Car Expenses and Deductions

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1 1 MODULE 1 Car Expenses and Deductions LEARNING OBJECTIVES At the completion of this chapter, the reader should be able to: Correctly claim the deductions available to employers for the operation of a car used in a business, or furnished to employees for their personal use Determine the correct tax treatment of an individual s expenses of operating a car either in an employer s business or in the individual s own business Determine the income an employee must report when an employer furnishes a car or parking for the employee s personal use Identify tax credits and possible excise taxes that may be claimed on some vehicles Report gain or loss on the sale or trade-in of a car Identify the records that individuals must keep to substantiate their car expenses INTRODUCTION Tax Consequences This chapter is your guide to determining the tax consequences of the business use of a car. Five important areas are covered: 1. Employers. Deductions an employer may claim for the operation of a car used in a business or furnished to employees for their personal use. 2. Employees and self-employed individuals. Treatment of an individual s expenses of operating a car either in an employer s business or in the individual s own business. The importance of employer reimbursement arrangements and the need to distinguish between business and personal use are stressed. 3. Fringe benefits. How to determine the income an employee must report when an employer furnishes a car for the employee s personal use. 4. Purchases, sales, and trade-ins. Allowable tax credits and possible excise taxes. Tax credits that may be claimed on some vehicles. Reporting of gain or loss on the sale or trade-in of a car. 5. Recordkeeping. The records that individuals must keep to substantiate their car expenses. In addition, procedures and examples for computing car expense deductions (or exclusions under accountable reimbursement plans) are presented in detail

2 2 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE at Figuring Car Expenses through Leasing Cars. The rules discussed and explained apply primarily to passenger cars, vans, or light trucks. Rules limiting deductions for luxury cars generally apply only to passenger cars and trucks and vans (including SUVs built on a truck chassis) with a gross vehicle weight rate rating (GVWR) of 6,000 pounds or less (see Luxury Car Limitations). Conservation Incentives Congress has enacted energy conservation incentives that have a favorable tax effect on taxpayers that place certain vehicles into service. Qualifying vehicles need not be used in a business in order to be eligible for these tax benefits. The tax benefits are: 1. Alternative motor vehicle credit. Effective for qualifying vehicles placed in service after 2005, a taxpayer may claim an alternative motor vehicle credit. (Code Sec. 30B, as added by the Energy Tax Incentives Act of 2005, P.L and amended by P.L ). The credit is the total of four credit components: a. Qualified fuel cell motor vehicle credit; b. Advanced lean burn technology motor vehicle credit; c. Qualified hybrid motor vehicle credit; and d. Qualified alternative fuel motor vehicle credit. The credit is calculated based on various factors such as vehicle weight, vehicle fuel efficiency, and lifetime fuel savings. There are distinct requirements for each of the four credits; however, three requirements are common to each credit: a. The original use of the vehicle must start with the taxpayer; b. The vehicle must be acquired for use or lease by the taxpayer and not for resale; and c. The vehicle must be made by a manufacturer. The third component of the alternative motor vehicle credit is the qualified hybrid motor vehicle credit. The IRS has issued procedures for manufacturers to certify that certain passenger automobile s or light trucks of a specific make, model, and model year qualify for the credit and the amount of the credit (Notice , I.R.B ). Generally, a taxpayer can rely on the manufacturer s certification for the specific vehicle and amount of the credit. A taxpayer may claim a credit in the certified amount if the following requirements are satisfied: a. The vehicle is placed in service by the taxpayer after December 31, 2005 and purchased on or before December 31, 2010; b. The original use of the vehicle must begin with the taxpayer claiming the credit and does not apply to a used hybrid vehicle;

