1998 publication 535 - internal revenue service › pub › irs-prior › p535--1998.pdf ·...

ContentsImportant Changes for 1998 ............. 2

Important Changes for 1999 ............. 2

1. Deducting Business Expenses .. 2

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 ..................................... 41

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

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

13. Depletion ...................................... 54

14. Business Bad Debts ................... 58

15. Electric and Clean-Fuel Vehicles 60

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

17. How To Get More Information ... 70

Index .................................................... 71

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

Help with unresolved tax issues. Mostproblems can be solved with one contact bycalling, writing, or visiting an IRS office. Butif you have tried unsuccessfully to resolve aproblem with the IRS, you should contact theTaxpayer Advocate's Problem ResolutionProgram (PRP). Someone at PRP will assignyou a personal advocate who is in the bestposition to try to resolve your problem. TheTaxpayer Advocate can also offer you specialhelp if you have a significant hardship as aresult of a tax problem.

You should contact the Taxpayer Advo-cate if:

• You have tried unsuccessfully to resolveyour problem with the IRS and have notbeen contacted by the date promised, or

• You are on your second attempt to re-solve a problem.

You may contact a Taxpayer Advocate bycalling a new assistance number, 1–877–777–4778. Persons who have access toTTY/TDD equipment can call 1–800–829–4059 and ask for the Taxpayer Advo-cate. If you prefer, you can write to the Tax-

Departmentof theTreasury

InternalRevenueService

Publication 535Cat. No. 15065Z

BusinessExpensesFor use in preparing

1998 Returns

payer Advocate at the office that last con-tacted you.

While Taxpayer Advocates cannot changethe tax law or make a technical tax decisionthey can clear up problems that resulted fromprevious contacts and ensure that your caseis given a complete and impartial review.Taxpayer Advocates are working to put ser-vice first. For more information about PRP,get Publication 1548, The Problem ResolutionProgram of the Internal Revenue Service.

Important Changesfor 1998The following items highlight some changesin the tax law for 1998.

Standard mileage rate. The standard mile-age rate for the cost of operating your car,van, pickup, or panel truck in 1998 is 32.5cents per mile for all business miles. You canuse the standard mileage rate for a vehicleyou lease, as well as one you own.

Vacation pay. An accrual method employercan generally deduct for a tax year vacationpay and other deferred compensation that ispaid to employees within 21/2 months after theend of the tax year. For tax years ending afterJuly 22, 1998, for determining whether anamount is deferred compensation and whendeferred compensation is paid, no amount isconsidered “paid” to an employee until it isactually received by the employee.

Meals furnished on your business prem-ises. For tax years beginning after 1997, the50% limit on deductions for meals generallydoes not apply to meals you furnish to em-ployees on your business premises if all of themeals are excluded from the employees'wages because you furnished them for yourconvenience (for substantial business rea-sons other than to provide additional pay).

Also, under a special rule enacted in 1998for any tax year, you can treat all meals youfurnish to employees on your businesspremises as furnished for your convenienceif more than half (instead of substantially all)of these employees are furnished the mealsfor your convenience. See chapter 3.

Qualified transportation fringe benefits inplace of pay. For tax years beginning after1997, you can exclude qualified transporta-tion fringe benefits from an employee's wageseven if you provide them in place of pay. Seechapter 4.

Group health plan requirements. For planyears beginning after 1997, you (or the plan,if a multi-employer plan) may be subject toan excise tax if your plan does not meet cer-tain new requirements. These requirementsgenerally:

1) Obligate plans to pay for a minimumhospital stay for mothers and newbornsif the plan otherwise provides benefits forhospital stays in connection withchildbirth, and

2) Prevent certain special limits from beingplaced on mental health benefits.

For more information, see chapter 5.

Participant's compensation. Beginning in1998, a plan participant's compensation in-cludes certain deferrals unless you elect notto include any amount contributed under asalary reduction agreement (that is not in-cluded in the gross income of the employee).The new rule, which takes into accountamounts deferred in certain employee benefitplans, will increase the tax-deferred amountthat you can contribute to a deferred contri-bution plan at the election of the employee.The deferrals include amounts contributed byan employee under a:

• Qualified cash or deferred arrangement(section 401(k) plan), or a

• Salary reduction agreement to contributeto a SIMPLE IRA plan or a SARSEP.

For more information, see chapter 6.

Matching contributions for self-employedindividuals. Beginning in 1998, matchingcontributions to a 401(k) plan on behalf of aself-employed individual will no longer betreated as elective contributions subject to thelimit on elective deferrals. The matching con-tributions for partners and other self-employed individuals will receive the sametreatment as the matching contributions ofother employees. For more information, seechapter 6.

Contributions to a SEP-IRA or a SIMPLEIRA. A SEP-IRA or a SIMPLE IRA cannotbe designated as a Roth IRA. Contributionsto a SEP-IRA or a SIMPLE IRA will not affectthe amount that an individual can contributeto a Roth IRA. For information about RothIRAs, see Publication 590.

Health insurance deduction for the self-employed. The deduction for health insur-ance of self-employed individuals increasesto 45% for 1998. For more information, seechapter 10.

Certain partnerships must figure depletionallowance. For partnership tax years begin-ning after 1997, an electing large partnership,rather than each partner, generally must fig-ure the depletion allowance for the partner-ship's oil and gas property. For more infor-mation, see chapter 13.

Taxable income limit for certain percent-age depletion. For tax years beginning after1997 and before 2000, percentage depletionon the marginal production of oil or naturalgas is not limited to taxable income from theproperty figured without the depletion de-duction. For more information, see chapter13.

Meal expense deduction for certain indi-viduals. Beginning in 1998, if an employeeis subject to the Department of Transporta-tion's hours of service limits, you may be ableto deduct 55% of the meal and beverage ex-penses you reimburse for their travel awayfrom their tax home. For more information,see chapter 16.

Important Changesfor 1999The following items highlight some changesin the tax law for 1999.

Health insurance deduction for the self-employed. For 1999, this deduction is in-creased to 60% of the amount you paid formedical insurance for yourself and your fam-ily. For more information, see chapter 10.

Business use of your home. Beginning in1999, you may be able to deduct expensesfor your home office, even if it is not whereyou perform your most important businessactivities or spend most of your businesstime. For more information, see Publication553, Highlights of 1998 Tax Changes, orPublication 587, Business Use of Your Home(Including Use by Day-Care Providers).

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

m 334 Tax Guide for Small Business

m 463 Travel, Entertainment, Gift andCar Expenses

m 529 Miscellaneous Deductions

m 536 Net Operating Losses

m 538 Accounting Periods and Methods

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

m 551 Basis of Assets

m 587 Business Use of Your Home (In-cluding Use by Day-Care Provid-ers)

m 925 Passive Activity and At-Risk Rules

m 936 Home Mortgage Interest De-duction

m 946 How To Depreciate Property

Chapter 1 Deducting Business Expenses

Form (and Instructions)

m Sch A (Form 1040) Itemized De-ductions

m 5213 Election To Postpone Determi-nation as To Whether thePresumption Applies That an Ac-tivity Is Engaged in for Profit

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

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.

TIPIf you have an expense that is partlyfor business and partly personal,separate the personal part from the

business 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.

The following are types of expenses thatgo into figuring cost of goods sold.

• The cost of products or raw materials inyour inventory, including the cost of hav-ing them shipped to you.

• The cost of storing the products you sell.

• Direct labor costs (including contributionsto pension or annuity plans) for workerswho produce the products.

• Depreciation on machinery used toproduce the products.

• Factory overhead expenses.

Under the uniform capitalization rules, youmay have to include certain indirect costs ofproduction and resale in your cost of goodssold. 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 sold—chapter 6 of Publi-cation 334.

• Inventories—Publication 538.

• Uniform capitalization rules—section1.263A of 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.

3) Improvements.

Recovery. Although you generally cannottake a current deduction for a capital ex-pense, you may be able to take deductionsfor the amount you spend through a methodof depreciation, amortization, or depletion.These methods allow you to deduct part ofyour cost each year over a number of years.In this way you are able to “recover” yourcapital expense. See Amortization (chapter12) and Depletion (chapter 13) in this publi-cation. For information on depreciation, seePublication 946.

Going Into BusinessThe costs of getting started in business, be-fore you actually begin business operations,are capital expenses. These costs may in-clude expenses for advertising, travel, utili-ties, 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 Business in chapter 12 formore information on business start-up costs.

If you do not go into business. If you arean individual, and your attempt to go intobusiness is not successful, the expenses youhad in trying to establish yourself in businessfall 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.

If you are a corporation, and your attemptto go into a new trade or business is notsuccessful, you may be able to deduct allinvestigatory costs as a loss.

The costs of any assets acquired duringyour unsuccessful attempt to go into businessare 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 capitalizationrules. 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 businessexpense.

Improvements include new 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. Capitalizethat 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 usuallycapitalize the cost of a motor vehicle you buyto use in your business. You can recover itscost through annual deductions for depreci-ation.

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 maintain-ing a private road on your business propertyis a deductible 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 theinterest 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 partof your home in your business, you may beable to claim part of the expenses of main-taining your home as a business expense.These expenses include mortgage interest,insurance, utilities, repairs and depreciation.

The business use of your home must meetstrict requirements before you can take anyof these expenses as business deductions.

To qualify to claim expenses for the busi-ness use of your home, you must meet thefollowing tests.

1) Your use must be:

a) Exclusive (however, see the ex-ceptions below),

b) Regular,

c) For your trade or business, AND

2) The business part of your home must beone of the following:

a) Your principal place of business foryour trade or business, or

b) A place of business where youmeet or deal with patients, clients,or customers in the normal courseof your trade or business, or

c) A separate structure (not attachedto your home) that you use in con-nection with your trade or business.

You do not have to meet the exclusive usetest if:

1) You use part of your home for the stor-age of inventory or product samples, or

2) You use part of your home as a day-carefacility.

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 the car forbusiness are deductible as business ex-penses.

You can deduct actual car expenses,which include depreciation (or lease pay-

ments), gas and oil, tires, repairs, tune-ups,insurance, and registration fees. Instead offiguring the business part of these actual ex-penses, you may be able to use a standardmileage rate to figure your deduction. For1998, the standard mileage rate for a car thatyou own or lease is 32.5 cents for eachbusiness mile.

If you are self-employed, you can alsodeduct the business part of interest on yourcar loan, state and local personal property taxon the car, parking fees, and tolls, whetheror not you claim the standard mileage rate.You can use the nonbusiness part of thepersonal property tax to determine your de-duction for taxes on Schedule A (Form 1040)if you itemize your deductions.

For more information on car expenses andthe rules for using the standard mileage rate,see Publication 463.

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 re-cover part of an expense in the same tax yearfor which you have claimed a deduction, re-duce your expense deduction by the amountof the recovery. If you have a recovery in alater year, include the recovered amount inincome. However, if part of the deduction forthe expense did not reduce your tax, you donot have to include all the recovery in income.Exclude an amount equal to the part that didnot reduce your tax.

For more information on recoveries andthe tax benefit rule, see Publication 525,Taxable and Nontaxable Income.

Payments in kind. If you provide servicesto pay a business expense, the amount youcan deduct is the amount you spend to pro-vide the services. It is not what you wouldhave paid 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.

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 activityfor:

1) The money and adjusted basis of prop-erty you contribute to the activity, and

2) 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.

When Can anExpense BeDeducted?When an expense can be deducted dependson your accounting method. An accountingmethod is a set of rules used to determinewhen and how income and expenses are re-ported. The two basic methods are the cashmethod and an accrual method.

For more information on accountingmethods, see Publication 538.

Cash method. Under the cash method ofaccounting, you deduct business expenses inthe tax year you actually paid them, even ifyou incur them in an earlier year.

Accrual method. Under an accrual methodof accounting, 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.

Economic performance rule. Under anaccrual method, you generally cannot deductor capitalize business expenses until eco-nomic performance occurs. If your expenseis for property or services provided to you, orfor your use of property, 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 services.

Example. Your tax year is the calendaryear. In December 1998, the Field PlumbingCompany did some repair work at your placeof business and sent you a bill for $150. Youpaid it by check in January 1999. If you usean accrual method of accounting, deduct the$150 on your tax return for 1998 because allevents that set the amount of liability and


economic performance occurred in that year.If you use the cash method of accounting, youcan deduct the expenses on your 1999 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 1998, you sign a 10-yearlease and immediately pay your rent for thefirst three years. Even though you paid therent for 1998, 1999, and 2000, you can de-duct only the rent for 1998 on your current taxreturn. You can deduct on your 1999 and2000 tax returns the rent for those years.

Contested liabilities. Under the cashmethod, you can deduct a contested liabilityonly in the year you pay the liability. Underan accrual method, you can deduct contestedliabilities, such as taxes (except foreign orU.S. possession income, war profits, and ex-cess profits taxes), in the tax year you pay theliability (or transfer money or other propertyto satisfy the obligation), or in the tax year yousettle the contest. However, to take the de-duction in the year of payment or transfer, youmust meet certain conditions. See ContestedLiability in Publication 538 for more informa-tion.

Related persons. 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 persons” 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 RelatedPersons in 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 consider are whether:

1) You carry on the activity in a business-like manner,

2) The time and effort you put into the ac-tivity indicate you intend to make it prof-itable,

3) You depend on income from the activityfor your livelihood,

4) Your losses are due to circumstancesbeyond your control (or are normal in thestart-up phase of your type of business),

5) You change your methods of operationin an attempt to improve profitability,

6) You, or your advisors, have the knowl-edge needed to carry on the activity asa successful business,

7) You were successful in making a profitin similar activities in the past,

8) The activity makes a profit in someyears, and how much profit it makes, and

9) You can expect to make a future profitfrom the appreciation of the assets usedin 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.

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

(Form 1040). They are subject to the2%-of-adjusted-gross-income limit. See Pub-lication 529 for information on this limit.

Example. Ida is engaged in a not-for-profit activity. The income and expenses ofthe 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), asfollows:

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

3 $300 = $225 depreciation for the automobile$800

$2003 $300 = $75 depreciation for the machine$800

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 following are the most significantfacts and circumstances in making this de-termination.

• The degree of organizational and eco-nomic interrelationship of various under-takings.

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

• 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.

TIPIf 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.

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


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 that your activity is not carried on forprofit until 5 (or 7) years have passed sinceyou started the activity.

TIPForm 5213 must be filed within 3years of the due date of your returnfor the year in which you first carried

on the activity; or, if earlier, within 60 days ofreceiving written notice from the InternalRevenue Service proposing to disallow de-ductions attributable to 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 earna profit in 3 (or 2) out of the first 5 (or 7) yearsyou carry on the activity. If you show 3 (or2) 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

Important Changefor 1998Vacation pay. An accrual method employercan generally deduct for a tax year vacationpay and other deferred compensation that ispaid to employees within 21/2 months after theend of the tax year. For tax years ending afterJuly 22, 1998, for determining whether anamount is deferred compensation and whendeferred compensation is paid, no amount isconsidered “paid” to an employee until it isactually received by the employee.

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

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

m 15 Circular E, Employer's Tax Guide

m 15–A Employer's Supplemental TaxGuide

m 521 Moving Expenses




m W–2 Wage and Tax Statement

m 3800 General Business Credit


Deductibility of PayYou generally can deduct as a business ex-pense salaries, wages, and other forms ofpay you make to employees for personalservices. 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.See Tests 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-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.

Chapter 2 Employees' Pay

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 recoveryour 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. Youmust 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, see 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 in carryingon 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 servicesunder similar circumstances.

You must be able to prove the pay isreasonable. Base this test on the circum-stances that exist when you contract for theservices, not those existing when the rea-sonableness is questioned. If the pay is ex-cessive, you can deduct only the part that isreasonable.

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 the employee.

If you use an accrual method of account-ing, deduct your expense for the salary orwage when you establish your obligation tomake the payment, when you can determinethe amount of the obligation with reasonablecertainty, and when economic performanceoccurs. Economic performance generally oc-curs as an employee performs the servicesfor you. The economic performance rule isdiscussed in When Can an Expense Be De-ducted? in chapter 1. Your payment need notbe made in the year the obligation exists. Youcan defer it to a later date, but special rulesapply. See Unpaid Salaries, 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, for you to deduct the amount as wages,the total bonuses, salaries, and other paymust be reasonable for the services per-formed. Include the bonus in the employee'sincome. You can pay a bonus in cash, prop-erty, or a combination 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 personalproperty that meets all the following require-ments.

• It is given for length of service or safetyachievement.

• It is awarded as part of a meaningfulpresentation.

• It is awarded under conditions and cir-cumstances that do not create a signif-icant likelihood of disguised pay.

Length-of-service award. An award willnot qualify as a length-of-service achievementaward if either of the following applies.

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

• 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 given to either of the following.

1) A manager, administrator, clerical em-ployee, or other professional employee.

2) More than 10% of the employees duringthe year, excluding those listed 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) is more than $400. To figure 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 arenot more than the limits, you can excludethem from the employee's income and youcan deduct them on the “Other deductions”line of your tax return or business schedule.

If the award costs more than the amountyou can deduct, include in the employee'sincome the larger of the following amounts.

• The part of the cost of the award youcannot deduct (up to the award's fairmarket value).

• 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 RateLoans in 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 at one of thefollowing times.

• By the close of your tax year.

• 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.

For tax years ending after July 22, 1998,vacation pay is not considered “paid” until itis actually received by the employee.

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 person (definednext) until the tax year that both the followinghave occurred.

• You make the payment.

• The amount is includible in the incomeof the person paid.

This rule applies even if you and that personcease to be related persons before the

amount is includible in that person's grossincome.

Related persons. For this special rule,related persons include the following.

1) Members of a family, but only the fol-lowing relatives.

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.

1) Stock owned directly or indirectly by orfor a corporation, partnership, estate, ortrust is considered owned proportion-ately by or for its shareholders, partners,or beneficiaries.

2) Stock owned directly or indirectly by orfor an individual's family is consideredowned by the individual. See Relatedpersons, earlier, for persons consideredmembers of a family.

3) An individual owning any stock in a cor-poration (other than because of rule (2)above) is considered to own the stockowned directly or indirectly by or for theindividual's partner.

4) Stock considered owned by a personbecause of rule (1) is treated, for apply-ing rules (1), (2), or (3), as actuallyowned by that person. But stock con-sidered owned by an individual becauseof rules (2) or (3) is not treated as ownedby that individual for applying either rule(2) or (3) again to consider another theowner of that 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. Tomcannot 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 holdingsto 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 relatedpersons 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 mustinclude 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 theexpense 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, include in the cost of goods soldthe cost of food your employees eat. If youoperate a cafeteria for your employees, de-duct the costs of operating it on your returnas business expenses. Similarly, if you rentor buy a house for an employee, you deductthe cost of insurance, utilities, rent, and/ordepreciation in each of those categories onyour 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 also depends onwhether you required it as a condition of em-ployment. 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.

• You deduct the payment under an ac-countable plan in the category of theexpense paid. For example, if you payan employee for travel expenses incurredon your behalf, deduct this payment asa travel expense on your return. See theinstructions for the form you file for infor-mation on which lines to use.

• Include the payment under a nonac-countable plan in 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 qualifiedmoving expense reimbursements. Qualifiedmoving expense reimbursements are thosefor expenses the employee could deduct ifhe or she paid or incurred them.

Deduct as wages any reimbursement thatis not for a qualified moving expense re-imbursement (that is, an expense the em-ployee cannot deduct).

Form W–2. You must show any reimburse-ment paid directly to an employee for movingexpenses on the employee's Form W–2.However, report any amount considered aqualified fringe benefit in box 13, not aswages 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 inRestricted 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 in

part 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 W–2 or Form 1099–MISC(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 1099–MISC, or

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

3.Meals andLodgingFurnished toEmployees

Important Changefor 1998Meals furnished on your business prem-ises. For tax years beginning after 1997, the50% limit on deductions for meals generallydoes not apply to meals you furnish to em-ployees on your business premises if all of themeals are excluded from the employees'wages because you furnished them for yourconvenience (for substantial business rea-sons other than to provide additional pay).See Deduction limit on meals under De-duction for Meals and Lodging.

Also, under a special rule enacted in 1998for any tax year, you can treat all meals youfurnish to employees on your businesspremises as furnished for your convenienceif more than half (instead of substantially all)of these employees are furnished the mealsfor your convenience. See Test 2—For YourConvenience under Exclusion From Em-ployee Wages.

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 thatall 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 must

include in your employees' wages.


• Deduction for meals and lodging

• Exclusion from employee wages


Publication



Deduction forMeals 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, later.

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.

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.

• Meals that qualify as a de minimis fringebenefit as discussed in chapter 4. For taxyears beginning after 1997, this generallyincludes meals you furnish to employeeson your business premises if more thanhalf of these employees are furnished themeals for your convenience.

• Meals whose value you include in anemployee's wages. For more information,see Exclusion From Employee Wages,later.

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

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

• Meals you must furnish to crew membersof a commercial vessel under a federallaw. This includes crew members ofcommercial 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 furnish

Chapter 3 Meals and Lodging Furnished to Employees

on vessels primarily providing luxury wa-ter transportation.

• 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 anyone else inconnection with the employee's services. Usethe general valuation rule, discussed inchapter 4, to determine the amount to includein the employee's wages. However, if youprovide meals at an employer-operated eat-ing facility, you may be able to use theemployer-operated eating facility rule to valuethe meals. For more information, see chapter4.

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, you canexclude from an employee's wages the valueof meals and lodging you, or a third party onyour behalf, furnish to the employee or theemployee's spouse or dependents if you meetall the following tests.

• 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 employee must accept thelodging on your business premises as acondition of his or her employment.

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 1—On 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 2—For 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.

• Meals you furnish during working hoursso your employee will be available foremergency calls during the meal period.However, you must be able to show thatthese emergency calls have occurred orcan reasonably be expected to occur.

• 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 qualify.

• Meals you furnish during work hours be-cause your employee could not otherwiseeat proper meals within a reasonableperiod of time. For example, meals canqualify if there are insufficient eating fa-cilities near the place of employment.

• Meals you furnish to a restaurant or otherfood service employee for each mealperiod in which the employee works, ifyou furnish the meals during, immediatelybefore, or immediately after work hours.For example, if a waitress works throughthe breakfast and lunch periods, you canexclude from her wages the value of thebreakfast and lunch you furnish in yourrestaurant for each day she works.

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

• All meals you furnish to employees onyour business premises if more than halfof these employees are furnished mealsfor a substantial nonpay business reason.

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. Theyare not furnished for your convenience unlessyou also have a substantial nonpay businessreason for furnishing the meals.

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 3—Lodging 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 whether or notthey eat the meals, do not include the flatamount you charge in your employees'wages. You have to include the actual valueof the meals in your employees' wages if Test1 and Test 2 are not met.

If you charge your employees a flatamount for meals whether or not they eat themeals, but you have to include the value ofthe meals in your employees' wages, includethe value of the meals whether it is more orless than the amount you charged. If no evi-dence indicates otherwise, the value of themeals is the amount you charged for them.

Test 3—Lodging 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 you meet Tests 1, 2, and3. If you do not meet all of these tests, 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.

Employment TaxesThe value of meals and lodging you properlyexclude from an employee's wages is notsubject to social security, Medicare, and fed-eral unemployment taxes, or income taxwithholding.

ExamplesThese examples will help you determinewhether to include in your employees' wagesthe 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).The facts are the same as in Example 1, ex-cept that you also allow Carol to have mealson your business premises without charge onher days off. You must include the value ofthese meals 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 limit

Chapter 3 Meals and Lodging Furnished to Employees

his 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'swages.

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 120 employees available foremergencies. Each of these employees is attimes called upon to perform services duringthe meal period. Although the hospital doesnot require these employees to remain on thepremises, they rarely leave the hospital duringtheir meal period. Since the hospital furnishesmeals to its employees to have more than halfof them available for emergency calls duringmeal periods, the hospital does not includethe value of these meals in the wages of anyof 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 Changesfor 1998Meals furnished to employees. For taxyears beginning after 1997, if the value ofmeals you provide at your eating facility foremployees can be excluded from wages be-cause you furnish them for your convenience,you may be able to treat the meals as a deminimis fringe benefit. See De Minimis (Mini-mal) Fringe.

Qualified transportation fringe benefits inplace of pay. For tax years beginning after1997, you can exclude qualified transporta-tion fringe benefits from an employee's wageseven if you provide them in place of pay. SeeQualified Transportation Fringe.

Vehicle cents-per-mile rule. The standardmileage rate you can use under the vehiclecents-per-mile rule to value the personal useof a car, van, pickup, or panel truck you pro-vide to an employee in 1998 is 32.5 cents permile for all personal miles. See VehicleCents-Per-Mile Rule.

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 1.61–21 of the Income Tax Reg-ulations.


• General information

• The general valuation rule

• Special valuation rules

• Exclusion of certain fringe benefits fromemployee income


Publication


m 521 Moving Expenses


General InformationA fringe benefit is a form of pay provided toany person for the performance of servicesby that person. For the rules discussed in thischapter, treat a person who agrees not toperform services (such as under a covenantnot to compete) as performing services.

Examples of fringe benefits you may pro-vide include the following items.

• 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, youmay 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” includesany 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 wages. The benefitsare subject to income and employment taxes.

You and the employee will generally usethe general valuation rule, discussed later, tofigure the amount of a fringe benefit to includein the employee's income. However, you andthe employee can use special rules to valuecertain fringe benefits. For more information,see Special Valuation Rules, later.

TIPNonemployee compensation. If therecipient of a taxable fringe benefit isnot your employee, the benefit is not

subject to employment taxes. However, youmay have to report it on Form 1099–MISC,Miscellaneous Income, and you may have towithhold income tax under the backup with-holding rules. See the Instructions for Forms1099, 1098, 5498, and W–2G for more infor-mation.

Deducting the cost. Even though youinclude an amount for noncash fringe benefitsin an employee's wages, you cannot deductthat amount as wages. But you may be ableto take an expense or depreciation deductionfor your costs to provide the benefit. For ex-ample, if a noncash fringe benefit you provideto an employee is the use of property youlease, you must include the amount (value)of the benefit in the employee's wages, butyou cannot deduct that amount as wages.However, you may be able to deduct the rentas a business expense.

When fringe benefits are treated as paid.You may choose to treat certain taxablenoncash fringe benefits (other than benefitsyou provide as nonemployee compensation)as paid by the pay period, or by the quarter,or on any other basis you choose as long asyou treat the benefits as paid at least as oftenas once a year. However, this choice doesnot apply to fringe benefits that involve thetransfer of personal property normally held forinvestment or the transfer of real property.Treat these benefits, and taxable cash fringebenefits, as paid when they are made avail-able to the employee.

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 longas 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 on

Chapter 4 Fringe Benefits

March 31, June 30, September 30, and De-cember 31.

Accounting period. You generally have theoption to report taxable noncash fringe bene-fits (other than benefits provided as nonem-ployee compensation) by using either of thefollowing rules.

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

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 deferonly the benefit you actually provide duringthe last 2 months.

Use of special rule is optional. You canuse the special accounting period rule forsome fringe benefits and not for others. Theperiod of use need not be the same for eachfringe benefit. However, if you use the rule fora particular benefit, use it for all employeeswho receive that benefit.

If you use the special accounting periodrule, your employee must use it for the sameperiod for all purposes. However, your em-ployee can use it only 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 marketvalue of a fringe benefit is more than the sumof the following amounts.

1) Any amount the employee paid for thebenefit.

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

However, you and the employee may usespecial rules to value certain fringe benefits.(See Special Valuation Rules, later.)

If the law excludes a fringe benefit costfrom gross income, do not include in the em-ployee's wages the difference between thefair market value and the excludable cost ofthat fringe benefit. If the law excludes a lim-

ited amount of the cost, however, include thefair market value of the fringe benefit that isdue to any excess cost.

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 theemployee would have to pay a third party inan arm's-length transaction to buy or leasethe 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.

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. A comparable leaseterm would be the amount of time the vehicleis available for the employee's use, such asa 1-year period.

Do not determine the value by multiplyinga cents-per-mile rate times the number ofmiles driven unless the employee can provethe vehicle could have been leased on acents-per-mile basis. (However, see VehicleCents-Per-Mile Rule, later.)

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 fol-lowing rules.

• Automobile lease rule.

• Vehicle cents-per-mile rule.

• Commuting rule.

• Unsafe conditions commuting rule.

• Employer-operated eating facility rule.

Conditions for use. When reporting fringebenefits, you can choose to use any of thespecial rules. However, neither you nor theemployee 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) The employee includes the value of thebenefit in income by the due date of thereturn for the year the employee receivesthe benefit.

3) The employee is not a control employeeas defined later under Commuting Rule.

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

Using the special rules. All of the followingrules apply when you use the special rules.

1) If you use one of the special rules tovalue a benefit you provide to the em-

ployee, the employee can use that spe-cial rule. If you do not use one of thespecial rules, the employee can use aspecial rule only if 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 always use the general val-uation rule discussed earlier.

2) If you and the employee properly use aspecial rule, the employee must includein gross income the value you determineunder the rule, minus any amount he orshe paid you and any amount excludedby law from gross income. If you alsoproperly determine the amount of theemployee's working condition fringebenefit (explained later under Exclusionof Certain Fringe Benefits), the em-ployee must include in gross income thenet value you determined, minus anyamount he or she paid you. You and theemployee can use the special rule todetermine the amount the employeeowes 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, you mustuse that rule for all employees who shareuse of the vehicle.

4) You can use the formulas in the specialrules only with those rules. When youproperly apply a special rule to a fringebenefit, the IRS will accept your value forthat fringe benefit. However, if you donot properly apply a special rule, or if youuse a special rule but are not entitled todo so, the IRS will use the general valu-ation rule to value the fringe benefit.

More information. For more information onthe special valuation rules, including those(such as the rules for aircraft) not discussedin this chapter, see section 1.61–21(c)–(k) ofthe Income Tax Regulations.

Automobile Lease RuleIf you provide an employee with an automo-bile for an entire calendar year, you can usethe automobile's annual lease value to valuethe benefit. If you provide an employee withan automobile for less than an entire calendaryear, the value of the benefit is either a pro-rated annual lease value or the daily leasevalue (discussed later). Include the leasevalue in the employee's wages unless it isexcluded from gross income by law.

For this rule, automobile means anyfour-wheeled vehicle manufactured primarilyfor use on public streets, roads, and high-ways.

Benefits excluded for business use. If theemployee uses the automobile for business,he or she may qualify to exclude part of thelease value as a working condition fringebenefit. You can reduce the amount of thelease value by the working condition fringeand include the net amount in the employee'swages, or you can choose to include the en-tire lease value. See Vehicle-allocation rulesunder Working Condition Fringe, later.


Annual Lease ValueGenerally, you figure the annual lease valueof an automobile as follows:

1) Determine the FMV of the automobile(discussed later) on the first date theautomobile is available to any employeefor personal use.

2) Using the following Annual Lease ValueTable, read down column 1 until youcome to the dollar range within which theFMV of the automobile falls. Then readacross to column 2 to find the annuallease value.

For vehicles with an FMV of more than$59,999, the annual lease value equals: (0.25× the FMV of the automobile) + $500.

Fair market value. The FMV of the auto-mobile is the amount a person would pay tobuy it from a third party, in an arm's lengthtransaction, in the area in which the vehicleis bought or leased. That amount includes allpurchase expenses, such as sales tax andtitle fees.

If you have 20 or more automobiles, seesection 1.61–21(d)(5)(v) of the Income TaxRegulations. If you and the employee own orlease the automobile together, see section1.61–21(d)(2)(ii) of the Income Tax Regu-lations.

You do not have to include the FMV of atelephone or any specialized equipmentadded to, or carried in, the automobile if theequipment is necessary for your business.However, include the value of specialized

equipment in the FMV if the employee towhom the automobile is available uses thespecialized equipment in a trade or businessother than yours.

Neither the amount the employee consid-ers to be the value of the fringe benefit noryour cost for either buying or leasing the au-tomobile determines its FMV. However, seeSafe-harbor value, next.

Safe-harbor value. You may be able touse a safe-harbor value as the FMV. For anautomobile you bought at arm's length, thesafe-harbor value is your cost, including tax,title, and other purchase expenses. You can-not have been the manufacturer of the vehi-cle.

For an automobile you lease, the safe-harbor value is:

1) The manufacturer's invoice price (in-cluding options) plus 4%,

2) The manufacturer's suggested retailprice less 8% (including sales tax, title,and other expenses of purchase), or

3) The retail value of the automobile re-ported by a nationally recognized pricingsource, if that retail value is reasonablefor that automobile.

Items included in annual lease value table.Each annual lease value in the table includesthe FMV of maintenance and insurance ser-vices for the automobile. Do not reduce thisvalue by the FMV of any of these servicesthat you did not provide. For example, do notreduce the annual lease value by the FMVof a maintenance service contract or insur-ance you did not provide. (You can take intoaccount the services actually provided for theautomobile by using the general valuationrule, discussed earlier.)

Items not included. The annual leasevalue does not include the FMV of fuel youprovide to an employee for personal use, re-gardless of whether you provide it, reimburseits cost, or have it charged to you. You mustinclude the value of the fuel separately in theemployee's wages. You can value fuel youprovided at FMV or at 5.5 cents per mile forall miles driven by the employee. However,you cannot value at 5.5 cents per mile fuelyou provide for miles driven outside theUnited States (including its possessions andterritories), Canada, and Mexico.

If you reimburse an employee for the costof fuel, or have it charged to you, you gener-ally value the fuel at the amount you reim-burse, or the amount charged to you if it wasbought at arm's length.

If you have 20 or more automobiles, seesection 1.61–21(d)(3)(ii)(D) of the Income TaxRegulations.

If you provide any service other thanmaintenance and insurance for an automo-bile, you must add the FMV of that service tothe annual lease value of the automobile indetermining the value of the benefit.

Consistency rules. If you adopt the auto-mobile lease rule for an automobile, the fol-lowing rules apply.

1) You must adopt it by the first day youmake the automobile available to anyemployee for personal use. However,the following exceptions apply.

a) If you adopt the commuting rulewhen you first make the automobileavailable to any employee for per-sonal use, you can change to the

automobile lease rule on the firstday for which you do not use thecommuting rule.

b) If you adopt the vehicle cents-per-mile rule when you first make theautomobile available to any em-ployee for personal use, you canchange to the automobile lease ruleon the first day on which the auto-mobile no longer qualifies for thatrule.

2) You must use the rule for all later yearsin which you make the automobile avail-able to any employee, except that forany year during which use of the auto-mobile qualifies, you can use the com-muting rule.

3) You must continue to use the rule if youprovide a replacement automobile to theemployee and your primary reason forthe replacement is to reduce federaltaxes.

4) The employee can use the automobilelease rule only if the employee uses therule beginning with the first day on whichthe automobile is made available to theemployee for personal use (and the em-ployer does not use the commuting rule.

4-year lease term. The annual lease valuesin the table are based on a 4-year lease term.These values will generally stay the same forthe period that begins with the first date youuse this special rule for the automobile andends on December 31 of the 4th full calendaryear following that date.

Figure the annual lease value for eachlater 4-year period by determining the FMVof the automobile on January 1 of the firstyear of the later 4-year period and selectingthe amount in column 2 of the table that cor-responds to the appropriate dollar range incolumn 1.

Using the special accounting periodrule. If you use the special accounting periodrule, discussed earlier, you can figure theannual lease value for each later 4-year pe-riod at the beginning of the special accountingperiod that starts immediately before theJanuary 1 date described in the previousparagraph.

For example, assume that you use thespecial accounting period rule and that be-ginning on November 1, 1997, the specialaccounting period is November 1 to October31. You elect to use the automobile leasevaluation rule as of January 1, 1998. You canrefigure the annual lease value on November1, 2001, rather than on January 1, 2002.

Transferring an automobile from one em-ployee to another. Unless the primary pur-pose of the transfer is to reduce federal taxes,you can refigure the annual lease valuebased on the FMV of the automobile on Jan-uary 1 of the calendar year of transfer.

However, if you use the special account-ing period rule, you can refigure the annuallease value (based on the FMV of the auto-mobile) at the beginning of the special ac-counting period in which the transfer occurs.If you do not refigure the annual lease value,the employee cannot refigure it.

Prorated annual lease value. If you providean automobile to an employee for continuousperiods of 30 or more days but less than anentire calendar year, you can prorate the an-nual lease value. Figure the prorated annual

Annual Lease Value Table(1) (2)

AnnualAutomobile LeaseFair Market Value Value

$0 to 999 ..................................................... $6001,000 to 1,999 ............................................. 8502,000 to 2,999 ............................................. 1,1003,000 to 3,999 ............................................. 1,3504,000 to 4,999 ............................................. 1,6005,000 to 5,999 ............................................. 1,8506,000 to 6,999 ............................................. 2,1007,000 to 7,999 ............................................. 2,3508,000 to 8,999 ............................................. 2,6009,000 to 9,999 ............................................. 2,85010,000 to 10,999 ......................................... 3,10011,000 to 11,999 ......................................... 3,35012,000 to 12,999 ......................................... 3,60013,000 to 13,999 ......................................... 3,85014,000 to 14,999 ......................................... 4,10015,000 to 15,999 ......................................... 4,35016,000 to 16,999 ......................................... 4,60017,000 to 17,999 ......................................... 4,85018,000 to 18,999 ......................................... 5,10019,000 to 19,999 ......................................... 5,35020,000 to 20,999 ......................................... 5,60021,000 to 21,999 ......................................... 5,85022,000 to 22,999 ......................................... 6,10023,000 to 23,999 ......................................... 6,35024,000 to 24,999 ......................................... 6,60025,000 to 25,999 ......................................... 6,85026,000 to 27,999 ......................................... 7,25028,000 to 29,999 ......................................... 7,75030,000 to 31,999 ......................................... 8,25032,000 to 33,999 ......................................... 8,75034,000 to 35,999 ......................................... 9,25036,000 to 37,999 ......................................... 9,75038,000 to 39,999 ......................................... 10,25040,000 to 41,999 ......................................... 10,75042,000 to 43,999 ......................................... 11,25044,000 to 45,999 ......................................... 11,75046,000 to 47,999 ......................................... 12,25048,000 to 49,999 ......................................... 12,75050,000 to 51,999 ......................................... 13,25052,000 to 53,999 ......................................... 13,75054,000 to 55,999 ......................................... 14,25056,000 to 57,999 ......................................... 14,75058,000 to 59,999 ......................................... 15,250


lease value by multiplying the annual leasevalue by a fraction, using the number of daysof availability as the numerator and 365 as thedenominator.

If you provide an automobile continuouslyfor at least 30 days, but the period covers 2calendar years (2 special accounting periodsif you are using the special accounting periodrule, discussed earlier), you can use the pro-rated annual lease value or the daily leasevalue.

If you have 20 or more automobiles, seesection 1.61–21(d)(6) of the Income TaxRegulations.

If an automobile is unavailable to the em-ployee because of his or her personal rea-sons (for example, if the employee is on va-cation), you cannot take into account theperiods of unavailability when you use a pro-rated annual lease value.

CAUTION!

You cannot use a prorated annuallease value if the reduction of federaltax is the main reason the automobile

is unavailable.

Daily lease value. If you provide an auto-mobile for continuous periods of one or morebut less than 30 days, use the daily leasevalue to figure its value. Figure the daily leasevalue by multiplying the annual lease valueby a fraction, using four times the number ofdays of availability as the numerator and 365as the denominator.

However, you can apply a prorated annuallease value for a period of continuous avail-ability of less than 30 days by treating theautomobile as if it had been available for 30days. Use a prorated annual lease value if itwould result in a lower valuation than applyingthe daily lease value to the shorter period ofavailability.

Vehicle Cents-Per-Mile RuleUnder this rule, you determine the value of avehicle you provide to an employee for per-sonal use by multiplying the standard mileagerate by the total miles the employee drives thevehicle for personal purposes. For 1998, thisrate is 32.5 cents per mile.

You can use the vehicle cents-per-milerule if you provide an employee with a vehiclethat:

1) You reasonably expect will be regularlyused in your trade or business through-out the calendar year (or for a shorterperiod during which you own or lease it),or

2) Meets the mileage rule requirementsdiscussed later.

CAUTION!

When you cannot use the cents-per-mile rule. You cannot use thevehicle cents-per-mile rule for an au-

tomobile first made available to an employeefor personal use in 1998 if the FMV of theautomobile is more than $15,600. If you andthe employee own or lease the automobiletogether, see section 1.61–21(e)(1)(iii) of theIncome Tax Regulations.

Apply the standard mileage rate only topersonal miles. Disregard business miles.For example, if the employee drives 20,000personal miles and 35,000 business miles in1998, the personal use value of the vehicleis $6,500 (20,000 × 0.325).

Personal use is any use of the vehicleother than use in your trade or business.

For the vehicle cents-per-mile rule, a ve-hicle is any motorized wheeled vehicle, in-cluding an automobile, manufactured prima-rily for use on public streets, roads, andhighways.

Regular use in your business. Determinewhether a vehicle is regularly used in yourtrade or business on the basis of all the factsand circumstances. A vehicle is regularlyused in your trade or business if it meets oneof the following safe-harbor conditions.

1) At least 50% of the vehicle's total annualmileage is for your trade or business.

2) You sponsor a commuting pool thatgenerally uses the vehicle each workdayto drive at least 3 employees to and fromwork.

Infrequent business use of the vehicle,such as for occasional trips to the airport orbetween your multiple business premises, isnot regular use of the vehicle in your tradeor business.

Mileage rule. If you provide an employeewith a vehicle you do not expect the employeeto use regularly in your trade or business butthat meets the mileage rule, you can use thecents-per-mile method to value the benefit. Avehicle meets the mileage rule for a calendaryear if:

1) It is actually driven at least 10,000 milesin that year, and

2) It is used during the year primarily byemployees.

Consider the vehicle used primarily byemployees if they use it consistently forcommuting. For example, if only one em-ployee uses a vehicle during the year and thatemployee drives the vehicle at least 10,000miles in that calendar year, the vehicle meetsthe mileage rule even if all miles driven by theemployee are personal. Do not treat use ofthe vehicle by an individual (other than theemployee) whose use would be taxed to theemployee as use by the employee. If youown or lease the vehicle only part of the year,reduce the 10,000 mile requirement propor-tionately.

