example, if you pro-vide your employee with a fringe benefit onMarch 31 that you value at $1,000, you cantreat the $1,000 as though it had been pro-vided equally over 4 quarters and paid onMarch 31, June 30, September 30, and De-cember 31.

Accounting period. You have the option toreport taxable noncash fringe benefits by us-ing either of the following rules:

1) The general rule: value the benefit for afull calendar year (January 1 - December31), or

2) The special accounting period rule (dis-cussed next).

Special accounting period rule. Insteadof reporting fringe benefits on a calendar yearbasis, you may choose to use a special ac-counting period rule. However, this choicedoes not apply to fringe benefits that involvethe transfer of personal property normallyheld for investment or the transfer of realproperty.

Under the special accounting period rule,you can treat the value of benefits you actu-ally provide in the last 2 months of the cal-endar year (or any shorter period) as thoughyou paid them in the next year. To do this,add the value of these benefits to the valueof benefits you provide in the first 10 monthsof the next year.

Benefits you actually provide. Only thebenefits you actually provide during the last2 months of a calendar year can be deferreduntil the next year. For example, if you treata fringe benefit as provided equally over theyear, as discussed earlier under When fringebenefits are treated as paid, you can defer

only the benefit you actually provide duringthe last 2 months.

Use of special rule is optional. You canuse the rule for some fringe benefits and notfor others. The period of use need not be thesame for each fringe benefit. However, if youuse the special accounting period rule for aparticular benefit, use it for all employees whoreceive that benefit.

If you use the special accounting periodrule, your employee must use it for the sameperiod. However, your employee can use itonly if you use it.

More information. For more information onwithholding from and reporting of taxablenoncash fringe benefits, see Publication 15.

GeneralValuation RuleYou generally must include in an employee'swages the amount by which the fair marketvalueof a fringe benefit is more than the sumof:

1) Any amount the employee paid for thebenefit, and

2) Any amount the law excludes from in-come.

However, you and your employees may usespecial rules to value certain fringe benefits(see Special Valuation Rules, later).

Fair market value (FMV). In general, youdetermine the FMV of a fringe benefit on thebasis of all the facts and circumstances. TheFMV of a fringe benefit is the amount youremployee would have to pay a third party tobuy or lease the particular fringe benefit.

Neither the amount the employee consid-ers to be the value of the fringe benefit nor thecost you incur to provide the benefit deter-mines its FMV.

If the law excludes a fringe benefit costfrom income, do not include in the employee'sgross income the difference between the FMVand the excludable cost of that fringe benefit.If the law excludes a limited amount of thecost, however, include the FMV of the fringebenefit that is due to any excess cost.

Employer-provided vehicles. In general,the value of an employer-provided vehicle isthe amount the employee would have to paya third party to lease the same or a similarvehicle on the same or comparable terms inthe same geographic area where the em-ployee uses the vehicle. Do not determine thevalue by multiplying the cents-per-mile ratetimes the number of miles driven unless your

employee can prove the vehicle could havebeen leased on a cents-per-mile basis. Acomparable lease term would be the amountof time the vehicle is available for your em-ployee's use, such as a 1-year period.

SpecialValuation RulesYou may be able to use special valuationrules instead of the general valuation rule tovalue certain fringe benefits, including the useof any vehicle or eating facility you provide.The special valuation rules include the:

1) Automobile lease rule,

2) Vehicle cents-per-mile rule,

3) Commuting rule, and

4) Employer-operated-eating-facility rule.

Conditions for use. When reporting fringebenefits, you can choose to use any of thespecial rules. However, neither you nor youremployee may use a special rule to value anybenefit, unless one of the following conditionsis met:

1) You treat the value of the benefit aswages for reporting purposes by the duedate of the return (including extensions)for the tax year you provide the benefit,

2) Your employee includes the value of thebenefit in income by the due date of thereturn for the year the employee receivesthe benefit,

3) Your employee is not a control employeeas defined later under Commuting Rule,or

4) You demonstrate a good faith effort totreat the benefit correctly for reportingpurposes.

Using the special rules. All of the followingapply when you use the special rules.

1) If you use one of the special rules tovalue a benefit you provide to your em-ployee, the employee can use a specialrule. In that case, however, the em-ployee must use the same special rulethat you use unless you do not treat thevalue of the benefit as wages for report-ing purposes by the due date of the re-turn (including extensions) and one ofthe conditions just listed in items 2through 4 is met. In any case, the em-ployee can use the general valuationrule discussed earlier.

2) If you and your employee properly usea special rule, your employee must in-clude in gross income the value you de-termine under the rule, minus anyamount he or she paid you and anyamount excluded by law from gross in-come. You and your employee can usethe special rule to determine the amountthe employee owes you.

3) If you provide vehicles to more than oneemployee, you do not have to use thesame special rule for each employee. Ifyou provide a vehicle for use by morethan one employee (for example, anemployer-sponsored van pool), you canuse any special rule. However,

us internal revenue service: p535--1997

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