3 MODULE 1 Car Expenses and Deductions 3 c. The vehicle is acquired for use or lease by the taxpayer, and not for resale; and d. The vehicle is used predominantly in the United States. At the time this book was produced, the IRS has acknowledged the manufacturers certification for the following qualified hybrid vehicles and credit amounts: Model Year Make and Model Credit Amount 2007 Toyota Camry Hybrid $2,600 Lexus GS 450h $1,550 Ford Escape Front WD Hybrid (or 2WD) $2,600 Ford Escape 4 WD Hybrid $1,950 Mercury Mariner 4 WD Hybrid $1,950 GMC Sierra (4WD) Hybrid Pickup Truck $650 GMC Sierra (2WD) Hybrid Pickup Truck $250 Chevrolet Silverado (4WD) $650 Hybrid Pickup Truck Chevrolet Silverado (2WD) $250 Hybrid Pickup Truck Saturn Vue Green line $ Toyota Prius $3,150 Toyota Highlander 4WD Hybrid $2,600 Toyota Highlander 2WD Hybrid $2,600 Lexus RX400h 2WD $2,200 Lexus RX400h 4WD $2,200 Honda Civic Hybrid CVT $2,100 Honda Insight CVT $1,450 Honda Accord Hybrid AT $1,300* with updated calibration Honda Navi AT with updated calibration $1,300** Ford Escape Hybrid Front WD $2,600 Ford Escape Hybrid 4 WD $1,950 Mercury Mariner Hybrid 4 WD $1,950 GMC Sierra (4WD) Hybrid Pickup Truck $650 GMC Sierra (2WD) Hybrid Pickup Truck $250 Chevrolet Silverado (4WD) $650 Hybrid Pickup Truck Chevrolet Silverado (2WD) $250 Hybrid Pickup Truck 2005 Toyota Prius $3,150 Honda Civic Hybrid (SULEV) MT $1,700 Honda Civic Hybrid (SULEV) CVT $1,700 Honda Insight CVT $1,450 Honda Accord Hybrid AT $650 Honda Navi AT $650 * 2006 Honda Accord Hybrid AT without updated control calibration qualifies for a credit amount of $650. ** 2006 Honda Navi AT without updated control calibration qualifies for a credit amount of $650

4 4 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE To check for any changes after the publication of this book, check the IRS Digital Daily Newsroom at Note, for example that although it has not yet been officially announced as of the time this book went to print, Toyota Motor Company (which includes Lexus) has now sold over 60,000 units as of June 30, 2006 and the phase out of the credit begins this year. EXAMPLE If a manufacturer of hybrid vehicles sells its 60,000th unit on June 30, 2006, consumers can continue to claim the full credit for a sale on September 30, However, starting in the second calendar quarter following this sales target, which begins October 1, 2006, the credit is reduced. The reduced credit, 50% of what had been allowed, applies through March 31, 2007 during the second and third quarters after June 30, The 25% credit applies for purchases made April 1, 2007 through September 30, No credit would be allowed for purchases made on or after October 1, The fourth component of the credit is the qualified alternative fuel motor vehicle credit. To qualify for the credit, in addition to the common requirements, the vehicle must be capable of operating on an alternative fuel (compressed natural gas, liquefied natural gas, liquefied petroleum gas, hydrogen, or any liquid consisting of at least 85% methanol). At the time this book was produced, Honda has two models that use compressed natural gas, the 2005 and 2006 Honda Civic GX, which are certified for the qualified alternative fuel motor vehicle credit. The credit amount for these vehicles is $4,000 (IR ). Mixed fuel vehicles also qualify for the credit, but at a fraction of the normal credit amount. The alternative motor vehicle credit is claimed on Form 8910, Alternative Motor Vehicle Credit. Taxpayers with qualified motor vehicles that are used in a trade or business and subject to depreciation will claim the alternative motor vehicle credit as part of, and subject to the rules of, the general business credit. A seller claiming the credit for a vehicle sold to a tax-exempt entity can only claim the credit as part of the general business credit (Code Sec. 30B(h)(6), as amended by the Gulf Opportunity Zone Act of 2005 (P.L )). The Energy Tax Incentives Act of 2005 also provided a credit for the installation of alternative fueling stations (Code Sec. 30C). The amount of the credit is equal to 30% of the cost of qualified alternative fuel vehicle refueling property placed in service after December 31, For property subject to depreciation, such as a commercial or retail refueling station, the credit cannot exceed $30,000. In other instances, such as refueling property installed at a personal residence, the credit cannot exceed $1,000.

5 MODULE 1 Car Expenses and Deductions 5 2. Deduction for clean-fuel vehicles. With the passage of the alternative motor vehicle credit, the deduction for clean-fuel vehicles was terminated. The deduction expires for vehicles placed in service after December 31, To encourage the use of vehicles powered by cleaner burning fuels, a deduction from gross income is permitted for a portion of the cost of certain clean-fuel vehicles placed in service after June 30, 1993, and before January 1, 2006 (Code Sec. 179A). Among clean fuels are natural gas and hydrogen and fuels that are composed of at least 85% methanol, ethanol, alcohol, or ether. The maximum deduction for cars and light trucks is $2,000. For some trucks and vans with a gross weight of more than 10,000 pounds but not more than 26,000 pounds, the maximum deduction is $5,000. For trucks and vans with gross weight of more than 26,000 pounds, the maximum deduction is $50,000. The $50,000 maximum also applies to buses that can sit at least 20 adult passengers. The deduction is claimed on line 36 of 2006 Form 1040 (this is the summation line for adjustments immediately above the adjusted gross income line). The original use of the vehicle must begin with the taxpayer. A used vehicle does not qualify. For a list of vehicles that qualify for the deduction, see the IRS web site ( 3. Tax credit for electric vehicles. A 10% tax credit may be claimed for vehicles powered primarily by an electric motor and placed in service after June 30, 1993, and before January 1, 2007 (Code Sec. 30). The original use of the vehicle must start with the taxpayer claiming the credit. The maximum credit may not exceed $4,000 and will be phased out, beginning with vehicles placed in service after 2005 (viz., a maximum credit of $1,000 in 2006 and no credit available after 2006 (Working Families Tax Relief Act of 2004 (P.L ))). The allowable credit is claimed on Form 8834, Qualified Electric Vehicle Credit. According to the IRS, gasoline/electric hybrid vehicles described above are not powered primarily by an electric motor and do not qualify for the credit (Instructions to 2005 Form 8834, Qualified Electric Vehicle Credit.). Cars Used in a Business A business uses its cars: 1. For business-related travel; and/or 2. For the personal benefit of its executives or other employees. (Personal use is generally taxed to these employees as additional compensation.) Generally, the expenses of using a car in either of these situations are deductible by employers as business expenses. An employer has the right to deduct the expenses of operating a car that is provided to an employee for business-related travel.