Items included in cents-per-mile rate. Thecents-per-mile rate includes the FMV ofmaintenance and insurance for the vehicle.Do not reduce the rate by the FMV of anyservice included in the rate that you did notprovide. (You can take into account the ser-vices actually provided for the vehicle by us-ing the general valuation rule, discussed ear-lier.)

For miles driven in the United States, itsterritories and possessions, Canada, andMexico, the cents-per-mile rate includes theFMV of fuel you provide. If you do not providefuel, you can reduce the rate by no more than5.5 cents.

For special rules that apply to fuel youprovide for miles driven outside the UnitedStates, Canada, and Mexico, see section1.61–21(e)(3)(ii)(B) of the Income Tax Regu-lations.

The FMV of any other service you providefor a vehicle is not included in the cents-per-mile rate. Use the general valuation rule tovalue these services.

Consistency rules. If you adopt the cents-per-mile rule for an automobile, the followingrules apply.

1) You must adopt it by the first day youmake the automobile available to anyemployee for personal use. However, ifyou adopt the commuting rule when youfirst make the automobile available toany employee for personal use, you canchange to the cents-per-mile rule on thefirst day for which you do not use thecommuting rule.

2) You must use the rule for all later yearsin which you make the automobile avail-able to any employee and the automo-bile qualifies, except that for any yearduring which use of the automobilequalifies for the commuting rule, you canuse the commuting rule. However, if thevehicle does not qualify for the cents-per-mile rule during a later year, you canadopt for that year and thereafter anyother special rule for which the vehiclethen qualifies.

3) You must continue to use the rule if youprovide a replacement automobile to theemployee and your primary reason forthe replacement is to reduce federaltaxes.

4) The employee can use the vehiclecents-per-mile rule only if the employeeuses the rule beginning with the first dayon which the automobile is made avail-able to the employee for personal use(and the employer does not use thecommuting rule).

Commuting RuleUnder this rule, the value of the commutinguse of a vehicle you provide is $1.50 perone-way commute (that is, from home to workor from work to home) for each employee whocommutes in the vehicle.

The term vehicle means any motorizedwheeled vehicle, including an automobile,manufactured primarily for use on publicstreets, roads, and highways.

You can use this special rule to figurecommuting value if you and the employeemeet all the following requirements.

1) You own or lease the vehicle and pro-vide it to one or more employees for usein your trade or business.

2) For bona fide noncompensatory busi-ness reasons, you require the employeeto commute in the vehicle.

3) You establish a written policy underwhich you do not allow the employee touse the vehicle for personal purposes,other than for commuting or de minimispersonal use (such as a stop for a per-sonal errand on the way between abusiness delivery and the employee'shome).

4) The employee does not use the vehiclefor personal purposes, other than com-muting and de minimis personal use.

5) If this vehicle is an automobile, the em-ployee who must use it for commuting isnot a control employee (defined later).

Personal use of a vehicle is all use that is notfor your trade or business.

An employer-provided vehicle generallyused each workday to carry at least three


employees to and from work in an employer-sponsored commuting pool meets require-ments (1) and (2) above.

CAUTION!

Chauffeur-driven vehicle. If the ve-hicle is a chauffeur-driven vehicle, youcannot use the commuting valuation

rule for any passenger. However, you canuse it to value the commuting use of thechauffeur.

Control employees. A control employee ofa nongovernment employer is any em-ployee who:

1) Is a board- or shareholder-appointed,confirmed, or elected officer of the em-ployer and whose pay for 1998 is$70,000 or more,

2) Is a director of the employer,

3) Receives pay for 1998 of $145,000 ormore from the employer, or

4) Owns a 1% or more equity, capital, orprofits interest in the employer.

Any individual who owns (or is consideredto own under section 318(a) of the InternalRevenue Code or principles similar to section318(a) for entities other than corporations) 1%or more of the FMV of an entity (the “ownedentity”) is considered a 1% owner of all otherentities grouped with the owned entity underthe rules of section 414(b), (c), (m), or (o).An employee who is an officer or director ofan employer is considered an officer or di-rector of all entities treated as a single em-ployer under section 414(b), (c), (m), or (o).

Instead of using the above definition, youcan choose to treat as control employees allof your highly compensated employees. Forthe definition of a highly compensated em-ployee, see Highly compensated employeeunder Exclusion of Certain Fringe Benefits,later.

A control employee of a governmentemployer is any:

1) Elected official, or

2) Employee whose pay is at least as muchas that paid to a federal governmentemployee at Executive Level V. For1998, this amount is $110,700.

For the commuting rule, the term “gov-ernment” includes any federal, state, or localgovernmental unit and any of their agenciesor instrumentalities.

Unsafe ConditionsCommuting RuleUnder this rule, the value of the commutinguse of transportation you provide each em-ployee solely because of unsafe conditionsis $1.50 per one-way commute (that is, fromhome to work or from work to home).

You can use this special rule to figurecommuting value if you and the employeemeet all the following requirements.

1) The employee would ordinarily walk oruse public transportation for commuting.

2) You establish a written policy underwhich you do not allow the employee touse the transportation for personal pur-poses other than commuting becauseof unsafe conditions.

3) The employee does not use the trans-portation for personal purposes otherthan commuting because of unsafeconditions.

4) The employee is a qualified employee.

This special valuation rule applies on atrip-by-trip basis. If you and the employee failto meet the requirements for any trip, use theFMV of the transportation to determine theamount to include in the employee's wages.

Transportation. This rule applies to trans-portation of a qualified employee to or fromwork by any motorized wheeled vehicle (in-cluding an automobile) manufactured for useon public streets, roads, and highways. Youor the employee must buy the transportationfrom a party that is not related to you. If theemployee buys it, you must reimburse theemployee for its cost (for example, cabfare)under a bona fide reimbursement arrange-ment.

Unsafe conditions. Unsafe conditions existif, under the facts and circumstances, a rea-sonable person would consider it unsafe forthe employee to walk or use public transpor-tation at the time of day the employee mustcommute. One factor indicating whether it isunsafe is the history of crime in the ge-ographic area surrounding the employee'sworkplace or home at the time of day theemployee commutes.

Qualified employee. A qualified employeeis one who:

1) Performs services during the currentyear,

2) Is paid on an hourly basis,

3) Is not claimed under section 213(a)(1)of the Fair Labor Standards Act of 1938(as amended) to be exempt from theminimum wage and maximum hour pro-visions,

4) Is within a classification for which youactually pay, or specify in writing you willpay, overtime pay equal to or exceedingone and one-half times the regular rateprovided in section 207 of the 1938 Act,and

5) Does not receive pay of more than$70,000 from you in 1998.

However, the employee will not be con-sidered a qualified employee if you do notcomply with the recordkeeping requirementsconcerning the employee's wages, hours, andother conditions and practices of employmentunder section 211(c) of the 1938 Act and therelated regulations.

Employer-Operated EatingFacility RuleYou can use this rule to determine the valueof taxable meals you provide at anemployer-operated eating facility for employ-ees. For situations where you do not have toinclude the value of meals in an employee'swages, see chapter 3 and the discussion un-der De Minimis (Minimal) Fringe, later.

Under this rule, you first figure the totalmeal value of meals provided at the facility.Then you use that value to figure the valuefor each employee under either of the follow-ing two methods.

1) The individual meal subsidy method.

2) The allocated total meal subsidymethod.

Employer-operated eating facility. Anemployer-operated eating facility for employ-ees is a facility that meets all the followingconditions.

1) You own or lease the facility.

2) You operate the facility. You are consid-ered to operate the eating facility if youhave a contract with another to operateit.

3) The facility is on or near your businesspremises.

4) You provide meals (food, drinks, andrelated services) at the facility during, orimmediately before or after, the employ-ee's workday.

Total meal value. The total meal value is150% of the direct operating costs of theeating facility. This total meal value is con-sidered the value of all meals provided at thatfacility for employees during the calendaryear.

Direct operating costs. The direct op-erating costs of an eating facility are the costsof food and drinks and the cost of labor foremployees performing services relating to thefacility primarily on the eating facility prem-ises. For example, the labor costs for cooks,waiters, and waitresses are included in directoperating costs. If an employee performs theservices both on and off premises, includeonly the labor costs for the services per-formed on premises.

CAUTION!

Do not include in direct operatingcosts the labor cost for a manager ofan eating facility who does not pri-

marily perform services on the eating facilitypremises.

Individual meal subsidy method. Underthis method, the value of meals provided toa particular employee during a calendar yearis the total of the individual meal subsidiesyou provide to that employee during that year.Figure the individual meal subsidy by multi-plying the price charged for a particular mealby a fraction, using the total meal value as thenumerator and the gross receipts of the eat-ing facility for the calendar year as the de-nominator. Then subtract the amount paidby the employee for the meal.

CAUTION!

Meal charge required. You can usethe individual meal subsidy methodonly if there is a charge for each meal

and the price charged each employee is thesame for any given meal.

Allocated total meal subsidy method. Un-der this method, you figure the value of mealsprovided to a particular employee by allocat-ing the total meal subsidy among the em-ployees in any manner reasonable under thecircumstances. It is presumed reasonable foryou to allocate the total meal subsidy on aper-employee basis if you can show that youprovided each employee with approximatelythe same number of meals at the facility.

Total meal subsidy. This is the totalmeal value (explained earlier) minus thegross receipts of the facility.


Exclusion of CertainFringe BenefitsSpecial rules allow you to exclude certainfringe benefits you provide to an employeefrom the employee's wages. You can excludeunder these rules all of the following fringebenefits.

• A no-additional-cost service.

• A qualified employee discount.

• A working condition fringe.

• A de minimis (minimal) fringe.

• A qualified transportation fringe.

• A qualified moving expense reimburse-ment.

• An on-premises athletic facility.

These are not the only employee benefitsyou can exclude from the employee's wages.You can also exclude certain benefits youprovide through employee benefit programs.For more information, see chapter 5.

Generally, the above exclusions do notapply if the tax treatment of the fringe benefitis provided by another tax rule. For example,an exclusion does not apply to employer-provided dependent care assistance or tuitionreductions, the tax treatments of which arecovered by other rules. However, if anothertax rule excludes a benefit from wages andthe exclusion is a limited amount of the ben-efit's cost, an exclusion under the fringe ben-efit rules may apply to the rest of the cost.

Nondiscrimination rules. You cannot ex-clude a no-additional-cost service, a qualifiedemployee discount, or a meal provided at anemployer-operated eating facility for employ-ees from the wages of a highly compensatedemployee unless the benefit is available onthe same terms to:

1) All employees, or

2) A group of employees defined under areasonable classification you set up thatdoes not favor highly compensated em-ployees.

Meals provided at an employer-operated eat-ing facility are discussed under De Minimis(Minimal) Fringe.

If any benefit is discriminatory, include thetotal value of the benefit, not only the valueof the discriminatory part, in the wages of yourhighly compensated employees.

Highly compensated employee. Ahighly compensated employee for 1998 is anemployee who:

1) Was a 5% owner at any time during theyear or the preceding year, or

2) Received more than $80,000 in pay forthe preceding year.

When you apply requirement (2), you maychoose to include only employees who werealso in the top 20% of employees whenranked by pay for the preceding year.

No-Additional-Cost ServiceIf you provide an employee with the sameservice you offer to customers in the ordinarycourse of the line of business in which theemployee performs substantial services, thisservice may be a no-additional-cost service.Do not include the value of the service in theemployee's wages if you do not incur anysubstantial additional costs to provide theservice to the employee. (But see the pre-ceding discussion, Nondiscrimination rules, ifthe employee is highly compensated.) Todetermine additional costs include lost reve-nue, but do not reduce the costs you incurby any amount the employee paid for thisservice.

Generally, no-additional cost services areexcess capacity services, such as airline, bus,or train tickets; hotel rooms; or telephoneservices provided free or at a reduced priceto employees working in those lines of busi-ness.

Generally, an employer's line of businessis determined by the Enterprise Standard In-dustrial Classification Manual (ESIC Manual)prepared by the Statistical Policy Division ofthe U.S. Office of Management and Budget.For more information, see section 1.132–4 ofthe Income Tax Regulations.

Reciprocal agreements. Employees canexclude the value of a no-additional-cost ser-vice provided by an unrelated employer if allthe following tests apply.

1) The service is the same type of servicegenerally provided to customers in boththe line of business in which the em-ployee works and the line of business inwhich the service is provided.

2) You and the employer providing theservice have a written reciprocal agree-ment under which a group of employeesof each employer, all of whom performsubstantial services in the same line ofbusiness, may receive no-additional-costservices from the other employer.

3) Neither you nor the other employer in-curs any substantial additional cost (in-cluding lost revenue) either in providingthe service or because of the writtenagreement.

Employee. For this fringe benefit,“employee” includes any:

1) Individual currently employed by you,

2) Individual who stopped working for youas an employee because of retirementor disability,

3) Surviving spouse of an individual whodied while working for you as an em-ployee or who stopped working for youas an employee because of retirementor disability, or

4) Partner who performs services for apartnership.

Treat services you provide to the spouseor dependent child of an employee as pro-vided to the employee.

Treat any use of air transportation by theparent of an employee as use by the em-ployee. This rule does not apply to use by theparent of a person considered an employeebecause of item (3) above.

Dependent child. For this fringe benefit,“dependent child” means any son, stepson,daughter, or stepdaughter who is a depend-ent of the employee, or both of whose parentshave died and who has not reached age 25.Treat a child of divorced parents as a de-pendent of both parents.

Qualified EmployeeDiscountDo not include in an employee's wages thevalue of a qualified employee discount. Aqualified employee discount is a price re-duction you give an employee on certainproperty or services you offer to customers inthe ordinary course of the line of business inwhich the employee performs substantialservices. For the rules on line of business,see No-Additional-Cost Services, earlier. Ifthe employee is highly compensated, seeNondiscrimination rules, the first discussionin this section.

However, a discount on real property(such as a building or land) or on personalproperty of a kind commonly held for invest-ment (such as stocks or bonds) is not aqualified employee discount. The exclusiondoes not apply where there is a reciprocalagreement under which another employerprovides the discount. A qualified employeediscount also does not include any amountthat is more than the following amount.

1) For a discount on property, your grossprofit percentage times the price youcharge customers for the property.

2) For a discount on services, 20% of theprice you charge customers for the ser-vice.

Determine your gross profit percentagebased on all property you offer to customers(including employee customers) in the ordi-nary course of your line of business and yourexperience during the tax year immediatelybefore the tax year in which the discount isavailable. To figure your gross profit percent-age, subtract the total cost of the propertyfrom the total sales price of the property anddivide the result by the total sales price of theproperty.

The term “employee” includes the sameindividuals listed earlier under No-Additional-Cost Service. For special rules concerningemployees of a leased section of a depart-ment store, see section 1.132–3(d) of the In-come Tax Regulations.

Working Condition FringeYou can exclude from an employee's wages(as a working condition fringe benefit) thevalue of property or services you provide if theemployee could deduct them as a trade orbusiness or depreciation expense if he or shepaid for them.

For this fringe benefit, “employee” in-cludes any:

1) Individual currently employed by you,

2) Partner who performs services for apartnership,

3) Director of your company, and

4) Independent contractor who performsservices for you.

However, do not exclude from the com-pensation you pay to an independent con-


tractor who performs services for you thevalue of parking or the use of consumergoods that you provide in a product testingprogram. Also, do not exclude from the com-pensation you pay to a director the value ofthe use of consumer goods you provide in aproduct testing program.

Vehicle-allocation rules. Generally, for anemployer-provided vehicle, the amount youcan exclude as a working condition fringe isthe amount that would be allowable as adeductible business expense if paid by theemployee. That is, if the employee uses thecar for business, as well as for personal use,the value of the working condition fringe is theportion determined to be for business use ofthe vehicle. See Business use of your car inchapter 1. Also, see the special rules for cer-tain demonstrator cars and qualified nonper-sonal use vehicles, discussed later.

However, instead of excluding the valueof the working condition fringe related to thedeductible car expense, you may include theentire annual lease value in an employee re-cipient's wages. The employee can then claimany deductible business car expense as anitemized deduction on his or her personal in-come tax return.

The total inclusion option is only allowedif you use the automobile lease rule (dis-cussed under Special Valuation Rules, ear-lier) to value the fringe benefit for a vehicleyou furnish to the employee.

Educational assistance. If you pay the costof an employee's education, you may be ableto exclude the cost from the employee'swages under the tax rules that apply to em-ployer-provided educational assistance pro-grams. Costs you cannot exclude under thoserules may be excluded only if they qualify asa working condition fringe. To qualify as aworking condition fringe, the cost of the edu-cation must be a job-related deductible ex-pense by the employee. For more informationon educational assistance programs, seechapter 5. For more information on deductibleeducation expenses, see Publication 508,Educational Expenses.

Outplacement services. You can excludefrom an employee recipient's wages the valueof outplacement services provided to theemployee on the basis of need if you get asubstantial business benefit from the servicesdistinct from the benefit you get from thepayment of additional wages. Substantialbusiness benefits include promoting a posi-tive business image, maintaining employeemorale, and avoiding wrongful terminationsuits.

You cannot exclude the value of servicesthat do not qualify as a working conditionfringe because the employee can choose toreceive cash or taxable benefits in place ofthe services. If you maintain a severanceplan and permit employees to get outplace-ment services with reduced severance pay,include in the employee's wages the differ-ence between the unreduced severance andthe reduced severance payments.

Demonstrator cars. All of the use of ademonstrator car by your full-time autosalesperson generally qualifies as a workingcondition fringe if the use is primarily to facil-itate the services the salesperson provided foryou and there are substantial restrictions onpersonal use. For more information and thedefinition of “full-time auto salesperson,” see

section 1.132–5(o) of the Income Tax Regu-lations.

Qualified Nonpersonal UseVehiclesAll of an employee's use of a qualified non-personal use vehicle qualifies as a workingcondition fringe. You can exclude the valueof that use from the employee's wages. Aqualified nonpersonal use vehicle is any ve-hicle the employee is not likely to use morethan minimally for personal purposes be-cause of its design. Qualified nonpersonaluse vehicles include all of the following vehi-cles.

1) Clearly marked police and fire vehicles.

2) Unmarked vehicles used by lawenforcement officers (explained later) ifthe use is officially authorized.

3) An ambulance or hearse used for itsspecific purpose.

4) Any vehicle designed to carry cargo witha loaded gross vehicle weight over14,000 pounds.

5) Delivery trucks with seating for the driveronly, or driver plus a folding jump seat.

6) A passenger bus with a capacity of atleast 20 passengers used for its specificpurpose.

7) School buses.

8) Tractors and other special purpose farmvehicles.

Clearly marked police or fire vehicles. Apolice or fire vehicle is a vehicle, owned orleased by a governmental unit (or any of itsagencies or instrumentalities), that a policeofficer or fire fighter who is always on callmust use for commuting. The governmentalunit must prohibit any personal use (otherthan commuting) of the vehicle outside thelimit of the police officer's arrest powers or thefire fighter's obligation to respond to anemergency. A police or fire vehicle is clearlymarked if, through a painted symbol or words,it is easy to see the vehicle is a police or firevehicle. A marking on a license plate is not aclear marking for this purpose.

Unmarked law enforcement vehicles. Thegovernmental agency or department thatowns or leases the vehicle and employs theofficer must authorize any personal use of anunmarked law enforcement vehicle. The per-sonal use must be necessary to help enforcethe law, such as being able to report directlyfrom home to a stakeout site or to an emer-gency. Use for vacation or recreation tripscannot qualify as an authorized use.

Law enforcement officer. A lawenforcement officer is a full-time employee ofa governmental unit that is responsible forpreventing or investigating crimes involvinginjury to persons or property (includingcatching or detaining persons for thesecrimes). The law must allow the employee totake all of the following actions.

1) Carry firearms.

2) Execute search warrants.

3) Make arrests (other than citizen's ar-rests).

The employee must regularly carryfirearms except when working undercover. A

law enforcement officer includes an arson in-vestigator if the investigator meets these re-quirements.

Trucks and vans. A pickup truck or van isnot a qualified nonpersonal use vehicle un-less specially modified so it is not likely to beused more than minimally for personal pur-poses. The following are guidelines that apickup truck or van can meet to be a qualifiednonpersonal use vehicle. Even if theseguidelines are not met, the vehicle may stillqualify, based upon the facts. In that case,contact the IRS for further guidance.

Pickup truck. A pickup truck with aloaded gross vehicle weight not over 14,000pounds qualifies if clearly marked with per-manently affixed decals, special painting, orother advertising associated with your trade,business, or function. It must be either:

1) Equipped with at least one of the fol-lowing:

a) Hydraulic lift gate,

b) Permanent tanks or drums,

c) Permanent side boards or panelsthat materially raise the level of thesides of the truck bed, or

d) Other heavy equipment (such asan electric generator, welder, boom,or crane used to tow automobilesand other vehicles), or

2) Used primarily to transport a particulartype of load (other than over the publichighways) in a construction, manufac-turing, processing, farming, mining, drill-ing, timbering, or other similar operationfor which it was specially designed orsignificantly modified.

Van. A van with a loaded gross vehicleweight not over 14,000 pounds qualifies ifclearly marked with permanently affixeddecals, special painting, or other advertisingassociated with your trade, business, orfunction. It must have a seat for the driveronly or the driver and one other person, andeither:

1) Permanent shelving that fills most of thecargo area, or

2) The cargo area is open and the van al-ways carries merchandise, material, orequipment used in your trade, business,or function.

Items Not ExcludableThe following are some items you cannot ex-clude from an employee's wages as workingcondition fringe benefits.

1) A service or property offered through aflexible spending account. A flexiblespending account is an agreement thatgives employees over a time period acertain amount of unspecified noncashbenefits with a predetermined cashvalue.

2) Any item for which the employee doesnot have the necessary substantiation todeduct as a trade, business, or depreci-ation expense.

3) Expenses the employee can deduct un-der sections of the Internal RevenueCode other than for trade or businessexpenses or depreciation.


4) A physical examination program,whether mandatory to some or all em-ployees.

5) A cash payment you made to the em-ployee unless you require the employeeto do all of the following:

a) Use the money for expenses for aspecific or prearranged activity thatare deductible as trade, business,or depreciation expenses,

b) Verify that he or she used themoney for these expenses, and

c) Return any unused money to you.

De Minimis (Minimal) FringeAn employee's wages do not include thevalue of a de minimis fringe benefit. Thisbenefit is any property or service you provideto an employee that has so little value (takinginto account how frequently you provide sim-ilar benefits to your employees) that ac-counting for it would be unreasonable or ad-ministratively impracticable. Cash, no matterhow little, is never excludable as a de minimisfringe, except for occasional meal money ortransportation fare as discussed next.

Examples of de minimis fringes include:

• Occasional typing of personal letters bya company secretary,

• Occasional personal use of a companycopying machine, if you sufficiently con-trol its use,

• Occasional parties or picnics for employ-ees and their guests,

• Occasional meals, meal money, or localtransportation fare, not based on hoursworked, provided to an employee be-cause the employee is working overtimeand, for meals and meal money, providedto enable the employee to work overtime,

• Holiday gifts, other than cash, with a lowFMV,

• Occasional tickets for entertainmentevents,

• Coffee, doughnuts, or soft drinks fur-nished to employees, and

• Group-term life insurance payable on thedeath of an employee's spouse or de-pendent if the face amount is not morethan $2,000.

Employer-operated eating facility. Thevalue of meals you provide to employees atan eating facility operated by you is a deminimis fringe benefit only if the annual reve-nue from the facility equals or exceeds thedirect operating costs of the facility. For thenondiscrimination requirements, see Nondis-crimination rules, the first discussion in thissection, Exclusion of Certain Fringe Benefits.For more information, including definitions ofan employer-operated eating facility and di-rect operating costs, see Employer-OperatedEating Facility Rule, the last discussion in thepreceding section, Special Valuation Rules.

Meals furnished for your convenience.For tax years beginning after 1997, if thevalue of the meals furnished at your eatingfacility for employees can be excluded fromthe employees' wages under the rules ex-plained in chapter 3, your revenue from themeals is considered to equal the facility's di-rect operating costs for them.

Qualified TransportationFringeYou can exclude qualified transportationfringe benefits from the wages of employees,up to certain limits. The following benefits,which you can provide in any combination atthe same time to an employee, are qualifiedtransportation fringe benefits.

1) A ride in a commuter highway vehicle ifthe ride is between the employee's homeand work place.

2) A transit pass.

3) Qualified parking.

Amounts you give to an employee forthese expenses under a bona fide re-imbursement arrangement are alsoexcludable. Cash reimbursements for transitpasses qualify only if a voucher or a similaritem that the employee can exchange only fora transit pass is not readily available for directdistribution by you to your employee.

Employee. You can provide qualified trans-portation fringe benefits only to employees.The definition of employee includes com-mon-law employees and other statutory em-ployees, such as officers of corporations.Self-employed individuals, including partners,2-percent shareholders in S corporations,sole proprietors, and other independent con-tractors are not employees for purposes ofthis fringe benefit.

Benefit provided in place of pay. For taxyears beginning after 1997, you can excludequalified transportation fringe benefits froman employee's wages even if you providethem in place of pay.

Relation to other fringe benefits. Youcannot exclude a qualified transportationfringe benefit under the de minimis or workingcondition fringe benefit rules. However, if youprovide a local transportation benefit otherthan by transit pass or commuter highwayvehicle, or to a person other than an em-ployee as defined earlier, you may be able toexclude all or part of the benefit under otherfringe benefit rules (de minimis, working con-dition, etc.).

Commuter highway vehicle. A commuterhighway vehicle is any highway vehicle thatseats at least 6 adults (not including thedriver). In addition, you must reasonably ex-pect that at least 80% of the vehicle mileagewill be for transporting employees betweentheir homes and work place, with your em-ployees occupying at least one-half of thevehicle's seats (not including the driver's).

Transit pass. A transit pass is any pass,token, farecard, voucher, or similar item enti-tling a person, free of charge or at a reducedrate, to ride:

• Mass transit, or

• In a vehicle that seats at least 6 adults(not including the driver), if a person inthe business of transporting persons forpay or hire operates it.

Mass transit may be publicly- or privately-operated and includes bus, rail, or ferry.

Qualified parking. Qualified parking isparking you provide to your employees on ornear your business premises. It also includesparking on or near the location from whichyour employees commute to work using masstransit, commuter highway vehicles, orcarpools. It does not include parking at ornear your employee's home.

Exclusion LimitsFor 1998, you may exclude from the wagesof each employee up to:

1) $65 per month for combined commuterhighway vehicle transportation andtransit passes, and

2) $175 per month for qualified parking.

Excess benefits taxable. If, for any month,the fair market value of a benefit is more thanits limit, include in the employee's wages onlythe amount over the limit, minus any amountpaid for the benefit by or for the employee.

Example 1. Each month, you provide atransit pass valued at $70 to your employee,Tom Travis. He does not pay you for any partof the pass. Because the value of the transitpass exceeds the limit, for each month youprovide this pass you must include $5 in hiswages for income and employment tax pur-poses.

Example 2. Each month, you providequalified parking valued at $180 to TravisRamon. He does not pay you for any part ofthe parking. Because the value of the parkingexceeds the limit, for each month you providethis parking you must include $5 in his wagesfor income and employment tax purposes.

Example 3. You provide qualified parkingwith a fair market value of $200 per month toyour employees, but you charge the employ-ees $25 per month. The value of the parkingexceeds the limit by $25. You reduce thatexcess benefit by the amount your employeespaid ($25). Do not include any amount in youremployees' wages.

Taxable Benefits – Withholdingand ReportingTreat taxable transportation fringe benefits aswages subject to employment taxes. Whenand how you withhold on and report the valueof qualified transportation fringe benefits thatyou must include in an employee's wagesdepends on whether the benefits are noncashbenefits or cash reimbursements.

Noncash benefits. For information on whenand how to withhold on and report taxablenoncash fringe benefits, see Including bene-fits in pay and When fringe benefits aretreated as paid under General Information atthe beginning of this chapter.

Cash reimbursements. For employment taxpurposes, treat taxable cash reimbursementsas paid when they are made available to theemployee. You must deposit and reportamounts withheld along with your FUTA taxand your part of the social security and Med-icare taxes.

More InformationFor more information on qualified transporta-tion fringe benefits, including van pools, andhow to determine the value of parking, seeNotice 94–3, 1994–1 C.B. 327.


Qualified Moving ExpenseReimbursementsYou can exclude from an employee recipi-ent's wages any qualified moving expensereimbursement. This is any amount you givethe employee, directly or indirectly (includingservices furnished in kind), as a payment for,or a reimbursement of, expenses that wouldbe deductible as moving expenses if youremployee paid or incurred them. You shouldmake the reimbursements under rules similarto those described in chapter 16 for re-imbursements of expenses for travel, meals,and entertainment under accountable plans.

Deductible moving expenses. Deductiblemoving expenses include only the reasonableexpenses of:

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

2) Traveling (including lodging) from theformer home to the new home.

CAUTION!

Deductible moving expenses do notinclude any expenses for meals.

For more information on deductible mov-ing expenses, see Publication 521.

Nonqualified reimbursements. Include anyreimbursements for moving expenses that arenot qualified moving expense reimburse-ments in the employee's wages. This includesany payment for, or reimbursement of, ex-penses the employee deducted in a prioryear.

Where to report reimbursements. Reportany qualified moving expense reimburse-ments you pay directly to an employee in1998 in box 13 of the employee's 1998 FormW–2. Qualified moving expense reimburse-ments you pay to a third party on behalf of theemployee and services that you furnish inkind to an employee are no longer reportedon Form W–2. Use code “P” to identify thereimbursements that are reported in box 13.

Include any nonqualified moving expensereimbursements with your employee's wagesin box 1.

On-Premises AthleticFacilitiesYou can exclude from an employee's wagesthe value of an on-premises gym or otherathletic facility you provide and operate ifsubstantially all use during the calendar yearis by employees, their spouses, and their de-pendent children.

For this purpose, the term “employee” in-cludes the same individuals included as em-ployees for no-additional-cost services (de-scribed earlier).

The exclusion does not apply if you makeaccess to the facility available to the generalpublic through the sale of memberships, therental of the facility, or a similar arrangement.The exclusion also does not apply to anyathletic facility that is for residential use. Forexample, a resort with athletic facilities wouldnot qualify.

5.EmployeeBenefitPrograms

Important Changefor 1998Group health plan requirements. For planyears beginning after 1997, you (or the plan,if a multi-employer plan) may be subject toan excise tax if your plan does not meet cer-tain new requirements. These requirementsgenerally:

1) Obligate plans to pay for a minimumhospital stay for mothers and newbornsif the plan otherwise provides benefits forhospital stays in connection withchildbirth, and

2) Prevent certain special limits from beingplaced on mental health benefits.

For more information on this excise tax, seeOther Requirements, under Accident andHealth Plans, later.

IntroductionThis chapter discusses some fringe benefits(defined in chapter 4) you can provide to youremployees as part of an employee benefitprogram.

You can generally deduct the cost of pro-viding the benefits discussed in this chapteron the “employee benefit programs” line ofyour business income tax return. However,you must be able to show that your cost foreach employee represents current pay andthat the total of this cost plus your other payto the employee was reasonable as dis-cussed in chapter 2.

You can generally exclude a limitedamount of the cost of benefits you provide toan employee through certain employee ben-efit programs from the employee's wages asyou withhold, pay, and report employmenttaxes. This chapter explains how to figure theamount you can exclude from your employ-ee's wages.


• Accident and health plans

• Adoption assistance

• Cafeteria plans

• Dependent care assistance

• Educational assistance

• Group-term life insurance

• Welfare benefit funds


Publication


m 15–A Employer's Supplemental TaxGuide

m 503 Child and Dependent Care Ex-penses

m 525 Taxable and Nontaxable Income

m 968 Tax Benefits for Adoption

m 969 Medical Savings Accounts(MSAs)



m 5500 Annual Return/Report of Em-ployee Benefit Plan (With 100 ormore participants)

m 5500–C/R Annual Return/Report of Em-ployee Benefit Plan (With fewerthan 100 participants)


Accident and HealthPlansThis section provides basic tax informationabout accident and health plans.

Deducting the cost. You can generally de-duct the cost of accident or health plan cov-erage you provide to your employees on the“employee benefit programs” line of yourbusiness income tax return.

Accident or health plan. This is an ar-rangement that provides benefits for youremployees, their spouses, and their depen-dents in the event of personal injuries orsickness. The benefits can be paid directlyby you, through insurance, or through a trustor fund that provides benefits directly orthrough insurance.

Accident and health benefits include thefollowing items.

• Contributions to the cost of accident orhealth insurance covering your em-ployee.

• Contributions to a separate trust or fundthat provides accident or health benefitsto your employees directly or through in-surance.

• Contributions to your employee's medicalsavings account.

• Payments or reimbursements of medicalexpenses.

• Payments for specific injuries or illnesses(such as the loss of the use of an armor leg).

• Payments that replace or supplementwages during an absence from work dueto illness or injury.

Special rules apply to accident or healthplans that include coverage under a grouphealth plan or contributions to an employee's

Chapter 5 Employee Benefit Programs

medical savings account. These rules areexplained later.

Your employee generally can exclude ac-cident or health plan benefits you providefrom his or her gross income. However, thisexclusion does not apply to payments basedon the length of absence from work.

Exclusion from wages. You generally canexclude benefits you provide to your em-ployee under an accident or health plan fromhis or her wages as you withhold, pay, andreport employment taxes. However, you can-not exclude payments you make under aself-insured plan as a continuation of youremployee's wages during his or her absencefrom work (sick pay). Treat these paymentsas wages.

Self-insured plans that favor highlycompensated individuals. If your plan is aself-insured plan and it favors highly com-pensated individuals, you must include all orpart of the amounts you pay to these individ-uals in their wages. Generally, a plan is notconsidered to favor highly compensated indi-viduals as to eligibility to participate solelybecause some employees enroll in a healthmaintenance organization (HMO) as an al-ternative to the self-insured plan, if your con-tributions to the HMO are at least as muchas those you would have made to your plan.

A self-insured plan is a group health planthat reimburses your employees for medicalexpenses not covered by an accident orhealth insurance policy. The plan can be forthe employees, their spouses, or their de-pendents.

A highly compensated individual (for thispurpose) is:

1) One of the five highest paid officers,

2) A shareholder who owns (directly or in-directly) more than 10% in value of theemployer's stock, or

3) Among the highest paid 25% of all em-ployees, other than those who can beexcluded from the plan.

For more information, see section 105(h)of the Internal Revenue Code and the relatedregulations.

Group Health PlansIf your accident or health plan includes cov-erage under a group health plan, you will besubject to an excise tax if the group healthplan does not meet certain requirements.These requirements are explained in the fol-lowing discussions.

Group health plan defined. This is a plan(including a self-insured plan) that providesmedical care to your employees, former em-ployees, or their families. The plan can pro-vide care directly or through insurance, re-imbursement, or otherwise. For moreinformation on insurance, see chapter 10.

Coverage RequirementsYou will be subject to an excise tax if yourplan does not cover the working aged, activedisabled, or those with end-stage renal dis-ease. The tax is 25% of the expenses youincur for all of your group health plans duringthe year.

Continuation-of-CoverageRequirementGenerally, you (or the plan, if a multi-employer plan) may be subject to an excisetax if your plan does not meet thecontinuation-of-coverage requirement.

Excise tax. The excise tax generally is $100per day during the noncompliance periodfor each beneficiary. For beneficiaries in thesame family, the maximum tax is $200 perday.

The noncompliance period begins onthe first day your plan does not meet this re-quirement and ends on the earlier of:

1) The first day your plan meets this re-quirement and the past failures havebeen corrected, or

2) 6 months after the last day in the periodfor which your plan could have been re-quired to meet this requirement (seePeriod of coverage, later).

Exceptions. The tax does not apply:

1) For any period during which:

a) You did not know that your planfailed to meet this requirement, and

b) By exercising reasonable diligenceyou would not have known that yourplan failed to meet this requirement,or

2) If:

a) Your plan failed to meet this re-quirement due to reasonable cause(not willful neglect), and

b) The plan's failure is corrected withina 30-day period beginning whenyou knew, or would have known ifreasonable diligence were used,that this requirement was not met.

However, even if you meet one of these ex-ceptions you may have to pay a minimum tax,discussed next.

Minimum tax. Even if you meet one ofthe preceding exceptions to the excise tax,you may still owe a minimum tax. To avoidall tax, you must correct the failure to meetthe continuation-of-coverage requirement be-fore the IRS sends you a notice of an incometax examination for a period during whichyour plan failed to meet this requirement. Formore information on this excise tax, see sec-tion 4980B of the Internal Revenue Code.

Plans exempt from the excise tax. Theexcise tax for failing to meet this requirementdoes not apply to any plan maintained onlyby employers who normally employed fewerthan 20 employees on a typical business dayin the preceding calendar year. In addition,government plans and church plans are notsubject to the excise tax.

Continuation of coverage. Your plan mustprovide qualified beneficiaries the choice ofcontinuing to be covered if they would other-wise lose coverage because of any of thefollowing events.

1) Death of the covered employee.

2) Termination of the covered employee(other than for gross misconduct) or re-duction in hours of employment.

3) Divorce or legal separation of the cov-ered employee from his or her spouse.

4) Entitlement to Medicare benefits for thecovered employee.

5) A dependent child ceasing to be a de-pendent, which ends the child's cover-age under the plan.

6) A bankruptcy proceeding (which beganafter June 30, 1986) under title 11 of theU. S. Code of the employer of a retiredcovered employee.

If any of these events occur, the plan mustprovide an election period of at least 60 daysto qualified beneficiaries to choose to con-tinue coverage under the plan.

In general, this coverage must be identi-cal to that received by beneficiaries who havenot experienced any of these events.

Qualified beneficiaries. A covered em-ployee's spouse and dependent children, ifcovered under the plan, are qualified benefi-ciaries. A child who is born to or placed foradoption with the covered employee duringthe period of continuation coverage is also aqualified beneficiary. The covered employeeis a qualified beneficiary if the event is a ter-mination or reduction of hours or a bankruptcyproceeding.

Period of coverage. Coverage generallymust extend for at least 36 months from theday the event occurs. If there is a terminationor reduction of hours, the coverage periodmust be at least 18 months (29 months incertain cases of disability).

In the case of a bankruptcy proceeding,coverage must extend until the death of thecovered employee or qualified beneficiary or,for the surviving spouse or dependent chil-dren of the employee, 36 months after thedeath of the employee.

Certain situations may shorten the periodof coverage. For example, the coverage pe-riod can end earlier if you cancel all of yourgroup health plans, if the beneficiary does notpay the premiums on time, or if the benefi-ciary becomes entitled to Medicare.

Required notice to employees andspouses. You must give your employeesand their spouses written notice of their rightsto continuation of coverage when their cov-erage under a plan begins.

You must generally notify the plan admin-istrator within 30 days of the death, termi-nation, reduction in hours, or Medicareentitlement of any covered employee, or ofyour own Title 11 bankruptcy proceeding.

Employees or other qualified beneficiariesare responsible for notifying the plan admin-istrator if there is a divorce or legal sepa-ration, or if a child's eligibility under the planends. They must generally do this within 60days after the date of the event.

Also, within 14 days of being notified of theoccurrence of a qualifying event, plan admin-istrators generally must inform qualified ben-eficiaries of their right to choose continuationcoverage.

Other RequirementsYou (or the plan, if a multi-employer plan)may also be subject to an excise tax if yourplan does not meet certain other require-ments. These requirements generally do thefollowing.

• Ensure accessibility by barring grouphealth plans from using an individual's


health status to exclude him or her fromcoverage.

• Increase portability by limiting the cir-cumstances under which plans can denycoverage for preexisting conditions.

• Guarantee renewability by limiting thecircumstances under which continuedaccess to health coverage can be deniedto an employer under a multi-employerplan.

• Obligate plans to pay for a minimumhospital stay following birth for mothersand newborns if the plan otherwise pro-vides benefits for hospital stays in con-nection with childbirth.

• Prevent certain special limits from beingplaced on mental health benefits.

Collective bargaining agreement. If yourplan stems from a collective bargainingagreement ratified before August 21, 1996,the accessibility, portability, and renewabilityrequirements (discussed later) will first applyto your plan for plan years that begin after thecollective bargaining agreement expires, ifthat is later than June 30, 1997.

Excise tax. The excise tax generally is $100per day during the noncompliance periodfor each beneficiary. This period begins onthe first day your plan does not meet theserequirements and ends on the first day yourplan meets these requirements and the pastfailures have been corrected.

Exceptions. The tax does not apply:

1) For any period during which:

a) You did not know that your planfailed to meet these requirements,and

b) By exercising reasonable diligenceyou would not have known that yourplan failed to meet these require-ments, or

2) If:

a) Your plan failed to meet these re-quirements due to reasonablecause (not willful neglect), and

b) The plan's failure is corrected withina 30-day period beginning whenyou knew, or would have known ifreasonable diligence were used,that these requirements were notmet. If your plan is a church plan,the 30-day period is replaced by aspecial period described in section414(e)(4)(C) of the Internal Reve-nue Code.

However, even if you meet one of these ex-ceptions, you may have to pay a minimumtax, discussed next.

Minimum tax. Even if you meet one ofthe preceding exceptions to the excise tax,you may still owe a minimum tax unless yourplan is a church plan. To avoid all tax, youmust correct the failure to meet these re-quirements before the IRS sends you a no-tice of an income tax examination for a periodduring which your plan failed to meet theserequirements. For more information on thisexcise tax, see section 4980D of the InternalRevenue Code.

Plans exempt from the excise tax. Theexcise tax for failing to meet these require-ments does not apply to any plan maintainedby a small employer whose coverage is froma contract with an insurance company. Inaddition, government plans and plans that onthe first day of the plan year had fewer thantwo participants who are current employeesare not subject to the excise tax.

Small employer. You are a small em-ployer if you employed an average of at leasttwo but not more than 50 employees onbusiness days during the preceding calendaryear. If you were not in business throughoutthe preceding calendar year, you are a smallemployer if you can reasonably be expectedto employ an average of at least two but notmore than 50 employees on business days inthe current year.

Benefits exempt from these requirements.These requirements do not apply to anygroup health plan in relation to its provisionof the following benefits.

1) Accident or disability income insurance.

2) Liability insurance and supplementalcoverage.

3) Workers' compensation or similar insur-ance.

4) Automobile medical payment insurance.

5) Credit-only insurance.

6) Coverage for on-site medical clinics.

7) In certain circumstances, the followingbenefits:

a) Limited-scope dental or vision ben-efits,

b) Long-term care benefits,

c) Coverage only for a specified dis-ease or illness,

d) Hospital indemnity or other fixedindemnity insurance, and

e) Medicare supplemental health in-surance and similar supplementalcoverage.

For more information on exempt benefits, seeInternal Revenue Code sections 9831(b),9831(c), and 9832(c) and the related regu-lations.

Accessibility. Your group health plan mustnot base eligibility rules for any individual onany of the following factors in relation to theindividual or his or her dependent.

• Health status.

• Medical condition (physical or mental).

• Claims experience.

• Receipt of health care.

• Medical history.

• Genetic information.

• Evidence of insurability.

• Disability.

Also, your plan cannot use these factors tocharge a higher premium or contribution forcertain individuals. Special rules apply tochurch plans.

For more information, see section 9802of the Internal Revenue Code and the relatedregulations.

Portability. Your group health plan must limitexclusions based on preexisting conditionsand give credit for certain periods of previouscoverage.

Preexisting conditions. Your plan canexclude an individual for a preexisting condi-tion only if all of the following tests are met.

1) The exclusion relates to a condition(whether physical or mental), regardlessof the cause, for which medical advice,diagnosis, care, or treatment was re-commended or received within the6-month period ending on the enrollmentdate.

2) The exclusion extends for not more than12 months (18 months for a lateenrollee) after the enrollment date.

3) Any creditable coverage the individualhas on the enrollment date reduces thelength of the preexisting condition ex-clusion period.

Your plan cannot impose preexisting condi-tion exclusions on certain newborns andadopted children. Also, pregnancy cannot betreated as a preexisting condition. For moreinformation on preexisting conditions, seesection 9801 of the Internal Revenue Codeand the related regulations.

Creditable coverage. Creditable cover-age is coverage that your employee had be-fore he or she enrolled in your plan. You donot have to count coverage an individual hadbefore any period of 63 or more days duringwhich the individual was not covered underany creditable coverage.

Creditable coverage is coverage underany of the following.

• A group health plan.

• Health insurance.

• Certain other health plans.

For more information on creditable coverage,see section 9801 of the Internal RevenueCode and the related regulations.

Special enrollment rights. Your planmust provide special enrollment rights to cer-tain employees and their dependents who areeligible for coverage but are not enrolled inyour plan. Loss-of-other-coverage specialenrollment rights occur if someone declinesto enroll under your plan when first eligibledue to other health coverage and then laterloses that other coverage. Dependent specialenrollment rights occur when an employeegets married or has a child (by birth, adoption,or placement for adoption). For more infor-mation, see Internal Revenue Code section9801(f) and the related regulations.

Renewability. A group health plan that is amulti-employer plan or a multiple employerwelfare arrangement can deny an employercontinued access to the same or differentcoverage under the plan only for one of thefollowing reasons.

1) Nonpayment of contributions.

2) Fraud or other intentional misrepresen-tation of material fact.

3) Noncompliance with material plan pro-visions.

4) Because the plan is ceasing to offer anycoverage in the employer's geographicarea.


5) If a network plan, because there is nolonger any individual enrolled throughthe employer who lives, resides, orworks in the plan's service area.

6) Failure to meet the terms of, to renew,or to employ employees covered by, acollective bargaining agreement.

For more information, see section 9803of the Internal Revenue Code.

Mother and newborn hospital stays. Forplan years beginning after 1997, your grouphealth plan generally must not restrict benefitsfor a mother or newborn's hospital stay fol-lowing birth to either of the following periods.

• Less than 48 hours following a normaldelivery.

• Less than 96 hours following a caesareansection.

However, these minimum stay requirementsdo not apply when the decision to dischargethe mother or her newborn child earlier ismade by the attending provider in consulta-tion with the mother.

These requirements also do not apply toa plan that does not provide benefits for ahospital stay following either a normal deliveryor a caesarean section.

For more information, see section 9811of the Internal Revenue Code.

Mental health benefits. For plan years be-ginning after 1997, the following rules applyif your group health plan provides both med-ical and surgical benefits and mental healthbenefits.

1) Your plan cannot impose an annual oraggregate lifetime limit on mental healthbenefits if it does not impose one onsubstantially all medical and surgicalbenefits.

2) If the plan does impose an annual oraggregate lifetime limit on medical andsurgical benefits, the plan must either:

a) Include mental health benefits un-der the same limit, or

b) Use a separate limit for mentalhealth benefits that is not less thanthis limit.

For more information, see section 9812of the Internal Revenue Code and the relatedregulations.

Medical Savings AccountsIf your health plan for your employees has ahigher annual deductible than typical healthplans, your employees may be able to set upmedical savings accounts (MSAs) to set asidemoney for medical expenses not reimburs-able by the plan. Generally, your employeescan set up MSAs only if you have 50 or feweremployees and your high-deductible healthplan has a limit on the annual out-of-pocketexpenses that an employee must pay forcovered expenses. For more information, seePublication 969, Medical Savings Accounts(MSAs).

If you contribute to an employee's MSA,treat your contribution as accident or healthplan benefits up to the maximum annualcontribution allowed for that employee. Gen-erally, this is 75% (65% for self-only cover-age) of the health plan's annual deductible,

limited to the amount of the employee'swages. (See Publication 969.)

TIPForm W–2. Show all contributions toan employee's MSA in box 13 of theemployee's Form W–2. Use code “R”

to identify this amount. For more information,see the Form W–2 instructions.

Failure to make comparable contributions.Generally, you will be subject to an excise taxif you make a contribution during any calen-dar year to an employee's MSA and do notmake comparable contributions for all com-parable participating employees for eachcoverage period during that year.

Comparable contributions. These arecontributions that are either:

1) The same amount, or

2) The same percentage of the annualdeductible limit under the high-deductible health plan covering the em-ployees.

Comparable participating employees.These are employees who:

1) Are covered by your high-deductiblehealth plan and eligible to establish anMSA,

2) Have the same category of coverage(either self-only or family coverage), and

3) Have the same category of employment(either part-time or full-time).

Part-time employees are those who usuallywork fewer than 30 hours a week.

Excise tax. The excise tax for not makingcomparable contributions is 35% of the totalamount the employer contributes to MSAsduring the calendar year. If your failure tomake comparable contributions was due toreasonable cause and not willful neglect, theIRS may waive the part of the excise tax thatwould be excessive relative to the degree ofnoncompliance involved.

Adoption AssistanceThis section provides basic tax informationabout adoption assistance programs.

Deducting the cost. You can deduct thecost of an adoption assistance program onthe “employee benefit programs” line of yourbusiness income tax return.

Exclusion from wages. You can excludeadoption assistance you provide to an em-ployee through an adoption assistance pro-gram from the employee's wages subject toincome tax withholding. You should not with-hold federal income tax on these amounts.However, you must withhold social securityand Medicare taxes on these amounts.

Adoption assistance program. An adoptionassistance program is a separate written planthat provides adoption assistance only to youremployees. The program qualifies only if allthe following tests are met.

1) The program benefits employees whoqualify under rules set up by you, whichdo not favor highly compensated em-ployees (as defined in chapter 4 under

Exclusion of Certain Fringe Benefits). Todetermine whether your program meetsthis test, do not consider employees ex-cluded from your program who are cov-ered by a collective bargaining agree-ment, if there is evidence that adoptionassistance was a subject of good-faithbargaining.

2) The program does not provide more than5% of its benefits during the year forshareholders or owners. A shareholderor owner is someone who owns (on anyday of the year) more than 5% of thestock or of the capital or profits interestof your business.

3) You give reasonable notice of the pro-gram to eligible employees.

4) Employees provide reasonable substan-tiation that payments or reimbursementsare for qualifying adoption expenses.

Employee's exclusion. Your employee maybe able to exclude from gross income a lim-ited amount of the adoption assistance youprovide through an adoption assistance pro-gram. For more information, see Publication968, Tax Benefits for Adoption.

Employment taxes. The cost of providingadoption assistance to an employee throughan adoption assistance program is subject tosocial security, Medicare, and federal unem-ployment taxes. However, these amounts arenot subject to federal income tax withholding.

TIPForm W–2. Report all qualifyingadoption expenses you paid or reim-bursed under your adoption assist-

ance program for each employee in box 13of the employee's Form W–2. Use code “T”to identify this amount. Also include thisamount with the wages you report in boxes3 and 5. However, do not include this amountwith the wages you report in box 1. For moreinformation, see the Form W–2 instructions.

Cafeteria PlansThis section provides basic tax informationabout cafeteria plans.

Deducting the cost. You can deduct thecost of the benefits provided under a cafeteriaplan on the “employee benefit programs” lineof your business income tax return.

Cafeteria plan. A cafeteria plan is a writtenplan that allows your employees to choosebetween receiving cash or certain qualifiedbenefits.

Generally, a cafeteria plan does not in-clude any plan that offers a benefit that deferspay. However, a cafeteria plan can include aqualified 401(k) plan as a benefit. Also, cer-tain life insurance plans maintained by edu-cational institutions can be offered as a ben-efit even though they defer pay.

The fact that your employee can choosebetween cash and qualified benefits does notmake the qualified benefits your employeechooses to receive taxable to the employee.

Qualified benefits. A qualified benefit isa benefit that you can exclude from an em-ployee's wages because of specific tax rules,including those discussed in this chapter.


However, a cafeteria plan cannot offer schol-arship or fellowship grants, educational as-sistance, medical savings accounts, long-term care insurance, or, generally, the fringebenefits discussed in chapter 4.

Exclusion from wages. You can generallyexclude the cost of providing qualified bene-fits chosen by an employee in a cafeteria planfrom the employee's wages as you withhold,pay, and report employment taxes. However,see Employment taxes, later. Also, if yourplan favors highly compensated or key em-ployees, see the following discussions.

Plans that favor highly compensated em-ployees. If your plan favors highly compen-sated employees as to eligibility to participate,contributions, or benefits, you must include intheir wages the value of taxable benefits theycould have selected. A plan you maintainunder a collective bargaining agreement doesnot favor highly compensated employees.

Highly compensated employee defined.A highly compensated employee (for thispurpose) is:

1) An officer,

2) A shareholder who owns more than 5%of the voting power or value of all classesof the employer's stock,

3) An employee who is highly compensatedbased on the facts and circumstances,or

4) A spouse or dependent of a person de-scribed in (1), (2), or (3).

Plans that favor key employees. If morethan 25% of the total of the nontaxable ben-efits you provide for all employees under theplan go to key employees, you must includein their wages the value of taxable benefitsthey could have selected. A plan you maintainunder a collective bargaining agreement doesnot favor key employees.

Key employee defined. The term “keyemployee” is defined later under Group-TermLife Insurance.

Employment taxes. The amount you ex-clude from an employee's wages is generallynot subject to social security, Medicare, andfederal unemployment taxes, or income taxwithholding. However, group-term life insur-ance coverage that exceeds $50,000 is sub-ject to social security and Medicare taxes.Also, adoption benefits are subject to socialsecurity, Medicare, and federal unemploy-ment taxes.

RECORDS

Recordkeeping requirements. If youmaintain a cafeteria plan, you mustkeep complete records showing all

the following.

1) The number of your employees.

2) The number of your employees eligibleto participate in the plan.

3) The number of your employees partic-ipating in the plan.

4) The total cost of the plan during the year.

5) Your name, address, and taxpayeridentifying number (TIN).

6) The type of business you are engagedin.

You will need these records to file Form 5500or Form 5500–C/R after the end of the planyear.

Forms 5500 and 5500–C/R. If you maintaina cafeteria plan, you must file informationabout the plan each year by the last day ofthe 7th month after the plan year ends. UseForm 5500 and Schedule F (Form 5500) fora plan with 100 or more participants. UseForm 5500–C/R and Schedule F (Form 5500)for a plan with fewer than 100 participants.See the instructions for those forms for infor-mation on extensions of time to file.

Dependent CareAssistanceThis section provides basic tax informationabout dependent care assistance programs.

Deducting the cost. You can generally de-duct the cost of a dependent care assistanceprogram on the “employee benefit programs”line of your business income tax return.However, if you provide the care in kind (op-erate a dependent care facility), deduct yourcosts as depreciation, utilities, salaries, etc.

Exclusion from wages. You can generallyexclude a limited amount of dependent careassistance you provide to an employeethrough a dependent care assistance pro-gram from the employee's wages as youwithhold, pay, and report employment taxes.However, if your program does not meet cer-tain tests, you must include the assistanceyou provide to each highly compensated em-ployee in his or her wages. See Dependentcare assistance program, later.

Exclusion limit. You can generally ex-clude from an employee's wages up to $5,000of dependent care assistance each year. Thislimit is reduced to $2,500 for married em-ployees filing separate returns.

However, the exclusion cannot be morethan the earned income of either:

1) The employee, or

2) The employee's spouse.

Special rules apply to determine the earnedincome of a spouse who is either a studentor not able to care for himself or herself. Formore information on the earned income limit,see Publication 503.

Dependent care assistance program. Adependent care assistance program is aseparate written plan that provides dependentcare assistance only to your employees.However, the plan will not be treated as adependent care assistance program for as-sistance provided to a highly compensatedemployee (as defined in chapter 4 under Ex-clusion of Certain Fringe Benefits) unless thetests described later are met.

Dependent care assistance defined.Dependent care assistance means the pay-ment of, or the providing of, work-relatedhousehold and dependent care services. Theservices are work related only if:

1) They allow the employee to work, and

2) They are for a qualifying person's care.

This is basically the same as the work-relatedexpense test that the employee would use ifhe or she paid the expenses and claimed thedependent care credit. For more information,including the definition of the term “qualifyingperson,” see Qualifying Person Test andWork-Related Expense Test in Publication503.

Assistance provided to a highly com-pensated employee. Dependent care as-sistance provided to a highly compensatedemployee is treated as provided under a de-pendent care assistance program and can beexcluded from the employee's wages only ifthe following tests are met.

1) The benefits provided under the programdo not favor highly compensated em-ployees.

2) The program benefits employees whoqualify under rules set up by you, whichdo not favor highly compensated em-ployees. To determine whether yourprogram meets this test, do not consider:

a) Employees who are under age 21and have not completed 1 year ofservice, and

b) Employees excluded from yourprogram who are covered by a col-lective bargaining agreement, ifthere is evidence that dependentcare assistance was a subject ofgood-faith bargaining.



5) By January 31, you provide each em-ployee with a Form W–2 showing theamount of dependent care assistance (iffurnished in kind, its fair market value)provided to the employee during thepreceding year.

6) The average benefits provided to youremployees who are not highly compen-sated is at least 55% of the averagebenefits provided to your highly com-pensated employees under all your de-pendent care programs. To determinewhether your programs meet this test,do not consider:

a) Employees who are under age 21and have not completed 1 year ofservice,

b) Employees excluded from yourprogram who are covered by a col-lective bargaining agreement, ifthere is evidence that dependentcare assistance was a subject ofgood-faith bargaining, and

c) If you provide the benefits througha salary reduction agreement, em-ployees whose pay is less than$25,000 before the reduction.

If all of these tests are not met, you must in-clude the dependent care assistance pro-vided to each highly compensated employeein his or her wages.


Employment taxes. The amount you ex-clude from an employee's wages is not sub-ject to social security, Medicare, and federalunemployment taxes, or income tax with-holding.

TIPForm W–2. Report all dependent careassistance provided to an employeeduring the year in box 10 of the em-

ployee's Form W–2. For more information,see the Form W–2 instructions.

EducationalAssistanceThis section provides basic tax informationabout educational assistance programs.

Deducting the cost. You can deduct thecost of an educational assistance program onthe “employee benefit programs” line of yourbusiness income tax return.

Exclusion from wages. You can exclude alimited amount of educational assistance youprovide to an employee through an educa-tional assistance program from the employ-ee's wages as you withhold, pay, and reportemployment taxes.

Exclusion limit. You can exclude froman employee's wages up to $5,250 of edu-cational assistance each year.

Assistance over the limit. If you providean employee with more than $5,250 of edu-cational assistance during the year, you maybe able to exclude part or all of the excessas a working condition fringe benefit. (Seechapter 4.)

Expiration date. This exclusion will notapply to expenses paid for courses beginningafter May 31, 2000.

Educational assistance program. An edu-cational assistance program is a separatewritten plan that provides educational assist-ance only to your employees. The programqualifies only if all of the following tests aremet.

1) The program benefits employees whoqualify under rules set up by you, whichdo not favor highly compensated em-ployees (as defined in chapter 4 underExclusion of Certain Fringe Benefits). Todetermine whether your program meetsthis test, do not consider employees ex-cluded from your program who are cov-ered by a collective bargaining agree-ment, if there is evidence thateducational assistance was a subject ofgood-faith bargaining.


3) The program does not allow employeesto choose to receive cash or other ben-efits that must be included in gross in-come instead of educational assistance.


Your program can cover former employees iftheir employment is the reason for the cover-age.

Educational assistance defined. Edu-cational assistance means amounts you payor incur for your employees' education ex-penses. These expenses generally includethe cost of books, equipment, fees, supplies,and tuition. However, these expenses do notinclude the cost of graduate-level courses ofa kind normally taken by a person pursuinga program leading to an advanced academicor professional degree. Also, these expensesdo not include the cost of a course or othereducation involving sports, games, or hob-bies, unless the education:

1) Has a reasonable relationship to yourbusiness, or

2) Is required as part of a degree program.

Education expenses do not include thecost of tools or supplies (other than text-books) that your employee is allowed to keepat the end of the course. Nor do they includethe cost of lodging, meals, or transportation.

Employment taxes. The amount you ex-clude from an employee's wages is not sub-ject to social security, Medicare, and federalunemployment taxes, or income tax with-holding.

TIPForm W–2. You may choose to usebox 14 of Form W–2 to show the costof providing the employee with edu-

cational assistance.

Group-TermLife InsuranceThis section provides basic tax informationabout group-term life insurance plans.

Deducting the cost. You can generally de-duct the cost of group-term life insurance onthe “employee benefit programs” line of yourbusiness income tax return. However, youcannot deduct the cost if you are directly orindirectly the beneficiary of the policy. Formore information on life insurance, seechapter 10.

Exclusion from wages. You can generallyexclude a limited amount of group-term lifeinsurance coverage you provide to an em-ployee from the employee's wages as youwithhold, pay, and report employment taxes.However, if your plan favors key employees,see Plans That Favor Key Employees, later.

Exclusion limit. You can generally ex-clude from an employee's wages the cost ofup to $50,000 of group-term life insurancecoverage.

Coverage over the limit. If you providean employee with more than $50,000 of cov-erage at any time during the year, you mustinclude in the employee's wages the cost ofinsurance that is more than the cost of$50,000 of coverage reduced by any amountthe employee pays toward the insurance.

The cost of this insurance that you mustinclude in your employees' wages is not theactual cost of the excess coverage. Instead,you figure this cost with monthly costs listed

under Cost To Include in Employee Wages,later.

Group-Term Life InsuranceDefinedThis is life insurance that meets all of the fol-lowing conditions.

1) It provides a general death benefit thatis not included in income.

2) You provide it to a group of employees.

3) You provide it under a policy you carrydirectly or indirectly. Even if you do notpay any of the policy's cost, you areconsidered to carry it if you arrange forpayment of its cost by your employeesand charge at least one employee lessthan the cost of his or her insurance andat least one other employee more thanthe cost of his or her insurance. Deter-mine the cost of the insurance, for thispurpose, using the table for the monthlycost per $1,000 of insurance under CostTo Include in Employee Wages, later.

4) It provides an amount of insurance toeach employee based on a formula thatprevents individual selection, using fac-tors such as age, years of service, pay,or position.

Employee. For this purpose, an employeeis one of the following.

1) A person who works for you whose legalrelationship to you is that of an em-ployee.

2) A full-time life insurance agent.

3) A person who was formerly your em-ployee.

Effect of permanent benefits. Permanentbenefits are economic values you provideunder a life insurance policy that extend be-yond one policy year, such as paid-up or cashsurrender value.

Life insurance that includes permanentbenefits is group-term life insurance only if itmeets both of the following conditions.

1) The policy or you, as the employer, statein writing which part of each employee'sdeath benefit is group-term life insur-ance.

2) That part for any policy year is not lessthan the employee's total death benefitminus the employee's deemed deathbenefit at the end of the policy year. Forinformation on figuring the deemeddeath benefit, see section 1.79–1(d)(3)of the Income Tax Regulations.

Ten-employee rule. Generally, group-termlife insurance is life insurance that you pro-vide to at least 10 full-time employees atsome time during the year.

For this rule, count employees whochoose not to receive the insurance unless,to receive it, they must contribute to the costof benefits other than the group-term life in-surance. For example, count an employeewho could receive insurance by paying partof the cost, even if that employee choosesnot to receive it. However, do not count anemployee who must pay part or all of the costof permanent benefits to get insurance, un-less that employee chooses to receive it.


Exceptions. Even if you do not meet theten-employee rule, two exceptions allow youto treat insurance as group-term life insur-ance.

Under the first exception, you do not haveto meet the ten-employee rule if all the fol-lowing conditions are met.

1) If evidence that the employee isinsurable is required, it is limited to amedical questionnaire (completed by theemployee) that does not require a phys-ical.

2) You provide the insurance to all yourfull-time employees or, if the insurer re-quires the evidence mentioned in (1), toall full-time employees who provide evi-dence the insurer accepts.

3) You figure the coverage based on eithera uniform percentage of pay or theinsurer's coverage brackets.

Under the second exception, you do nothave to meet the ten-employee rule if all thefollowing conditions are met.

1) You provide the insurance under acommon plan covering your employeesand the employees of at least one otheremployer who is not related to you.

2) The insurance is restricted to, but man-datory for, all your employees who be-long to or are represented by an organ-ization (such as a union) that carries onsubstantial activities besides obtaininginsurance.

3) Evidence of whether an employee isinsurable does not affect an employee'seligibility for insurance or the amount ofinsurance that employee gets.

To apply either exception, do not consideremployees who were denied insurance forany of the following reasons.

1) They were 65 or older.

2) They customarily work 20 hours or lessa week or 5 months or less in a calendaryear.

3) They have not been employed for thewaiting period given in the policy. Thiswaiting period cannot be more than 6months.

Accidental or other death benefits. A pol-icy that provides accidental death benefits ordeath benefits other than general death ben-efits (travel insurance, for example), is notgroup-term life insurance.

Policy covering employee's spouse or de-pendent. A policy that provides insuranceon the life of your employee's spouse or de-pendent is not group-term life insurance.However, you may be able to exclude the costof this insurance from your employee's wagesas a de minimis fringe benefit. (See chapter4.)

Plans That FavorKey EmployeesGenerally, if your group-term life insuranceplan favors key employees you must includethe entire cost of the insurance in your keyemployees' income. However, this rule gen-erally does not apply to church plans.

A plan favors key employees if it favorsthem as to eligibility to participate or as to thetype and amount of benefits it provides. Applythe participation and benefits tests (discussedlater) separately to your active and formeremployees.

Key employee. A key employee during 1998is an employee or former employee who wasone of the following.

1) An officer having, for any year listed be-low, annual pay of more than the listedamount.

a) 1994 — $59,400

b) 1995 — $60,000

c) 1996 — $60,000

d) 1997 — $62,500

e) 1998 — $65,000

2) A person who, for 1998 or any of the 4preceding years, was:

a) One of the 10 employees havingannual pay of more than $30,000and owning (or considered to ownunder the related-person rules) thelargest interests in your business,

b) A 5% owner of your business, or

c) A 1% owner of your businesswhose annual pay was more than$150,000.

A former employee who was a key employeeupon retirement or separation from service isalso a key employee.

Related person rules. To determineownership in (2) above, count any relatedperson's interest. Treat your employee asowning both his or her own interest and anyrelated person's interest. The term “relatedperson” includes members of the employee'simmediate family (including spouse, children,grandchildren, and parents). It also includesany corporations, partnerships, estates, ortrusts in which the employee has at least a5% interest.

Participation test. Your plan meets this testif all of the following are true.

1) It benefits at least 70% of your employ-ees.

2) At least 85% of those employees are notkey employees.

3) It benefits employees who qualify undera set of rules you set up that do not favorkey employees.

Your plan also meets this test if it is partof a cafeteria plan (discussed earlier) and itmeets the participation test for those plans.

When applying this test do not consideremployees who:

1) Have not completed 3 years of service,

2) Are part time or seasonal,

3) Are nonresident aliens who receive noU.S. source earned income from you, or

4) Are not included in the plan but are in aunit of employees covered by a collectivebargaining agreement, if the benefitsprovided under the plan were the subjectof good-faith bargaining between youand employee representatives.

Benefits test. Your plan meets this test if itdoes not favor key employees as to the typeand amount of life insurance it provides. Yourplan does not favor key employees just be-cause the amount of insurance you provideto your employees is uniformly related to theirpay.

Cost To Includein Employee WagesGenerally, you must include in an employee'swages the cost of group-term life insurancethat is more than the cost of $50,000 of thisinsurance reduced by any amount the em-ployee pays toward the insurance. However,do not reduce the cost by the amount of anemployee's before-tax contributions for insur-ance coverage through a cafeteria plan.

No cost included for certain employees.Do not include any cost of this insurance inyour employee's wages if any of the followingapply.

1) Your employee is disabled and no longerworks for you.

2) Your employee's policy named you thebeneficiary for the entire period it was inforce during the year.

3) Your employee's policy named a charityto which contributions are deductible asthe only beneficiary for the entire periodit was in force during the year.

4) Your employee is retired and meetscertain requirements. (See Retired em-ployees under Group-Term Life Insur-ance Premiums in Publication 525.)

Entire cost included for certain employ-ees. You must include in your employee'swages the entire actual cost of group-term lifeinsurance coverage you provide through aqualified pension, profit-sharing, stock bonus,or annuity plan.

You must also include the entire cost inthe wages of key employees if the plan favorskey employees as discussed earlier underPlans That Favor Key Employees. Include thelarger of:

1) The actual cost of the insurance, or

2) The cost of the insurance you figure us-ing the monthly cost table, shown later.

Permanent benefits. If your policy includespermanent benefits (defined earlier), youmust include in your employees' wages thecost of the permanent benefits minus theamount the employee pays for them.

Figure the cost of these benefits as ex-plained in section 1.79–1(d)(2) of the IncomeTax Regulations.

Figuring the cost to include in employeewages. Follow these steps to figure the costto include in your employee's wages for theyear.

Step one. Subtract 50 (if the $50,000exclusion applies) from the amount of youremployee's insurance coverage for a givenmonth (in thousands, figured to the nearesttenth) to get the excess insurance coverage.

Step two. Multiply the result from stepone by the cost you find using the employee'sage at the end of the year and the followingtable to get the cost of the excess insurancefor one month.


Step three. Multiply the result from steptwo by the number of full months during theyear the employee had that coverage. If youprovide less than a full month of coverage forany month, you must prorate the cost from thetable. This step gives you the cost of theemployee's excess insurance for the tax year.

Step four. If the amount of your employ-ee's insurance coverage changed during theyear, repeat steps one through three for eachother level of coverage. For any month duringwhich the level of coverage changed, use theaverage of the coverage at the beginning ofthe month and the end of the month as thecoverage for that month. Add the step threeresult for each coverage level to get the totalcost of the employee's excess insurance forthe tax year.

Step five. Subtract any amount youremployee paid from the step four result. In-clude the resulting amount in your employee'swages.

Example. You provide $80,000 ofgroup-term life insurance coverage to anemployee for the entire year. Your employeewas 51 years old at the end of the year. Youremployee pays premiums of $50 a year. Youfigure the amount to include in your employ-ee's wages as follows:

Employment TaxesThe cost of group-term life insurance that youmust include in your employee's wages is notsubject to income tax withholding and is ex-empt from federal unemployment tax. How-ever, the cost is subject to social security andMedicare taxes.

Report the cost of group-term life insur-ance coverage exceeding $50,000 in box 13of the employee's Form W–2. Use code C toidentify this amount. Also include this amountwith the wages you report in boxes 1, 3, and5. For more information, see the Form W–2instructions.

Former employees. If you provide group-term life insurance to former employees, in-cluding retirees, the following rules apply to

Cost Per $1,000 Of ProtectionFor One Month

the cost of coverage exceeding $50,000 dur-ing periods after the employees stoppedworking for you.

• The cost is not subject to income taxwithholding and is exempt from federalunemployment tax.

• The cost is subject to social security andMedicare taxes, but not subject to with-holding for these taxes. The former em-ployee must pay the uncollected em-ployee's portion of these taxes with hisor her federal income tax return.

• The employer must report the cost ofcoverage exceeding $50,000 and theamount of the uncollected social securityand Medicare taxes to the former em-ployee on Form W–2.

In completing a Form W–2 for the formeremployee, include in boxes 1, 3, and 5 thecost of coverage exceeding $50,000. Showin box 13:

1) The cost of coverage exceeding $50,000with code C,

2) The uncollected social security tax withcode M, and

3) The uncollected Medicare tax with codeN.

Welfare Benefit FundsThis section provides basic tax informationabout welfare benefit funds.

Deducting the cost. You can deduct a lim-ited amount of the cost of a welfare benefitfund on the “employee benefit programs” lineof your business income tax return.

Deduction limit. You cannot deductmore than the fund's qualified cost, discussedlater, for the tax year. However, if you paymore than the fund's qualified cost, you cancarry the excess over to the next tax year.

Welfare benefit fund defined. A welfarebenefit fund is any fund that is part of a planthrough which you provide welfare benefits toyour employees, independent contractors, ortheir beneficiaries.

Welfare benefits include any benefit otherthan:

1) The transfer of restricted property in re-turn for services (as described in chapter2), and

2) Amounts you put in a deferred pay plan.

The term “fund” means:

1) Any corporation, trust, or other organ-ization that is subject to income tax,

2) Any exempt organization described inIRC 501(c)(7), IRC 501(c)(9), IRC501(c)(17), or IRC 501(c)(20), and

3) Any account held for you by any person,as described under Temporary Regu-lations section 1.419–1T (as modified byAnnouncement 86–45, IRB 1986–15,and section 1851(a)(8)(B) of the TaxReform Act of 1986).

The term “fund” does not include:

1) Any life insurance contract covering thelife of yourself, an employee, or anyperson with a financial interest in yourbusiness if you are a beneficiary of thepolicy, or

2) Any other insurance contract that:

a) Has no guarantee of renewal, and

b) Other than for insurance protection,provides payments only forexperience-rated refunds or policydividends that are not guaranteedand that are determined by factorsother than the amount of welfarebenefits you pay to your employeesor their beneficiaries.

Your fund's qualified cost. Your fund'squalified cost is the total of the “qualified di-rect cost” plus any addition to a “qualifiedasset account” for the year. You must reducethis qualified cost by any after-tax income thefund has for the year.

“After-tax income” means the gross in-come of your fund less the total of:

1) The deductions directly related toproducing the gross income, and

2) The fund's income tax liability for theyear.

The gross income of your fund for thispurpose includes any amounts received fromyour employees. However, it does not includeyour contributions.

Qualified direct cost. Qualified directcost is the total cost (including administrativeexpenses) that you would deduct for benefitsprovided during the tax year if:

1) You provided the benefits directly, and

2) You used the cash method of account-ing.

Treat a benefit as provided by you to theemployee when the benefit would be includedin the employee's gross income if you pro-vided it directly to the employee (or would beincluded but for any rule excluding the benefitfrom income).

Child care facility. You must use a spe-cial rule to figure the qualified direct costs ofa child care facility you provide for your em-ployees' use. Beginning with the month thefacility is placed in service, deduct the ad-justed basis of the facility ratably over 60months rather than depreciating it. A childcare facility is any tangible depreciable prop-erty located in the United States primarily forchildren of your employees.

Qualified asset account. A qualified as-set account is an account holding assets setaside to provide supplemental unemploy-ment, severance pay, disability, medical, orlife insurance benefits. A “qualified cost” doesnot include any part of an addition to a qual-ified asset account that is more than the ac-count limit. The account limit for a tax yearis generally the amount actuarially necessaryto fund:

1) Claims incurred but not paid (as of theclose of the year) for the benefits listed,and

2) Administrative costs for the claims.

Age Cost

Under 30 ........................................................ $.08

30 through 34 ................................................ .09

35 through 39 ................................................ .11

40 through 44 ................................................ .17

45 through 49 ................................................ .29

50 through 54 ................................................ .48

55 through 59 ................................................ .75

60 through 64 ................................................ 1.17

65 through 69 ................................................ 2.10

70 and older ................................................... 3.76

Coverage (in thousands) ........................... $80

Minus: Exclusion (in thousands) ................ − 50

Excess amount (in thousands) .................. $30

Multiply by cost per $1,000 per month,age 51 (from table) .................................... × .48

Cost of excess insurance for 1 month ...... $14.40

Multiply by number of full monthscoverage at this cost ................................. × 12

Cost of excess insurance for tax year ....... $172.80

Minus: Premiums the employee paid ........ − 50.00

Cost to include in wages ........................ $122.80


6.RetirementPlans

Important Changesfor 1998Participant's compensation. Beginning in1998, a plan participant's compensation in-cludes certain deferrals unless you elect notto include any amount contributed under asalary reduction agreement (that is not in-cluded in the gross income of the employee).The new rule, which takes into accountamounts deferred in certain employee benefitplans, will increase the tax-deferred amountthat you can contribute to a deferred contri-bution plan at the election of the employee.The deferrals include amounts contributed byan employee under a:

• Qualified cash or deferred arrangement(section 401(k) plan), or a

• Salary reduction agreement to contributeto a SIMPLE IRA plan or a SARSEP.

The limit on elective deferrals is discussedlater under Salary Reduction Arrangement.

Matching contributions for self-employedindividuals. Beginning in 1998, matchingcontributions to a 401(k) plan on behalf of aself-employed individual will no longer betreated as elective contributions subject to thelimit on elective deferrals. The matching con-tributions for partners and other self-employed individuals will receive the sametreatment as the matching contributions ofother employees.

Contributions to a SEP-IRA or a SIMPLEIRA. A SEP-IRA or a SIMPLE IRA cannotbe designated as a Roth IRA. Contributionsto a SEP-IRA or a SIMPLE IRA will not affectthe amount that an individual can contributeto a Roth IRA. For information about RothIRAs, see Publication 590.

Tax law changes for 1999. This chapterdoes not cover the changes to pension pro-visions that may affect your 1999 tax return.These changes are covered in Publication553.

IntroductionRetirement plans are savings plans that offeryou tax advantages to set aside money foryour own and your employees' retirement.

In general, a sole proprietor or a partneralso is considered an employee for purposesof participating in a retirement plan.

Funding the plan. A retirement plan can befunded entirely by your contributions or by amix of your contributions and employee con-

tributions. Employee contributions do nothave to satisfy the minimum funding require-ments for your plan. For example, a retire-ment plan can require after-tax employeecontributions that, by themselves, do not meetthe minimum funding requirements. Em-ployee contributions can be mandatory orvoluntary.

A plan can allow your employees to makeelective deferrals, although they are consid-ered employer contributions. This allowsemployees to elect to have you contributepart of their current compensation (pay) to aretirement plan. Only the remaining portionof their pay is currently taxable. The incometax on the contributed pay (and earnings onit) is deferred .

Employer contributions. Your contributionsas an employer to an employer-sponsoredretirement plan generally are deductible asdiscussed later under Deduction Limits.

Employer contributions that must becapitalized. You cannot currently deduct youremployer contributions to a retirement plan(or any other expenses) if the uniform cap-italization rules apply to you. If you are subjectto these rules, you must capitalize (include inthe basis of certain property or in inventorycosts) your contributions. See chapter 1.

Kinds of plans. Retirement plans are either:

1) Qualified plans. This includes retirementplans for small businesses, including theself-employed (such as HR–10 (Keogh)plans, SIMPLE plans, and simplifiedemployee pensions (SEPs)), or

2) Nonqualified plans.

Also, in general, individuals who work can setup and contribute to individual retirement ar-rangements (IRAs).


• Qualified plans

• Retirement plans for small businesses

• SIMPLE retirement plans

• Nonqualified plans

• Individual retirement arrangements(IRAs)


Publication


m 533 Self-Employment Tax

m 560 Retirement Plans for Small Busi-ness (SEP, SIMPLE, and KeoghPlans)

m 575 Pension and Annuity Income

m 590 Individual Retirement Arrange-ments (IRAs) (Including RothIRAs and Education IRAs)



m 5305–SEP Simplified Employee

Pension-Individual RetirementAccounts Contribution Agreement

m 5305A–SEP Salary Reduction and OtherElective Simplified EmployeePension-Individual RetirementAccounts Contribution Agreement

m 5304–SIMPLE Savings Incentive MatchPlan for Employees of Small Em-ployers (SIMPLE) (Not subject tothe Designated Financial Institu-tion Rules)

m 5305–SIMPLE Savings Incentive MatchPlan for Employees of Small Em-ployers (SIMPLE) (for Use With aDesignated Financial Institution)

m 5500–EZ Annual Return of One-Participant (Owners and TheirSpouses) Retirement Plan


Qualified PlansA qualified retirement plan is a written planthat you can establish for the exclusive ben-efit of your employees and their beneficiaries.

Contributions to the plan may be made byyou, or by both you and your employees. Ifyour plan meets the qualification require-ments, you generally can deduct your contri-butions to the plan when you make them,except for any amount capitalized. For moreinformation, get Publication 560.

Your employees generally are not taxedon your contributions or increases in theplan's assets until they are distributed tothem. However, certain loans made fromqualified employer plans are treated as taxa-ble distributions. For more information, getPublication 575.

Qualification requirements. To be a qual-ified plan, the plan must meet many require-ments. Among these are rules concerning:

1) Who must be covered by the plan,

2) How contributions to the plan are to beinvested,

3) How contributions to the plan and bene-fits under the plan are to be determined,and

4) How much of an employee's interest inthe plan must be guaranteed (vested).

For more information, get Publication 560.

More than one job. If you are self-employedand also work for someone else, you canparticipate in retirement plans for both jobs.Generally, your participation in a retirementplan for one job does not affect your partic-ipation in a plan for the other job. However,if you have an IRA, you might not be permit-ted to deduct some or all of your IRA contri-butions.

Your deduction for IRA contributions mightbe limited if you also participate in a SEP-IRA.See Publication 560. In addition, your IRAdeduction might be limited because you arecovered by an employer's retirement plan andyour income is above a certain amount. SeePublication 590.

Chapter 6 Retirement Plans

Kinds of Qualified PlansThere are two basic kinds of qualified retire-ment plans: defined contribution plans anddefined benefit plans.

Defined Contribution PlansThese are plans that provide for a separateaccount for each person covered by the plan.Benefits are based only on amounts contrib-uted to or allocated to each account.

There are three types of defined contri-bution plans: profit-sharing plans, stock bonusplans, and money purchase pension plans.

Profit-sharing plan. This is a plan that letsyour employees or their beneficiaries sharein the profits of your business. The plan musthave a definite formula for allocating thecontributions made to the plan among theparticipating employees and for distributingthe funds in the plan.

Stock bonus plan. This type of plan is sim-ilar to a profit-sharing plan, but it can be setup only by a corporation. Benefits are payablein stock of the employer.

Money purchase pension plan. Under thisplan, your contributions are a stated amount,or are based on a stated formula that is notsubject to your discretion. For example, yourformula could be 10% of each participatingemployee's compensation. Your contributionsto the plan are not based on your profits.

Defined Benefit PlansThese are any plans that are not definedcontribution plans. In general, a qualifieddefined benefit plan must provide for setbenefits. Your contributions to the plan arebased on actuarial assumptions. Generally,you will need continuing professional help tohave a defined benefit plan.

Plan ApprovalThe Internal Revenue Service (IRS) will issuea determination or opinion letter regarding aplan's qualification. The determination oropinion of the IRS will be based on how theplan is written, not on how it operates.

You do not have to request a determi-nation or opinion letter to get all the tax ben-efits of a plan. But, if your plan does not havea determination letter, you may want to re-quest one to ensure that your plan meets therequirements for tax benefits.

A request for a determination, opinion, orruling letter can be complex; therefore, youmay need professional help. Also, the IRScharges a fee for issuing these letters. AttachForm 8717, User Fee for Employee Plan De-termination Letter Request, to your determi-nation letter application.

Master and prototype plans. It may beeasier for you to adopt an existingIRS-approved master or prototype retirementplan than to set up your own original plan.Master and prototype plans can be providedby the following sponsoring organizations.

• Trade or professional organizations.

• Banks (including some savings and loanassociations and federally insured creditunions).

• Insurance companies.

• Mutual funds.

Adoption of a master or prototype plan doesnot mean that your plan is automaticallyqualified. It must still meet all of the quali-fication requirements stated in the tax law.

Retirement Plans forSmall BusinessesIf you are the owner of a small business (in-cluding a self-employed person), you can setup certain qualified retirement plans. SeeQualified Plans, earlier. These plans gener-ally are called Keogh or HR–10 plans. Youalso can set up a less complicated tax-advantaged retirement plan. See SimplifiedEmployee Pension (SEP), later.

A small employer can also set up a SIM-PLE retirement plan. See SIMPLE Retire-ment Plans after the Simplified EmployeePension (SEP) discussion.

Keogh PlansOnly a sole proprietor or a partnership (butnot a partner) can set up a Keogh plan. Forplan purposes, a self-employed person isboth an employer and an employee. It is notnecessary to have employees besides your-self to set up a Keogh plan. The plan mustbe for the exclusive benefit of employees ortheir beneficiaries. You generally can deductcontributions to the plan. Contributions arenot taxed to your employees until plan bene-fits are distributed to them.

TIPSee Publication 560 for the definitionof employer, employee, and com-mon-law employee.