6 6 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE A detailed discussion of the computations required to arrive at an allowable car expense deduction appears at Figuring Car Expenses through Leasing Cars. Rules governing the amount that must be included in the gross income of employees that make personal use of employer-provided cars or parking appear at Use of Employer-Provided Cars as Fringe Benefits through Employee Parking. The treatment of expenses incurred for employee-owned cars and cars owned by self-employed individuals is discussed at Types of Car Expenses through Commuting Expenses. Business Deductions A car expense, like any other business expense, must meet the following tests in order to be a deductible business expense: 1. Trade or business. The expense must be incurred in a trade or business carried on by the taxpayer. A trade or business is an activity generally carried on with the primary purpose of making income or a profit (R.P. Groetzinger, SCt, 87-1 USTC 9191). 2. Ordinary and necessary. The expense must be ordinary and necessary (Code Sec. 162(a)). An expense is generally considered ordinary if it is frequently incurred in the particular trade or business. In order to qualify as necessary, the expense must be appropriate or helpful to the business. Whether an expense is necessary is determined at the time the expense is incurred. 3. Deductible currently. Generally, the deduction cannot be for a capital expense. However, some capital expenses may be deducted over a period of years through depreciation (see Deductible Costs at Actual Cost Method). Exclusive Business Use If an employee uses a car owned by the employer exclusively for the employer s business purposes, the employer may generally deduct the full cost of operating the car. Deductible expenses include: Gas and oil; Cleaning and washing; Repairs and maintenance; Insurance; Interest; Tires and supplies; Parking and garage rental; Tolls; Motor club membership; and Personal property taxes.

7 MODULE 1 Car Expenses and Deductions 7 Depreciation Deductions and Lease Inclusion Amounts The cost of the car itself is not a deductible expense, nor is the cost of replacements, modifications, or repairs that prolong the useful life of the car or increase its value. These costs are capitalized, which means they are added to the taxpayer s basis in the car. Capitalized costs are claimed through depreciation deductions that are taken for a number of years after the business first places the car in service. The amount of annual depreciation, including the Code Sec. 179 expense allowance, 30% or 50% MACRS bonus depreciation, and GO Zone bonus depreciation may be limited under the luxury car depreciation cap rules discussed at Luxury Car Limitations. A complete discussion of depreciation appears beginning at Methods of Depreciation. The lessee of a vehicle used for business is generally required to include a lease inclusion amount in income during each year of the lease (see Leasing Cars). Actual Cost and Alternative Methods of Computing Car Expenses While deductions may be based on the employer s actual costs (see Actual Cost Method), three other methods of computing car expenses may be available: 1. The standard mileage rate; 2. The FAVR (fixed and variable rate) method; and 3. Other mileage allowances. An employer that reimburses employees car expenses under an accountable plan may generally compute reimbursements (and therefore its deductions) using any of the three methods. A complete discussion of these three methods appears at Mileage Allowances. The actual cost method is discussed at Actual Cost Method. Employee s Personal Use When an employer provides a car to an employee that is available for the employee s personal use, the value of that availability is generally considered to be a taxable fringe benefit (Reg (a)). The tax treatment of this fringe benefit and exceptions to this rule are discussed at Use of Employer- Provided Cars as Fringe Benefits through Employee Parking. STUDY QUESTION 1. For a 2006 Toyota Prius that a taxpayer places in service in the first quarter of 2006, but not in a trade or business, how much may the taxpayer claim as a credit against tax? a. $0 b. $2,200 c. $2,600