Deduction LimitsThe limit on your deduction for your contribu-tions to a Keogh plan depends on the kindof plan you have.

Defined contribution plans. The deductionlimit for a defined contribution plan dependson whether it is a profit-sharing plan or amoney purchase pension plan.

Profit-sharing plan. Your deduction forcontributions to a profit-sharing plan cannotbe more than 15% of the compensation fromthe business paid (or accrued) during the yearto the common-law employees participatingin the plan. You must reduce this 15% limit infiguring the deduction for contributions youmake for your own account. See Deductionof contributions for yourself, later.

Money purchase pension plan. Yourdeduction for contributions to a money pur-chase pension plan is generally limited to25% of the compensation from the businesspaid during the year to a participating com-mon-law employee. You must reduce this25% limit in figuring the deduction for contri-butions you make for yourself, as discussedlater.

Defined benefit plans. The deduction forcontributions to a defined benefit plan isbased on actuarial assumptions and compu-tations. Consequently, an actuary must figureyour deduction limit.

CAUTION!

In figuring the deduction for contribu-tions, you cannot take into accountany contributions or benefits that ex-

ceed the limits discussed under Limits onContributions and Benefits in Publication 560.

The deduction limit for contributions to adefined benefit plan may be greater than thedefined contribution plan limits just described,but actuarial calculations are needed to de-termine the amount. For more informationabout these plans, see Kinds of Plans inPublication 560.

Deduction of contributions for yourself.To take a deduction for contributions youmake for yourself to a plan, you must havenet earnings from the trade or business forwhich the plan was established.

Limit on deduction. If the Keogh plan isa profit-sharing plan , your deduction foryourself is limited to the smaller of $30,000or 13.0435% (15% reduced as discussedbelow) of your net earnings from the trade orbusiness that has the plan. If the plan is amoney purchase pension plan, the de-duction is limited to the smaller of $30,000or 20% (25% reduced as discussed below)of your net earnings.

Net earnings. Your net earnings mustbe from self-employment in a trade or busi-ness in which your personal services are amaterial income-producing factor. If you area partner who only contributed capital, andwho did not perform personal services, youcannot participate in the partnership's plan.Your net earnings do not take into accounttax-exempt income (or deductions related tothat income) other than foreign earned in-come and foreign housing cost amounts.

Your net earnings are your business grossincome minus allowable deductions from thatbusiness. Allowable deductions include con-tributions to the plan for your common-lawemployees along with your other businessexpenses.

If you are a partner other than a limitedpartner, your net earnings include your dis-tributive share of the partnership income orloss (other than separately computed itemssuch as capital gains and losses) and anyguaranteed payments you receive from thepartnership. If you are a limited partner, yournet earnings include only guaranteed pay-ments you receive for services rendered toor for the partnership. For more information,see Partners under Who Must Pay Self-Employment Tax in Publication 533.

Net earnings do not include incomepassed through to shareholders of S corpo-rations.

Adjustments. You must reduce your netearnings by the income tax deduction forone-half of your self-employment tax. Also,net earnings must be reduced by the de-duction for contributions you make for your-self. This reduction is made indirectly, as ex-plained next.

Net earnings reduced by adjustingcontribution rate. You must reduce netearnings by your deduction for contributionsfor yourself. The deduction and the netearnings depend on each other. You canmake the adjustment to your net earnings in-directly by reducing the contribution ratecalled for in the plan and using the reducedrate to figure your maximum deduction forcontributions for yourself.

Annual compensation limit. You gen-erally cannot take into account more than$160,000 of your compensation in figuringyour contribution to a defined contributionplan.


TIPFor employees in a collective bar-gaining unit covered by a plan forwhich the $160,000 limit does not

apply, the compensation limit is $250,000.

Figuring your deduction. Use the RateWorksheet for Self-Employed illustrated in thefollowing example to find the reduced contri-bution rate for yourself. Make no reduction tothe contribution rate for any common-lawemployees.

After you have your self-employed rate,you can figure your maximum deduction forcontributions for yourself by using the De-duction Worksheet for Self-Employed also il-lustrated in the example:

Example. You are a sole proprietor andhave employees. The terms of your planprovide that you contribute 101/2% (.105) ofyour compensation, and 101/2% of your com-mon-law employees' compensation. Your netearnings from line 31, Schedule C (Form1040) are $200,000. In figuring this amount,you deducted your common-law employees'pay of $100,000 and contributions for themof $10,500 (101/2% x $100,000). You figureyour self-employed rate and maximum de-duction for employer contributions for yourbenefit as follows:

When to make contributions. To take adeduction for contributions for a particularyear, you must make the contributions notlater than the due date (plus extensions) ofyour tax return for that year.

More information. See Publication 560 formore information about retirement plans forsmall business owners, including the self-employed. It also discusses the reportingforms that must be filed for these plans.

Simplified EmployeePension (SEP)A simplified employee pension (SEP) is awritten plan that allows you to make deduct-ible contributions toward your own and youremployees' retirement without getting in-volved in more complex retirement plans. Acorporation also can have a SEP and makedeductible contributions toward its employ-ees' retirement. But some advantages avail-able to Keogh and other qualified plans, suchas the special tax treatment that may applyto lump-sum distributions, do not apply toSEPs.

Under a SEP, you make the contributionsto an individual retirement arrangement(called a SEP-IRA in this chapter), which isowned by you or your common-law employee.

SEP-IRAs are set up for, at a minimum,each qualifying employee. A SEP-IRA mayhave to be set up for a leased employee, butneed not be set up for an excludable em-ployee. You may be able to use Form5305–SEP in setting up your SEP. For moreinformation, get Publication 560.

Contribution limits. Contributions you makefor a year to a common-law employee'sSEP-IRA cannot exceed the smaller of 15%of the employee's compensation or $30,000.Compensation, for this purpose, generallydoes not include employer contributions to theSEP.

Annual compensation limit. You gener-ally cannot consider the part of compensationof an employee that is over $160,000 whenyou figure your contributions limit for thatemployee.

CAUTION!

For employees in a collective bar-gaining unit for which the $160,000limit does not apply, the compen-

sation limit is $250,000

More than one plan. If you also contrib-ute to a defined contribution retirement plan,annual additions to an account are limited tothe lesser of (1) $30,000 or (2) 25% of theparticipant's compensation. When you figurethese limits, your contributions to all of theplans must be added. Since a SEP is con-sidered a defined contribution plan for pur-poses of these limits, your contributions to aSEP must be added to your contributions todefined contribution plans.

Reporting on Form W–2. Do not includeSEP contributions on Form W–2, Wage andTax Statement, unless there are contributionsunder a salary reduction arrangement.

Contributions for yourself. The annuallimits on your contributions to a common-lawemployee's SEP-IRA also apply to contribu-tions you make to your own SEP-IRA. How-ever, special rules apply when you figure yourmaximum deductible contribution. See De-duction of contributions for yourself, later.

Deduction limits. The most you can deductfor employer contributions for common-lawemployees is 15% of the compensation paidto them during the year from the business thathas the plan.

Deduction of contributions for yourself.When figuring the deduction for employercontributions made to your own SEP-IRA,compensation is your net earnings from self-employment, which takes into account:

1) The deduction allowed to you for one-half of the self-employment tax, and

2) The deduction for contributions on behalfof yourself to the plan.

The deduction amount for (2), above, andyour compensation (net earnings) are eachdependent on the other. For this reason, thededuction amount for (2) is figured indirectlyby reducing the contribution rate called for inyour plan. This is done by using the RateWorksheet for Self-Employed, shown earlierin the chapter.

SEP and profit-sharing plans. If you alsocontributed to a qualified profit-sharing plan,you must reduce the 15% deduction limit forthat plan by the allowable deduction for con-tributions to the SEP-IRAs of those partic-ipating in both the SEP and the profit-sharingplan.

SEP and other qualified plans. If you alsocontributed to any other type of qualified plan,treat the SEP as a separate profit-sharingplan for purposes of applying the overall 25%deduction limit described in section 404(h)(3)of the Internal Revenue Code.

Employee contributions. Participants canalso make contributions of up to $2,000 totheir SEP-IRAs independent of the employer'sSEP contributions. The portion of the IRAcontributions that is deductible may be re-duced or eliminated because the participantis covered by an employer retirement plan(the SEP plan). See Publication 590 for de-tails.

Salary Reduction Arrangement

CAUTION!

An employer is no longer allowed toestablish a SARSEP. However, par-ticipants in a SARSEP established

before 1997 (including employees hired after1996) can continue to elect to have their em-ployer contribute part of their pay to the plan.

A SEP can include a salary reduction(elective deferral) arrangement. Under thearrangement, employees can elect to haveyou contribute part of their pay to theirSEP-IRAs. The income tax on the part con-tributed is deferred. This choice is called anelective deferral, which remains tax free untildistributed (withdrawn).

This election is available only if:

1) At least 50% of your employees eligibleto participate choose the salary re-duction arrangement,

2) You had 25 or fewer employees whowere eligible to participate in the SEP (orwould have been eligible to participate ifyou had maintained a SEP) at any timeduring the preceding year, and

3) The deferral each year by each eligiblehighly compensated employee (asdefined in Publication 560) as a per-centage of pay (deferral percentage) isno more than 125% of the averagedeferral percentage (ADP) of all non-highly compensated employees eligibleto participate (the ADP test ). You gen-erally cannot consider compensation ofan employee in excess of $160,000 infiguring an employee's deferral percent-age.

Limits on elective deferrals. In general, thetotal income an employee can defer under asalary reduction arrangement included in a

Rate Worksheet for Self-Employed1) Plan contribution rate as a decimal (for

example, 101 / 2% would be 0.105) ....... 0.105

2) Rate in line 1 plus one, (for example,0.105 plus one would be 1.105) ......... 1.105

3) Self-employed rate as a decimal (di-vide line 1 by line 2) ........................... 0.0950

Deduction Worksheet for Self-EmployedStep 1 Enter the contribution rate shown inline 3 above ........................................ 0.0950

Step 2 Enter the amount from: line 31,Schedule C (Form 1040); line 3,Schedule C–EZ (Form 1040); line 36,Schedule F (Form 1040); or line 15a,Schedule K–1 (Form 1065) ................ $200,000

Step 3 Enter your deduction for self-employment tax from line 27, Form1040 .................................................... $6,733

Step 4 Subtract step 3 from step 2 and enterthe result ............................................. $193,267

Step 5 Multiply step 4 by step 1 and enter theresult ................................................... $18,360

Step 6 Multiply $160,000 by your plan contri-bution rate. Enter the result, but notmore than $30,000 .............................. $16,800

Step 7 Enter the smaller of step 5 or step 6.This is your maximum deductiblecontribution Enter your deduction online 29, Form 1040 .............................. $16,800


SEP and certain other elective deferral ar-rangements for 1998 is limited to the lesserof 15% of the participant's compensation (asdefined in Publication 560) or $10,000. Thislimit applies only to the amounts that repre-sent a reduction from the employee's pay, notto any contributions from employer funds.

Employment taxes. Elective deferrals, notexceeding the ADP test, are not subject toincome tax in the year of deferral, but are in-cluded in wages for social security, Medicare,and unemployment (FUTA) tax purposes.

Reporting SEP Contributionson Form W–2Your SEP contributions are excluded fromyour employees' income. Unless there arecontributions under a salary reduction ar-rangement, do not include these contributionsin your employees' wages on Form W–2, forincome, social security, or Medicare tax pur-poses. Your SEP contributions under a sal-ary reduction arrangement are included inyour employees' Form W–2 wages for socialsecurity and Medicare tax purposes only.

Example. Jim's salary reduction ar-rangement calls for a deferral contributionrate of 10% of his salary to be contributed byhis employer as an elective deferral to Jim'sSEP-IRA. Jim's salary for the year is $30,000(before reduction for the deferral). The em-ployer did not elect to treat deferrals as com-pensation under the arrangement. To figurethe deferral amount, the employer multipliesJim's salary of $30,000 by 9.0909%, the re-duced rate equivalent of 10%, to get thedeferral amount of $2,727.27. (This methodis the same one that you, as a self-employedperson, use to figure the contributions youmake on your own behalf.) See Rate Work-sheet for Self-Employed, earlier in the chap-ter.

On Jim's Form W-2, the employer showstotal wages of $27,272.73 ($30,000 minus$2,727.27), social security wages of $30,000,and Medicare wages of $30,000. Jim reports$27,272.73 as wages on his individual incometax return.

If the employer elects to treat deferrals ascompensation under the salary reduction ar-rangement, Jim's deferral amount would be$3,000 ($30,000 x 10%) because, in thiscase, the employer uses the rate called forunder the arrangement (not the reduced rate)to figure the deferral and the ADP test. OnJim's Form W-2, the employer shows totalwages of $27,000 ($30,000 minus $3,000),social security wages of $30,000, and Medi-care wages of $30,000. Jim reports $27,000as wages on his return.

In either case, the maximum deductiblecontribution would be $3,913.05 ($30,000 x13.0435%).

For more information on employer with-holding requirements, see Publication 15.

For more information on SEPs, see Pub-lication 560.

SIMPLE RetirementPlansA SIMPLE plan is a written salary reductionarrangement that allows a small business (anemployer with 100 or fewer employees) to

make elective contributions to a SIMPLE re-tirement account on behalf of each eligibleemployee. An eligible employer is not al-lowed to maintain another retirement plan.

Setting Up a SIMPLE Plan If an employer has 100 or fewer employees(who received at least $5,000 of compen-sation from the employer for the precedingyear), the employer may be able to set up aSIMPLE retirement plan on behalf of eligibleemployees. The plan can be either:

• An IRA for each eligible employee, or

• Part of a qualified cash or deferred ar-rangement (a 401(k) plan).

The SIMPLE plan must be the only retire-ment plan of the employer to which contribu-tions are made, or benefits are accrued, forservice in any year beginning with the yearthe SIMPLE plan becomes effective.

Under the qualified salary reduction ar-rangement the employer's contributions onbehalf of the employee (elective deferrals) arestated as a percentage of the employee'scompensation and are limited to $6,000. Thedollar limit is indexed for inflation in $500 in-crements.

Under the qualified salary reduction ar-rangement the employer is also required tomake either a matching contribution to theSIMPLE retirement account on behalf of eachemployee who elects to make elective defer-rals, or a nonelective contribution to the SIM-PLE retirement account on behalf of each el-igible employee. These two methods fordetermining the employer contribution formulaare explained under Dollar-for-dollar em-ployer matching contributions and Nonelec-tive contributions.

Contributions to a SIMPLE plan aredeductible by the employer and are excludedfrom the gross income of the employee.

Definitions

SIMPLE retirement account. The SIMPLEretirement account of an eligible employee isan individual retirement plan that can be ei-ther an individual retirement account or anindividual retirement annuity, as described inPublication 590. Employees' rights to thecontributions cannot be forfeited.

A SIMPLE plan can also be set up as a401(k) plan. See Publication 560 for informa-tion on how to adopt a SIMPLE plan as partof a 401(k) plan.

Qualified salary reduction arrangement.An employee eligible to participate in theSIMPLE plan may elect (during the 60-dayperiod before the beginning of any year) tohave the employer make contributions (calledelective deferrals) to the SIMPLE retirementaccount on his or her behalf. An employeewho so elects may also stop making electivedeferrals at any time during the year. Theemployer is required to match the employee'scontributions or to make nonelective contri-butions. No other types of contributions areallowed under the qualified salary reductionarrangement.

Eligible employer. Any employer who has100 or fewer eligible employees in any yearcan establish a SIMPLE plan provided theemployer does not maintain anotheremployer-sponsored retirement plan.

Eligible employee. Any employee who re-ceives at least $5,000 in compensation duringany 2 years preceding the plan year can electto have his or her employer make contribu-tions to a SIMPLE retirement account undera qualified salary reduction arrangement. Theemployee must be expected to earn at least$5,000 during the calendar year.

Compensation. Compensation for employ-ees is the total amount of wages required tobe reported on Form W-2, plus electivedeferrals. For the self-employed individual,compensation is the net earnings from self-employment (without regard to any contribu-tion made to the SIMPLE plan for the self-employed individual).

TIPAny SIMPLE elective deferrals relat-ing to an employee's wages under asalary reduction arrangement are in-

cluded in the Form W-2 wages for social se-curity and Medicare tax purposes only.

Contribution Limits Contributions are made up of employeeelective deferrals and employer contributions.The employer is required to satisfy one of twocontribution formulas: the matching contribu-tion formula or a 2% nonelective contribution.No other contributions can be made to theSIMPLE plan. These contributions, which aredeductible by the employer, must be madetimely.

Employee elective deferral limit. Theamount that the employee elects to have theemployer contribute to a SIMPLE retirementaccount on his or her behalf (elective defer-rals) must not exceed $6,000 for any year andmust be expressed as a percentage of theemployee's compensation.

Dollar-for-dollar employer matching con-tributions. The employer is required tomatch all eligible employees' elective contri-butions, on a dollar-for-dollar basis, up to 3%of the employee's compensation.

CAUTION!

If the employer elects a matchingcontribution that is less than 3%, thepercentage must not be less than 1%.

The employer must notify the employees ofthe lower match within a reasonable time be-fore the employee's 60-day election period forthe calendar year. A percentage less than 3%cannot be elected for more than two yearsduring a five-year period.

Nonelective contributions. In lieu of thedollar-for-dollar matching contributions, theemployer may elect to make nonelectivecontributions of 2% of compensation on be-half of each eligible employee. Only$160,000 of the employee's compensationcan be taken into account to figure the con-tribution limit.

CAUTION!

If the employer elects this 2% contri-bution formula, he or she must notifythe employees timely (within the em-

ployee's 60-day election period describedearlier).

Time limits for contributing funds. Theemployer is required to contribute the em-ployee's deferral to the SIMPLE accountwithin 30 days after the end of the month forwhich the payments to the employee weredeferred. The employer's matching contribu-tions to the SIMPLE plan, however, are re-


quired to be made by the tax return filingdeadline, including extensions, for the taxyear that begins with or within the calendaryear for which the contributions are made.

Distributions (Withdrawals)Distributions from a SIMPLE retirement ac-count are subject to IRA rules and areincludible in income when withdrawn. Tax-free rollovers can be made from one SIMPLEaccount into another SIMPLE account or intoan IRA. Early withdrawals generally are sub-ject to a 10% (or 25%) additional tax.

See Publication 590 for information aboutIRA rules, including those on the tax treat-ment of distributions, rollovers, required dis-tributions, and income tax withholding.

Exceptions. A rollover to an IRA can bemade tax free only after a 2-year participationin the SIMPLE plan. A 25% additional tax forearly withdrawal applies if funds are with-drawn within 2 years of beginning partic-ipation.

Employee notification. The employer whosets up a SIMPLE plan must notify each eli-gible employee of his or her opportunity tomake contributions under the plan. The em-ployer must also notify all eligible employeesof the contribution alternative that was cho-sen. This information must be provided be-fore the beginning of the employee's 60-dayelection period.

More information. This chapter does notcontain all the rules and exceptions that applyto a SIMPLE IRA or a SIMPLE 401(k) plan.See Publication 560 for additional informa-tion, including reporting and disclosure re-quirements for SIMPLE plans. You can alsoget Form 5304–SIMPLE or Form5305–SIMPLE and their instructions.

Nonqualified PlansYou can deduct contributions made to anonexempt trust or premiums paid under anonqualified annuity plan. Your employeesgenerally must include the contributions orpremiums in their gross income.

Deduct your contributions to the plan inthe tax year in which any of your employeesmust include an amount of the contributionsin their gross income. You can deduct contri-butions only if you maintain separate ac-counts for each participating employee.

Transferable interest. When an employee'sinterest in your contributions or premiums forthat employee is transferable, the employeemust include those amounts in gross incomefor the tax year in which you make them. Thisrule also applies if the employee's interest isnot subject to a substantial risk of forfeiture(that is, there is not much of a risk that theemployee will lose his or her interest) whenyou make contributions or pay premiums forthat employee.

Nontransferable interest. If, when youmake the contributions, the employee's inter-est in the trust or in the value of the annuitycontract is not transferable and is subject toa substantial risk of forfeiture, the employeedoes not include that interest in gross incomeuntil the tax year in which the interest be-comes transferable or is no longer subject toa substantial risk of forfeiture.

Individual RetirementArrangements (IRAs)An individual retirement arrangement (IRA) isa personal savings plan that allows you to setaside money for your retirement or for certaineducation expenses. You may be able to de-duct your contributions in whole or in part,depending on the kind of IRA and your cir-cumstances. Generally, amounts in your IRA,including earnings and gains, are not taxeduntil they are distributed. They may not betaxed at all if they are distributed accordingto the rules. For more information on IRAs,see Publication 590.

7.Rent Expense

IntroductionThis chapter discusses the tax treatment ofrent or lease payments you make for propertyyou use in your business but do not own. Italso discusses how to treat other kinds ofpayments you make that are related to youruse of this property. These include paymentsyou make for taxes on the property, im-provements to the property, and getting alease. At the end of the chapter is a dis-cussion about capitalizing (including in thecost of property) certain rent expenses.

The rules in this chapter can apply to soleproprietors, partnerships, corporations, es-tates, trusts, and any other entity that carrieson a trade or business.


• The definition of rent

• Taxes on leased property

• The cost of getting a lease

• Improvements by the lessee

• Capitalizing rent expenses


Publication

m 334 Tax Guide for Small Business




RentRent is any amount you pay for the use ofproperty that you do not own. In general, youcan deduct rent as an expense only if the rentis for property that you use in your trade or

business. If you have or will receive equity inor title to the property, the rent is not deduct-ible.

Unreasonable rent. You cannot take arental deduction for rents that are unreason-able. Ordinarily, the issue of reasonablenessof the rent will not arise unless you and thelessor are related. Rent paid to a relatedperson is reasonable if it is the same amountyou would pay to a stranger for use of thesame property. A percentage rental is rea-sonable if the rental paid is reasonable. Fora definition of related persons, see chapter2.

Rent on your home. If you rent rather thanown a home and use part of your home asyour place of business, you may be able todeduct the rent you pay for that part. Youmust meet the requirements for business useof your home. For more information, seeQualifying for a Deduction in Publication 587,Business Use of Your Home (Including Useby Day-Care Providers).

Rent paid in advance. Generally, rent paidin your trade or business is deductible in theyear paid or accrued. If you pay rent in ad-vance, you can deduct only the amount thatapplies to your use of the rented propertyduring the tax year. You can deduct the restof your payment only over the period to whichit applies.

Example 1. In May, you leased a buildingfor 5 years beginning July 1 and ending June30 five years later. According to the terms ofthe lease, your rent is $12,000 per year. Youpaid the first year's rent ($12,000) on June30. You can deduct only $6,000 (6/12 ×$12,000) for the rent that applies to the firstyear.

Example 2. Last January you leasedproperty for 3 years for $6,000 a year. Youpaid the full $18,000 (3 × $6,000) during thefirst year of the lease. Each year you candeduct only $6,000, the part of the rent thatapplies to that year. You can deduct the rest($12,000) over the remaining 2-year term ofthe lease at $6,000 each year.

Lease or purchase. There may be in-stances in which you must determine whetheryour payments are for rent or for the purchaseof the property. You must first determinewhether your agreement is a lease or a con-ditional sales contract. If, under the agree-ment, you acquired or will acquire title to orequity in the property, you should treat theagreement as a conditional sales contract.Payments made under a conditional salescontract are not deductible as rent expense.

Whether the agreement is a conditionalsales contract depends on the intent of theparties. Determine intent based on the factsand circumstances that exist when you makethe agreement.

Determining the intent. In general, anagreement may be considered a conditionalsales contract rather than a lease if any of thefollowing is true.

• The agreement applies part of each pay-ment toward an equity interest that youwill receive.

• You get title to the property upon thepayment of a stated amount requiredunder the contract.

Chapter 7 Rent Expense

• The amount you pay to use the propertyfor a short time is a large part of theamount you would pay to get title to theproperty.

• You pay much more than the current fairrental value for the property.

• You have an option to buy the propertyat a nominal price compared to the valueof the property when you may take ad-vantage of the option. Determine thisvalue when you make the agreement.

• You have an option to buy the propertyat a nominal price compared to the totalamount you have to pay under the lease.

• The lease designates some part of thepayments as interest, or part of the pay-ments are easy to recognize as interest.

Leveraged leases. Leveraged leasetransactions may be considered leases. Lev-eraged leases generally involve three parties:a lessor, a lessee, and a lender to the lessor.Usually the lease term covers a large part ofthe useful life of the leased property, and thelessee's payments to the lessor are enoughto cover the lessor's payments to the lender.

If you plan to take part in what appears tobe a leveraged lease, you may want to getan advance ruling. The following revenueprocedures contain the guidelines the IRS willuse to determine if a leveraged lease is alease for federal income tax purposes.

• Revenue Procedure 75–21, 1975–1 C.B.715




In general, the revenue procedures pro-vide that, for advance ruling purposes only,the IRS will consider the lessor in a leveragedlease transaction to be the owner of theproperty and the transaction to be a validlease if all the factors in the revenue proce-dures are met, including the following.

• The lessor must maintain a minimumunconditional “at risk” equity investmentin the property (at least 20%) during theentire lease term.

• The lessee may not have a contractualright to buy the property from the lessorat less than fair market value when theright is exercised.

• The lessee may not invest in the property,except as provided by Revenue Proce-dure 79–48.

• The lessee may not lend any money tothe lessor to buy the property or guaran-tee the loan used to buy the property.

• The lessor must show that it expects toreceive a profit apart from the tax de-ductions, allowances, credits, and othertax attributes.

The IRS may charge you a user fee forissuing a tax ruling. See Publication 1375 formore information.

Leveraged leases of limited-use prop-erty. The IRS will not issue advance rulingson leveraged leases of so-called limited-useproperty. Limited-use property is property notexpected to be either useful to or usable by

a lessor at the end of the lease term exceptfor continued leasing or transfer to a memberof the lessee group. See Revenue Procedure76–30 for examples of limited-use propertyand property that is not limited-use property.

Leases over $250,000. Special rules areprovided for certain leases of tangible prop-erty. The rules apply if the lease calls for totalpayments of more than $250,000 and eitherof the following apply.

• Any rents are payable after the close ofthe calendar year following the calendaryear the use occurs.

• Rents increase during the lease.

Generally, if these conditions exist, youmust accrue rents for the periods to which therents are allocated under the lease. If a leaseonly contains a rent payment schedule, therents payable for a period during the leaseare the rents allocated to that period. If thelease allocates any rent to a calendar yearthat is not payable until after the close of thesucceeding calendar year, only the presentvalue of that rent should be accrued and in-terest on the unpaid rent accrues until the rentis paid. For certain leases designed toachieve tax avoidance, IRS may require theparties to accrue rent and interest on rentusing the constant rental method.

Taxes onLeased Property If you lease business property, you can de-duct as additional rent any taxes that youhave to pay to or for the lessor. When youcan deduct these taxes as additional rentdepends on your accounting method.

Cash method. If you use the cash methodof accounting, you can deduct the taxes asadditional rent only for the tax year in whichyou pay them.

Accrual method. If you use an accrualmethod of accounting, you can deduct taxesas additional rent for the tax year in which youcan determine all of the following.

• That you have a liability for taxes on theleased property.

• How much the liability is.

• That economic performance occurred.

The liability and amount of taxes are de-termined by state or local law and the leaseagreement. Economic performance occurs asyou use the property.

Example. Oak Corporation is a calendaryear taxpayer that uses an accrual methodof accounting. Oak leases land for use in itsbusiness. Under the law, owners of realproperty become liable (incur a lien on theproperty) for real estate taxes for the year onJanuary 1 of that year. However, they do nothave to pay these taxes until July 1 of the nextyear (18 months later) when tax bills are is-sued. This means that property owners be-come liable for real estate taxes for a yearon January 1 of that year, but do not have topay them until July 1 of the next year.

Under the terms of the lease, Oak be-comes liable for the real estate taxes when

the tax bills are issued. Oak cannot deductthe real estate taxes as rent until the tax billis issued. This is when Oak's liability underthe lease becomes fixed.

If, according to the terms of the lease, Oakis liable for the real estate taxes when theowner of the property becomes liable forthem, Oak will deduct the real estate taxesas rent on its tax return for the earlier year.This is the year in which Oak's liability underthe lease becomes fixed.

Cost ofGetting a Lease You may either enter into a new lease withthe lessor of the property or get an existinglease from another lessee. Very often whenyou get an existing lease from another lessee,besides paying the rent on the lease, youmust pay the previous lessee money to getthe lease.

If you get an existing lease on propertyor equipment for your business, you mustamortize any amount you pay to get thatlease over the remaining term of the lease.For example, if you pay $10,000 to get alease and there are 10 years remaining on thelease with no option to renew, you can deduct$1,000 each year.

The cost of getting a lease is not subjectto the amortization rules that apply to section197 intangibles discussed in chapter 12.

Option to renew. The term of the lease foramortization includes all renewal options ifless than 75% of the cost is for the term re-maining on the purchase date. Treat as re-newal options any period for which the lesseeand lessor reasonably expect the lease to berenewed. In determining the term of the leaseremaining on the purchase date, do not in-clude any period for which the lessee maychoose to renew, extend, or continue thelease. Allocate the lease cost to the originalterm and any option term based on the factsand circumstances. Make the allocation usinga present value computation. For more infor-mation, see section 1.178–1(b)(5) of the In-come Tax Regulations.

Example 1. You paid $10,000 to get alease with 20 years remaining on it and twooptions to renew for 5 years each. Of thiscost, you paid $7,000 for the original leaseand $3,000 for the renewal options. Because$7,000 is less than 75% of the total cost of thelease of $10,000, you must amortize the$10,000 over 30 years. That is the remaininglife of your present lease plus the periods forrenewal.

Example 2. Assume the same facts asin Example 1, except that the amount thatapplies to the original lease is $8,000. Youcan amortize the entire $10,000 over the20-year remaining life of the original lease.The $8,000 cost of getting the original leasewas not less than 75% of the total cost of thelease.

Cost of a modification agreement. Youmay have to pay an additional “rent” amountover part of the lease period to change certainprovisions in your lease. You must capitalizethese payments and amortize them over theremaining period of the lease. You cannotdeduct the payments as additional rent, evenif they are described as rent in the agreement.

Chapter 7 Rent Expense

Example. You are a calendar year tax-payer and sign a 20-year lease to rent partof a building starting on January 1. However,before you occupy it, you decide that you re-ally need less space. The lessor agrees toreduce your rent from $7,000 to $6,000 peryear and to release the excess space fromthe original lease. In exchange, you agree topay an additional rent amount of $3,000,payable in 60 monthly installments of $50each.

You must capitalize the $3,000 andamortize it over the 20-year term of the lease.Your amortization deduction each year willbe $150 ($3,000 ÷ 20). You cannot deduct the$600 that you will pay during each of the first5 years as rent.

Commissions, bonuses, and fees. Com-missions, bonuses, fees, and other amountsthat you pay to get a lease on property youuse in your business are capital costs. Youmust amortize these costs over the term ofthe lease.

Loss on merchandise and fixtures. If yousell at a loss merchandise and fixtures thatyou bought solely to get a lease, the loss isa cost of getting the lease. You must capital-ize the loss and amortize it over the remainingterm of the lease.

Improvementsby Lessee If you add buildings or make other permanentimprovements to leased property, depreciatethe cost of the improvements using the mod-ified accelerated cost recovery system(MACRS). Depreciate the property over itsappropriate recovery period. You cannotamortize the cost over the remaining term ofthe lease.

If you do not keep the improvements whenyou end the lease, figure your gain or lossbased on your adjusted basis of the im-provements then.

For more information, see the discussionof MACRS in Publication 946.

Assignment of a lease. If a long-term lesseemakes permanent improvements to land andlater assigns all lease rights to you for moneyand you pay the rent required by the lease,the amount you pay for the assignment is acapital investment. If the rental value of theleased land increased since the lease began,part of your capital investment is for that in-crease in the rental value. The rest is for yourinvestment in the permanent improvements.

The part that is for the increased rentalvalue of the land is a cost of getting a lease,and you amortize it over the remaining termof the lease. You can depreciate the part thatis for your investment in the improvementsas discussed earlier.

CapitalizingRent Expenses Under the uniform capitalization rules, youhave to capitalize direct costs and anallocable part of most indirect costs that ben-efit or are incurred because of production orresale activities.

Generally, you are subject to the uniformcapitalization rules if you do any of the fol-lowing.

• Produce real or tangible personal prop-erty for use in a trade or business or anactivity engaged in for profit.

• Produce real or tangible personal prop-erty for sale to customers.

• Acquire property for resale. However, thisrule does not apply to personal propertyif your average annual gross receipts arenot more than $10 million.

Indirect costs include amounts incurred forrent of equipment, facilities, or land.

Example 1. You rent construction equip-ment to build a storage facility. You mustcapitalize as part of the cost of the buildingthe rent you paid for the equipment. You re-cover your cost by claiming a deduction fordepreciation on the building.

Example 2. You rent space in a facilityto conduct your business of manufacturingtools. You must include the rent you paid tooccupy the facility in the cost of the tools youproduce.

More information. For more information,see the regulations under section 263A of theInternal Revenue Code.

8.Interest

Important ReminderInterest 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 con-tract that was issued or deemed issued afterJune 8, 1997, and covers any individual, un-less that individual is a key person.

A new rule reduces interest deductionsallocable to the unborrowed policy cash val-ues of certain life insurance, endowment, orannuity contracts issued after June 8, 1997.For more information, see Interest on loanswith respect to life insurance policies, later.

IntroductionThis chapter discusses the tax treatment ofbusiness interest expenses. Interest is theamount charged for the use of borrowedmoney. You can generally deduct all interestyou pay or accrue during the tax year ondebts related to your trade or business.However, special rules apply to the following.

• Interest you must capitalize (see Capital-ization of Interest, discussed later).

• Loans on which the interest rate is lessthan the applicable federal rate (seeBelow-Market Interest Rate Loans, later).


• Allocation of interest

• Interest you can deduct

• Interest you cannot deduct

• Capitalization of interest

• When to deduct interest

• Below-market interest rate loans


Publication

m 537 Installment Sales


m 550 Investment Income and Expenses

m 936 Home Mortgage Interest De-duction


m Sch A (Form 1040) Itemized De-ductions

m Sch E Supplemental Income and Loss

m Sch K–1 (Form 1065) Partner's Shareof Income, Credits, Deductions,etc.

m Sch K–1 (Form 1120S) Shareholder'sShare of Income, Credits, De-ductions, etc.

m 1098 Mortgage Interest Statement

m 3115 Application for Change in Ac-counting Method

m 4952 Investment Interest Expense De-duction

m 8582 Passive Activity Loss Limitations


Allocation of InterestThe rules for deducting interest vary, de-pending on whether the loan proceeds areused for business, personal, home mortgage,investment, or passive activities. If you usethe proceeds of a loan for more than one ex-pense, you must make an allocation to de-termine the amount of interest for each useof the loan's proceeds. However, qualifiedhome mortgage interest is fully deductibleregardless of how the funds are used. Formore information on home mortgage interest,see Publication 936.

The best way to allocate interest is to keepthe proceeds of a particular loan separatefrom any other funds. You can treat a pay-ment made from any account (or in cash)within 30 days before or after the debt pro-ceeds are deposited (or received in cash) asbeing made from the debt proceeds.

TIPIn general, you allocate interest on aloan the same way you allocate theloan. This is true even if the funds are

paid directly to a third party. You allocateloans by tracing disbursements to specificuses. Use the following categories to allocateyour interest expense.

Chapter 8 Interest

1) Trade or business interest.

2) Passive activity interest.

3) Investment interest.

4) Portfolio expenditure interest.

5) Personal interest.

Any interest allocated to proceeds usedfor personal purposes is treated as personalinterest, which is not deductible. Proceedsare used for personal purposes if they are notused in connection with your trade or busi-ness, passive activity, or investment activity.

Allocation based on use of loan's pro-ceeds. Loan proceeds and the related inter-est are allocated based on the use of theproceeds. The allocation is not affected by theuse of property that secures the loan.

Example. You secure a loan with prop-erty used in your business. You use the loanproceeds to buy an automobile for personaluse. You must allocate interest expense onthe loan to personal use (purchase of theautomobile) even though the loan is securedby business property.

Allocation period. The period for whicha loan is allocated to a particular use beginson the date the proceeds are used and endson the earlier of the date the loan is:

1) Repaid, or

2) Reallocated to another use.

Proceeds not disbursed to borrower. Evenif the lender pays the loan proceeds to a thirdparty, the allocation of the loan is still basedon your use of the funds. This applies if youpay for property, services, or anything elseby incurring a loan, or if you take propertysubject to a debt.

Proceeds deposited in borrower's ac-count. Treat loan proceeds deposited in anaccount as property held for investment. Itdoes not matter whether the account paysinterest. Any interest you pay on the loan isinvestment interest expense. If you withdrawthe proceeds of the loan, you must reallocatethe loan based on the use of the funds.

Example. Connie, a calendar-year tax-payer, borrows $100,000 on January 4 andimmediately uses the proceeds to open achecking account. No other amounts aredeposited in the account during the year, andno part of the loan principal is repaid duringthe year. On April 1, Connie uses $20,000from the checking account for a passive ac-tivity expenditure. On September 1, Connieuses an additional $40,000 from the accountfor personal purposes.

Under the interest allocation rules, theentire $100,000 loan is treated as propertyheld for investment for the period of January4 through March 31. From April 1 throughAugust 31, Connie must treat $20,000 of theloan as used in the passive activity and$80,000 of the loan as property held for in-vestment. From September 1 through De-cember 31, she must treat $40,000 of the loanas used for personal purposes, $20,000 asused in the passive activity, and $40,000 asproperty held for investment.

Order of funds spent. Generally, youtreat loan proceeds deposited in an accountas used (spent) before:

1) Any unborrowed amounts held in thesame account, and

2) Any amounts deposited after these loanproceeds.

Example. On January 9, Edith opened achecking account, depositing $500 of theproceeds of Loan A and $1,000 of unbor-rowed funds. The following table shows thetransactions in her account during the taxyear.

Edith treats the $800 used for personalpurposes as made from the $500 proceedsof Loan A and $300 of the proceeds of LoanB. She treats the $700 used for a passiveactivity as made from the remaining $200proceeds of Loan B and $500 of unborrowedfunds. She treats the $800 used for an in-vestment as made entirely from the proceedsof Loan C.

Edith treats the $600 used for personalpurposes as made from the remaining $200proceeds of Loan C and $400 of unborrowedfunds. Note that for the periods during whichloan proceeds are held in the account, theyare treated as property held for investment.

Payments from checking accounts.Generally, you treat a payment from achecking or similar account as made at thetime the check is written if you mail or deliverit to the payee within a reasonable period af-ter you write it. You can treat checks writtenon the same day as written in any order.

Amounts paid within 30 days. If loanproceeds are deposited in an account, youcan treat any payment (up to the amount ofthe proceeds) made from any account youown, or from cash, as made from those pro-ceeds. This applies to any payment madewithin 30 days before or after the proceedsare deposited in your account. You can applythis rule even if the rules stated earlier underOrder of funds spent would otherwise requireyou to treat the proceeds as used for otherpurposes. If you apply this rule to any pay-ments, disregard those payments (and theproceeds from which they are made) whenapplying the rules stated under Order of fundsspent.

Optional method for determining dateof reallocation. You can use the followingmethod to determine the date loan proceedsare reallocated to another use. You can treatall payments from loan proceeds in the ac-count during any month as taking place on thelater of:

1) The first day of that month, or

2) The date the loan proceeds are depos-ited in the account.

However, you can use this optional methodonly if you treat all payments from the accountduring the same calendar month in the sameway.

Interest on a separate account. If youhave an account that contains only loan pro-ceeds and interest earned on the account,

you can treat any payment from that accountas being made first from the interest. Whenthe interest earned is used up, any remainingpayments are from loan proceeds.

Example. In April you borrowed $20,000and used the proceeds of this loan to open anew savings account. The account earnedinterest of $867 during the year. Interest paidon the loan proceeds while they remain in theaccount is investment interest.

If you withdraw $20,000 from the savingsaccount for personal purposes, you can treatthe $20,000 as coming first from the interest,$867, and then from the loan proceeds,$19,133 ($20,000 − $867). The total amountof interest you are charged on the $20,000from the time it was deposited in the accountuntil the time of the withdrawal is investmentinterest. The amount charged on the pro-ceeds used for personal purposes ($19,133)from the time you withdraw it until you eitherrepay it or reallocate it to some other use ispersonal interest. The amount charged on theproceeds you left in the account ($867) con-tinues to be investment interest until you ei-ther repay it or reallocate it to some other use.

Loan proceeds received in cash. If youreceive the proceeds of a loan in cash, youcan treat any payment (up to the amount ofthe proceeds) made from any account youown, or from cash, as made from those pro-ceeds. This applies to any payment youmake within 30 days before or after you re-ceive the proceeds of the loan. Also, you cantreat the payment as made on the date youreceived the cash instead of the date youactually made the payment.

Example. Frank gets a loan of $1,000 onAugust 4 and receives the proceeds in cash.Frank deposits $1,500 in an account on Au-gust 18 and on August 28 writes a check onthe account for a passive activity expense.Also, Frank deposits his paycheck, depositsother loan proceeds, and pays his bills duringthe same period. Regardless of these othertransactions, Frank can treat $1,000 of thedeposit he made on August 18 as being paidfrom the loan proceeds on August 4. In addi-tion, Frank can treat the passive activity ex-pense he paid on August 28 as made fromthe $1,000 loan proceeds treated as depos-ited in the account.

Loan repayments. When you repay any partof a loan allocated to more than one use, treatit as being repaid in the following order.

1) Amounts allocated to personal use.

2) Amounts allocated to investments andpassive activities (other than those in-cluded in (3) below).

3) Amounts allocated to passive activitiesin connection with a rental real estateactivity in which you actively participate.

4) Amounts allocated to former passiveactivities.

5) Amounts allocated to trade or businessuse and to expenses for certain low-income housing projects.

Continuous borrowings. The followingrules apply if you have a line of credit orsimilar arrangement that allows you to borrowfunds periodically under a single loan agree-ment.