8 8 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE NOTE Answers to Study Questions, with feedback to both the correct and incorrect responses, are provided in a special section beginning on page 257. CARS USED BY OWNERS: REQUIREMENTS Types of Car Expenses Employees and self-employed individuals, like employers, are entitled to certain tax deductions for expenses incurred in connection with their cars. These deductions fall into four main categories: 1. Business expenses. Expenses incurred for a car that is used in an individual s business are generally allowed as deductions from gross income. However, expenses that an individual incurs as an employee are usually only deductible as miscellaneous itemized deductions, although certain statutory employees may deduct their business expenses from gross income. (See Employee Expenses.) 2. Investment-related expenses. Expenses incurred for a car that is used in connection with an individual s investments (or otherwise connected with the production of income) are generally treated as miscellaneous itemized deductions, subject to a 2%-of-adjusted-gross-income floor. Deductible hobby expenses also fall into this category. However, car expenses associated with rental real estate or royalties reported on Schedule E of Form 1040 are deductible from gross income. 3. Reimbursed expenses. Expenses incurred for a car that is used in an individual s employment are disregarded if reimbursed by the employer under an accountable plan. Neither the reimbursement nor the expense is reported. Reimbursements for car expenses received under a nonaccountable plan are treated as taxable wages. An employee who is reimbursed under a nonaccountable plan must claim any allowable car expenses as a miscellaneous itemized deduction. (See Reimbursement of Employee Expenses.) 4. Personal expenses. Property taxes and casualty losses allocable to the personal use of a car are deductible to a limited extent. When the use of the car is personal, these deductions are claimed as itemized deductions. No other deductions are allowed for personal use of a car (Code Sec. 262(a)). (See Personal Expenses.) Commuting expenses are discussed at Commuting Expenses.

9 MODULE 1 Car Expenses and Deductions 9 Allocation Between Types of Use An individual who uses a car for more than one purpose must allocate any car expenses among them in proportion to the number of miles driven during the year for each purpose. EXAMPLE Joe Long drove his car a total of 25,000 miles during the year. He drove 5,000 miles for his employer, 8,000 miles for a business Joe owns as a sole proprietor, and 12,000 miles for commuting and other personal use. Joe is not classified as a statutory employee by his employer. Assume that his total car expense for the year is $5,230. The expense is allocated as follows: Business expense (8,000/25,000 of $5,230) $1,674 Employee expense: unreimbursed (5,000/25,000 of $5,230) 1,046 Personal expense (12,000/25,000 of $5,230) 2,510 This allocation applies to each component of a car s operating expense. For example, when a deduction limitation applies only to nonbusiness expenses, the business and nonbusiness portions of the particular expense must be dealt with separately. EXAMPLE Assume the same facts as in the previous Example. Of the $5,230 in expenses, $4,700 is for operation of the car and $530 is for interest on a car loan. There is no limit on the deduction of interest when it is incurred in a business, but interest is not deductible if it is incurred for personal purposes or in connection with the performance of services as an employee (see Employee Expenses). Applying the fractions derived in the first Example, Joe s expenses are allocated as follows: Operating Expense Interest Expense Business expense $1,504 $170 Employee expenses Personal expenses 2, Both the $1,504 of business operating expenses and $170 of business interest are deductible from gross income on Schedule C or C-EZ (see Claiming Deductions). The $940 of unreimbursed employee expenses is treated as a miscellaneous itemized deduction on Schedule A (see Employee Expenses). The $106 of interest incurred as an employee expense is treated as nondeductible personal interest. The $2,256 of personal operating expenses is not deductible, nor is the $254 of personal interest.

10 10 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE Some expenses may clearly be identified with a particular use of a car. For example, tolls, parking fees, or extra insurance may be paid solely for the business use of the car. In this case, the costs are deductible in full as business expenses. A similar rule may also apply to special equipment added to a car (for example, a cellular telephone see Actual Cost Method). Depreciation of such equipment may be claimed without allocation if the equipment is used 100% for business purposes. Self-Employed Individuals An individual who is self-employed is entitled to deduct car expenses incurred in the individual s trade or business. However, self-employed individuals must be particularly careful concerning how personal use of a car will affect the deductibility of their car expenses. Generally, no deductions are allowed for personal use other than itemized deductions for personal property taxes and casualty losses (see Personal Expenses). Furthermore, if personal use of the car equals or exceeds 50% of the total mileage, depreciation deductions for business use of the car are subject to additional limits (see Personal Use Limitation). Activities Not Engaged in for Profit How an individual s car expenses are treated also depends on whether the business is an activity engaged in for profit. The pursuit of a hobby is generally not an activity engaged in for profit. Because some hobbies generate income and occasionally show a profit, it is sometimes difficult to distinguish between a business and a hobby. There is a rebuttable legal presumption that, if an activity results in a profit in any three of five consecutive years ending with the tax year in question, the activity is a business (Code Sec. 183(d)). In the case of breeding, training, showing and racing horses, this presumption arises if a profit is shown in two out of seven consecutive years. The total amount of deductions attributable to an activity not engaged in for profit may not exceed income from the hobby. However, any hobby expenses that are deductible regardless of the type of activity engaged in, are fully deductible even if they do exceed the amount of hobby income. These expenses include such items as real estate taxes and mortgage interest (see Personal Expenses). These deductions are claimed on the appropriate lines of Schedule A of Form If there is any remaining hobby income after deducting the fully allowable expenses (e.g., real estate tax), expenses that do not result in a basis adjustment (e.g., rent) are deducted next. Finally, if any hobby income remains, expenses that result in a basis adjustment (e.g., depreciation) are deducted. These last two types of expenses may only be claimed as miscellaneous itemized deductions on Schedule A and are subject to the 2% floor imposed on such deductions (see Employee Expenses).

11 MODULE 1 Car Expenses and Deductions 11 Starting a Business In most situations, a car used in a business was purchased for the business. However, this is not always true, particularly for individuals that are just starting a business. The owner of a new business may find it more economical to use a car that is already owned, rather than invest additional capital in the purchase of another car. By the same token, the owner of an established business may want to place a personal car into service when new business opportunities create the need. When a car is converted to business use, depreciation is allowed beginning in the year it is placed in service for the business use. Depreciation is computed in the normal manner (see Methods of Depreciation), except that the owner must use the car s fair market value on the date of conversion to business use as the basis for computing depreciation if it is less than the car s adjusted basis (this is generally its original cost) (Reg (g)-1). Because this will usually be the situation, the owner may find that the standard mileage method produces a larger deduction (see Mileage Allowances). Employee Expenses An employee is generally allowed a deduction for travel expenses (both local and away from home) incurred in the performance of services as an employee (Code Sec. 62(a)(2)). The specific treatment of these expenses, however, depends on whether the expenses are reimbursed and, if they are, whether they are considered reimbursed under an accountable plan. Commuting expenses are not deductible (see Commuting Expenses). In addition, special rules apply to employees who are classified as statutory employees (see Statutory employees). Reimbursement Arrangements: Accountable Plans Reimbursements for car expenses that are received under an accountable plan (see Reimbursement of Employee Expenses) and substantiated to the employer are excluded from gross income. That is, the employer does not include them in taxable wages on Form W-2. These reimbursements are also exempt from withholding and employment taxes (Reg (c)(4)). Because the reimbursements do not appear in income, the employee may not deduct the reimbursed expenses. However, in the case of excess reimbursements for car expenses that are not substantiated to the employer, any such amount that is not returned to the employer within a reasonable period of time is not considered paid under an accountable plan and is includible in the employee s gross income. The excess reimbursement is treated as taxable wages on Form W-2 and is subject to withholding and employment taxes (Reg (c)(2)(ii)).

12 12 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE Reimbursement Arrangements: Nonaccountable Plans Reimbursements for car expenses received under a nonaccountable plan (see Reimbursement of Employee Expenses) are treated as taxable wages on Form W-2 and are subject to withholding and employment taxes (Reg (c)(5)). Deduction for Car Expenses: No Reimbursement or Accountable Plan Employee car expenses that are not reimbursed or that are reimbursed under a nonaccountable plan are generally claimed as miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income floor imposed on such deductions (see 2% of AGI Floor on Unreimbursed Expenses). Other types of business expenses (e.g., telephone) that exceed reimbursements are also subject to the 2% floor. However, special rules apply to statutory employees (see Statutory employees). Actual Cost or Standard Mileage Rate Under the actual cost method of claiming car expenses, deductible expenses include gasoline, oil, tires, repairs, insurance, losses not covered by insurance, parking fees and tolls, garage rent, licenses, and property taxes. Depreciation is also deductible if the employee uses the actual expense method and meets the requirements discussed at Methods of Depreciation. Employees may not take deductions for depreciation (including Code Sec. 179 expense see Methods of Depreciation), however, unless the use of a car (Reg F-6(a)): 1. Is required as a condition of employment; and 2. Is for the convenience of the employer. In order to satisfy these requirements, the use of the car must be required in order for the employee to perform the employment duties properly. Whether the use of the car is so required depends on all the facts and circumstances. The employer need not make the use of the car an explicit requirement. However, according to the IRS, a mere statement by the employer that the use of a car is a condition of employment is not sufficient. Instead of using the actual cost method, employees may be able to base their deduction for car expenses on the standard mileage rate (see Mileage Allowances). 2% of AGI Floor on Unreimbursed Expenses Unreimbursed employee business expenses, including other types of miscellaneous itemized deductions, are allowed only to the extent that the total of these deductions exceeds 2% of the individual s adjusted gross income (AGI).