Date Transaction

January 9 $500 proceeds of Loan A and$1,000 unborrowed fundsdeposited

January 13 $500 proceeds of Loan Bdeposited

February 18 $800 used for personal purposesFebruary 27 $700 used for passive activityJune 19 $1,000 proceeds of Loan C

depositedNovember 20 $800 used for an investmentDecember 18 $600 used for personal purposes

Chapter 8 Interest

1) Treat all borrowings on which interestaccrues at the same fixed or variablerate as a single loan.

2) Treat borrowings or parts of borrowingson which interest accrues at differentfixed or variable rates as different loans.Treat these loans as repaid in the ordershown on the loan agreement.

Loan refinancing. Allocate the replacementloan to the same items to which the repaidloan was allocated. This is true only to theextent you use the proceeds of the new loanto repay any part of the original loan.

Partnerships andS CorporationsSpecial rules apply to the allocation of interestexpense in connection with debt-financedacquisitions of, and distributions from, part-nerships and S corporations. These rules donot apply if the partnership or S corporationis formed or used for the principal purposeof avoiding the interest allocation rules.

Debt-financed acquisitions. This is the useof loan proceeds to purchase an interest inan entity or to make a contribution to thecapital of the entity.

If you purchase an interest in an entity,(other than by way of a contribution to capi-tal), allocate the loan proceeds and the inter-est expense among all the assets of the en-tity. You can use any reasonable method.Reasonable methods include a pro-rata allo-cation based on the fair market value, bookvalue, or adjusted basis of the assets, re-duced by any debts allocated to the assets.

If you contribute to the capital of an entity,make the allocation using any reasonablemethod. For this purpose, reasonable meth-ods ordinarily include allocating the debtamong all the assets or tracing the loan pro-ceeds to the entity's expenditures.

Treat the purchase of an interest in anentity as a contribution to capital to the extentthe entity receives any proceeds of the pur-chase.

Example. You purchase an interest in apartnership for $20,000 using borrowedfunds. The partnership's only assets includemachinery used in its business valued at$60,000 and stocks valued at $15,000. Youallocate the loan proceeds based on the valueof the assets. Therefore, you allocate $16,000of the loan proceeds ($60,000/$75,000 ×$20,000) and the interest expense on thatpart to trade or business use. You allocate theremaining $4,000 ($15,000/$75,000 ×$20,000) and the interest on that part to in-vestment use.

Reallocation. If you allocate the loanproceeds among the assets, you must makea reallocation if the assets or the use of theassets change.

How to report. Individuals should reporttheir deductible interest expense either onSchedule A or Schedule E of Form 1040 de-pending on the type of asset (or expenditureif the allocation is based on the tracing of loanproceeds) to which the interest expense isallocated.

For interest allocated to trade or businessassets (or expenditures), report the interestin Part II, Schedule E (Form 1040). On aseparate line, put “business interest” and the

name of the entity in column (a) and theamount in column (i).

For passive activity use, enter the intereston Form 8582 as a deduction from the pas-sive activity of the entity. Show any deductibleamount in Part II, Schedule E (Form 1040).On a separate line, put “passive interest” andthe name of the entity in column (a) and theamount in column (g).

For investment use, enter the interest onForm 4952. Carry any deductible amount al-located to royalties to Part II, Schedule E(Form 1040). On a separate line enter “in-vestment interest” and the name of the entityin column (a) and the amount in column (i).Carry the balance to line 13, Schedule A(Form 1040).

Any interest allocated to proceeds usedfor personal purposes is personal interestwhich is not deductible.

Debt-financed distributions. Generally, ifthe entity borrows funds, the general allo-cation rules discussed earlier in this sectionapply. If those funds are allocated to distri-butions made to partners or shareholders, thedistributed loan proceeds and related interestexpense must be reported to the partners andshareholders separately. This is because theloan proceeds and the interest expense mustbe allocated depending on how the partneror shareholder uses the proceeds. For ex-ample, if a shareholder uses distributed loanproceeds to invest in a passive activity, thatshareholder's portion of the entity's interestexpense on the loan proceeds is allocated toa passive activity use.

Optional method. The entity can chooseto allocate the distributed loan proceeds toother expenditures it makes during the taxyear of the distribution. This allocation is lim-ited to the amount of the other expendituresless any loan proceeds already allocated tothem. For any distributed loan proceeds thatare more than the amount allocated to theother expenditures, the rules in the previousparagraph apply.

How to report. If the entity does not usethe optional method, it reports the interestexpense on the loan proceeds on the line onSchedule K–1 (Form 1065 or Form 1120S) for“Other deductions.” The expense is identifiedon an attached schedule as “Interest expenseallocated to debt-financed distributions.” Thepartner or shareholder claims the interest ex-pense depending on how the distribution wasused.

If the entity uses the optional method, itreports the interest expense on the loan pro-ceeds allocated to other expenditures on theappropriate line or lines of Schedule K–1. Forexample, if the entity chooses to allocate theloan proceeds and related interest to a rentalactivity expenditure, the entity will take theinterest into account in figuring the net rentalincome or loss reported on Schedule K–1.

More information. For more information onallocating and reporting these interest ex-penses, see Notice 88–37, 1988–1 C.B. 522,and Notice 89–35, 1989–1 C.B. 675, whichare available at most IRS offices.

Interest YouCan DeductYou can generally deduct all interest you payor accrue during the tax year on debts related

to your trade or business. Interest relates toyour trade or business if you use the pro-ceeds of the loan for a trade or business ex-pense. It does not matter what type of prop-erty secures the loan. You can deductinterest on a debt only if you meet all of thefollowing requirements.

• You are legally liable for that debt.

• Both you and the lender intend that thedebt be repaid.

• You and the lender have a true debtor-creditor relationship.

You cannot currently deduct interest thatmust be capitalized and (except for corpo-rations) you can never deduct personal inter-est.

Mortgages. Generally, mortgage interestpaid or accrued on real estate you own legallyor equitably is deductible. However, ratherthan deducting the interest currently, you mayhave to add it to the cost basis of the propertyas explained later under Capitalization of In-terest.

Statement. If you paid $600 or more ofmortgage interest (including certain points)during the year on any one mortgage, yougenerally will receive a Form 1098 or a simi-lar statement. You will receive the statementif you pay interest to a person (including afinancial institution or a cooperative housingcorporation) in the course of that person'strade or business. A governmental unit is aperson for purposes of furnishing the state-ment.

If you receive a refund of interest youoverpaid in an earlier year, this amount willbe reported in box 3 of Form 1098. Youcannot deduct this amount. For informationon how to report this refund, see Refunds ofinterest later in this chapter.

Expenses paid to obtain a mortgage.Certain expenses you pay to obtain a mort-gage cannot be deducted as interest. Theseexpenses, which include mortgage commis-sions, abstract fees, and recording fees, arecapital expenses. If the property mortgagedis business or income-producing property,you can deduct the costs over the life of themortgage.

Prepayment penalty. If you pay off yourmortgage early and pay the lender a penaltyfor doing this, you can deduct the penalty asinterest.

Points. The term “points” is often used todescribe some of the charges paid by a bor-rower when the borrower takes out a loan ora mortgage. These charges are also calledloan origination fees, maximum loancharges, or premium charges. If any of thesecharges (points) are solely for the use ofmoney, they are interest.

Points paid when you take out a loan ormortgage result in original issue discount(OID). In general, the points (OID) aredeductible as interest unless they must becapitalized. How you figure the amount ofpoints (OID) you can deduct each year de-pends on whether or not your total OID, in-cluding the OID resulting from the points, isde minimis. If the OID is not de minimis, youmust use the constant-yield method to figurehow much you can deduct.

De minimis rule. In general, the OID isde minimis if it is less than one-fourth of 1%(.0025) of the stated redemption price at ma-turity (generally, the principal amount of the

Chapter 8 Interest

loan) multiplied by the number of full yearsfrom the date of original issue to maturity (theterm of the loan).

If the OID is de minimis, you can chooseone of the following ways to figure the amountyou can deduct each year.

1) Constant-yield basis over the term of theloan.

2) Straight line basis over the term of theloan.

3) In proportion to stated interest payments.

4) Entire amount at maturity of the loan.

You make this choice by deducting the OIDin a manner consistent with the method cho-sen on your timely filed tax return for thetaxable year in which the loan or mortgage isissued.

Example of de minimis amount. OnJanuary 1, 1998, you take out a loan for$100,000. The loan matures on January 1,2008 (a 10-year term) and the stated principalamount of the loan ($100,000) is payable onthat date. An interest payment of $10,000 ispayable to the bank on January 1 of eachyear, beginning on January 1, 1999. Whenthe loan is made, you pay $1,500 in points tothe bank. The points reduce the issue priceof the loan from $100,000 to $98,500, result-ing in $1,500 of OID. You determine that thepoints (OID) you paid are de minimis basedon the following computation.

The points (OID) you paid ($1,500) are lessthan the de minimis amount; therefore, youhave de minimis OID and you can choose oneof the four ways discussed earlier to figure theamount you can deduct each year. Under thestraight line method, you can deduct $150each year for 10 years.

Constant-yield method. If the OID is notde minimis, you must use the constant-yieldmethod to figure how much you can deducteach year. You figure your deduction for thefirst year in the following manner.

1) Determine the issue price of the loan.For example, if you paid points on a loansubtract the points you paid from theprincipal amount of the loan to get theissue price.

2) Multiply the issue price (the result in (1))by the yield to maturity.

3) Subtract any qualified stated interestpayments from the result in (2).

4) The result in (3) is the amount of OIDyou can deduct in the first year.

To figure your deduction in any subse-quent years, you start with the adjusted is-sue price. To get the adjusted issue price,add to the issue price any OID previouslydeducted. Then follow steps (2) through (4)above.

The yield to maturity (YTM) is generallyshown in the literature you receive from yourlender. If you do not have this information,

consult your lender or tax advisor. In general,the YTM is the discount rate that, when usedin computing the present value of all principaland interest payments, produces an amountequal to the principal amount of the loan.

Qualified stated interest (QSI) generallyis stated interest that is unconditionally paya-ble in cash or property (other than debt in-struments of the issuer) at least annually ata single fixed rate.

Example of constant yield. The factsare the same as in the previous example. Theyield to maturity on your loan is 10.2467%,compounded annually. You figure theamount of points (OID) you can deduct eachyear as follows.

In 1999, you can deduct $103 of the points(OID). You figure the deduction for 1999 asfollows.

Loan or mortgage ends. If your loan ormortgage ends, you may be able to deductany remaining points (OID) in the taxable yearin which the loan or mortgage ends. A loanor mortgage may end due to a refinancing,prepayment, foreclosure, or similar event.However, if the refinancing is with the samelender, the remaining points (OID) generallyare not deductible in the year in which therefinancing occurs, but may be deductibleover the term of the new mortgage or loan.

Partial liability. If you are liable for part ofa business debt, you can deduct only yourshare of the total interest paid or accrued.

Example. You and your brother borrowmoney. You are liable for 50% of the note.You use your half of the loan in your busi-ness, and you make one-half of the loanpayments. You can deduct your half of thetotal interest payments as a business de-duction.

Partial payments on a nontax debt. If youmake partial payments on a debt (other thana debt owed IRS), the payments are appliedfirst to interest and any remainder to principal.You can deduct only the interest.

Installment purchases. If you make an in-stallment purchase of business property, thecontract between you and the seller generallyprovides for the payment of interest. If no in-terest or a low rate of interest is charged un-der the contract, a portion of the stated prin-cipal amount payable under the contract maybe recharacterized as interest (unstated in-terest). The amount recharacterized as inter-est reduces your basis in the property andincreases your interest expense. For moreinformation on installment sales and unstatedinterest, see Publication 537.

Interest YouCannot DeductSome interest payments cannot be deducted.In addition, certain other expenses that mayseem to be interest are not and you cannotdeduct them as interest.

Payment by cash or equivalent. A cash-basis taxpayer generally cannot deduct inter-est unless it is paid in cash or its equivalent.If you use the cash method of accounting, youcannot deduct interest you pay with borrowedfunds you get from the original lender througha second loan, an advance, or any other ar-rangement similar to a loan. You can deductthe interest expense once you start makingpayments on the new loan. When you makepartial payments on loans, you first apply thepayment to interest and then to the principal.All amounts you apply to the interest on thefirst loan are deductible, along with any inter-est you pay on the second loan, subject toany limits that apply.

Capitalized interest. In addition to the cap-italization of interest rules, discussed later,there are certain interest expenses you mustcapitalize rather than deduct.

If you buy property and pay interest owedby the seller (for example, by assuming thedebt and any interest accrued on the prop-erty), you cannot deduct the interest. Add tothe basis of the property the interest you paidthat the seller owed.

Commitment fees or standby charges.Fees you incur to have business funds avail-able on a standby basis, but not for the actualuse of the funds, are not deductible as inter-est payments. You may be able to deductthem as business expenses.

If the funds are for inventory or certainproperty used in your business, the fees areindirect costs and you must capitalize themunder the uniform capitalization rules. Formore information on uniform capitalizationrules, see section 1.263A–8 through1.263A–15 of the Income Tax Regulations.

Income tax owed. Interest charged on in-come tax assessed on your individual incometax return is not a business deduction eventhough the tax due is related to income fromyour trade or business. Treat this interest asa business deduction only in figuring a netoperating loss deduction.

Penalties. Penalties on deficiencies andunderestimated tax are not interest. Youcannot deduct them. Generally, you cannotdeduct any fines or penalties.

Interest on loans with respect to life in-surance policies. For contracts issued be-fore June 9, 1997, you generally cannot de-duct interest paid or accrued after October13, 1995, on debt incurred with respect to anylife insurance, annuity or endowment contractcovering someone who is or was an em-ployee, officer, or someone financially inter-ested in your business unless that person isa key person. For contracts issued ordeemed issued after June 8, 1997, you gen-erally cannot deduct interest with respect toany life insurance, annuity or endowmentcontract that covers any individual, unlessthat individual is a key person.

Principal amount of the loan ................... $100,000Minus: Points .......................................... 1,500Issue price of the loan ............................ $98,500Multiplied by: YTM .................................. × .102467Total ........................................................ 10,093Minus: QSI .............................................. 10,000Points (OID) deductible in 1998 $93

Issue price .............................................. $98,500Plus: Points (OID) deducted in 1998 ...... 93Adjusted issue price ............................... $98,593Multiplied by: YTM .................................. × .102467Total ........................................................ 10,103Minus: QSI .............................................. 10,000Points (OID) deductible in 1999 ............. $103

Redemption price at maturity (principalamount of the loan) ................................. $100,000Multiplied by: The term of the loan incomplete years ........................................ × 10Multiplied by ............................................. × .0025De minimis amount $2,500

Chapter 8 Interest

If the policy or contract covers a key per-son, you can deduct the interest to the extent:

1) The aggregate debt is not more than$50,000 for that key person, and

2) The interest paid or accrued for anymonth beginning after 1995 is not morethan the Moody's Corporate Bond YieldAverage-Monthly Average Corporates(Moody's rate) for that month.

Key person. A key person is an officeror 20% owner. However, the number of indi-viduals you can treat as key persons is limitedto the greater of:

1) Five individuals, or

2) The lesser of 5% of the total officers andemployees of the company or 20 indi-viduals.

Proration rule. A rule applies to disallowa portion of the entire interest deduction forthe taxable year of corporations, partnershipsand S corporations allocable, under prorationrules, to the unborrowed cash values of cer-tain life insurance, annuity or endowmentcontracts issued or deemed issued after June8, 1997, of which they are a direct or indirect(including by separate agreement) benefi-ciary. These proration rules generally do notapply with respect to such contracts thatcover only a single officer, director, employeeor 20% owner of the taxpayer. See section264(f) of the Internal Revenue Code.

Existing debt and contracts. Notwith-standing the general rules of nondeductibility,a limited deduction exists for otherwise al-lowable interest expense paid or accrued af-ter October 13, 1995, but before January 1,1999, on debt with respect to certain life in-surance, endowment or annuity contracts, ifthe debt was incurred within an applicableperiod before 1997. Also, special rules allowincome arising from the complete surrenderof certain life insurance, endowment and an-nuity contracts in 1996, 1997 or 1998 to bespread over a 4-year period. For more infor-mation, see PL 104–191, section 501(c) and(d).

Pre-June 21, 1986 contracts. With a fewexceptions, otherwise allowable interest (notin excess of the maximum rates set by law)paid or accrued on debt with respect to con-tracts purchased before June 21, 1986, canbe deducted no matter when the debt wasincurred.

For more information, see section 264 ofthe Internal Revenue Code.

Interest related to tax-exempt income.Generally, you cannot deduct interest relatedto tax-exempt income. You cannot take adeduction for any of the following.

1) Interest on a debt incurred to buy orcarry tax-exempt securities.

2) Amounts paid or incurred in connectionwith personal property used in a shortsale.

3) Amounts paid or incurred by others forthe use of any collateral used in con-nection with a short sale.

If you deposit cash as collateral in a sale andthe cash does not earn a material return dur-ing the period of sale, item (2) above doesnot apply. For more information on shortsales, see Short Sales in Publication 550.

Limit on investment interest. Your de-duction for investment interest expense islimited to the amount of your net investmentincome. This rule applies only if:

1) You are a noncorporate taxpayer (in-cluding shareholders and partners of Scorporations and partnerships), and

2) You paid or accrued interest on moneyyou borrowed to buy or carry propertyheld for investment (including amountsallowable as a deduction in connectionwith personal property used in a shortsale).

For more information about the limit on theinvestment interest expense deduction, seePublication 550.

Capitalization ofInterestUnder the uniform capitalization rules, yougenerally must capitalize interest on debtequal to the amount of expenditures used toproduce real or certain tangible personalproperty. The property must be produced byyou for use in your trade or business or forsale to customers. Interest related to propertyacquired and held for resale is not capitalized.

Interest you paid or incurred during theproduction period must be capitalized if theproperty produced is designated property.Designated property is:

1) Real property,

2) Tangible personal property with a classlife of 20 years or more,

3) Tangible personal property with an esti-mated production period of more than 2years, or

4) Tangible personal property with an esti-mated production period of more thanone year if the estimated cost of pro-duction is more than $1 million.

You produce property if you construct,build, install, manufacture, develop, improve,create, raise, or grow the property. Treat theproperty produced for you under a contractas produced by you up to the amount you payor incur for the property.

Capitalized interest. Treat capitalized inter-est as a cost of the property produced. Yourecover the interest when you sell or use theproperty, or dispose of it under the rules thatapply to such transactions. You recovercapitalized interest through cost of goodssold, an adjustment to basis, depreciation,amortization, or other method.

Partnerships and S corporations. The in-terest capitalization rules are applied first atthe level of the partnership or S corporation,and then at the level of the partners orshareholders. These rules are applied to theextent the partnership or S corporation hasinsufficient debt to support the production orconstruction costs.

If you are a shareholder in an S corpo-ration or a partner in a partnership, you mayhave to capitalize interest you incur during thetax year for the production costs of the Scorporation or partnership. You may alsohave to capitalize interest incurred by the S

corporation or partnership for your own pro-duction costs. You must provide the requiredinformation in an attachment to the ScheduleK–1 to properly capitalize interest for thispurpose.

Additional information. The procedures forapplying the uniform capitalization rules arecomplex and beyond the scope of this publi-cation. For more information, see section1.263A–8 through 1.263A–15 of the IncomeTax Regulations and Internal Revenue Notice88–99, 1988–2 C.B. 422, (as amended byAnnouncement 89-72) available at most IRSoffices.

When To DeductInterestIf the earlier discussion of capitalized interestdoes not apply to you, deduct interest as fol-lows.

Cash method. In general, you can deductonly the interest you actually paid during thetax year. You cannot deduct a promissorynote you gave as payment because it is apromise to pay and not an actual payment.

Prepaid interest. Under the cashmethod, you generally cannot deduct any in-terest paid before the year it is due. Interestpaid in advance can be deducted over theterm of the loan.

Discounted loans. If interest or a dis-count is subtracted from your loan proceeds,it is not a payment of interest and you cannotdeduct it when you get the loan. The amountof interest or discount subtracted from yourloan produces original issue discount (OID).If the OID is de minimis, you can choose todeduct the OID in one of the following ways.

1) Constant-yield basis over the term of theloan.

2) Straight line basis over the term of theloan.

3) In proportion to stated interest payments.

4) Entire amount at maturity of the loan.

You make this choice by reporting the OID ina manner consistent with the method chosenon your timely filed tax return for the taxableyear in which the loan is issued. If the OID ismore than a de minimis amount, it is deduct-ible over the term of the loan based on aconstant yield. Discount on a short-term obli-gation is not deductible until paid. For infor-mation on the de minimis rule and theconstant-yield method, see the discussionearlier under Points.

Refunds of interest. If you pay interestand then receive a refund in the same taxyear of any part of the interest, reduce yourinterest deduction by the refund. If you re-ceive the refund in a later tax year, include therefund in income if the deduction for the in-terest reduced your tax. You should includein income only the amount of the interest de-duction that reduced your tax.

Accrual method. You can deduct only in-terest that has accrued during the tax year.

Prepaid interest. Under the accrualmethod, you generally cannot deduct any in-terest paid before it is due. Instead, deduct itover the term of the loan.

Chapter 8 Interest

Discounted loans. If interest or a dis-count is subtracted from your loan proceeds,it is not a payment of interest and you cannotdeduct it when you get the loan. For moreinformation, see Discounted loans earlier un-der Cash method.

Tax deficiency. If you contest a federalincome tax deficiency, interest does not ac-crue until the tax year the final determinationof liability is made. If you do not contest thedeficiency, then the interest accrues in theyear the tax was asserted and agreed to.

However, if you contest but pay the pro-posed tax deficiency and interest, and you donot designate the payment as a cash bond,then the interest is deductible in the year paid.

Related persons. If you use the accrualmethod, you cannot deduct interest owed toa related person who uses the cash methoduntil payment is made and the interest isincludible in the gross income of that person.The relationship is determined as of the endof the tax year for which the interest wouldotherwise be deductible. If a deduction is de-nied under this rule, the rule will continue toapply even if your relationship with the personceases to exist before the interest is includiblein the gross income of that person. See Re-lated Persons in Publication 538.

Below-MarketInterest Rate LoansA below-market loan is a loan on which nointerest is charged or on which interest ischarged at a rate below the applicable federalrate. A below-market loan generally is treatedas an arm's-length transaction in which you,the borrower, are treated as having received:

1) A loan in exchange for a note that re-quires the payment of interest at theapplicable federal rate, and

2) An additional payment.

The additional payment is treated as a gift,dividend, contribution to capital, payment ofcompensation, or other payment, dependingon the substance of the transaction.

In the case of a demand loan covered bythe below-market loan rules, two transactionsare assumed to have taken place:

1) A transfer of forgone interest from thelender to the borrower, and

2) A retransfer of the forgone interest fromthe borrower to the lender.

Forgone interest. For any period, forgoneinterest is:

1) The amount of interest that would bepayable for that period if interest accruedat the applicable federal rate and waspayable annually on December 31, mi-nus

2) Any interest actually payable on the loanfor the period.

Applicable federal rates are published by theIRS each month in the Internal Revenue Bul-letin. You can also contact an Internal Reve-nue Service office to get these rates.

How you treat the forgone interest de-pends on the type of loan you have. Thevarious loans and types of treatment of for-gone interest are discussed next.

Gift and demand loans. A gift loan isany below-market loan where the forgone in-terest is in the nature of a gift. A demandloan is one payable in full at any time uponthe lender's demand.

If you receive a below-market gift loan ordemand loan, you are treated as receiving anadditional payment (as a gift, dividend, etc.)equal to the forgone interest on the loan. Youthen treat this amount as being transferredback to the lender as interest. You may beentitled to deduct that amount as an interestexpense, if it qualifies. The lender must reportthis amount as interest income. These trans-fers are considered to occur annually, gener-ally on December 31.

Term loans. If you receive a below-market term loan (a loan that is not a demandloan), you are treated as receiving a cashpayment (as a gift, dividend, etc.) on the datethe loan is made. This payment is equal to theloan amount minus the present value of allpayments due under the loan. This excessamount is also treated as original issue dis-count on the loan and the original issue dis-count rules apply. See Original Issue Dis-count (OID) in Publication 550.

Loans subject to the rules. The rules forbelow-market loans apply to:

1) Gift loans,

2) Compensation-related loans,

3) Corporation-shareholder loans,

4) Tax avoidance loans,

5) Loans to qualified continuing care facili-ties (made after October 11, 1985), and

6) Other below-market loans to the extentprovided in the Regulations.

Exceptions. The rules for below-marketloans do not apply to certain loans on dayson which the total amount of outstandingloans between the borrower and lender is$10,000 or less. This exception applies onlyto:

1) Gift loans between individuals if the giftloan is not directly used to buy or carryincome-producing assets, or

2) Compensation-related loans orcorporation-shareholder loans if theavoidance of federal tax is not a principalpurpose of the loan.

A compensation-related loan is anybelow-market loan between an employer andan employee or between an independentcontractor and a person for whom the con-tractor provides services.

Limit on forgone interest for gift loansof $100,000 or less. For gift loans betweenindividuals, if the outstanding loans betweenthe lender and borrower total $100,000 orless, the forgone interest included in incomeby the lender and deemed paid by the bor-rower is limited to the borrower's net invest-ment income for the year. This limit does notapply to a loan if the avoidance of federal taxis one of the main purposes of the interestarrangement. Additionally, if the borrower'snet investment income is $1,000 or less, theborrower's net investment income is treatedas zero.

Loans not subject to the rules. Some loansare specifically exempted from the rules forbelow-market loans, such as:

1) Loans made available by lenders to thegeneral public on the same terms andconditions that are consistent with thelender's customary business practices,

2) Loans subsidized by a federal, state, ormunicipal government that are madeavailable under a program of generalapplication to the public,

3) Certain employee-relocation loans,

4) Certain loans to or from a foreign person,unless the interest income would be ef-fectively connected with the conduct ofa U.S. trade or business and not exemptfrom U.S. tax under an income tax treaty,and

5) Any loan if the taxpayer can show theinterest arrangement has no significanteffect on the federal tax liability of thelender or the borrower. See Significanteffect on federal tax liability, later.

Certain loans to qualified continuingcare facilities. The below-market interestrules do not apply to loans made by a lenderto a qualified continuing care facility pursuantto a continuing care contract. These loans areexempt if both of the following requirementsare met.

1) The principal amount of the loan, whenadded to the total outstanding amountof all loans from the lender (or lender'sspouse) does not exceed $134,800 for1998.

2) The lender (or lender's spouse) is age65 or older by the end of the calendaryear.

A continuing care facility is one or morefacilities that are designed to provide servicesunder continuing care contracts and wheresubstantially all of the residents living therehave entered into continuing care contracts.In addition, substantially all of the facilitiesused to provide services required under thecontinuing care contract must be owned oroperated by the loan borrower.

A written contract between an individualand a qualified continuing care facility mustmeet all four of the following conditions.

1) The individual and/or the individual'sspouse must be entitled to use the facil-ity for the rest of their life or lives.

2) The residential use must begin in aseparate, independent living unit pro-vided by the continuing care facility andcontinue until the individual (or individ-ual's spouse) is incapable of living inde-pendently. The facility must provide var-ious “personal care” services to theresident such as maintenance of theresidential unit, meals, and daily aid andsupervision relating to routine medicalneeds.

3) The facility must also be obligated toprovide long-term nursing care if theresident is no longer capable of livingindependently.

4) The contract must require the facility toprovide the “personal services” and“long-term nursing care” without sub-stantial additional cost to the individual.

Tax avoidance loans. If one of the principalpurposes of structuring a transaction as anexempted loan is the avoidance of federal tax,the loan will be considered a tax avoidance

Chapter 8 Interest

loan and will be subject to the rules forbelow-market loans.

Significant effect on federal tax liability.Whether an interest arrangement has a sig-nificant effect on the federal tax liability (seeitem 5, earlier under Loans not subject to therules) of the lender or the borrower will bedetermined by all the facts and circum-stances. Consider all of the following factors.

1) Whether items of income and deductiongenerated by the loan offset each other.

2) The amount of the items.

3) The cost of complying with the below-market loan provisions if they applied.

4) Any reasons, other than taxes, forstructuring the transaction as a below-market loan.

Effective dates. Except as provided above,these rules apply to term loans made afterJune 6, 1984, and to demand loans out-standing after that date.

For more information, see section 7872of the Internal Revenue Code and 1.7872–5Tof the regulations.

Sale or exchange of property. Differentrules generally apply to a loan connected withthe sale or exchange of property. If the loandoes not provide adequate stated interest,part of the principal payment may be consid-ered interest. However, there are exceptionsthat may require you to apply the below-market interest rate rules to these loans. Seethe Unstated Interest discussion in Publica-tion 537.

9.Taxes

IntroductionYou can deduct various federal, state, local,and foreign taxes directly attributable to yourtrade or business as business expenses.

When to deduct taxes. Generally, you canonly deduct taxes in the year you pay them.This applies whether you use the cashmethod or an accrual method of accounting.

If you use an accrual method, you candeduct a tax before you pay it. But you mustmeet the exception for recurring items dis-cussed under Economic Performance inPublication 538. You can also choose toratably accrue real estate taxes as discussedlater under Real Estate Taxes.

Limit on accrual of taxes. A taxing ju-risdiction can require the use of a date foraccruing taxes that is earlier than the date itpreviously required. However, if you use anaccrual method and can deduct the tax beforeyou pay it, a special rule applies. The specialrule sets the accrual date for federal incometax purposes as the date on which the taxwould have accrued had no action beentaken.

Uniform capitalization rules. Uniform cap-italization rules apply to certain taxpayers whoproduce real or tangible personal property foruse in a trade or business or for sale to cus-tomers. They also apply to taxpayers whoacquire property for resale. Under these rules,you may have to either include in inventorycosts or capitalize certain expenses relatedto the property, such as taxes. For more in-formation, see Publication 551.

Carrying charges. Carrying charges includetaxes you pay to carry or develop real estateor to carry, transport, or install personalproperty. You can choose to capitalize carry-ing charges not subject to the uniform cap-italization rules if they are otherwise deduct-ible. For more information, see chapter 11.

CAUTION!

You cannot deduct federal estate andgift taxes, or state inheritance, legacy,and succession taxes.

Refunds of taxes. If you receive a refund forany taxes you deducted in an earlier year,include the refund in income only to the extentthe deduction reduced your tax in the earlieryear. For more information, see Recovery ofamount deducted in chapter 1.

TIPYou must include any interest youreceive with state or local tax refundsin income.


• Real estate taxes

• Income taxes

• Employment taxes

• Other taxes


Publication


m 378 Fuel Tax Credits and Refunds

m 533 Self-Employment Tax




m 1040 U.S. Individual Income Tax Return

m Sch SE (Form 1040) Self-EmploymentTax

m 3115 Application for Change in Ac-counting Method


Real Estate TaxesDeductible real estate taxes are any state,local, or foreign taxes on real estate levied forthe general public welfare. The taxing au-thority must base the taxes on the assessedvalue of the real estate and charge themuniformly against all property under its juris-

diction. Deductible real estate taxes generallydo not include taxes charged for local benefitsand improvements that increase the value ofthe property. See Taxes for local benefits,later.

If you use an accrual method of account-ing, you generally cannot accrue real estatetaxes until you pay them to the governmentauthority. You can, however, choose toratably accrue the taxes during the year. SeeElection to ratably accrue, later.

Taxes for local benefits. Generally, youcannot deduct taxes charged for local benefitsand improvements that tend to increase thevalue of your property. These include as-sessments for streets, sidewalks, watermains, sewer lines, and public parking facili-ties. You should increase the basis of yourproperty by the amount of the assessment.

You can deduct taxes for these localbenefits only if the taxes are for maintenance,repairs, or interest charges related to thosebenefits. If part of the tax is for maintenance,repairs, or interest, you can deduct that part.But you have to be able to show how muchit is. Otherwise, you cannot deduct any of it.

Example. City X, to improve downtowncommercial business, converted a downtownbusiness area street into an enclosed pedes-trian mall. The city assessed the full cost ofconstruction, financed with 10-year bonds,against the affected properties. The city ispaying the principal and interest with the an-nual payments made by the property owners.

The assessments for construction costsare not deductible as taxes or as businessexpenses, but are depreciable capital ex-penses. The part of the payments that is topay the interest charges on the bonds isdeductible as taxes.

Charges for services. Water bills,sewerage, and other service charges as-sessed against your business property arenot real estate taxes, but are deductible asbusiness expenses.

Purchase or sale of real estate. If real es-tate is sold during the year, the real estatetaxes must be divided between the buyer andthe seller.

The buyer and seller must divide the realestate taxes according to the number of daysin the real property tax year (the period towhich the tax imposed relates) that eachowned the property. Treat the seller as pay-ing the taxes up to but not including the dateof sale. Treat the buyer as paying the taxesbeginning with the date of sale. For this pur-pose, disregard the accrual or lien dates un-der local law. You can usually find this infor-mation on the settlement statement youreceived at closing.

If you (the seller) cannot deduct taxes untilthey are paid because you use the cashmethod of accounting and the buyer of yourproperty is personally liable for the tax, youare considered to have paid your part of thetax at the time of the sale. This lets you de-duct the part of the tax to the date of saleeven though you did not pay it. You must alsoinclude the amount of that tax in the sellingprice of the property.

If you (the seller) use an accrual methodand have not chosen to ratably accrue realestate taxes, you are considered to have ac-crued your part of the tax on the date you sellthe property.

Chapter 9 Taxes

Example. Al Green, a calendar year ac-crual method taxpayer, owns real estate in XCounty. He has not chosen to ratably accrueproperty taxes. November 30 of each year isthe assessment and lien date. He sold theproperty on June 30, 1998. Under his ac-counting method he would not be able toclaim a deduction for the taxes because thesale occurred before November 30. He istreated as having accrued his part of the tax,180 / 365 (January 1–June 29), on June 30, andhe can deduct it for 1998.

Election to ratably accrue. If you use anaccrual method, you can choose to accruereal estate tax that is related to a definite pe-riod ratably over that period.

Example. John Smith is a calendar yeartaxpayer who uses an accrual method. Hisreal estate taxes for the real property tax year,July 1, 1998, to June 30, 1999, amount to$1,200. July 1 is the assessment and liendate.

If John chooses to ratably accrue thetaxes, $600 will accrue in 1998 ($1,200 ×6 / 12, July 1–December 31) and the balancewill accrue in 1999.

Separate elections. You can make achoice for each separate trade or businessand for nonbusiness activities if you accountfor them separately. Once you choose toratably accrue real estate taxes, you must usethat method unless you get permission fromthe IRS to change from that method. SeeRevoking the election, later.

Making the election. If you make yourelection for the first year in which you incurreal estate taxes, attach a statement to yourincome tax return for that year. You must fileyour return by the due date (including exten-sions). The statement should show all of thefollowing items.

1) The trades or businesses to which theelection applies and the accountingmethod or methods used.

2) The period to which the taxes relate.

3) The computation of the real estate taxdeduction for the first year of theelection.

If you make the election for a year afterthe first year in which you incur real estatetaxes, file Form 3115, Application for Changein Accounting Method. Generally, you mustfile this form during the tax year for which theelection is to be effective. For more informa-tion, see the instructions for Form 3115.

Revoking the election. To revoke anelection to ratably accrue real estate taxes,file Form 3115, as discussed above.

Income TaxesThis section discusses federal, state, local,and foreign income taxes.

Federal income taxes. You cannot deductfederal income taxes.

State and local income taxes. A corpo-ration or partnership can deduct state incometaxes imposed on the corporation or partner-

ship as business expenses. An individual candeduct state income taxes imposed on himor her only as an itemized deduction onSchedule A (Form 1040).

However, an individual can deduct a statetax on gross income (as distinguished fromnet income) directly attributable to a trade orbusiness as a business expense.

Accrual of contested income taxes. Ifyou use an accrual method, can deduct taxesbefore you pay them, and contest a state orlocal income tax liability, a special rule ap-plies. Under this special rule, you must accrueand deduct any contested amount only in thetax year in which the liability is finally deter-mined.

Filing a tax return is not considered con-testing a liability. If you do not make an ob-jective act of protest or show some affirmativeevidence of denial of the liability, you candeduct any additional state or local incometaxes found to be due for a prior year only inthe year for which they were originally im-posed. You cannot deduct them in the yearin which the liability is finally determined.

Foreign income taxes. Generally, you cantake either a deduction or a credit for incometaxes imposed on you by a foreign countryor a U.S. possession. However, an individualcannot take a deduction or credit for foreignincome taxes paid on income that is exemptfrom U.S. tax under the foreign earned in-come exclusion or the foreign housing exclu-sion. For information on these exclusions, seePublication 54, Tax Guide for U.S. Citizensand Resident Aliens Abroad.

Employment TaxesIf you have employees, you must withholdvarious taxes from your employees' pay. Mostemployers must withhold their employees'share of social security and Medicare taxesalong with state and federal income taxes.You may also need to pay certain taxes fromyour own funds. These include your share ofsocial security and Medicare taxes along withunemployment taxes.

You should treat the taxes you withholdfrom your employees' pay as wages on yourtax return. You can deduct the employmenttaxes you must pay from your own funds astaxes.

Example. You pay your employee$18,000 a year. However, after you withholdvarious taxes, your employee receives$14,500. You also pay an additional $1,500in employer taxes. You should deduct the full$18,000 as wages. You can deduct the$1,500 you pay from your own funds as taxes.

For more information on employmenttaxes, see Publication 15.

Other TaxesThe following are other taxes that you candeduct if you incur them in the ordinarycourse of your trade or business.

Excise taxes. You can deduct all excisetaxes you pay or incur as ordinary and nec-essary expenses of carrying on your trade orbusiness.

Franchise taxes. You can deduct corporatefranchise taxes as a business expense. If youare a cash method taxpayer, deduct thefranchise tax in the year paid. If you are anaccrual method taxpayer, deduct the tax inthe year you become legally liable to pay itregardless of the year the tax is based on.For example, if your state imposes a fran-chise tax for 1998 that is based on your cor-porate net income for 1997, deduct the tax in1998 if you use an accrual method becausethat is the year you became legally liable forthe tax.

Fuel taxes. Taxes on gasoline, diesel fuel,and other motor fuels that you use in yourbusiness are usually included as part of thecost of the fuel. Do not deduct these taxesas a separate item.

You may be entitled to a credit or refundfor federal excise tax you paid on fuels usedfor certain purposes. For more information,see Publication 378.

Occupational taxes. You can deduct as abusiness expense an occupational taxcharged at a flat rate by a locality for theprivilege of working or conducting a businessin the locality.

Personal property tax. You can deduct anytax imposed by a state or local governmenton personal property used in your trade orbusiness.

Sales tax. Treat any sales tax you pay on aservice or on the purchase or use of propertyas part of the cost of the service or property.If the service or the cost or use of the propertyis a deductible business expense, you candeduct the tax as part of that service or cost.If the property is merchandise bought for re-sale, the sales tax is part of the cost of themerchandise. If the property is depreciable,add the sales tax to the basis for depreciation.For more information on basis, see Publica-tion 551.

CAUTION!

Do not deduct state and local salestaxes imposed on the buyer that youmust collect and pay over to the state

or local government. Do not include thesetaxes in gross receipts or sales.

Self-employment tax. You can deduct one-half of your self-employment tax as a busi-ness expense in figuring your adjusted grossincome. This deduction only affects your in-come tax. It does not affect your net earningsfrom self-employment or your self-employment tax.

To deduct the tax, enter on Form 1040,line 27, the amount shown on the “Deductionfor one-half of self-employment tax” line ofSchedule SE (Form 1040).

For more information on self-employmenttax, see Publication 533.

Unemployment fund taxes. As an em-ployer, you may have to make payments toa state unemployment compensation fund orto a state disability benefit fund. Deduct thesepayments as taxes.

Chapter 9 Taxes

10.Insurance

Important Changefor 1998Health insurance deduction for the self-employed. In 1998, the deduction for healthinsurance of self-employed individuals in-creases from 40% to 45%. See Health Insur-ance Deduction for the Self-Employed, later.

Important Changefor 1999Health insurance deduction for the self-employed. For 1999, this deduction is in-creased to 60% of the amount you paid formedical insurance for yourself and your fam-ily. After 2001, the deduction will increaseagain. For more information, see Health In-surance Deduction for the Self-Employed,later.

IntroductionYou generally can deduct the ordinary andnecessary cost of insurance as a businessexpense if it is for your trade, business, orprofession. However, you may have to capi-talize certain insurance costs under the uni-form capitalization rules. For more informa-tion, see Capitalizing Premiums, later.


• Deductible premiums

• Nondeductible premiums

• Capitalizing premiums

• When to deduct premiums


Publication



m 547 Casualties, Disasters, and Thefts


m 1040 U.S. Individual Income Tax Return


Deductible PremiumsYou can generally deduct premiums you payfor the following kinds of insurance related toyour trade or business.

1) Fire, theft, flood, or similar insurance.

2) Credit insurance on losses from unpaiddebts.

3) Group hospitalization and medical insur-ance for employees, including long-termcare insurance.

a) If a partnership pays accident andhealth insurance premiums for itspartners, it can deduct them asguaranteed payments made to thepartners.

b) If an S corporation pays accidentand health insurance premiums forits 2% shareholder-employees, itcan deduct the premiums.

4) Liability insurance.

5) Malpractice insurance that covers yourprofessional personal liability fornegligence resulting in injury or damageto patients or clients.

6) Workers' compensation insurance set bystate law that covers any claims forbodily injuries or job-related diseasessuffered by employees in your business,regardless of fault.

a) If a partnership pays workers' com-pensation premiums for its partners,it can deduct these amounts asguaranteed payments to the part-ners.

b) If an S corporation pays the work-ers' compensation premiums for itsshareholders, it can deduct theseamounts.

7) Contributions to a state unemploymentinsurance fund. You can deduct thesecontributions as taxes if they are con-sidered taxes under state law.

8) Overhead insurance. This insurancepays you for business overhead ex-penses you have during long periods ofdisability caused by your injury or sick-ness.