13 MODULE 1 Car Expenses and Deductions 13 The term miscellaneous itemized deductions includes unreimbursed employee expenses, such as travel, meals, lodging, education, equipment, special clothing, or professional dues; some types of hobby expenses (to the extent of hobby income see Self-Employed Individuals); and investment expenses, such as certain legal and accounting fees, financial consulting fees, the cost of tax return preparation, clerical help, office rent, and custodial fees. EXAMPLE For 2006, Dave Sumner, a single individual, has an AGI of $48,000. He also has the following expenses: Charitable contribution $1,000 Real estate taxes 6,000 Investment advice 1,500 Employment-related car expenses for local business travel (unreimbursed) 1,200 Employment-related car expenses for out-of-town trip (reimbursed under accountable plan) 900 Sumner s deductions based on these expenses are computed as follows: Itemized deductions: Regular itemized deductions: Charitable contribution $1,000 Taxes 6,000 Total $7,000 Miscellaneous itemized deductions: Investment expenses $1,500 Employee expenses (local travel) 1,200 Total $2,700 Less: 2% of $48,000 AGI 960 Net miscellaneous itemized deductions $1,740 Total itemized deductions $8,740 Sumner may not deduct the $900 reimbursed car expense because his employer s $900 reimbursement is excluded from Sumner s gross income.

14 14 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE Statutory Employees Individuals who are considered to be statutory employees may deduct their allowable business expenses on Schedule C or Schedule C-EZ of Form As a result, they are able to deduct their expenses directly from gross income. The term statutory employees includes (Rev. Rul , CB 33): 1. A full-time traveling or city salesperson. These individuals must solicit orders from wholesalers, retailers, contractors, or operators of hotels, restaurants, or similar establishments, on behalf of a principal. The merchandise sold must be for resale (e.g., food sold to a restaurant) or for supplies used in the buyer s business. 2. A full-time insurance sales agent. The individual s principal business activity must be selling life insurance and/or annuity contracts for one life insurance company. 3. An agent-driver or commission-driver. The individual must be engaged in distributing meat, vegetables, bakery goods, beverages (other than milk), or laundry or dry cleaning services. 4. A home worker. The individual must work on material or goods furnished by the employer. If the individual is a statutory employee, the employer should check the appropriate box in Box 13 of the 2005 or 2006 Form W-2 issued to the employee. Personal Expenses Expenses of operating a car for personal purposes are generally not deductible. However, even if a car is used entirely for personal purposes, all or a portion of the following expenses may be deducted as itemized deductions: 1. Interest. An employee s interest on a car loan is generally not deductible because it is classified as personal interest. (However, interest related to the use of a car in a business (other than that of being an employee) is deductible from gross income (Code Sec. 163(h)(2)).) Interest on home equity loans is deductible (within limits), (Code Sec. 163(h)(3)) so it is good tax planning to finance a car used for employment and/or personal purposes with a home equity loan rather than with a traditional car loan. 2. State or local taxes. State or local personal property taxes based on the value of a car are deductible (Code Sec. 164(a)). Car registration fees based on value may be deductible if they qualify as personal property taxes in the taxpayer s state. 3. Casualty or theft loss. Loss of a business car or damage due to accident, fire, or theft is deductible to the extent that the loss or damage is not compensated for by insurance (Code Sec. 165(h)(4)(E)). The amount of