9) Car and other vehicle insurance. Thisinsurance covers vehicles used in yourbusiness for liability, damages, and otherlosses. If you operate a vehicle partly forpersonal use, you can deduct only thepart of your insurance premiums thatapplies to the business use of the vehi-cle. If you use the standard mileage rateto figure your car expenses, you cannotdeduct any car insurance premiums.

10) Life insurance covering your officers andemployees if you are not directly or indi-rectly the beneficiary under the contract.

11) Use and occupancy and business inter-ruption insurance. This insurance paysyou for lost profits if your business is shutdown due to a fire or other cause.

Health Insurance Deductionfor the Self-Employed You can deduct 45% of the amount paidduring 1998 for medical insurance and qual-ified long-term care insurance for yourself andyour family, if you are one of the following.

1) A self-employed individual.

2) A general partner (or a limited partnerreceiving guaranteed payments) in apartnership.

3) A shareholder owning more than 2% ofthe outstanding stock of an S corpo-ration.

You are allowed this deduction whetheryou paid the premiums yourself or your part-nership or S corporation paid them and youincluded the premium amounts in your grossincome. Take this deduction on line 28 ofForm 1040.

Percentage increases after 1998. For taxyears beginning after 1998, the deductiblepercentage of your health insurance premi-ums gradually increases. The increases areshown in the following table.

Long-term care insurance. If you pay thepremiums on a qualified long-term care in-surance contract for yourself, your spouse,or your dependents, you can include thosepremiums when figuring your deduction. Butyou can include only the lesser of the follow-ing amounts.

1) The amount you pay.

2) The amount shown below.

a) Age 40 or less — $210

b) Age 41 to 50 — $380

c) Age 51 to 60 — $770

d) Age 61 to 70 — $2,050

e) Age 71 and above — $2,570

Use your age at the end of the tax year.Long-term care insurance contract. A

long-term care insurance contract is any in-surance contract that only provides coverageof qualified long-term care services. Thecontract must:

1) Be guaranteed renewable,

2) Provide that refunds, other than refundson the death of the insured or completesurrender or cancellation of the contract,and dividends under the contract maybe used only to reduce future premiumsor increase future benefits,

3) Not provide for a cash surrender valueor other money that can be paid, as-signed, pledged as collateral for a loan,or borrowed, and

4) Generally, not pay or reimburse ex-penses incurred for services or itemsthat would be reimbursed under Medi-care, except where Medicare is a sec-ondary payer or the contract makes perdiem or other periodic payments withoutregard to expenses.

Qualified long-term care services.Qualified long-term care services are:

• Necessary diagnostic, preventive,therapeutic, curing, treating, mitigating,and rehabilitative services, and

• Maintenance or personal care services.

For Tax Years Beginning in:Deductible

Percentage

1999 through 2001 ............................. 60%2002 .................................................... 70%After 2002 ........................................... 100%

Chapter 10 Insurance

The services must be required by a chron-ically ill individual and prescribed by a li-censed health care practitioner.

Chronically ill individual. A chronicallyill individual is a person who has been certi-fied as one of the following.

• An individual who, for at least 90 days, isunable to perform at least two activitiesof daily living without substantial assist-ance due to loss of functional capacity.Activities of daily living are eating,toileting, transferring, bathing, dressing,and continence.

• An individual who requires substantialsupervision to be protected from threatsto health and safety due to severe cog-nitive impairment.

The certification must have been made by alicensed health care practitioner within theprevious 12 months.

Benefits received. For information onexcluding from gross income benefits you re-ceive from a long-term care contract, seePublication 525.

Limits. You cannot deduct an amount morethan your net earnings from the trade orbusiness in which the medical insurance planor long-term care insurance plan is estab-lished. If the business in which the insuranceplan is established is an S corporation, youcannot deduct more than your wages from theS corporation. Do not subtract the health in-surance deduction when figuring net earningsfor your self-employment tax. However, sub-tract the amount of this deduction from yourmedical insurance when figuring your medicalexpenses on Schedule A (Form 1040) if youitemize your deductions.

Other coverage. You cannot take thededuction for any month if you were eligibleto participate in any employer (including yourspouse's) subsidized health plan at any timeduring that month. This rule is applied sepa-rately to plans that provide long-term care in-surance and plans that do not provide long-term care insurance. However, any medicalinsurance payments not deductible on line 28of Form 1040 can be included as part of yourmedical expenses on Schedule A (Form1040) if you itemize your deductions.

How to figure the deduction. Generally, youcan use the worksheet in the Form 1040 in-structions to figure your deduction. However,if either of the following applies, you must usethe worksheet that follows.

• You have more than one source of in-come subject to self-employment tax.

• You file Form 2555 or Form 2555–EZ(relating to foreign earned income).

CAUTION!

If you have more than one health planduring the year, and each plan is es-tablished under a different business,

you must use separate worksheets (in thischapter) to figure each plan's net earningslimit. Include your insurance payments underthat plan on line 1 of the separate worksheetand your net profit (or wages) from that busi-ness on line 4 (or line 11).

Table 10-1. Self-Employed Health Insurance DeductionWorksheet (Keep for your records.)

1)

2)

3)

4)

5)

6)

7)

8)

9)

10)

11)

12)

13)

14)

Enter total payments made during the taxable year for healthinsurance coverage for yourself, your spouse, and yourdependents. (Do not include payments for coverage for anymonth during which you were eligible to participate in a healthplan subsidized by your or your spouse’s employer.)

Percentage used to figure deduction for 1998 .45

Multiply the amount on line 1 by the percentage on line 2

Enter your net profit and any other earned income* from the tradeor business under which the insurance plan is established. (If thebusiness is an S corporation, skip to line 11.)

Enter the total of all net profits from: line 31, Schedule C (Form1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F(Form 1040); or line 15a, Schedule K-1 (Form 1065); plus anyother income allocable to the profitable businesses. See theinstructions for Schedule SE (Form 1040). (Do not include anynet losses shown on these schedules.)

Divide the amount on line 4 by the amount on line 5

Multiply the amount on Form 1040, line 27, by the percentage online 6

Subtract the amount on line 7 from the amount on line 4

Enter the amount, if any, from Form 1040, line 29, attributable tothe same trade or business in which the health insurance plan isestablished

Subtract the amount on line 9 from the amount on line 8

Enter your wages from your S corporation in which the healthinsurance plan is established

Enter the amount from Form 2555, line 43, attributable to theamount entered on line 4 or 11 above, or the amount from Form2555-EZ, line 18, attributable to the amount entered on line 11above

Subtract the amount on line 12 from the amount on line 10 or 11,whichever applies

Compare the amounts on lines 3 and 13 above. Enter thesmaller of the two amounts here and on Form 1040, line 28. (Donot include this amount when figuring a medical expensededuction on Schedule A (Form 1040).)

*Earned income includes net earnings and gains from the sale, transfer, or licensing of property youcreated. It does not include capital gain income.

NondeductiblePremiumsYou cannot deduct the following kinds of in-surance premiums.

1) Self-insurance reserve funds. Youcannot deduct amounts credited to a re-serve you set up for self-insurance. Thisapplies even if you cannot get businessinsurance coverage for certain businessrisks. However, your actual losses maybe deductible. See Publication 547.

2) Loss of earnings. You cannot deductpremiums for a policy that pays for yourlost earnings due to sickness or disabil-ity. However, see the earlier discussionon overhead insurance, item (8), underDeductible Premiums.

3) Certain life insurance and annuities.For contracts issued before June 9,1997, you cannot deduct the premiumson a life insurance policy covering your-self, an employee, or any person with afinancial interest in your business if you

are directly or indirectly a beneficiary ofthe policy. You are included amongpossible beneficiaries of the policy if thepolicy owner is obligated to repay a loanfrom you using the proceeds of the pol-icy. A person has a financial interest inyour business if the person is an owneror part owner of the business or has lentmoney to the business.

For contracts issued after June 8,1997, you generally cannot deduct thepremiums on any life insurance policy,endowment contract, or annuity contractif you are directly or indirectly a benefi-ciary. The disallowance applies withoutregard to whom the policy covers.

Partners. If, as a partner in a part-nership, you take out an insurance policyon your own life and name your partnersas beneficiaries to induce them to retaintheir investments in the partnership, youare considered a beneficiary. You cannotdeduct the insurance premiums.

4) Insurance to secure a loan. If you takeout a policy on your life or on the life ofanother person with a financial interestin your business to get or protect abusiness loan, you cannot deduct the

Chapter 10 Insurance

premiums as a business expense. Norcan you deduct the premiums as intereston business loans or as an expense offinancing loans. In the event of death,the proceeds of the policy are not taxedas income even if they are used to liqui-date the debt.

Capitalizing PremiumsUnder the uniform capitalization rules, youmust capitalize the direct costs and part of theindirect costs for production or resale activ-ities. Include these costs in the basis ofproperty you produce or in inventory ratherthan claiming them as a current deduction.Also, recover the costs through depreciation,amortization, cost of goods sold, or by anadjustment to basis when you use, place inservice, or dispose of the property.

When the uniform capitalization rules ap-ply. You must use the uniform capitalizationrules if, in your trade or business or activitycarried on for profit, you:

1) Produce real property or tangible per-sonal property for use in the businessor activity,

2) Produce real property or tangible per-sonal property for sale to customers, or

3) Acquire property for resale. However,you generally do not have to use theuniform capitalization rules for personalproperty acquired for resale if your av-erage annual gross receipts are notmore than $10,000,000.

Indirect costs include premiums for insur-ance on your plant or facility, machinery,equipment, materials, property produced, orproperty acquired for resale.

More information. For more information onthe uniform capitalization rules, see UniformCapitalization Rules in Publication 538 andthe regulations under Internal Revenue Codesection 263A.

When To DeductPremiumsYou can usually deduct insurance premiumsin the tax year to which they apply.

Cash method. If you use the cash methodof accounting, you must generally deduct in-surance premiums in the tax year in whichyou actually pay them, even if you incurredthem in an earlier year.

Accrual method. If you use an accrualmethod of accounting, you can generally de-duct insurance premiums in the tax year inwhich you incur a liability for them, whetheror not you pay them in the same year.

Cash or accrual method prepayments.You cannot deduct the entire premium for aninsurance policy that covers more than onetax year in the year you make the paymentor incur a liability for the payment. For the

year in which you make the payment or incurthe liability, you can deduct only the part ofthe premium that applies to that year. Foreach later tax year, you can deduct the partthat applies to that tax year.

Example. You operate a business andfile your returns on a calendar-year basis.You bought a fire insurance policy on yourbuilding effective October 1, 1998, and paida premium of $1,200 for 2 years of coverage.On your 1998 return, you can deduct only thepart of the total premium that applies to the3 months of coverage in 1998. For 1999 and2000, you can deduct the part of the premiumthat applies to each of those years. Since thetotal policy premium is $1,200 for 2 years, theyearly rate is $600 and the monthly rate is$50. For the 3-month period in 1998, you candeduct $150; for 1999, you can deduct $600;and for the 9-month period in 2000, you candeduct $450.

If you use the cash method of accountingand you pay the $1,200 premium in January1999, you cannot deduct any amount on your1998 return. However, you can deduct $750(the $150 that applies to 1998 plus the $600that applies to 1999) on your return for 1999.

Dividends received. If you receive dividendsfrom business insurance and you deductedthe premiums in prior years, part of the divi-dends are income. For more information,seeTax Benefit Rule in Publication 525.

11.Costs You CanDeduct orCapitalize

IntroductionThis chapter discusses the two ways oftreating certain costs—deduction or capital-ization.

If you deduct a cost (expense), you gen-erally recover it by subtracting it from yourincome in either the year you incur it or theyear you pay it.

If you capitalize a cost, you may be ableto recover it over a period of years throughperiodic deductions for amortization, de-pletion, or depreciation. When you capitalizea cost, you add it to the basis of property towhich it relates.

Except for exploration costs for mineraldeposits, a partnership, corporation, estate,or trust makes the choice to deduct or capi-talize these costs. Each individual partner,shareholder, or beneficiary chooses whetherto deduct or capitalize exploration costs.

CAUTION!

You may be subject to the alternativeminimum tax (AMT) if you deduct anyof the expenses listed in the topics

area except carrying charges and the costsof removing architectural barriers.

For more information on alternative mini-mum tax, see the instructions for Form 6251(individuals) or Form 4626 (corporations).


• Carrying charges

• Research and experimental costs

• Drilling and development costs

• Exploration costs

• Circulation costs

• Costs of removing barriers to the disabledand the elderly


Publication


m 544 Sales and Other Dispositions ofAssets



m 3115 Application for Change in Accounting Method

m 3468 Investment Credit

m 6251 Alternative MinimumTax—Individuals

m 6765 Credit for Increasing ResearchActivities

m 8826 Disabled Access Credit


Carrying Charges Carrying charges include the taxes and in-terest you pay to carry or develop real prop-erty or to carry, transport, or install personalproperty. Certain carrying charges must becapitalized under the uniform capitalizationrules. (For more information on capitalizationof interest, see chapter 8.) You can chooseto capitalize carrying charges not subject tothe uniform capitalization rules, but only ifthey are otherwise deductible.

You can choose to capitalize carryingcharges separately for each project you haveand for each type of carrying charge. For un-improved and unproductive real property,your choice is good for only one year. Youmust decide whether to capitalize carryingcharges each year the property remains un-improved and unproductive. For other prop-erty, your choice to capitalize carryingcharges remains in effect until construction,development, or installation is completed (or,for personal property, the date you first useit, if later).

How to make the choice. To make thechoice to capitalize a carrying charge, writea statement saying which charges youchoose to capitalize. Attach it to your originaltax return for the year the choice is to be ef-fective. You may be able to extend the timeyou have to make the choice.

Chapter 11 Costs You Can Deduct or Capitalize

Research andExperimental CostsThe costs of research and experimentationare generally capital expenses. However, youcan choose to deduct these costs as currentbusiness expenses.

For information on amortizing these costs,see Research and Experimental Costs inchapter 12.

Research and experimental costs defined.Research and experimental costs are rea-sonable costs you incur in your trade orbusiness for activities intended to provide in-formation to help eliminate uncertainty aboutthe development or improvement of a prod-uct. Uncertainty exists if the informationavailable to you does not establish how todevelop or improve a product or the appro-priate design of a product. Whether costsqualify as research and experimental costsdepends on the nature of the activity relatedto the costs. Neither the nature of the productor improvement being developed nor the levelof technological advancement matters whenmaking this determination.

The costs of obtaining a patent, includingattorneys' fees in making and perfecting apatent application, are research and exper-imental costs.

Product. The term “product” includesany:

1) Pilot model,

2) Process,

3) Formula,

4) Invention,

5) Technique,

6) Patent, or

7) Similar property.

It also includes products used by you in yourtrade or business or held for sale, lease, orlicense.

Costs not included. Research and ex-perimental costs do not include expenses for:

1) Quality control testing,

2) Efficiency surveys,

3) Management studies,

4) Consumer surveys,

5) Advertising or promotions,

6) The acquisition of another's patent,model, production or process, or

7) Research in connection with literary,historical, or similar projects.

When and how to choose. Generally, youcan only make the choice to deduct thesecosts in the first year you incur such costs.

You choose to deduct research and ex-perimental costs, rather than capitalize them,by deducting them on your tax return for theyear in which you first have this type of cost.

If you: Then:

Deduct research and experimental costs asa current business expense,

Do not deduct research and experimentalcosts as a current business expense,

Deduct all research and experimental costsfor the year of choice and all later years.

Amortize them over at least 60 months,starting the month you first receive aneconomic benefit from the research.

IntangibleDrilling CostsThe costs of developing oil, gas, orgeothermal wells are ordinarily capital ex-penses. You can usually recover themthrough depreciation or depletion. However,you can choose to deduct as current businessexpenses certain drilling and developmentcosts for wells in the United States in whichyou hold an operating or working interest. Youcan only deduct costs for drilling or preparinga well for the production of oil, gas,geothermal steam, or geothermal hot water.

You can choose to deduct only costs foritems that do not have a salvage value. Theseinclude wages, fuel, repairs, hauling, andsupplies related to drilling wells and preparingthem for production. The costs to you of anydrilling or development work (other thanamounts properly allocable to the cost ofdepreciable property and amounts paid onlyout of production or proceeds from productionare depletable income to the recipient) doneby contractors under any form of contract isalso an intangible drilling and developmentcost.

You can also choose to deduct the costof drilling bore holes to determine the locationand delineation of offshore hydrocarbon de-posits if the shaft is capable of conductinghydrocarbons to the surface on completion.It does not matter whether there is any intentto produce hydrocarbons.

If you do not choose to deduct your in-tangible drilling and development costs cur-rently, you can choose to deduct them overthe 60-month period beginning with the monththey were paid or incurred.

How to make the choice. You choose todeduct intangible drilling and developmentcosts currently by taking the deduction onyour income tax return for the first tax yearyou have eligible costs. No formal statementis required. If you file Form 1040 (ScheduleC), enter these costs under “Otherexpenses.”

Energy credit for costs of geothermalwells. If you capitalize the drilling and de-velopment costs of geothermal wells that youplace in service, you may be able to claim abusiness energy credit. See Form 3468 formore information.

Nonproductive well. If you capitalize yourintangible drilling and development costs fora nonproductive well, you have another op-tion. You can deduct these costs as an ordi-nary loss if you indicate and clearly state yourchoice on your tax return for the year the wellis completed. Once made, the choice for oiland gas wells is binding for all later years.You can revoke your choice for a geothermal

well by filing an amended return that does notclaim the loss.

Costs incurred outside the United States.You cannot deduct, in one year, all of the in-tangible drilling and development costs paidor incurred for an oil, gas, or geothermal welllocated outside the United States. However,you can choose to include them in the ad-justed basis of the well to figure depletion. Ifyou do not make this choice, you can deductthe costs over the 10–year period beginningwith the tax year in which you paid or incurredthem. These rules do not apply to a nonpro-ductive well.

Exploration Costs The costs of determining the existence, lo-cation, extent, or quality of any mineral de-posit that lead to the development of a mineare ordinarily capital expenses. You recoverthese costs through depletion as the mineralis removed from the ground. However, youcan deduct currently the costs of explorationin the United States (except those for oil, gas,and geothermal wells) you paid or incurredbefore the development stage began.

Partnerships. Each partner, not the part-nership, chooses whether to capitalize or todeduct that partner's share of explorationcosts.

How to make the choice. To deduct explo-ration costs currently, take the deduction onyour income tax return or an amended in-come tax return. Your return must adequatelydescribe and identify each property or mine,and clearly state how much is being deductedfor each one. The choice applies to all thedomestic exploration costs you have duringthe tax year that you make this choice andall following tax years.

Reduced corporate deductions for explo-ration costs. A corporation (other than anS corporation) can deduct only 70% of itsdomestic exploration costs. It must capitalizethe remaining 30% and amortize them overthe 60-month period starting with the monththe exploration costs are paid or incurred. The30% the corporation capitalizes cannot beadded to its basis in the property for purposesof figuring cost depletion. However, theamount amortized is treated as additionaldepreciation and is subject to recapture asordinary income on a disposition of the prop-erty. See Section 1250 Property under De-preciation Recapture in chapter 3 of Publica-tion 544.

These rules also apply to the deductionof development costs for corporations. SeeDevelopment Costs, later.

Recapture of exploration expenses. Whenyour mine reaches the producing stage, youmust recapture any exploration costs you


chose to deduct for it. Use either of the fol-lowing methods.

Method 1—include the deducted costs ingross income for the tax year the minereaches the producing stage. You mustchoose this recapture method by the duedate (including extensions) of your return.Your choice must be clearly indicated onthe return. Increase your adjusted basis inthe mine by the amount included in in-come.

Method 2— do not claim any depletion de-duction for the tax year the mine reachesthe producing stage and following taxyears until the amount of depletion youwould have deducted equals the amountof deducted exploration costs.

You must also recapture deducted explo-ration costs if you receive a bonus or royaltyfrom mine property before it reaches theproducing stage. Do not claim any depletiondeduction for the tax year you receive thebonus or royalty and following tax years, untilthe amount of depletion you would have de-ducted equals the amount of your deductedexploration costs.

If you dispose of the mine before yourdeducted exploration costs have been fullyrecaptured, recapture the balance by treatingall or part of your gain as ordinary income.

Foreign exploration costs. If you pay orincur exploration costs for a mine or othernatural deposit located outside the UnitedStates, you cannot deduct all of the costs inthe current year. You can choose to includethe costs (other than for an oil, gas, orgeothermal well) in the adjusted basis of themineral property to figure cost depletion. Ifyou do not make this choice, you must deductthe costs over the 10-year period beginningwith the tax year in which you pay or incurthem. These rules also apply to foreign de-velopment costs.

Cost depletion is discussed in chapter 13.

Development CostsYou can deduct costs paid or incurred duringthe tax year for developing a mine or anyother natural deposit (other than an oil or gaswell) located in the United States. Thesecosts must be paid or incurred after the dis-covery of ores or minerals in commerciallymarketable quantities. Development costs in-clude those incurred by a contractor for you.Also, development costs include depreciationon improvements used in the developmentof ores or minerals. They do not include costsof depreciable property.

You can choose to treat developmentcosts as deferred expenses and deduct themratably as the units of produced ores or min-erals related to the expenses are sold. Thischoice applies each tax year to expensespaid or incurred in that year. Once made, thechoice is binding for the year and cannot berevoked for any reason.

How to make the choice. The choice todeduct development costs ratably as the oresor minerals are sold must be made for eachmine or other natural deposit by a clear indi-cation on your return or by a statement filedwith the IRS office where you file your return.You must make the choice by the due dateof the return (including extensions).

Foreign development costs. The samerules discussed earlier for foreign explorationcosts apply to foreign development costs.

Reduced corporate deductions for devel-opment costs. The treatment of corporatedeductions for exploration costs, discussedearlier, also applies to corporate deductionsfor development costs.

See Reduced corporate deductions forexploration costs, earlier.

Circulation CostsA publisher can deduct as a business ex-pense the costs of establishing, maintaining,and increasing the circulation of a newspaper,magazine, or other periodical. For example,a publisher can deduct the cost of hiring extraemployees for a limited time to get new sub-scriptions through telephone calls. Circulationcosts are deductible even if they result in anasset (for example, a subscriber list) havinga useful life of more than one year.

Other treatment of circulation costs. Apublisher can choose to capitalize the costsof establishing or increasing circulation. Also,a publisher can choose to deduct circulationcosts over the 3–year period beginning withthe tax year they were paid or incurred.

These rules do not apply to the purchaseof land or depreciable property or to acquisi-tions of circulation through the purchases ofany part of the business of another publisherof a newspaper, magazine, or other period-ical. These costs must be capitalized.

How to make the choice. Indicate yourchoice to capitalize circulation costs by at-taching a statement to your return for the firsttax year the choice applies. Your choice isbinding for the year it is made and for all lateryears, unless you get IRS approval to revokeit.

Costs of RemovingBarriers to theDisabled and theElderlyThe cost of an improvement to a businessasset is normally a capital expense. However,you can choose to deduct the costs of makinga facility or public transportation vehicleowned or leased by you for use in connectionwith your trade or business more accessibleto and usable by those who are disabled orelderly.

A facility is all or any part of buildings,structures, equipment, roads, walks, parkinglots, or similar real or personal property. Apublic transportation vehicle is a vehicle, suchas a bus or railroad car, that provides trans-portation service to the public (including ser-vice for your customers, even if you are notin the business of providing transportationservices).

You cannot deduct any costs that you paidor incurred to completely renovate or build anew facility or public transportation vehicle,or to replace depreciable property in thenormal course of business.

Deduction limits. The most you can deductas a cost of removing barriers to the disabledand the elderly for any tax year is $15,000.However, you can add any amount over thislimit to the basis of the property and depreci-ate.

Partners and partnerships. The $15,000limit applies to a partnership and also to eachpartner in the partnership. A partner can di-vide the $15,000 limit in any manner amongthe partner's individually incurred costs andthe partner's distributive share of partnershipcosts. If the partner cannot deduct the entireshare of partnership costs, the partnershipcan add any costs not deducted back to thebasis of the improved property.

A partnership must be able to show thatany amount added back to basis was notdeducted by the partners and that it was overa partner's $15,000 limit (as determined bythe partner). If the partnership cannot showthis, it is presumed all the partners were ableto deduct their distributive shares of the part-nership's costs in full.

Example. John Duke's distributive shareof ABC partnership's deductible expenses forthe removal of architectural barriers was$20,000. John had $10,000 of similar ex-penses in his sole proprietorship. He choseto deduct $5,000 of them. John allocated theremaining $10,000 of the $15,000 limit to hisshare of ABC's expenses. John can add theexcess $5,000 in the sole proprietorship tothe basis of his property. Also, if ABC canshow that John could not deduct $10,000 ofhis share of the partnership's expenses be-cause of the limit as applied by John, ABCcan add that amount to the basis of its prop-erty.

Qualification standards. You must meet thefollowing specific standards for improved ac-cess for the disabled or the elderly to deductyour costs as a current expense.

Grading. The ground must be graded tothe level of a normal entrance to make thefacility accessible to people with physicaldisabilities.

Walks.

1) A public walk must be at least 48 incheswide and cannot slope more than 5%.A fairly long walk of maximum or nearmaximum steepness must have levelareas at regular intervals. A walk ordriveway must have a nonslip surface.

2) A walk must have a continuing commonsurface and must not have steps orsudden changes in level.

3) Where a walk crosses another walk, adriveway, or a parking lot, they mustblend to a common level. However, thisdoes not require the removal of curbswhich are a safety feature for those withdisabilities, especially blindness.

4) A sloping walk must have a level plat-form at the top and at the bottom. If adoor swings out onto the platform at thetop or bottom of the walk, the platformmust be at least 5 feet deep and 5 feetwide. If a door does not swing onto theplatform, the platform must be at least 3feet deep and 5 feet wide. The platformmust extend at least 1 foot past theopening side of any doorway.


Parking lots.

1) At least one parking space close to afacility must be set aside and marked foruse by persons with disabilities.

2) A parking space must be open on oneside to allow room for a person in awheelchair or on braces or crutches toget in and out of a car onto a level sur-face suitable for wheeling and walking.

3) A parking space marked for use by per-sons with disabilities, when placed be-tween two regular diagonal or head-onparking spaces, must be at least 12 feetwide.

4) A parking space must be located so thata person in a wheelchair or on bracesor crutches does not have to go behindparked cars.

Ramps.

1) A ramp must not rise more than 1 inchin each foot of length.

2) A ramp must have at least one handrailthat is 32 inches high, measured fromthe surface of the ramp. The handrailmust be smooth and extend at least 1foot past the top and bottom of the ramp.However, this does mean that a handrailextension which is itself a hazard is re-quired.

3) A ramp must have a nonslip surface.

4) A ramp must have a level platform at thetop and at the bottom. If a door swingsout onto the platform, the platform mustbe at least 5 feet deep and 5 feet wide.If a door does not swing onto the plat-form, the platform must be at least 3 feetdeep and 5 feet wide. The platform mustextend at least 1 foot past the openingside of any doorway.

5) A ramp must have level platforms nofarther than 30 feet apart and at any turn.

6) A curb ramp with a nonslip surface mustbe provided at an intersection. The curbramp must not be less than 4 feet wideand must not rise more than 1 inch ineach foot of length. The two surfacesmust blend smoothly.

Entrances. A building must have at leastone main entrance a person in a wheelchaircan use. The entrance must be on a levelaccessible to an elevator.

Doors and doorways.

1) A door must have a clear opening atleast 32 inches and must be operableby a single effort.

2) The floor on the inside and outside of adoorway must be level for at least 5 feetfrom the door in the direction the doorswings and must extend at least 1 footpast the opening side of the doorway.

3) There must not be any sharp slopes orsudden changes in level at a doorway.The threshold must be flush with thefloor. The door closer must be selected,placed, and set so as not to impair theuse of the door by persons with disabili-ties.

Stairs.

1) Stairsteps must have round nosing ofbetween 1 and 11/2 inch radius.

2) Stairs must have a handrail 32 incheshigh, measured from the tread at theface of the riser.

3) Stairs must have at least one handrailthat extends at least 18 inches past thetop step and the bottom step. But thisdoes not mean that a handrail extensionwhich is itself a hazard is required.

4) Each step must not be more than 7inches high.

Floors.

1) Floors must have a nonslip surface.

2) Floors on each story of a building mustbe on the same level or must be con-nected by a ramp of the type discussedpreviously.

Toilet rooms.

1) A toilet room must have enough spacefor persons in wheelchairs to movearound.

2) A toilet room must have at least one toi-let stall that—

a) Is at least 36 inches wide,

b) Is at least 56 inches deep,

c) Has a door, if any, that is at least32 inches wide and swings out,

d) Has handrails on each side that are33 inches high and parallel to thefloor, 11 / 2 inches in outside diam-eter, 11 / 2 inches away from the wall,and fastened securely at the endsand center, and

e) Has a toilet with a seat 19 to 20inches from the finished floor.

3) A toilet room must have, in addition toor instead of the toilet stall described in(2), at least one toilet stall that:

a) Is at least 66 inches wide,

b) Is at least 60 inches deep,

c) Has a door, if any, that is at least32 inches wide and swings out,

d) Has a handrail on one side, 33inches high and parallel to the floor,11 / 2 inches in outside diameter, 11 / 2inches away from the wall, andfastened securely at the ends andcenter, and

e) Has a toilet with a seat 19 to 20inches from the finished floor witha centerline 18 inches from the sidewall on which the handrail is lo-cated.

4) A toilet room must have sinks with nar-row aprons. Drain pipes and hot waterpipes under a sink must be covered orinsulated.

5) A mirror and a shelf above a sink mustnot be higher than 40 inches above thefloor, measured from the top of the shelfand the bottom of the mirror.

6) A toilet room for men must have wall-mounted urinals with the opening of thebasin 15 to 19 inches from the finishedfloor or floor-mounted urinals that arelevel with the main floor.

7) Towel racks, towel dispensers, and otherdispensers and disposal units must not

be mounted higher than 40 inches fromthe floor.

Water fountains.

1) A water fountain and a cooler must haveup-front spouts and controls.

2) A water fountain and a cooler must behand-operated or hand-and-foot-operated.

3) A water fountain mounted on the sideof a floor-mounted cooler must not bemore than 30 inches above the floor.

4) A wall-mounted, hand-operated watercooler must be mounted with the basin36 inches from the floor.

5) A water fountain must not be fully re-cessed and must not be set into analcove unless the alcove is at least 36inches wide.

Public telephones.

1) A public telephone must be placed sothat the dial and the headset can bereached by a person in a wheelchair.

2) A public telephone must be equipped fora person who is hearing impaired and itmust be identified as such with in-structions for its use.

3) Coin slots of public telephones must notbe more than 48 inches from the floor.

Elevators.

1) An elevator must be accessible to, andusable by, persons with disabilities andthe elderly on the levels they use to enterthe building and all levels and areasnormally used.

2) Cab size must measure at least 54 by68 inches to allow for turning a wheel-chair.

3) Door clear opening width must be atleast 32 inches.

4) All controls needed must be within 48 to54 inches from the cab floor. Thesecontrols must be usable by a person witha visual impairment and must be iden-tifiable by touch.

Controls. Switches and controls for light,heat, ventilation, windows, draperies, firealarms, and all similar controls needed orused often must be placed within the reachof a person in a wheelchair. These switchesand controls must not be higher than 48inches from the floor.

Identification.

1) Raised letters or numbers must be usedto identify rooms and offices. Theseidentification marks must be placed onthe wall to the right or left of the door ata height of 54 to 66 inches above thefinished floor.

2) A door that might prove dangerous if aperson who is blind were to use it, suchas a door leading to a loading platform,boiler room, stage, or fire escape, mustbe identifiable by touch.

Warning signals.

1) An audible warning signal must be ac-companied by a simultaneous visualsignal for the benefit of those who arehearing impaired.


2) A visual warning signal must be accom-panied by a simultaneous audible signalfor the benefit of persons who are blind.

Hazards. Hanging signs, ceiling lights,and similar objects and fixtures must be atleast 7 feet above the floor.

International accessibility symbol. Theinternational accessibility symbol must bedisplayed on routes to a wheelchair-accessible entrance to a facility, at the en-trance itself, and at wheelchair-accessibleentrances to public transportation vehicles.

Rail facilities.

1) A rail facility must have a fare controlarea with at least one entrance with aclear opening at least 36 inches wide.

2) A boarding platform edge bordering adrop-off or other dangerous conditionmust be marked with a strip of floor ma-terial different in color and texture fromthe rest of the floor surface. The gapbetween the boarding platform and ve-hicle doorway must be as small as pos-sible.

Buses.

1) A bus must have a mechanism such asa lift or ramp to enter the bus andenough clearance to let a wheelchairuser reach a secure location.

2) The bus must have a wheelchair-securing device. However, this does notmean that a wheelchair-securing devicethat is itself a barrier or hazard is re-quired.

3) The vertical distance from a curb or fromstreet level to the first front doorstepmust not be more than 8 inches. Eachfront doorstep after the first step up fromthe curb or street level must also not bemore than 8 inches high. The steps atthe front and rear doors must be at least12 inches deep.

4) The bus must have clear signs that indi-cate that seats in the front of the bus arepriority seats for persons who have adisability or are elderly. The signs mustencourage other passengers to makethese seats available to those who havepriority.

5) Handrails and stanchions must be pro-vided in the entrance to the bus so thatpassengers who have a disability or areelderly can grasp them from outside thebus and use them while boarding and

paying the fare. This system must in-clude a rail across the front of the businterior that passengers can lean againstwhile paying fares. Overhead handrailsmust be continuous except for a gap atthe rear doorway.

6) Floors and steps must have nonslip sur-faces. Step edges must have a band ofbright contrasting color running the fullwidth of the step.

7) A stepwell next to the driver must have,when the door is open, at least 2 foot-candles of light measured on the steptread. Other stepwells must have, at alltimes, at least 2 foot-candles of lightmeasured on the step tread.

8) The doorways of the bus must haveoutside lighting that provides at least 1foot-candle of light on the street surfacefor a distance of 3 feet from the bottomstep edge. This lighting must be belowwindow level and must be shielded fromthe eyes of entering and exiting pas-sengers.

9) The fare box must be located as far for-ward as practical and must not blocktraffic in the vestibule.

Rapid and light rail vehicles.

1) Passenger doorways on the vehiclesides must have clear openings at least32 inches wide.

2) Audible or visual warning signals mustbe provided to alert passengers of clos-ing doors.

3) Handrails and stanchions must permitsafe boarding, moving around, sittingand standing assistance, and getting offby persons who have a disability or areelderly. On a level-entry vehicle,handrails, stanchions, and seats mustbe located to allow a wheelchair user toenter the vehicle and position thewheelchair in a location that does notblock the movement of other passen-gers. On a vehicle with steps that mustbe used in boarding, handrails andstanchions must be provided in the en-trance so that persons who have a dis-ability or are elderly can grasp them anduse them from outside the vehicle whileboarding.

4) Floors must have nonslip surfaces. Stepedges on a light rail vehicle must havea band of bright contrasting color runningthe full width of the step.

5) A stepwell next to the driver must have,when the door is open, at least 2 foot-candles of light measured on the steptread. Other stepwells must have, at alltimes, at least 2 foot-candles of lightmeasured on the step tread.

6) Doorways on a light rail vehicle musthave outside lighting that provides atleast 1 foot-candle of light on the streetsurface for a distance of 3 feet from thebottom step edge. This lighting must bebelow window level and must beshielded from the eyes of entering andexiting passengers.

Other barrier removals. To be deduct-ible, expenses of removing any barrier notcovered by the above standards must meetall three of the following tests.

1) The removed barrier must be a sub-stantial barrier to access or use of a fa-cility or public transportation vehicle bypersons who have a disability or are el-derly.

2) The removed barrier must have been abarrier for at least one major group ofpersons who have a disability or are el-derly (such as people who are blind,deaf, or wheelchair users).

3) The barrier must be removed withoutcreating any new barrier that significantlyimpairs access to or use of the facilityor vehicle by a major group of personswho have a disability or are elderly (suchas people who are blind, deaf, orwheelchair users).

How to make the choice. If you choose todeduct your costs for removing barriers to thedisabled or the elderly, claim the deductionon your income tax return (partnership returnfor partnerships) for the tax year the ex-penses were paid or incurred. Identify thededuction as a separate item. For your choiceto be valid, you must file your return by its duedate, including extensions. Your choice isirrevocable after the due date, including ex-tensions of your return. The choice applies toall the qualifying costs you have during theyear, up to the $15,000 limit. If you make thischoice, you must maintain adequate recordsto support your deduction.

Disabled access credit. If you make yourbusiness accessible to persons with a disa-bility and your business is an eligible smallbusiness, you may be able to take the disa-bled access credit. If you make this choice,you must reduce the amount you deduct orcapitalize by the amount of the credit.

For more information, see Form 8826.

12.Amortization

IntroductionYou may be able to amortize and deduct eachyear a part of certain capital expenses.Amortization allows you to recover these ex-penses in a manner similar to straight linedepreciation. It also allows you to write offexpenses that are not ordinarily deductible.

The purpose of this chapter is to explainthe following.

• The rules of amortization.

• What expenses you can amortize.

• How and when you can amortize ex-penses.

These subjects are discussed later undereach type of expense.


• Amortizing costs of section 197 intangi-bles

Chapter 12 Amortization

• Amortizing costs of going into business

• Amortizing reforestation costs

• Amortizing costs of pollution control fa-cilities

• Amortizing costs of research and exper-imentation

• Amortizing bond premiums

• Amortizing the cost of getting a lease


Publication





m 3468 Investment Credit

m 4562 Depreciation and Amortization



How To DeductAmortizationThe purpose of this section is to explain howyou can deduct amortization.

Form 4562. You elect to amortize your ex-penses in Part VI of Form 4562 in the year inwhich you make the election. For informationon how to report bond premium, see Publi-cation 550.

For later years, do not report your de-duction for amortization on Form 4562 unlessyou must file the form for another reason.You must file Form 4562 in any of the fol-lowing situations.

• You start claiming amortization this taxyear.

• You claim depreciation on propertyplaced in service this year.

• You claim a section 179 deduction.

• You claim a deduction for any vehiclereported on a form other than ScheduleC (Form 1040) or Schedule C–EZ (Form1040).

• You claim depreciation on any vehicle orother listed property (regardless of whenit was placed in service).

• You claim depreciation on a return for acorporation (other than an S corporation).

Other forms to use. If you do not have to fileForm 4562, claim amortization directly on the“Other expenses” line of Schedule C (Form1040) or the “Other deductions” line of Form1065 or Form 1120. For information on howto report bond premium, see Publication 550.

Optional write-off of tax preferences.There are optional write-off periods for intan-gible drilling and development costs, circu-lation costs, and mining exploration and de-velopment costs. They are discussed inInternal Revenue Code section 59(e).

Section 197IntangiblesYou must amortize over 15 years the capital-ized costs of “section 197 intangibles” youacquired after August 10, 1993. Section 197intangibles are defined later. You mustamortize these costs if you hold the section197 intangibles in connection with your tradeor business or in an activity engaged in for theproduction of income. Your deduction eachyear is the part of the adjusted basis (forpurposes of determining gain) of the intangi-ble amortized ratably over a 15-year period,beginning with the month acquired. You arenot allowed any other depreciation or amorti-zation deduction for a section 197 intangible.

Section 197Intangibles DefinedThe following assets are section 197 intangi-bles.

1) Goodwill.

2) Going concern value.

3) Workforce in place, including its compo-sition and the terms and conditions(contractual or otherwise) of its employ-ment.

4) Business books and records, operatingsystems, or any other information base,including lists or other information con-cerning current or prospective custom-ers.

5) A patent, copyright, formula, process,design, pattern, know-how, format, orsimilar item.

6) A customer-based intangible.

7) A supplier-based intangible.

8) Any item similar to items 3) through 7).

9) A license, permit, or other right grantedby a governmental unit or agency (in-cluding renewals).

10) A covenant not to compete entered intoin connection with the acquisition of aninterest in a trade or business.

11) A franchise, trademark, or trade name(including renewals).

CAUTION!

You cannot amortize any of the in-tangibles listed in items 1) through 8)that you created, unless you created

them in connection with the acquisition ofassets constituting a trade or business or asubstantial part of a trade or business.

Goodwill. Goodwill is the value of a trade orbusiness based on expected continued cus-tomer patronage due to its name, reputation,or any other factor.

Going concern value. Going concern valueis the additional value of a trade or businessthat attaches to property because the prop-erty is an integral part of a going concern. It

includes value based on the ability of a busi-ness to continue to function and generate in-come even though there is a change in own-ership.

Workforce in place, etc. This includes thecomposition of a workforce (for example, itsexperience, education, or training). It also in-cludes the terms and conditions of employ-ment, whether contractual or otherwise, andany other value placed on employees or anyof their attributes.

For example, you must amortize the partof a purchase price of a trade or businessbased on the existence of a highly skilledworkforce. You must also amortize the costof acquiring an existing employment contractor relationship with employees or consultantsas part of the acquisition of a trade or busi-ness.

Business books and records, etc. This in-cludes the cost of technical manuals, trainingmanuals or programs, data files, and ac-counting or inventory control systems. It alsoincludes the cost of customer lists, sub-scription lists, insurance expirations, patientor client files, and lists of newspaper, maga-zine, radio, or television advertisers.

Patents, copyrights, etc. This category in-cludes package designs, computer software,and any interest in a film, sound recording,videotape, book, or other similar property,except as discussed later under Assets ThatAre Not Section 197 Intangibles.

Customer-based intangible. A customer-based intangible is the composition of market,market share, and any other value resultingfrom the future provision of goods or servicesbecause of relationships with customers inthe ordinary course of business. You mustamortize that part (if any) of the purchaseprice of a trade or business that is for thefollowing intangible.

• Customer base.

• Circulation base.

• Undeveloped market or market growth.

• Insurance in force.

• Mortgage servicing contract.

• Investment management contract.

• Any other relationship with customersthat involves the future provision of goodsor services.

Accounts receivable or other similar rightsto income for goods or services provided tocustomers before the acquisition of that tradeor business are not section 197 intangibles.

Supplier-based intangible. A supplier-based intangible is the value resulting fromthe future acquisition of goods or servicesbecause of relationships in the ordinarycourse of business with suppliers of goodsor services. These goods and services mustbe used or sold by the business.

For example, you must amortize the partof the purchase price of a trade or businessthat is based on the existence of any one ofthe following.

• A favorable relationship with distributors(such as favorable shelf or display spaceat a retail outlet).

• A favorable credit rating.


• A favorable supply contract.

Government-granted license, permit, etc.Any license, permit, or other right granted bya governmental unit or an agency or instru-mentality of a governmental unit is a section197 intangible. For example, you must amor-tize the capitalized costs of acquiring (includ-ing issuing or renewing) a liquor license, ataxicab medallion or license, or a televisionor radio broadcasting license.

Covenant not to compete. A covenant notto compete (or similar arrangement) enteredinto in connection with the acquisition of aninterest in a trade or business or substantialportion of a trade or business, is a section 197intangible. An interest in a trade or businessincludes an interest in a partnership or stockin a corporation engaged in a trade or busi-ness.

If you pay or incur an amount under acovenant not to compete (or similar arrange-ment) after the year in which you entered intothe covenant (or similar arrangement), youmust amortize that amount over the monthsremaining in the 15-year amortization period.

You cannot amortize amounts paid undera covenant not to compete (or similar ar-rangement) that represent additional consid-eration for the purchase of stock in a corpo-ration. You must add them to the basis of theacquired stock.

Franchise, trademark, or trade name. Afranchise, trademark, or trade name is asection 197 intangible. You can deductamounts paid or incurred on the transfer,sale, or other disposition of a franchise,trademark, or trade name if all of the followingapply to the amounts.

• They are contingent on the productivity,use, or disposition of the franchise,trademark, or trade name.

• They are part of a series of paymentspayable at least annually throughout theterm of the transfer agreement.

• They are part of a series of paymentswhich are substantially equal in amountor payable under a fixed formula.

You must amortize any other amount,whether fixed or contingent that you paid orincurred because of the transfer of a fran-chise, trademark, or trade name.

Assets That Are NotSection 197 IntangiblesThe following assets are not section 197 in-tangibles.

1) Any interest in a corporation, partner-ship, trust or estate.

2) Any interest under an existing futurescontract, foreign currency contract,notional principal contract, or similar fi-nancial contract.

3) Any interest in land.

4) Most computer software (see Computersoftware defined, later).

5) Any of the following not acquired inconnection with the acquisition of a trade

or business or a substantial part of atrade or business:

a) An interest in a film, sound record-ing, videotape, book, or similarproperty,

b) A right to receive tangible propertyor services under a contract orgranted by a governmental agency,

c) An interest in a patent or copyright,

d) A right under a contract (or a rightgranted by a governmental agency)if the right:

i) Has a fixed life of less than 15years, or

ii) Is of a fixed amount that, ex-cept for the section 197 intan-gible provisions, would be re-coverable under a methodsimilar to the unit-of-productionmethod of cost recovery.

6) An interest under either:

a) An existing lease or sublease oftangible property, or

b) A debt that was in existence whenthe interest was acquired.

7) A professional sports franchise and anyitem acquired in connection with thefranchise.

8) A right to service residential mortgagesunless the right is acquired in the acqui-sition of a trade or business or a sub-stantial part of a trade or business.

9) Certain transaction costs under a corpo-rate organization or reorganization inwhich any part of a gain or loss is notrecognized.

Computer software. Section 197 intangiblesdo not include computer software that is:

1) Readily available for purchase by thegeneral public,

2) Subject to a nonexclusive license, and

3) Not substantially changed.

Software that is not acquired in the acquisitionof a substantial part of a business is not asection 197 intangible.

If you are allowed to depreciate any com-puter software that is not a section 197 in-tangible, use the straight line method with auseful life of 36 months.

For more information on depreciation ofcomputer software, see Publication 946.

Computer software defined. Computersoftware includes all programs designed tocause a computer to perform a desired func-tion. It also includes any database or similaritem in the public domain and incidental to theoperation of qualifying software.

Costs associated with nonsection 197 in-tangibles. Amounts you take into account indetermining the cost of nonsection 197 prop-erty are not considered section 197 intangi-bles. These amounts are added to the basisof the property. For example, none of thecosts of acquiring real property held for theproduction of rental income are consideredgoodwill, going concern value, or any othersection 197 intangible.

Disposition of Section197 IntangiblesA section 197 intangible is treated as depre-ciable property used in your trade or busi-ness. If you dispose of property held for morethan one year, any gain on the disposition,up to the amount of allowable amortization,is ordinary income (section 1245 gain). Anyremaining gain, or loss, is a section 1231 gainor loss. If you held the property one year orless, any gain or loss on its disposition is anordinary gain or loss. For more informationon ordinary or capital gain or loss, see chap-ter 2 in Publication 544, Sales and OtherDispositions of Assets.

If you acquire more than one section 197intangible in a transaction (or series of relatedtransactions) and later dispose of one of themor if one of them becomes worthless, youcannot recognize any loss on the intangible.Instead, increase the adjusted basis of eachremaining amortizable section 197 intangibleby the part of the loss not recognized. Figurethe increase by multiplying the loss not rec-ognized on the disposition by the followingfraction.

• The numerator is the adjusted basis ofthat remaining intangible as of the dateof its disposition.

• The denominator is the total adjustedbasis of all retained amortizable section197 intangibles as of the date of the dis-position.

Covenant not to compete. A covenant notto compete, or similar arrangement, is notconsidered disposed of or worthless beforeyou dispose of your entire interest in the tradeor business for which you entered into thecovenant.

Nonrecognition transfers. If you disposeof one section 197 intangible and acquireanother in a nonrecognition transfer, treat thepart of the adjusted basis of the acquired in-tangible that is not more than the adjustedbasis of the transferred intangible as thetransferred section 197 intangible. This in-cludes your continuing to amortize the partof the adjusted basis treated as the trans-ferred section 197 intangible over its remain-ing amortization period. Nonrecognitiontransfers include transfers to a corporation,partnership contributions and distributions,like-kind exchanges, and involuntary conver-sions.

Example. You own a section 197 intan-gible you have amortized for 4 full years. Ithas a remaining unamortized basis of$30,000. You exchange the asset plus$10,000 for a like-kind section 197 intangible.The nonrecognition provisions of like-kindexchanges apply. You amortize $30,000 ofthe basis of the acquired section 197 intangi-ble over the 11 years remaining in the original15-year amortization period for the trans-ferred asset and the other $10,000 of ad-justed basis over 15 years.

Anti-Churning RulesYou cannot amortize certain section 197 in-tangible over 15 years. Special rules preventyou from converting section 197 intangiblesfrom property that does not qualify foramortization to property that would qualify foramortization.


You cannot use 15-year amortization forgoodwill, going concern value, or any intan-gible for which you cannot claim a depreci-ation deduction and for which an amortizationdeduction is only allowable under section 197if:

1) You acquired the goodwill, going con-cern value, or other intangible after Au-gust 10, 1993, and

2) Any of the following conditions apply:

a) You or a related person (definedlater) held or used the intangible atany time from July 25, 1991,through August 10, 1993,

b) You acquired the intangible from aperson who held the intangible atany time from July 25, 1991,through August 10, 1993, and aspart of the transaction, the userdoes not change, or

c) You grant the right to use the in-tangible to a person (or a personrelated to that person) who held orused the intangible at any time fromJuly 25, 1991, through August 10,1993.

Exception. The anti-churning rules do notapply to an intangible acquired from a dece-dent if the property's basis is stepped up tofair market value.

Related person. For purposes of the anti-churning rules, the following are related per-sons.

• Members of a family, including onlybrothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents,grandparents, etc.), and lineal descend-ants (children, grandchildren, etc.).

• An individual and a corporation when theindividual owns, directly or indirectly,more than 20% in value of the corpo-ration's outstanding stock.

• Two corporations that are members ofthe same controlled group as defined insection 1563(a) of the Internal RevenueCode, except that “more than 20%” issubstituted for “at least 80%” in that defi-nition and the determination is madewithout regard to subsection (a)(4) and(e)(3)(C) of section 1563.

• A trust fiduciary and a corporation whenthe trust or grantor of the trust owns, di-rectly or indirectly, more than 20% invalue of the corporation's outstandingstock.

• A grantor and fiduciary, and the fiduciaryand beneficiary, of any trust.

• Fiduciaries of two different trusts, and thefiduciary and beneficiary of two differenttrusts, if the same person is the grantorof both trusts.

• A tax-exempt educational or charitableorganization and a person who, directlyor indirectly, controls the organization, ora member of that person's family.

• A corporation and a partnership if thesame persons own more than 20% invalue of the outstanding stock of thecorporation and more than 20% of thecapital or profits interest in the partner-ship.

• Two S corporations if the same personsown more than 20% in value of the out-standing stock of each corporation.

• Two corporations, one of which is an Scorporation, if the same persons ownmore than 20% in value of the outstand-ing stock of each corporation.

• Two partnerships if the same personsown, directly or indirectly, more than 20%of the capital or the profits interests inboth partnerships.

• A person and a partnership when theperson owns, directly or indirectly, morethan 20% of the capital or profits interestsin the partnership.

Treat these persons as related to you ifthe relationship exists immediately before orimmediately after you acquire the intangible.

Ownership of stock. In determiningwhether an individual owns, directly or indi-rectly, any of the outstanding stock of a cor-poration, the following rules apply.

Rule 1. Stock owned, directly or indi-rectly, by or for a corporation, partnership,estate, or trust is considered owned propor-tionately by or for its shareholders, partners,or beneficiaries.

Rule 2. An individual is considered asowning the stock owned, directly or indirectly,by or for his or her family. Family includesonly brothers and sisters, half-brothers andhalf-sisters, spouse, ancestors, and linealdescendants.

Rule 3. An individual owning (other thanby applying rule 2) any stock in a corporationis considered to own the stock owned, directlyor indirectly, by or for his or her partner.

Rule 4. For purposes of applying rule 1,2, or 3, treat stock constructively owned by aperson under rule 1 as actually owned by thatperson. Do not treat stock constructivelyowned by an individual under rules 2 or 3 asowned by the individual for reapplying rule 2or 3 to make another person the constructiveowner of the stock.

Exception. An exception to the anti-churningrules applies if you acquire an intangible froma person related to you by more than 20%,but not more than 50%, under both of thefollowing conditions.

• The seller recognizes gain on the dispo-sition of the intangible.

• The tax the seller pays on the gain plusany other federal income tax imposed onthe gain equals tax on the gain at thehighest tax rate.

If this exception applies, the anti-churningrules apply only to the amount of your ad-justed basis in the intangible that is more thanthe gain recognized by the seller.

Note. The seller reports any additional taxunder this exception on line 40 of the seller'sForm 1040. On the dotted line next to line 40,the seller should also write “197.”

Anti-abuse rule. You cannot amortize anysection 197 intangible acquired in a trans-action in which either of the following was oneof the principal purposes.

1) To avoid the requirement that the intan-gible be acquired after August 10, 1993.

2) To avoid any of the anti-churning rules.

Incorrect Amount ofAmortization DeductedIf you did not deduct the correct amount ofamortization for a section 197 intangible inany year, you may be able to make a cor-rection for that year by filing an amended re-turn. See Amended Return, later. If you arenot allowed to make the correction on anamended return, you can change your ac-counting method to claim the correct amountof amortization. See Changing Your Ac-counting Method, later.

Basis adjustment. Even if you do not claimamortization you are entitled to deduct, youmust reduce the basis of the section 197 in-tangible by the full amount of amortization youwere entitled to deduct. If you deduct moreamortization than you should, you must de-crease your basis by any amount deductedfrom which you received a tax benefit.

Amended ReturnIf you did not deduct the correct amount ofamortization, you can file an amended returnto make any of the following three corrections.

• To correct a mathematical error made inany year.

• To correct a posting error made in anyyear.

• To correct the amount of amortization forsection 197 intangibles for which youhave not adopted a method of account-ing. See Changing Your AccountingMethod, later.

If you did not deduct the correct amount ofamortization for the section 197 intangible ontwo or more consecutively filed tax returns,you have adopted a method of accounting forthat property. If you have adopted a methodof accounting, you cannot change the methodby filing amended returns.

If an amended return is allowed, you mustfile it by the later of the following two dates.

• 3 years from the date you filed your ori-ginal return for the year in which you didnot deduct the correct amount.

• 2 years from the time you paid your taxfor that year.

A return filed early is considered filed on thedue date.

Changing YourAccounting MethodIf you did not deduct the correct amount ofamortization for the section 197 intangible onany two or more consecutively filed tax re-turns, you have adopted a method of ac-counting for that property. You can claim thecorrect amount of amortization only bychanging your method of accounting foramortization. You will then be able to takeinto account any unclaimed or excessamortization from years before the year ofchange.

Consent required. You must have the con-sent of the Commissioner of Internal Revenueto change your method of accounting. Youcan get the Commissioner's consent by fol-lowing the instructions in Revenue Procedure97–27 which is in Internal Revenue Bulletin(IRB) 1997–21. Internal Revenue Bulletinsare available at many libraries and IRS of-


fices. To get the consent, you must file Form3115 requesting a change to a permissiblemethod of accounting for amortization. Youcannot use Revenue Procedure 97–27 tocorrect any mathematical or posting error.See Amended Return, earlier.

In some instances, you can receive auto-matic consent from the Commissioner tochange your method of accounting. See Au-tomatic consent, next.

Automatic consent. You may be able toobtain automatic consent from the Commis-sioner if you deducted less than the allowableamount of amortization for the section 197intangible in at least two years immediatelypreceding the year of change. Instead of fol-lowing the instructions in Revenue Procedure97–27, you can receive an automatic consentby following the instructions in Revenue Pro-cedure 97–37 and section 2.01 of the Ap-pendix of Revenue Procedure 97–37, whichare in Internal Revenue Bulletin (IRB)1997–33. This will enable you to change youraccounting method to take into account pre-viously unclaimed allowable amortization. Toget the consent, you must file Form 3115 re-questing a change to a permissible methodof accounting for amortization.

You generally can use this procedure forproperty that meets all of the following threeconditions.

• It is property for which you computeamortization under section 197 of theInternal Revenue Code.

• It is property for which, under your pres-ent accounting method, you claimed lessthan the amount of amortization allowablein at least the two years immediatelypreceding the year of change. (The yearof change is the year you designate onthe Form 3115 and for which you havetimely filed the Form 3115.)

• It is property you owned at the beginningof the year of change.

Exceptions. You generally cannot usethe automatic consent procedure if any of theexceptions listed in section 2.01(2)(b) of theAppendix of Revenue Procedure 97–37 ap-ply.

Other restrictions. You generally cannotuse the automatic consent procedure underany of the following situations.

• You (your federal income tax return) areunder examination.

• You are before a federal court or an ap-peals office for any income tax issue andthe method of accounting to be changedis an issue under consideration by thefederal court or appeals office.

• You changed the same method of ac-counting (with or without obtaining theconsent of the Commissioner) during thefour years before the year of change.

• You filed a Form 3115 to change thesame method of accounting during thefour years before the year of change butdid not make the change because theForm 3115 was withdrawn, not perfected,denied, or not granted.

More information. For more informationon how to get this automatic consent tochange your method of accounting in orderto claim previously unclaimed allowableamortization and when you cannot use it, see

Revenue Procedure 97–37 and section 2.01of the Appendix of Revenue Procedure97–37, Internal Revenue Bulletin 1997–33.

Recapture of AmortizationAmortization you claim on section 197 prop-erty is subject to the recapture rules of section1245 of the Internal Revenue Code. For moreinformation on these rules, see chapter 3 inPublication 544.

Going Into BusinessWhen you go into business, treat all costs youincur to get your business started as capitalexpenses. Capital expenses are part of yourbasis in the business. Generally, you recovercosts for particular assets through depreci-ation deductions. However, you generallycannot recover other costs until you sell thebusiness or otherwise go out of business. SeeCapital Expenses in chapter 1 for a dis-cussion of how to treat these costs if you donot go into business.

You can elect to amortize certain costs forsetting up your business. To be amortizable,the cost must qualify as one of the following.

• A business start-up cost.

• An organizational cost for a corporation.

• An organizational cost for a partnership.

Business Start-Up CostsStart-up costs are costs for setting up an ac-tive trade or business or investigating thepossibility of creating or acquiring an activetrade or business. Start-up costs include anyamounts paid or incurred in connection withany activity engaged in for profit and for theproduction of income before the trade orbusiness begins, in anticipation of the activitybecoming an active trade or business.

To be amortizable, your start-up cost mustmeet both of the following tests.

1) It must be a cost you could deduct if youpaid or incurred it to operate an existingactive trade or business.

2) You must pay or incur the cost beforethe day your active trade or businessbegins.

Start-up costs include what you pay forinvestigating a prospective business and get-ting the business started. They may includecosts for the following items.

• A survey of potential markets.

• An analysis of available facilities, labor,supplies, etc.

• Advertisements for the opening of thebusiness.

• Salaries and wages for employees whoare being trained, and their instructors.

• Travel and other necessary costs for se-curing prospective distributors, suppliers,or customers.

• Salaries and fees for executives andconsultants, or for other professionalservices.

Start-up costs do not include deductibleinterest, taxes, and research and exper-imental costs. See Research and Exper-imental Costs, later.

Disposition of business. You can deductany remaining deferred start-up costs for thebusiness if you completely dispose of yourbusiness before the end of the amortizationperiod. However, you can only deduct thesedeferred start-up costs to the extent theyqualify as a loss from a business.

Costs of Organizing aCorporationThe costs of organizing a corporation are thedirect costs of creating the corporation.

Qualifying costs. You can amortize an or-ganizational cost only if it meets all three ofthe following tests.

• It must be for the creation of the corpo-ration.

• It must be chargeable to a capital ac-count.

• You could amortize the cost over the lifeof the corporation, if the corporation hada fixed life.

You must have incurred the cost before theend of the first tax year in which the corpo-ration was in business. A corporation usingthe cash method of accounting can amortizeorganizational expenses incurred within thefirst tax year, even if it does not pay them inthat year.

Examples of organizational costs arelisted next.

• Expenses of temporary directors.

• The cost of organizational meetings.

• State incorporation fees.

• Accounting services for setting up theorganization.

• The cost of legal services (such as draft-ing the charter, bylaws, terms of the ori-ginal stock certificates, and minutes oforganizational meetings).

Costs you cannot amortize. You cannotamortize costs for issuing and selling stockor securities, such as commissions, profes-sional fees, and printing costs, because theyare not organizational costs. Also, you can-not amortize cost associated with the transferof assets to the corporation. You must capi-talize these costs.

Costs of Organizing aPartnershipPartnership organizational costs are the directcosts of creating a partnership.

Qualifying costs. You can amortize an or-ganizational cost only if it meets all three ofthe following tests.

• It must be for the creation of the partner-ship and not for starting or operating thepartnership trade or business.

• It must be chargeable to a capital ac-count.

• You could amortize the cost over the lifeof the partnership if the partnership hada fixed life.

Organizational costs include the followingfees.


• Legal fees for services incident to theorganization of the partnership, such asnegotiation and preparation of the part-nership agreement.

• Accounting fees for services incident tothe organization of the partnership.

• Filing fees.

Costs you cannot amortize. You cannotamortize expenses connected with any of thefollowing activities.

• Acquiring assets for the partnership ortransferring assets to the partnership.

• Admitting or removing partners, otherthan at the time the partnership is firstorganized.

• Making a contract concerning the opera-tion of the partnership trade or business(including a contract between a partnerand the partnership).

• Syndication fees.

Syndication fees are costs for issuing andmarketing interests in the partnership (suchas commissions, professional fees, andprinting costs). You must capitalize syndi-cation fees. You cannot depreciate or amor-tize them.

How To AmortizeYou deduct start-up and organizational costsin equal amounts over a period of 60 monthsor more. You can elect a period for start-upcosts that is different from the period you electfor organizational costs, as long as both are60 months or more. Once you elect anamortization period, you cannot change it.

To figure your deduction, divide your totalstart-up or organizational costs by the monthsin the amortization period. The result is theamount you can deduct each month.

CAUTION!

A partnership using the cash methodof accounting cannot deduct an ex-pense it has not paid by the end of the

tax year. However, any expense the partner-ship could have deducted as an organiza-tional expense in an earlier tax year can bededucted in the tax year of payment.

When to begin amortization. The amorti-zation period starts with the month you beginbusiness operations.

Making the election. You must completePart VI of Form 4562 and attach it to yourincome tax return. You must also attach oneor more statements to your return. If you haveboth start-up and organizational costs, attacha separate statement to your return for eachtype of cost. Each statement should have thefollowing information.

• The total start-up or organizational costsyou will amortize.

• A description of what each cost is for.

• The date each cost was incurred.

• The month your active business began(or the month you acquired the business).

• The number of months in your amorti-zation period (not less than 60).

Attach Form 4562 and the accompanyingstatements to your return for the first tax yearyou are in business. You must file the returnby the due date (including any extensions).

Corporations and partnerships. If yourbusiness is organized as a corporation orpartnership, only your corporation or partner-ship can elect to amortize its start-up or or-ganizational costs. A shareholder or partnercannot make this election.

You, as shareholder or partner, cannotamortize any costs you incur in setting upyour corporation or partnership. The corpo-ration or partnership can amortize thesecosts, but only if it reimburses you for them.These costs then become part of the basisof your interest in the business. You can re-cover them only when you sell your interestin the corporation or partnership.

TIPYou, as an individual, can elect toamortize costs you incur to investigatean interest in an existing partnership.

These costs qualify as business start-up costsif you succeed in acquiring an interest in thepartnership.

ReforestationExpensesYou can elect to amortize part of your qual-ified timber property reforestation expenses.These are the direct costs of planting orseeding for forestation or reforestation.

Qualifying expenses. Qualifying ex-penses include only those costs you mustcapitalize and include in the adjusted basisof the property. They include costs for thefollowing items.

• Site preparation.

• Seeds or seedlings.

• Labor.

• Tools.

• Depreciation on equipment used inplanting and seeding.

Costs you can deduct currently are not quali-fying expenses.

If the government reimburses you for ex-penses under a cost-sharing program, youcan amortize these expenses only if you in-clude the reimbursement in your income.

Qualified timber property. Qualified timberproperty can be a woodlot or other site thatyou own or lease. To qualify, the propertymust meet all of the following requirements.

1) It must be located in the United States.

2) It must be held for the growing and cut-ting of timber you will either use in, orsell for use in the commercial productionof timber products.

3) It must consist of at least one acreplanted with tree seedlings in the man-ner normally used in forestation orreforestation.

Qualified timber property does not includeproperty on which you have planted shelterbelts or ornamental trees, such as Christmastrees.

Annual limit. Each year, you can elect toamortize up to $10,000 of qualified expensesyou pay or incur during the tax year. If youare married and file a separate return, theannual limit is $5,000. You cannot carry over

or carry back qualifying expenses over theannual limit. The annual limit applies to ex-penses you pay or incur during a tax year onall of your qualified timber property.

If you pay or incur more than $10,000 inexpenses for more than one piece of timberproperty, you can divide the annual limitamong any of the properties in any manneryou wish.

For example, if you incurred $10,000 ofqualifying expenses on each of four qualifiedtimber properties last year, you can divide$2,500 to each property, $5,000 to two prop-erties, the entire $10,000 to any one property,or you can divide the $10,000 among someor all of the properties in any other manner.

Partnerships and S corporations. Sim-ilar rules apply to partnerships and S corpo-rations.

A partnership or S corporation makes theelection to amortize its qualified expenses.The annual limit ($10,000) applies to thepartnership or S corporation, as well as toeach partner or shareholder. The amortizableexpenses (limited to $10,000) are allocatedamong the partners or shareholders.

A partner or shareholder is also subject tothe annual limit of $10,000 ($5,000, if marriedand filing a separate return) regardless of thesource of the expenses. For example, if amarried individual is a partner in two or morepartnerships that elect to amortize qualifiedexpenses, the individual's total share of part-nership amortizable basis acquired during theyear cannot be more than $10,000 on a jointreturn or $5,000 on a separate return.Amortizable basis is the part of the basis ofqualified property that is from reforestationexpenses.

Estates. Estates can elect to amortizeup to $10,000 of qualified reforestation ex-penses paid or incurred in each tax year. Anyamortizable basis acquired by an estate isdivided between the estate and the incomebeneficiary based on the income of the estateallocable to each. The amortizable basis dis-tributed from an estate to a beneficiary istaken into account in determining the benefi-ciary's annual limit.

Life tenant and remainderman. If oneperson holds the property for life with the re-mainder going to another person, the lifetenant is entitled to the full amortization (upto the annual limit) for reforestation expensesmade by the life tenant. Any remainder inter-est in the property is ignored for amortizationpurposes.

Amortization period. You can amortizequalified reforestation expenses over a periodof 84 months. The 84-month period starts onthe first day of the first month of the secondhalf of the tax year you incur the expenses(July 1st for a calendar year taxpayer). Youcan claim amortization deductions for nomore than 6 months of the first and last(eighth) tax years of the period.

Example. Last year (a full 12-month taxyear), John Jones incurred qualifiedreforestation expenses of $8,400. His monthlydeduction ($100) is figured by dividing $8,400by 84 months. Since it was the first year ofthe 84-month period, he can deduct only $600($100 × 6 months).

Maximum annual amortization. The maxi-mum annual amortization deduction for ex-penses incurred in any taxable year is$1,428.57 ($10,000 ÷ 7). The maximum de-duction in the first and last tax year of the


84-month amortization period is one half of$1,428.57 or $714.29.

Recapture. If you dispose of qualified timberproperty within 10 years after the tax year youcreate an amortizable basis in the property,report any gain as ordinary income up to theamount of the amortization you took.

Investment credit. Reforestation expenseseligible to be amortized qualify for the invest-ment credit, whether or not they are amor-tized. See the instructions for Form 3468 forinformation on the investment credit.

How to elect amortization. To make thiselection, attach Form 4562 to your income taxreturn and enter the deduction in Part VI.Also, attach a statement to Form 4562 thatdescribes the expenses and provides thedates you incurred them. Show the type oftimber being grown and the purpose for whichit is grown. Attach a separate statement foreach property for which you amortizereforestation expenses. You can make theelection only on a timely filed return (includingextensions) for the tax year in which you in-curred the expenses.

Where to report. If you do not have to fileSchedule C, C-EZ, or F for the activity inwhich you incurred reforestation expenses,include your amortization deduction in thetotal on line 32 of Form 1040. Enter theamount and “RFST” (for reforestation) on thedotted line next to line 32.

Revocation. You must get IRS ap-proval to revoke an election to amor-tize reforestation expenses. Your ap-

plication to revoke the election must includeyour name, address, the years for which yourelection was in effect, and your reason forrevoking it. You, or your duly authorized rep-resentative, must sign the application and fileit at least 90 days before the due date (with-out extensions) for filing your income tax re-turn for the first tax year for which yourelection is to end.

Send the application to:

Commissioner of Internal RevenueWashington, DC 20224

Pollution ControlFacilitiesYou can elect to amortize over 60 months thecost of a certified pollution control facility.

Certified pollution control facility. A certi-fied pollution control facility is a new identifi-able treatment facility used, in connection witha plant or other property in operation before1976, to reduce or control water or atmo-spheric pollution or contamination. The facilitymust do so by removing, changing, disposing,storing, or preventing the creation or emissionof pollutants, contaminants, wastes, or heat.The facility must be certified by state andfederal certifying authorities.

The facility must not significantly increasethe output or capacity, extend the useful life,

or reduce the total operating costs of the plantor other property. It also must not significantlychange the nature of the manufacturing orproduction process or facility.

The federal certifying authority will notcertify your property to the extent it appearsyou will recover (over the property's usefullife) all or part of its cost of a facility from theprofit based on its operation (such as throughsales of recovered wastes). The federal cer-tifying authority will describe the nature of thepotential cost recovery. You must then reducethe amortizable basis of the facility.

New identifiable treatment facility. Anew identifiable treatment facility is tangibledepreciable property which is identifiable asa treatment facility. This does not include abuilding and its structural components unlessthe exclusively building is a treatment facility.

For more information, see section 169 ofthe Internal Revenue Code and the appropri-ate Income Tax Regulations.

CAUTION!

Alternative minimum tax. Individ-uals, estates, and trusts who electamortization may be liable for alter-

native minimum tax. Individuals should seeForm 6251 and its instructions. Estates andtrusts should see Form 1041.

Research andExperimental CostsYou can either amortize your research andexperimental costs, deduct them as currentbusiness expenses, or write them off over a10-year period. If you choose to amortizethese costs, deduct them in equal amountsover 60 months or more. The amortizationperiod begins the month you first receive aneconomic benefit from the research. For adefinition of “research and experimentalcosts” and information on deducting them ascurrent business expenses, see chapter 11.

Optional write-off method. Rather thanamortize these costs or deduct them as acurrent expense, you have the option of de-ducting (writing off) research and exper-imental costs ratably over a 10-year periodbeginning with the tax year in which you in-curred the costs.

For more information on the optionalwrite-off method, see Internal Revenue Codesection 59(e).

Costs you can amortize. You can amortizecosts chargeable to a capital account if bothof the following apply.

• You paid or incurred the costs in yourtrade or business.

• You are not deducting the costs currently.

For more information, see sections 174and 59(e) of the Internal Revenue Code andthe Income Tax Regulations.

Election to amortize. To make this election,attach Form 4562 to your income tax returnand enter the deduction in Part VI.

Bond PremiumBond premium is the amount by which yourbasis in a bond right after you get it is morethan the total of all amounts payable on thebond after you get it (other than payments ofqualified stated interest).

The term “bond,” as used in this dis-cussion, means any interest-bearing bond,debenture, note, or certificate or other evi-dence of debt issued by a corporation or agovernment or political subdivision of a gov-ernment. The term does not include any ob-ligation listed below.

• Your stock in trade.

• Properly that would properly be includedin your inventory if on hand at the closeof the taxable year.

• Property held by you primarily for sale tocustomers in the ordinary course of yourtrade or business.

Tax-exempt bonds. You must amortize thepremium on tax-exempt bonds. You cannotdeduct the amortizable premium in figuringyour taxable income. You must reduce yourbasis in the bond each year by the premiumamortized for the year.

Taxable bonds. You can elect to amortizethe premium on taxable bonds. This gener-ally means that each year, over the life of thebond, you use part of the premium to reducethe amount of interest includible in your in-come. If you make this choice, you must re-duce your basis in the bond by the amorti-zation for the year. The premium on the bondis part of your basis in the bond.

Inflation-indexed instruments. Aninflation-indexed debt instrument is generallya debt instrument on which the payments areadjusted for inflation and deflation (such asTreasury Inflation-Indexed Securities). De-termine the premium on an inflation-indexeddebt instrument, as of the date you acquirethe instrument, by assuming that there will beno inflation or deflation over the remainingterm of the instrument. Allocate the premiumover the remaining term of the instrument bymaking the same assumption. Reduce theinstrument's interest income for the tax yearby the premium allocable to the tax year. Useany excess premium allocable to the tax yearto offset the original issue discount on the in-strument for the year.

Basis adjustment. If you are required toamortize bond premium, or elect to do so, youmust decrease the basis of the bond by theamortizable bond premium. The result is theadjusted basis you use to figure gain or losson the sale or redemption of the bond.

More information. For more information anda discussion of how to report bond premium,see Publication 550.

Cost of Gettinga LeaseIf you get a lease for business property, yourecover the cost by amortizing it over the termof the lease. The term of the lease foramortization includes all renewal options (and


any other period for which the lessee andlessor reasonably expect the lease to be re-newed) if less than 75% of the cost of gettingthe lease is attributable to the term of thelease remaining on the acquisition date. Theterm of the lease remaining on the acquisitiondate does not include any period for which thelease may later be renewed, extended, orcontinued under an option exercisable by thelessee.

Enter your deduction in Part VI of Form4562, if you must file that form, or on the ap-propriate line of your tax return. Enter “178”as the code section under which you areamortizing these costs.

13.Depletion

Important Changesfor 1998Certain partnerships must figure depletionallowance. For partnership tax years begin-ning after 1997, an electing large partnership,rather than each partner, generally must fig-ure the depletion allowance for the partner-ship's oil and gas property. For more infor-mation, see Certain partnerships must figuredepletion allowance, later.

Temporary suspension of taxable incomelimit for certain percentage depletion. Fortax years beginning after 1997 and before2000, percentage depletion on the marginalproduction of oil or natural gas is not limitedto taxable income from the property figuredwithout the depletion deduction. For more in-formation, see Temporary suspension of tax-able income limit for marginal production,later.

IntroductionDepletion is the using up of natural resourcesby mining, quarrying, drilling, or felling. Thedepletion deduction allows an owner or oper-ator to account for the reduction of a product'sreserves.

There are two ways of figuring depletion:cost depletion and percentage depletion. Formineral property, you generally must use themethod that gives you the larger deduction;for standing timber, you must use cost de-pletion.

If you have an economic interest in min-eral property or standing timber, you can takea deduction for depletion. More than oneperson can have an economic interest in thesame mineral deposit or timber.

You have an economic interest if bothof the following apply.

1) You have acquired by investment a legalinterest in mineral deposits or standingtimber.

2) You have the right to income from theextraction of the mineral or cutting of the

timber, to which you must look for a re-turn of your capital investment.

A contractual relationship you have that al-lows you an economic or monetary advantagefrom products of the mineral deposit orstanding timber is not, in itself, an economicinterest. A production payment carved out of,or retained on the sale of, mineral property isnot an economic interest.

The term “mineral property” means eachseparate interest you own in each mineraldeposit in each separate tract or parcel ofland. You can treat mineral properties sepa-rately or as a group. See section 614 of theInternal Revenue Code for rules on how totreat separate properties.

The term “timber property” means youreconomic interest in standing timber in eachtract or block representing a separate timberaccount.

CAUTION!

Alternative minimum tax. Individ-uals, corporations, estates, and trustswho claim depletion deductions may

be liable for alternative minimum tax.

For more information on individual alter-native minimum tax, see the instructions forForm 6251. For more information on corpo-rate alternative minimum tax, see Publication542. For more information on estate and trustalternative minimum tax, see Form 1041 andits instructions.


• Mineral property

• Timber


Publication



m T Forest Activities Schedules

m Sch E (Form 1040) Supplemental In-come and Loss

m 6198 At-Risk Limitations


m 8582 Passive Activity Loss Limitations


Mineral PropertyMineral property includes oil and gas wells,mines, and other natural deposits (includinggeothermal deposits).

There are two ways of figuring depletionon mineral property: cost depletion and per-centage depletion. You generally must usethe method that gives you the larger de-duction.

However, unless you are a small produceror royalty owner, you generally cannot use

percentage depletion for oil and gas wells.See Oil and Gas Wells, later.

Cost depletion. Figure cost depletion by di-viding the property's basis for depletion (ex-plained later) by the total recoverable units(explained later) in the property's natural de-posit. The result is the rate per unit. Multiplythe rate per unit by the number of units soldduring the tax year, which is one of the fol-lowing.

1) The units sold for which you receivepayment during your tax year (regard-less of the year of sale), if you use thecash method of accounting.

2) The units sold based on your invento-ries, if you use the accrual method ofaccounting.

The number of units sold during the taxyear does not include any on which depletiondeductions were allowed or allowable in ear-lier years.

Basis for depletion. To figure the prop-erty's basis for depletion, subtract all of thefollowing from the property's adjusted basis.

1) The amounts recoverable through:

a) Depreciation deductions,

b) Deferred expenses (including de-ferred exploration and developmentcosts), and

c) Deductions other than depletion.

2) The residual value of land and improve-ments at the end of operations.

3) The cost or value of land acquired forpurposes other than mineral production.

Adjusted basis. The adjusted basis ofyour property is your original cost or otherbasis, plus certain additions and improve-ments, and minus certain deductions such asdepletion allowed or allowable and casualtylosses. Your adjusted basis can never be lessthan zero. See Publication 551 for more in-formation on adjusted basis.

Total recoverable units. The total re-coverable units is the sum of the following twoitems.

1) The number of units of mineral remainingat the end of the year (including unitsrecovered but not sold).

2) The number of units sold during the taxyear (determined under your method ofaccounting, as explained earlier).

You can estimate or determine recovera-ble units (tons, pounds, ounces, barrels,thousands of cubic feet, or other measure)of mineral products using the method currentin the industry and using the most accurateand reliable information you can obtain.

Percentage depletion. Figure percentagedepletion by multiplying a certain percentage,specified for each mineral, by your gross in-come from the property during the tax year.

Taxable income. The depletion de-duction under this method cannot be morethan 50% (100% for oil and gas property) ofyour taxable income from the property figuredwithout the depletion deduction. See Taxableincome, later for more information about fig-uring your taxable income from the property.See Mines and other natural deposits, laterfor the percentages for each mineral.

Chapter 13 Depletion

CAUTION!

For tax years beginning after 1997and before 2000, percentage de-pletion on the marginal production of

oil or natural gas is not limited to taxable in-come from the property figured without thedepletion deduction. For more information,see Temporary suspension of taxable incomelimit for marginal production, later.

Gross income. When figuring your per-centage depletion, exclude from your grossincome from the property an amount equal toany rents and royalties you pay or incur forthe property.

Also, exclude from your gross incomefrom the property an amount equal to the partof any bonus you paid for a lease on theproperty that is allocable to the product sold(or that otherwise gives rise to gross income)for the tax year. This includes a bonus foreither a mineral lease or an oil and gas lease.Figure the part of the bonus to exclude bymultiplying the total bonus you paid by afraction. The numerator of the fraction is thenumber of units you sold in that tax year andthe denominator is the total estimated recov-erable units from the property.

Taxable income. When figuring your tax-able income from the property for purposesof the taxable income limit, follow the threerules listed here.

1) Do not deduct any net operating lossdeduction from the gross income fromthe property.

2) Corporations do not deduct charitablecontributions from the gross income fromthe property.

3) If during the year, you dispose of an itemof section 1245 property which had beenused in connection with the property,reduce any allowable deduction for min-ing expenses by the part of any gain youmust report as ordinary income that isallocable to the property. See Regu-lations section 1.613–5(b)(1) for infor-mation on how to determine the amountof ordinary gain allocable to the property.

Oil and Gas WellsGenerally, only small producers and royaltyowners can claim percentage depletion forany oil or gas well. However, if you are not asmall producer or royalty owner, you may beable to claim percentage depletion for thefollowing items.

• Natural gas sold under a fixed contract(see Natural Gas Wells, later).

• Natural gas from geopressured brine (seeNatural Gas Wells, later).

• Domestic gas and oil production — if youare a small producer (explained next).

Small ProducersYou figure percentage depletion using a rateof 15% of the gross income from the propertyon your average daily production of domesticcrude oil or domestic natural gas up to yourdepletable oil or natural gas quantity. Averagedaily production and depletable oil or naturalgas quantity are explained later.

Refiners who cannot claim percentagedepletion. You cannot claim percentagedepletion if you or a related person refine

crude oil and the refinery runs of you and thatrelated person are more than 50,000 barrelson any day during the tax year.

Related person. You and another personare related persons if either of you hold asignificant ownership interest in the otherperson or if a third person holds a significantownership interest in both of you.

For example, a corporation, partnership,estate, or trust and anyone who holds a sig-nificant ownership interest in it are relatedpersons. A partnership and a trust are relatedpersons if one person holds a significantownership interest in each of them.

For purposes of the related person rules,significant ownership interest means director indirect ownership of 5% or more of anyone of the following interests.

• The value of the outstanding stock of acorporation.

• The interest in the profits or capital of apartnership.

• The beneficial interests in an estate ortrust.

Any interest owned by or for a corporation,partnership, trust, or estate is considered tobe owned directly both by itself and propor-tionately by its shareholders, partners, orbeneficiaries.

Retailers who cannot claim percentagedepletion. You cannot claim percentagedepletion if both of the following apply.

1) You sell oil or natural gas or their by-products directly or through a relatedperson in any of the following situations.

a) Through a retail outlet operated byyou or a related person.

b) To any person who is required un-der an agreement with you or a re-lated person to use a trademark,trade name, or service mark orname owned by you or a relatedperson in marketing or distributingoil, natural gas, or their by-products.

c) To any person given authority underan agreement with you or a relatedperson to occupy any retail outletowned, leased, or controlled by youor a related person.

2) The combined gross receipts from sales(not counting resales) of oil, natural gas,or their by-products of all retail outletstaken into account in 1) are more than$5 million for the tax year.

For this purpose, do not count any of thefollowing.

• Bulk sales of oil or natural gas to com-mercial or industrial users.

• Bulk sales of aviation fuels to the De-partment of Defense.

• Sales of oil or natural gas or their by-products outside the United States ifnone of your domestic production or thatof a related person is exported during thetax year or the prior tax year.

Sales through a related person. Youare considered to be selling through a relatedperson if any sale by the related personproduces gross income from which you may

benefit because of your direct or indirectownership interest in the person.

You are not considered to be sellingthrough a related person who is a retailer ifall of the following apply.

• You do not have a significant ownershipinterest in the retailer.

• You sell your production to persons whoare not related to either you or theretailer.

• The retailer does not buy oil or naturalgas from your customers or persons re-lated to your customers.

• There are no arrangements for theretailer to acquire oil or natural gas youproduced for resale or made available forpurchase by the retailer.

• Neither you nor the retailer knows of orcontrols the final disposition of the oil ornatural gas you sold or the original sourceof the petroleum products the retailer ac-quired for resale.

Transferees who cannot claim percentagedepletion. You cannot claim percentagedepletion if you received your interest in aproven oil or gas property by transfer after1974 and before October 12, 1990. For thisrule the term “transfer” usually does not in-clude any of the following.

• Transfers at death.

• Certain transfers to controlled corpo-rations.

• Certain changes of beneficiaries of atrust.

• Transfers between businesses undercommon control.

• Transfers between members of the samefamily.

• Transfers between a trust and relatedpersons in the same family.

• Certain transfers by individuals to corpo-rations solely in exchange for stock.