15 MODULE 1 Car Expenses and Deductions 15 the loss is the lesser of the car s adjusted basis before the casualty or theft or the difference between its fair market values before and after the casualty or theft. For a car not used in a trade or business or for the production of income, the amount of a loss that is deductible is limited to the excess of such loss (reduced by $100 for each casualty) over 10% of the taxpayer s adjusted gross income. If the nonbusiness car is covered by insurance, the individual must file a claim with the insurance company. Otherwise, a casualty or theft loss cannot be claimed, except for the portion of the loss that was not covered by the insurance (e.g., the deductible). In addition, the IRS has ruled that a business taxpayer who sustained a loss could not claim either a loss or a business expense when he did not file a claim with his insurance company (Rev. Rul , CB 58). 4. Charitable use. Taxpayers who use a car in connection with the performance of volunteer work for a charitable organization may claim a charitable deduction of 14 cents per mile (Code Sec. 170(i)). This is a fixed statutory rate that is not adjusted for inflation. For charity work related to Hurricane Katrina, the mileage rate for August 25 - August 31, 2005 is 29 cents per mile for deduction purposes and 40.5 cents per mile for reimbursement purposes. For the period September 1, 2005 to December 31, 2005, the mileage rate is 34 cents per mile for deduction purposes and 48.5 cents per mile for reimbursement purpose. For 2006 the mileage rate is 32 cents per mile for deduction purposes and 44.5 cents per mile for reimbursement purposes (Rev. Proc , I.R.B. 1177) (see Mileage Allowance). 5. Moving expenses. Individuals who move in connection with the start of work at a new location are entitled to deduct (among other limited types of expenses) the expense of driving to the new location (Code Sec. 217). This is computed at 15 cents per mile for the first eight months of 2005, and at 22 cents per mile for mileage incurred the last four months of 2005 (September 1, 2005 December 31, 2005). For 2006 the mileage rate is 18 cents per mile. (see Mileage Allowances). To qualify for this deduction, the distance between the new place of employment and the former home must be at least 50 miles farther than the distance from the former home to the former place of work. Additional requirements must be met before a moving expense deduction may be claimed. Allowable moving expenses are deducted from gross income. 6. Medical use. The cost of traveling to and from a doctor, dentist, hospital, or pharmacy is a deductible medical expense (Code Sec. 213). The deduction is computed at 15 cents per mile for the first eight months of 2005, and at 22 cents per mile for mileage incurred the last four months of 2005, and at 18 cents per mile for 2006 (Rev. Proc , I.R.B. 1177) (see Mileage Allowances).

16 16 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE Split Business and Personal Use When a car is used both for business and personal purposes, the individual must make an allocation based on the car s mileage (see Types of Car Expenses). In the case of the self-employed or statutory employees, the portion of any expense or loss that is allocable to business use is treated as a business deduction and is claimed on Schedule C, C-EZ, or any other appropriate schedule. The personal portion of the expense, if deductible, is claimed as an itemized deduction on Schedule A of Form Employees deduct their unreimbursed business expenses and their allowable personal expenses and/or casualty losses on Schedule A (see Employee Expenses). Employees must generally complete Form 2106 or Form 2106-EZ in order to support the business expenses that they claim as deductions (see Filled-in Form 2106). STUDY QUESTIONS 2. Interest expense on a loan used to purchase a car that is used by an employee 100% for business purposes is: a. Deductible from gross income in computing adjusted gross income. b. Deductible as an itemized deduction not subject to any adjusted gross income floor. c. Deductible as a miscellaneous itemized deduction subject the 2% of adjusted gross income floor. d. Not deductible. 3. Car expenses incurred by an individual related to the individual s investments, other than rental real estate or royalties, are: a. Not deductible. b. Deductible as miscellaneous itemized deductions. c. Deductible on Schedule C of Form d. Deductible on Schedule E of Form Except for expenses that are otherwise deductible such as property taxes, expenses of an activity not engaged in for profit (i.e. hobby expense ) are: a. Not deductible. b. Deductible up to the remaining income from the activity as itemized deductions but not subject to any reduction based on adjusted gross income. c. Deductible up to the remaining income from the activity as miscellaneous itemized deductions. d. Deductible up to the remaining income from the activity on Schedule C of Form 1040.

17 MODULE 1 Car Expenses and Deductions 17 Commuting Expenses Car expenses incurred commuting between an individual s home and the individual s main or regular place of business are nondeductible personal expenses (Regs (e) and (b)(5)). EXAMPLE Doctor Ruth Stat is employed at a hospital that is located in the same city as her home. She always drives to and from the hospital. She may not deduct any portion of these commuting costs. However, the cost of traveling between one business location and another business location is generally deductible (Rev. Rul , CB 261). EXAMPLE Assume the same facts as in the previous Example, except that on occasion, Doctor Stat leaves the hospital and drives to an outpatient clinic where she serves as a consultant. On these occasions, she returns to the hospital and then drives home. She is entitled to deduct the costs she incurs in driving between the hospital and the clinic. Deducting Travel Costs Between Home and Work In the following situations, the costs incurred in traveling between an individual s home and a business location are deductible (Rev. Rul. 99-7, CB 361): Situation 1. The travel is between the individual s residence and a temporary work location outside the metropolitan area where the individual lives and normally works. (Expenses incurred to travel to a temporary work location inside the metropolitan area are not deductible unless situation (2) or (3), below, apply). Situation 2. The travel is between the individual s residence and a temporary work location in the same trade or business, regardless of the distance, if the individual has one or more regular work locations away from the residence. Situation 3. The travel is between the individual s residence that qualifies as a principal place of business under Code Sec. 280A(c)(1)(A) for purposes of the home office deduction and another work location in the same trade or business, regardless of whether the work location is temporary or regular and regardless of the distance.

18 18 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE EXAMPLE Assume the same facts as in the previous Example, except that Doctor Stat is assigned by her employer to work at the outpatient clinic on a fulltime basis for a few weeks (i.e., a temporary assignment). In this situation, she may deduct the costs that she incurs in traveling between her home and the clinic. The term temporary work location as used by the IRS is defined using a one-year standard. That is, if employment at a work location is realistically expected to last (and does in fact last) for one year or less, the employment is temporary, absent facts and circumstances to the contrary. Employment at a work location is not temporary, regardless of the actual duration, if it is realistically expected to last more than one year or if there is no realistic expectation that employment will last for one year or less (Rev. Rul. 99-7, CB 361). An individual may at first realistically expect that employment at a work location will last one year or less, but at a later date, may realistically expect that the work will last for more than one year. In this situation, the employment will be treated as temporary until the date that the taxpayer s realistic expectation changes and will be treated as not temporary after that date (unless facts and circumstances indicate otherwise). EXAMPLE Assume the same facts as in the previous Example, except that after a few months, Dr. Stat s employer informs her that she will be working at the outpatient clinic for the indefinite future. Once this decision is made, her transportation costs are no longer deductible because the assignment is no longer temporary. No deduction (or exclusion of reimbursement) is available for the cost of commuting to an indefinite or permanent job location. This is so even though neither public transportation nor housing is available near the job site (W.L. Heuer, Jr., (CA-5) 61-1 USTC 9123; L.W. Tauferner, (CA- 10) 69-1 USTC 9241; R.L. Edmerson, (CA-9) 72-2 USTC 9702; O.L. Tucker, 31 TCM 215, Dec. 31,272(M), TC Memo ). Conducting Business While Commuting When determining the amount of a car s business usage for purposes of depreciation and other deductions, an individual may not consider commuting. Commuting is not business use regardless of whether work is performed on the trip.

19 MODULE 1 Car Expenses and Deductions 19 EXAMPLE A business call made on a car phone while the individual is commuting to work does not transform the character of the trip from commuting to business. Along the same lines, a business meeting that is held in a car while an individual is commuting to work does not change the character of the trip to a business trip, nor does the fact that the car is used to display advertising convert an otherwise personal use into business use (Conference Committee Report to P.L ). Car Pools Car expenses incurred in a car pool are not deductible. Payments received from passengers are not includible in income because these amounts are considered to be reimbursements for the driver s expenses. However, drivers of car pools that are operated for profit, must include payments received from their riders in their gross income and deduct expenses as in any other business (Rev. Rul , CB 20). Hauling Tools or Equipment Commuting expenses may be partially deductible (or reimbursement excludable) if a taxpayer has to transport heavy or bulky tools, materials, or equipment to and from work. If an individual incurs expenses for transporting job-required tools and materials above the ordinary, nondeductible expenses of commuting, the individual may deduct the additional expenses (such as the cost of renting a trailer that is towed by the car) (D.W. Fausner, SCt, 73-2 USTC 9515, aff g per curiam, CA-5, 73-1 USTC 9180, rehearing den.; Rev. Rul , CB 59). The deduction (or exclusion of reimbursement) is available only for that portion of the cost of transporting the work implements that is in excess of the cost of commuting by that same mode of transportation without the work implements. The fact that an employee would have used a less expensive mode of transportation were it not for the tools is immaterial (Rev. Rul , CB 59).

20 20 CAR, TRAVEL & ENTERTAINMENT, AND HOME OFFICE DEDUCTIONS CPE COURSE STUDY QUESTIONS 5. Reimbursements for car expenses paid to an employee under an accountable plan are: a. Included in wages on the employee s Form W-2. b. Exempt from income tax withholding. c. Subject to employment taxes. d. Included in the employee s gross income under other income. 6. A car used 100% for business purposes was damaged in an accident. The car originally cost $25,000. The accumulated depreciation and Code Sec. 179 deduction at the time of the accident was $15,000. The fair market value of the car immediately before the accident was $13,000. The fair market value of the car after the accident was $2,000. What is the amount of the casualty loss deduction? a. $10,000 b. $11,000 c. $13,000 d. $25, To qualify for a deduction for moving expenses, the distance between the new place of employment and the former home must be at least farther than the distance from the former home and the former place of employment. a. 18 miles b. 39 miles c. 50 miles d. 78 miles 8. Car expenses incurred in commuting between an individual s home and the individual s main or regular place of employment are generally: a. Not deductible. b. Deductible on Form 1040 as an adjustment to income. c. Deductible as a miscellaneous itemized deduction. d. Deductible on Schedule C. 9. The IRS defines the term temporary work location using a standard. a. 3 month b. 6 month c. 1 year d. 2 year

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