• Reversions of all or part of an interest thatmake a small producer eligible for de-pletion.

• Conversions of a retained interest, that iseligible for such depletion, into an interestwhich was all or part of an interest previ-ously owned that is also eligible for de-pletion.

An election by a corporation to becomean S corporation is treated as a transfer ofall its properties on the day on which theelection first takes effect. If an S corporationceases to be an S corporation and becomesa C corporation, each shareholder is treatedas transferring to the corporation the share-holder's pro rata share of all the S corpo-ration's assets.

Figuring percentage depletion. If your av-erage daily production (explained later) for theyear is more than your depletable oil or na-tural gas quantity (explained later), figure yourallowance for depletion for each domestic oilor natural gas property as follows.

1) Figure your average daily production ofoil or natural gas for the year.

2) Figure your depletable oil or natural gasquantity for the year.


3) Figure depletion for all oil or natural gasproduced from the property using a per-centage depletion rate of 15%.

4) Multiply the result figured in 3) by afraction, the numerator of which is theresult figured in 2) and the denominatorof which is the result figured in 1). Thisis your depletion allowance for thatproperty for the year.

Average daily production. Figure youraverage daily production by dividing your totalproduction for the tax year by the number ofdays in your tax year.

Part interest. If you have a part interestin the production from a property, figure yourshare of the production by multiplying totalproduction from the property by your per-centage of interest in the revenues from theproperty.

You have a part interest in property, forexample, if you have a net profits interest. Tofigure the share of production for your netprofits interest, you must determine your per-centage participation (as measured by the netprofits) in the gross revenue from the prop-erty. To figure this percentage, you divide theincome you receive for your net profits inter-est by the gross revenue from the property.

Example. John Oak owns oil property inwhich Paul Elm owns a 20% net profits inter-est. During the year, the property produced10,000 barrels of oil, which John sold for$200,000. John had expenses of $90,000 at-tributable to the property. The property gen-erated a net profit of $110,000. Paul receivedincome of $22,000 ($110,000 × .2) for his netprofits interest.

Paul determined his percentage partic-ipation to be 11% by dividing $22,000 (theincome he received) by $200,000 (the grossrevenue from the property). Paul determinedhis share of the oil production to be 1,100barrels (10,000 barrels × 11%).

Depletable oil or natural gas quantity.Generally, your depletable oil quantity is1,000 barrels and your depletable natural gasquantity is 6,000 cubic feet multiplied by thenumber of barrels of your depletable oilquantity that you choose to apply. If you claimdepletion on both oil and natural gas, youmust reduce your depletable oil quantity bythe number of barrels you use to figure yourdepletable natural gas quantity. If you are in-volved in marginal production, see section613A(c) of the Internal Revenue Code andthe related regulations to figure yourdepletable oil or natural gas quantity.

You must allocate the depletable oil ornatural gas quantity among corporations thatare members of the same controlled group.The common control test is more than 50%.

You must allocate the depletable oilamong the following.

• Corporations, trusts, and estates if 50%or more of the beneficial interest is ownedby the same or related persons (consid-ering only persons that own at least 5%of the beneficial interest).

• You and your spouse and minor children.

For purposes of this allocation, a related per-son is anyone mentioned in Related person

in chapter 15 except that the term “family” islimited to a spouse and minor children.

Limit. If you are an independent produceror royalty owner of oil and gas, your deductionfor percentage depletion is limited to thesmaller of the following two amounts.

• Your taxable income from the propertyfigured without the deduction for de-pletion.

• 65% of your taxable income from allsources, figured without the depletion al-lowance, any net operating losscarryback, and any capital losscarryback.

You can carry over to the following year anyamount you cannot deduct because of the65% (of taxable income) limit. Add it to yourdepletion allowance (before applying anylimits) for the following year.

Temporary suspension of taxable incomelimit for marginal production. For tax yearsbeginning after 1997 and before 2000, per-centage depletion on the marginal productionof oil or natural gas is not limited to taxableincome from the property figured without thedepletion deduction.

Marginal production. This is domesticcrude oil or domestic natural gas producedduring any tax year from a property that iseither of the following.

• A stripper well property for the calendaryear in which the tax year begins.

• A property from which substantially all ofthe production during the calendar yearis heavy oil.

Stripper well property. For any calendaryear, stripper well property is any property forwhich the average daily production per wellis 15 barrel equivalents or less. Determine theaverage daily production per week by dividingthe average daily production of domesticcrude oil and domestic natural gas fromproducing wells on the property for the cal-endar year by the number of producing wellson the property.

Heavy oil. This means, as used here,domestic crude oil produced from any prop-erty if the crude oil had a weighted averagegravity of 20 degrees API or less (correctedto 60 degrees Fahrenheit).

Gross income from oil and gas property.For purposes of percentage depletion, grossincome from oil and gas property is theamount you receive from the sale of the oilor gas in the immediate vicinity of the well. Ifyou do not sell the oil or gas on the property,but manufacture or convert it into a refinedproduct before sale or transport it before sale,the gross income from the property is therepresentative market or field price (RMFP)of the oil or gas, before conversion or trans-portation.

If you sold gas after you removed it fromthe premises, for a price that is lower than theRMFP, determine gross income from theproperty for percentage depletion purposeswithout regard to the RMFP.

Gross income from the property does notinclude lease bonuses, advance royalties, orother amounts payable without regard toproduction from the property.

PartnershipsGenerally, each partner, and not the partner-ship, figures the depletion allowance sepa-rately. (However, see Certain partnershipsmust figure depletion allowance, later.) Eachpartner must decide whether to use cost orpercentage depletion. If a partner uses per-centage depletion, the partner must apply the65% of taxable income limit to the partner'staxable income from all sources.

Partner's adjusted basis. The partnershipmust allocate to each partner that partner'sproportionate share of the adjusted basis ofeach partnership domestic oil or gas property.The partnership makes the allocation as ofthe date it acquires the oil or gas property.The partner's share of the adjusted basis ofthe oil or gas property generally is figuredaccording to that partner's interest in part-nership capital. However, in some cases, it isfigured according to the partner's interest inpartnership income.

The partnership adjusts the partner'sshare of the adjusted basis of the oil and gasproperty for any capital expenditures made forthe property and for any change in partner-ship interests.

RECORDS

Recordkeeping. Each partner, afterreceiving the information from thepartnership, must separately keep

records of the partner's share of the adjustedbasis in each oil and gas property of thepartnership. Later, in those separate records,the partner must reduce the share of the ad-justed basis of each property by the depletiontaken on the property each year by that part-ner. The partner must use that reduced ad-justed basis to figure any cost depletion or thepartner's gain or loss if the partnership dis-poses of the property.

Reporting the deduction. Deduct oil andgas depletion for a partnership interest onSchedule E (Form 1040). If you have a loss,see the Schedule E (Form 1040) instructionsfor Parts II and III to determine whether youfirst need to use Form 6198 to figure thedeductible loss. Further, if the loss is from apassive activity, you generally need to com-plete Form 8582 to figure the allowable lossto enter in Part II, column (g) of Schedule E,for that activity.

Enter your net income or loss from thepartnership, before depletion, in either thepassive or nonpassive section of Part II. Usethe same lettered line for which you enter thename of the partnership, the employer iden-tification number and other partnership infor-mation. On the next lettered line of thatsection's loss column, enter the depletiondeduction. If you are entitled to a depletiondeduction from more than one oil and gaspartnership, show this information for eachpartnership.

Certain partnerships must figure depletionallowance. For partnership tax years begin-ning after 1997, an electing large partnership,rather than each partner, generally must fig-ure the depletion allowance. The partnershipfigures the depletion allowance without takinginto account the limits on the amount of pro-duction and taxable income. Also, the ad-justed basis of a partner's interest in thepartnership is not affected by the depletionallowance.


An electing large partnership is onewhich had 100 or more partners in the pre-ceding year and elects to be an electing largepartnership. The election applies to the yearmade and all subsequent years unless re-voked with the consent of the IRS.

Treatment of disqualified partners. Adisqualified partner's distributive share of anyincome, deduction, gain, loss, or credit attrib-utable to any partnership oil or gas propertyis treated the same way as discussed inPartnerships, earlier.

Disqualified partners. All of the followingare disqualified partners.

• Refiners who cannot claim percentagedepletion (discussed under Small Pro-ducers, earlier).

• Retailers who cannot claim percentagedepletion (discussed under Small Pro-ducers, earlier).

• Any partner whose average daily pro-duction of domestic crude oil and naturalgas is more than 500 barrels during thetax year in which the partnership tax yearends.

Average daily production is discussedearlier.

S CorporationEach shareholder, and not the S corporation,figures the depletion allowance separately inthe same way as a partner in a partnership.

The S corporation must allocate to eachshareholder that shareholder's adjusted basisof each oil or gas property held by the S cor-poration. The corporation makes the allo-cation as of the date it acquires the property.The S corporation adjusts the shareholder'sshare of the adjusted basis of the oil and gasproperty for any capital expenditures made forthe property and for any change in theshareholder's interest.

RECORDS

Recordkeeping. Each shareholdermust separately keep records of theshareholder's pro rata share of the

adjusted basis in each oil and gas propertyof the S corporation. The shareholder mustreduce the share of the adjusted basis by thedepletion taken on the property by theshareholder. The shareholder must use thatreduced adjusted basis to figure cost de-pletion or the shareholder's gain or loss onthe disposition of the property by the S cor-poration.

For any distribution of the oil or gas prop-erty to its shareholders by the S corporation,the corporation's adjusted basis in the prop-erty is the total of all the shareholders' ad-justed bases in the property.

See Reporting the deduction earlier underPartnerships, for information on how S cor-poration shareholders should report their de-duction.

Natural Gas WellsYou are allowed percentage depletion fornatural gas sold under a fixed contract orproduced from geopressured brine.

Fixed contract. Natural gas sold under afixed contract qualifies for a percentage de-pletion rate of 22%.

Natural gas sold under a fixed contractis domestic natural gas sold by the producer

under a contract provided that the price can-not be adjusted to reflect any increase in theseller's tax liability because of the repeal ofpercentage depletion for gas. The contractmust have been in effect from February 1,1975, until the date of sale of the gas. Priceincreases after February 1, 1975, are pre-sumed to take the increase in tax liability intoaccount unless demonstrated otherwise byclear and convincing evidence.

Natural gas from geopressured brine.Qualified natural gas from geopressured brineis eligible for a percentage depletion rate of10%. Qualified natural gas from geopres-sured brine is natural gas produced from awell you began to drill after September 1978and before 1984 determined in accordancewith section 503 of the Natural Gas Policy Actof 1978 to be produced from geopressuredbrine.

Mines andGeothermal DepositsCertain mines, wells, and other natural de-posits, including geothermal deposits, qualifyfor percentage depletion.

Mines and other natural deposits. Thepercentage of your gross income from a na-tural deposit that you can deduct as depletionis based on the type of deposit.

Some of the depletion percentages for themore common minerals follow.

You can find a complete list of depositsand the percentage depletion rates that applyto them in section 613(b) of the Internal Rev-enue Code.

Corporate deduction for iron ore andcoal. The percentage depletion deduction ofa corporation for iron ore and coal (includinglignite) is reduced by 20% of:

• The percentage depletion deduction forthe tax year (figured without regard to thisreduction), minus

• The adjusted basis of the property at theclose of the tax year (figured without thedepletion deduction for the tax year).

Gross income from mining. In the case ofproperty other than a geothermal deposit oran oil or gas well, gross income from theproperty means the gross income from min-ing. Mining includes all of the following.

• Extracting ores or minerals from theground.

• Applying certain treatment processes.

• Transporting ores or minerals (generally,not more than 50 miles) from the pointof extraction to the plants or mills in whichthe treatment processes are applied.

Excise tax. Gross income from miningincludes the separately stated excise tax re-ceived by a mine operator from the sale ofcoal to compensate the operator for excisetax the mine operator must pay to financeblack lung benefits.

Extraction. Extracting ores or mineralsfrom the ground includes extraction by mineowners or operators of ores or minerals fromthe waste or residue of prior mining. Thisdoes not apply to extraction from waste orresidue of prior mining by the purchaser of thewaste or residue or the purchaser of the rightsto extract ores or minerals from the waste orresidue.

Treatment processes. The processesthat are included as mining depend on the oreor mineral mined. To qualify as mining, thetreatment processes must be applied by themine owner or operator. For a listing oftreatment processes considered as mining,see section 613(c)(4) of the Internal RevenueCode and the related regulations.

Transportation of more than 50 miles.If the Internal Revenue Service finds that theore or mineral must be transported more than50 miles to plants or mills to be treated be-cause of physical and other requirements, theadditional transportation that is authorized isincluded in the computation of gross incomefrom mining.

If you wish to include transportationof more than 50 miles in the compu-tation of gross income from mining,

file an application in duplicate. Include on theapplication the facts concerning the physicaland other requirements which prevented theconstruction and operation of the plant within50 miles of the point of extraction. Send thisapplication to:

Internal Revenue ServiceWashington, DC 20224Attention: Assistant Chief Counsel,Passthroughs and Special Industries

Disposal of coal or iron ore. You cannottake a depletion deduction on coal (includinglignite) or iron ore mined in the United Statesthat you disposed of after holding it for morethan 1 year if you retained an economic in-terest in it. Treat any gain on the dispositionas a capital gain.

Disposal to related person. This ruledoes not apply if you dispose of the coal oriron ore to one of the following persons.

• A related person (as listed in chapter 15).

• A person owned or controlled by thesame interests that own or control you.

Geothermal deposits. Geothermal depositslocated in the United States or its pos-sessions qualify for a percentage depletionrate of 15%. A geothermal deposit is ageothermal reservoir of natural heat stored inrocks or in a watery liquid or vapor. For per-centage depletion purposes, a geothermaldeposit is not considered a gas well.

Figure gross income from a geothermalsteam well in the same way as for oil and gas

DEPOSITS PERCENT

Sulphur, uranium, and, if from depositsin the United States, asbestos, lead ore,zinc ore, nickel ore, and mica ............... 22

Gold, silver, copper, iron ore, and certainoil shale, if from deposits in the UnitedStates ..................................................... 15

Coal, lignite, and sodium chloride ......... 10

Clay and shale used or sold for use inmaking sewer pipe or bricks or used orsold for use as sintered or burned light-weight aggregates ................................. 71 / 2

Clay used or sold for use in makingdrainage and roofing tile, flower pots,and kindred products, and gravel, sand,and stone (other than stone used or soldfor use by a mine owner or operator asdimension or ornamental stone) ............ 5

Borax, granite, limestone, marble,mollusk shells, potash, slate, soapstone,and carbon dioxide produced from a well 14


wells. See Gross income from oil and gasproperty, earlier, under Oil and Gas Wells.

Lessor's Gross IncomeA lessor's gross income from the lease of gas,oil, or mineral property for percentage de-pletion purposes usually is the total of theroyalties received from the lease, excludingrentals that are not payment for units of min-eral produced or to be produced.

Bonuses and advanced royalties. Bonusesreceived upon the grant of rights and ad-vanced royalties are payments a lesseemakes to a lessor for the lease or for min-erals, gas, or oil to be extracted from leasedproperty. Both types of payments are madebefore production. If you are the lessor, yourincome from bonuses and advanced royaltiesis subject to an allowance for depletion.

Figuring cost depletion on bonusesand advanced royalties. To figure cost de-pletion on a bonus, multiply your adjustedbasis in the property by a fraction, the nu-merator of which is the bonus and the de-nominator of which is the total bonus androyalties expected to be received. To figurecost depletion on advanced royalties, use thecomputation explained earlier under Cost de-pletion, treating the units for which the ad-vanced royalty is received as the units sold.

When you figure percentage depletion(for other than gas, oil, or geothermal prop-erty), the bonus or advanced royalty pay-ments are part of your gross income from theproperty.

Terminating the lease. For a bonus ona lease that has expired, been terminated, orabandoned before you derived any incomefrom the extraction of mineral or cutting oftimber, include in income the depletion de-duction you took. Also increase your adjustedbasis in the property to restore the depletiondeduction you previously subtracted.

For advanced royalties, include in incomethe depletion claimed on minerals for whichthe advanced royalties were paid if the min-erals were not produced before lease termi-nation. Increase your adjusted basis in theproperty by the amount you include in in-come.

Delay rentals. These are payments for de-ferring development of the property. Sincedelay rentals are ordinary rent, they are ordi-nary income that is not subject to depletion.These rentals can be avoided by eitherabandoning the lease, beginning develop-ment operations, or obtaining production.

TimberYou can figure timber depletion only by thecost method. Percentage depletion does notapply to timber. Base your depletion on yourcost or other basis in the timber. Your costdoes not include the cost of land.

Figuring the deduction. Depletion takesplace when you cut standing timber. You canfigure your depletion deduction when thequantity of cut timber is first accuratelymeasured in the process of exploitation.

Figure your depletion allowance bymultiplying the number of timber units cut byyour depletion unit.

Figure your depletion unit by doing thefollowing.

1) Determine your cost or adjusted basisof the timber on hand at the beginningof the year.

2) Add to the amount determined in 1) thecost of any units acquired during theyear and any additions to capital.

3) Figure the number of units to take intoaccount by adding the number of unitsacquired during the year to the numberof units on hand in the account at thebeginning of the year and then adding(or subtracting) any correction to the es-timate of the number of units remainingin the account.

4) Divide the result of 2) by the result of 3).This is your depletion unit.

Example. You bought a timber tract for$160,000 and the land was worth as muchas the timber. Your basis for the timber is$80,000. Based on an estimated one millionboard feet (1,000 MBF) of standing timber,you figure your depletion unit to be $80 perMBF ($80,000 divided by 1,000). If you cut500 MBF of timber, your depletion allowancewould be $40,000 (500 MBF multiplied by$80).

When to claim depletion. Claim your de-pletion allowance as a deduction in the yearof sale or other disposition of the products cutfrom the timber, unless you elect to treat thecutting of timber as a sale or exchange. In-clude allowable depletion for timber productsnot sold during the tax year the timber is cutas a cost item in the closing inventory of tim-ber products for the year. The inventory isyour basis for determining gain or loss in thetax year that you sell the timber products.

Example. In the previous example if yousold half of the timber products in the cuttingyear, you would deduct $20,000 of the$40,000 depletion that year. You would addthe remaining $20,000 depletion to yourclosing inventory of timber products.

Electing to treat the cutting of timber as asale or exchange. You can elect, undercertain circumstances, to treat the cutting oftimber as a sale or exchange. You must makethe election in your income tax return for thetaxable year it applies. If you make thiselection, subtract the adjusted basis for de-pletion from the fair market value of the timberat the beginning of the tax year in which youcut it to figure the gain or loss to report on thecutting. You generally report the gain aslong-term capital gain. The fair market valuethen becomes your basis for figuring your or-dinary gain or loss on the sale or other dis-position of the products cut from the timber.See Publication 544.

Form T. Attach Form T to your income taxreturn if you are claiming a deduction for tim-ber depletion.

14.Business BadDebts

IntroductionIf someone owes you money you cannot col-lect, you have a bad debt. You may be ableto deduct the uncollectible amount when youfigure your tax.

There are two kinds of bad debts — busi-ness bad debts and nonbusiness bad debts.A business bad debt is generally one thatcomes from operating your trade or business.You can deduct business bad debts as anexpense on your business tax return to figureyour business income or loss.

All other bad debts are nonbusiness baddebts and deductible as short-term capitallosses on Schedule D (Form 1040). For moreinformation on nonbusiness bad debts, seePublication 550.


• Definition of business bad debts

• How to treat business bad debts

• Where to deduct business bad debts


Publication


m 536 Net Operating Losses



m 556 Examination of Returns, AppealRights, and Claims for Refund


DefinedA business bad debt is a loss from theworthlessness of a debt that was either:

1) Created or acquired in your trade orbusiness, or

2) Closely related to your trade or businesswhen it became partly or totallyworthless.

The bad debts of a corporation are alwaysbusiness bad debts.

A debt is closely related to your trade orbusiness if your primary motive for incurringthe debt is a business reason.

Example. John Smith, an advertisingagent, made loans to certain clients to keeptheir business. His main reason for makingthese loans was to help his business. One ofthese clients later went bankrupt and could

Chapter 14 Business Bad Debts

not repay him. Since John's business was themain reason for making the loan, the debtwas a business debt and he can take a busi-ness bad debt deduction.

When debt is worthless. You do not haveto wait until a debt is due to determinewhether it is worthless. A debt becomesworthless when there is no longer any chancethat the amount owed will be paid.

It is not necessary to go to court if you canshow that a judgement from the court wouldbe uncollectible. You must only show that youhave taken reasonable steps to collect thedebt. Bankruptcy of your debtor is generallygood evidence of the worhtlessness of atleast a part of an unsecured and unpreferreddebt.

Debts from sales or services. Businessbad debts are mainly the result of credit salesto customers. They can also be the result ofloans to suppliers, clients, employees, or dis-tributors. Goods and services customers havenot paid for are shown in your books as eitheraccounts receivable or notes receivable. Ifyou are unable to collect any part of theseaccounts or notes receivable, the uncollect-ible part is a business bad debt. Accounts ornotes receivable valued at fair market valueat the time of the transaction are deductibleonly at that fair market value, even though thevalue may be less than face value.

You can take a bad debt deduction forthese accounts and notes receivable only ifthe amount owed you was included in yourgross income; either for the year the de-duction is claimed or for a prior year. Thisapplies to amounts owed you from all sourcesof taxable income, such as sales, services,rents, and interest.

If you qualify under certain rules, you canuse the nonaccrual-experience method ofaccounting, discussed later. Under thismethod, you do not have to accrue incomethat, based on your experience, you expectto be uncollectible.

Accrual method taxpayers. Accrualmethod taxpayers normally report income asthey earn it. They can take a bad debt de-duction for an uncollectible receivable if theyhave included the uncollectible amount in in-come.

Cash method taxpayers. Cash methodtaxpayers normally report income when theyreceive payment. They cannot take a baddebt deduction for amounts owed to them thatthey have not received and cannot collect ifthey never included those amounts in income.

Debts from a former business. If you sellyour business but keep its accounts receiv-able, these debts are business debts sincethey arose in your trade or business. If anaccount becomes worthless, the loss is abusiness bad debt. These accounts wouldalso be business debts if sold to the newowner of the business.

If you sell your business to one personand sell your accounts receivable to someoneelse, the character of the debts as businessor nonbusiness is based on the activities ofthe new holder of these debts. A loss from thedebts is a business bad debt to the newholder if that person acquired the debts in hisor her trade or business or if the debts wereclosely related to the new holder's trade orbusiness when they became worthless. Oth-erwise, a loss from these debts is a nonbusi-ness bad debt.

Debt acquired from a decedent. Thecharacter of a loss from debt of a businessacquired from a decedent is determined in thesame way as a debt sold by a business. If youare in a trade or business, a loss from thedebts is a business bad debt if you acquiredthem in your trade or business or if the debtswere closely related to your trade or businesswhen they became worthless. Otherwise, aloss from these debts is a nonbusiness baddebt.

Liquidation. If you liquidate your busi-ness and some of your accounts receivablebecome worthless, they are business baddebts.

Debts of political parties. If a political party(or other organization that accepts contribu-tions or spends money to influence elections)owes you money and the debt becomesworthless, you cannot take a bad debt de-duction unless you use an accrual method ofaccounting and meet all the following tests.

1) The debt was from the sale of goods orservices in the ordinary course of yourtrade or business.

2) More than 30% of all your receivablesaccrued in the year of the sale were fromsales made to political parties.

3) You made substantial continuing effortsto collect on the debt.

Loan or capital contribution. You cannottake a bad debt deduction for a loan youmade to a corporation if, based on the factsand circumstances, the loan is actually acontribution to capital.

Debts of an insolvent partner. If yourbusiness partnership breaks up and one ofyour former partners is insolvent and cannotpay any of the partnership's debts, you mayhave to pay more than your share of thepartnership's debts. If you pay any part of theinsolvent partner's share of the debts, you cantake a bad debt deduction.

Business loan guarantee. If you guaranteea debt that becomes worthless, the debt canqualify as a business bad debt. However, allthe following requirements must be met.

1) You made the guarantee in the courseof your trade or business.

2) You have a legal duty to pay the debt.

3) You made the guarantee before the debtbecame worthless. You meet this re-quirement if you reasonably expectedthat you would not have to pay the debtwithout full reimbursement from theissuer.

4) You receive reasonable considerationfor making the guarantee. You meet thisrequirement if you made the guaranteein accord with normal business practiceor for a good faith business purpose.

Consider any guarantee you make toprotect or improve your job as closely relatedto your trade or business as an employee.

Deductible in the year paid. You candeduct a payment you make on a loan youguaranteed in the year of payment unless youhave rights against the borrower.

Example. Bob Zayne owns the ZayneDress Company. He guaranteed payment ofa $20,000 note for Elegant Fashions, a dress

outlet. Elegant Fashions is one of Zayne'slargest clients. Elegant Fashions later filed forbankruptcy and defaulted on the loan. Mr.Zayne made full payment to the bank. He cantake a business bad debt deduction, since hisguarantee was made in the course of histrade or business for a good faith businesspurpose. He was motivated by the desire toretain one of his better clients and keep asales outlet.

Rights against a borrower. When youmake payment on a loan you guaranteed, youmay have the right to take the place of thelender. The debt is then owed to you. If youhave this right, or some other right to demandpayment from the borrower, you cannot takea bad debt deduction until these rights be-come partly or totally worthless.

How To TreatThere are two ways to treat business baddebts: the specific charge-off and nonaccru-al-experience methods. Most taxpayers, ex-cept certain financial institutions, must use thespecific charge-off method. However, certaintaxpayers can use the nonaccrual-experiencemethod if they meet the requirements dis-cussed later.

Recovery of bad debt. If you deduct a baddebt and later recover (collect) all or part ofit, you may have to include all or part of therecovery in gross income. The amount youinclude is limited to the amount you actuallydeducted. You can exclude the amount de-ducted that did not reduce your tax.

Example. In 1997, the Willow Corporationhad gross income of $158,000, a bad debtdeduction of $3,500, and other allowable de-ductions of $49,437. The corporation reportedon the accrual method of accounting andused the specific charge-off method for baddebts. The entire bad debt deduction reducedthe tax on the 1997 corporate return. In 1998,the corporation recovers part of the $3,500deducted in 1997. It must include the partrecovered in income for 1998. For 1998,Willow reports the recovery as “Otherincome” on its corporate return.

Net operating loss (NOL) carryover. Ifa bad debt deduction increases an NOL car-ryover that has not expired before the begin-ning of the tax year in which the recoverytakes place, the deduction is treated as hav-ing reduced your tax. A bad debt deductionthat contributes to a net operating loss helpslower taxes in the year to which you carry thenet operating loss.

See Publication 536 for more informationabout net operating losses.

More information. See Recoveries inPublication 525 for more information on re-covered amounts.

Bankruptcy claim. You can deduct as a baddebt only the difference between the amountowed to you by a bankrupt entity and theamount you received from the distribution ofits assets.

Sale of mortgaged property. If mortgagedor pledged property is sold for less than thedebt, the unpaid, uncollectible balance of thedebt after the sale is a bad debt. If the debtrepresents capital or an amount you previ-ously included in income, you can deduct it

Chapter 14 Business Bad Debts

as a bad debt in the year it becomes totallyworthless or in the year you charged it off aspartially worthless.

Specific Charge-Off MethodIf you use the specific charge-off method, youcan deduct specific business bad debts thatbecome either partly or totally worthless dur-ing the tax year.

Partly worthless debts. You can deductspecific bad debts that are partly uncollect-ible. Your deduction is limited to the amountyou charge–off on your books during the taxyear. You do not have to charge–off and de-duct your partly worthless debts annually. Youcan delay the charge-off until a later year. Youcan wait until more of the debt becomesworthless, or you have collected all you canand it is totally worthless. You cannot, how-ever, deduct any part of a debt after the yearit becomes totally worthless.

Deduction disallowed. You can gener-ally take a partial bad debt deduction only inthe year you make the charge–off on yourbooks. If the Internal Revenue Service (IRS)does not allow your deduction and the debtbecomes partly worthless in a later tax year,you can deduct the amount you charge–off inthat year, plus the amount charged off in theearlier year. The charge–off in the earlieryear, unless reversed on your books, fulfillsthe charge-off requirement for the later year.

Totally worthless debts. Deduct a totallyworthless debt only in the tax year it becomestotally worthless. You cannot include anyamount deducted in an earlier tax year whenthe debt was only partly worthless.

You do not have to make an actualcharge–off on your books to claim a bad debtdeduction for a totally worthless debt. How-ever, you may want to do so. If you do notand the IRS later rules the debt is only partlyworthless, you will not be allowed a deductionfor the debt in that tax year. A deduction ofa partly worthless bad debt is limited to theamount actually charged–off.

Filing a claim for refund. If you do not de-duct a bad debt on your original return for theyear it becomes worthless, you can file aclaim for a credit or refund due to the baddebt. You must use Form 1040X, AmendedU.S. Individual Income Tax Return, to amendyour return for the year the debt becameworthless. If the bad debt was totallyworthless, you must file the claim within 7years from the date your original return forthat year had to be filed, or 2 years from thedate you paid the tax, whichever is later.(Claims not due to totally worthless bad debtsgenerally must be filed within 3 years from thedate the tax is paid.) For more informationabout filing a claim, see Publication 556, Ex-amination of Returns, Appeal Rights, andClaims for Refund.

Property received for debt. If you receiveproperty in partial settlement of a debt, reducethe debt by the fair market value of the prop-erty received. You can deduct the remainingdebt as a bad debt in the year you determineit is worthless.

If you later sell the property, include anygain from the sale in gross income. For in-

formation on the sale of an asset, see Publi-cation 544.

Nonaccrual-ExperienceMethodIf you use an accrual method of accountingand qualify under the rules explained in thissection, you can use the nonaccrual-experience method of accounting for baddebts. Under this method, you do not accrueincome that you expect to be uncollectible.

If you determine, based on your experi-ence, that certain amounts (accounts receiv-able) are uncollectible, do not include them inyour gross income for the tax year.

Amounts must be for performing services.You can use the nonaccrual-experiencemethod only for amounts earned by perform-ing services that you would otherwise includein income. You cannot use this method foramounts owed to you from activities such aslending money, selling goods, or acquiringreceivables or other rights to receive pay-ments.

Interest or penalty charged. Generally, youcannot use the nonaccrual-experiencemethod for amounts due on which you chargeinterest or a late payment penalty. However,do not treat a discount offered for early pay-ment as interest or a late payment penaltycharged if:

1) You otherwise accrue the full amountdue as gross income at the time youprovide the services, and

2) You treat the discount allowed for earlypayment as an adjustment to gross in-come in the year of payment.

How to apply this method. You can applythe nonaccrual-experience method under ei-ther a separate receivable system or a peri-odic system. Under the separate receivablesystem, apply the nonaccrual-experiencemethod separately to each account receiv-able. Under the periodic system, apply thenonaccrual-experience method to total qual-ified accounts receivable at the end of yourtax year.

Treat each system as a separate methodof accounting. You generally cannot changefrom one system to the other without IRSapproval.

Generally, you also need IRS approval tochange to either system under the nonaccru-al-experience method from a different ac-counting method.

For more information on the separatereceivable system, see section 1.448–2T ofthe Income Tax Regulations. For more infor-mation on the periodic system, see Notice88–51, 1988–1 C.B. 535.

Where To DeductUse the following guide to find where to de-duct your business bad debts.

Individuals. Deduct a bad debt from op-erating a trade or business on line 9 ofSchedule C (Form 1040) or line 2 of ScheduleC–EZ (Form 1040). Deduct a bad debt from

operating a farm business on line 34 ofSchedule F (Form 1040).

Corporations. Corporations deduct baddebts on line 15 of Form 1120, line 15 of Form1120–A, or line 10 of Form 1120S.

Partnerships. Partnerships deduct busi-ness bad debts on line 12 of Form 1065.

15.Electric andClean-FuelVehicles

IntroductionYou are allowed a limited deduction for thecost of clean-fuel vehicle property and clean-fuel vehicle refueling property you place inservice during the tax year. Also, you are al-lowed a tax credit of 10% of the cost of anyqualified electric vehicle you place in serviceduring the tax year.

TIPYou can take the electric vehiclecredit or the deduction for clean-fuelvehicle property regardless of

whether you use the vehicle or vehicle prop-erty in a trade or business. However, you cantake a deduction for clean-fuel vehicle refuel-ing property only if you use the property inyour trade or business.


• The deduction for clean-fuel vehicleproperty

• The deduction for clean-fuel vehicle re-fueling property

• Recapture of the deductions

• The electric vehicle credit

• Recapture of the credit


Publication

m 463 Travel, Entertainment, Gift, andCar Expenses




m 8834 Qualified Electric Vehicle Credit


Chapter 15 Electric and Clean-Fuel Vehicles

Deductions forClean-Fuel Vehicleand RefuelingPropertyYou are allowed a limited deduction for thecost of clean-fuel vehicle property. You arealso allowed a limited deduction for the costof clean-fuel vehicle refueling property. Thesedeductions are allowed only in the tax yearyou place the property in service.

Nonqualifying property. You cannot deductthe part of a property's cost that you claim asa section 179 deduction. You also cannotclaim the deduction for property used:

1) Predominantly outside the United States,

2) Predominantly to furnish lodging or inconnection with the furnishing of lodging,

3) By certain tax-exempt organizations, or

4) By governmental units or foreign per-sons or entities.

Clean-burning fuels. Clean-burning fuelsinclude:

1) Natural gas,

2) Liquefied natural gas,

3) Liquefied petroleum gas,

4) Hydrogen,

5) Electricity, and

6) Any fuel that is at least 85% alcohol (anykind) or ether.

Deduction for Clean-FuelVehicle PropertyThe deduction for this property may beclaimed regardless of whether the property isused in a trade or business.

Clean-fuel vehicle property. Clean-fuel ve-hicle property is made up of two kinds ofproperty.

1) Motor vehicles produced by an originalequipment manufacturer and designedto be propelled by a clean-burning fuel.The only part of a vehicle's basis thatqualifies for the deduction is:

a) A clean-fuel engine that can use aclean-burning fuel,

b) The property used to store or de-liver the fuel to the engine, or

c) The property used to exhaust gasesfrom the combustion of the fuel.

2) Any property installed on a motor vehicle(including installation costs) to enable itto be propelled by a clean-burning fuelif:

a) The property is an engine (or mod-ification of an engine) that can usea clean-burning fuel, or

b) The property is used to store ordeliver that fuel to the engine or toexhaust gases from the combustionof that fuel.

For vehicles that may be propelled by botha clean-burning fuel and any other fuel, yourdeduction is generally the additional cost ofpermitting the use of the clean-burning fuel.

CAUTION!

Clean-fuel vehicle property does notinclude an electric vehicle that quali-fies for the qualified electric vehicle

credit discussed later.

Motor vehicle defined. A motor vehicle isany vehicle that has four or more wheels andis manufactured primarily for use on publicstreets, roads, and highways. It does not in-clude a vehicle operated exclusively on a railor rails.

Qualifying requirements. For your propertyto qualify for the deduction:

1) It must be acquired for your own use andnot for resale,

2) Its original use must begin with you,

3) The motor vehicle of which it is a partmust satisfy any federal or state emis-sions standards that apply to each fuelby which the vehicle is designed to bepropelled, and

4) It must satisfy any federal and stateemissions certification, testing, and war-ranty requirements that apply if it is in-stalled on a retrofitted vehicle.

Deduction limit. The maximum deductionyou can claim for qualified clean-fuel vehicleproperty with respect to any motor vehicle is:

1) $50,000 for a truck or van with a grossvehicle weight rating over 26,000 poundsor for a bus with a seating capacity ofat least 20 adults (excluding the driver),

2) $5,000 for a truck or van with a grossvehicle weight rating over 10,000 poundsbut not more than 26,000 pounds, or

3) $2,000 for a vehicle not included in (1)or (2).

Deduction for Clean-FuelVehicle Refueling PropertyProperty is eligible for the deduction if:

1) The property is depreciable property,and

2) The original use of the property beginswith you.

Clean-fuel vehicle refueling property de-fined. Clean-fuel vehicle refueling propertyincludes any property (other than a buildingor its structural components) used to:

1) Store or dispense a clean-burning fuelinto the fuel tank of a motor vehicle pro-pelled by the fuel, but only if the storageor dispensing is at the point where thefuel is delivered into the tank, or

2) Recharge motor vehicles propelled byelectricity, but only if the property is lo-cated at the point where the vehicles arerecharged.

Recharging property. This property in-cludes any equipment used to provide elec-tricity to the battery of a vehicle propelled byelectricity. It includes low-voltage and high-voltage (quick) charging equipment and an-cillary connection equipment, such as induc-

tive charging equipment. It does not includeproperty used to generate electricity, such assolar panels or windmills, and does not in-clude the battery used in the vehicle.

Deduction limit. The maximum deductionyou can claim for clean-fuel vehicle refuelingproperty placed in service at one location is$100,000. To figure your maximum deductionfor any tax year, subtract from $100,000 thetotal you (or any related person or predeces-sor) claimed for clean-fuel vehicle refuelingproperty placed in service at that location forall earlier years.

CAUTION!

You must specify on your tax returnthe property (and portions of theproperty's cost) that you are using as

a basis for the deduction.

Related person. For this purpose, a re-lated person includes the following persons.

1) An individual and his or her brothers andsisters, half-brothers, half-sisters,spouse, ancestors, and lineal descend-ants.

2) An individual and a corporation when theindividual owns, directly or indirectly,more than 50% in value of the out-standing stock of the corporation.

3) Two corporations that are members ofthe same controlled group as defined insection 267(f) of the Internal RevenueCode.

4) A grantor and a fiduciary of any trust.

5) Fiduciaries of two separate trusts if thesame person is a grantor of both trusts.

6) A fiduciary and a beneficiary of the sametrust.

7) A fiduciary and a beneficiary of twoseparate trusts if the same person is agrantor of both trusts.

8) A fiduciary of a trust and a corporationwhen the trust or a grantor of the trustowns, directly or indirectly, more than50% in value of the outstanding stockof the corporation.

9) A person and a tax-exempt educationalor charitable organization that is con-trolled directly or indirectly by that personor by members of the family of that per-son.

10) A corporation and a partnership if thesame person owns more than 50% invalue of the outstanding stock of thecorporation and more than 50% of thecapital or profits interest in the partner-ship.

11) Two S corporations or an S corporationand a regular corporation if the samepersons own more than 50% in value ofthe outstanding stock of each corpo-ration.

12) A partnership and a person owning, di-rectly or indirectly, more than 50% of thecapital or profits interest in the partner-ship.

13) Two partnerships if the same personsown, directly or indirectly, more than50% of the capital or profits interest inboth partnerships.

14) An executor of an estate and a benefi-ciary of the estate, except in the case


of a sale or exchange in satisfaction ofa pecuniary bequest.

For the indirect stock ownership rules, seeIndirect ownership of stock, under UnpaidSalaries, in chapter 2.

How To Claimthe DeductionsHow you claim the deductions for clean-fuelvehicles and refueling property depends onthe use of the property and the kind of incometax return you file.

Nonbusiness use of clean-fuel vehicleproperty by individuals. Individuals canclaim the deduction for the nonbusiness useof clean-fuel vehicle property by including thededuction in the total on line 32 of Form 1040.Also, enter the amount of your deduction and“Clean-Fuel” on the dotted line next to line 32.If you use the vehicle partly for business, seethe next two discussions.

Business use by employees. Employeeswho use clean-fuel vehicle property for busi-ness or partly for business and partly fornonbusiness purposes should enter the entirededuction in the total on line 32 of Form 1040.Also, enter the amount of your deduction and“Clean-Fuel” on the dotted line next to line 32.

Business use by sole proprietors. Individ-uals who operate a business as a sole pro-prietor can claim their deduction for the busi-ness use of clean-fuel vehicles and clean-fuelvehicle refueling property on the Other ex-penses line of either Schedule C (Form 1040)or Schedule F (Form 1040). If clean-fuel ve-hicle property is used partly for nonbusinesspurposes, claim the nonbusiness part of thededuction as explained earlier under Non-business use of clean-fuel vehicle propertyby individuals.

Partnerships. Partnerships claim the de-duction for the business use of clean-fuel ve-hicle and clean-fuel vehicle refueling propertyon line 20 of Form 1065.

S corporations. S corporations claim thededuction for the business use of clean-fuelvehicle and clean-fuel vehicle refueling prop-erty on line 19 of Form 1120S.

Other corporations. Corporations claim thededuction for the business use of clean-fuelvehicle and clean-fuel vehicle refueling prop-erty on line 26 of Form 1120 (line 22 of Form1120–A).

Recapture of theDeductionsIf the property no longer qualifies, you mustrecapture the deduction. You recapture thededuction by including it, or a part of it, in yourincome in the year recapture occurs.

Clean-Fuel Vehicle PropertyClean-fuel vehicle property no longer qualifiesif, within 3 years after the date you placed itin service, the property:

1) Is modified so that it can no longer bepropelled by a clean-burning fuel,

2) Ceases to be a qualified clean-fuel ve-hicle property (such as failing to meetemissions standards), or

3) Is used—

a) Predominantly outside the UnitedStates,

b) Predominantly to furnish lodging orin connection with the furnishing oflodging,

c) By certain tax-exempt organiza-tions, or

d) By governmental units or foreignpersons or entities.

Sales or other dispositions. If you sell orotherwise dispose of the vehicle and knowor have reason to know that it will be used ina manner described above, you are subjectto the recapture rules. In other sales or dis-positions (including a disposition by reasonof an accident or other casualty), the recap-ture rules do not apply.

If the vehicle was subject to depreciation,the deduction (minus any recapture) is con-sidered depreciation when figuring the partof the gain that is ordinary income. See Pub-lication 544 for more information on disposi-tions of depreciable property.

Recapture amount. Figure your recaptureamount by multiplying the deduction by a re-capture percentage. The percentages are asfollows.

• 100% if the recapture date is within thefirst full year after the date the vehiclewas placed in service.

• 662 / 3% if the recapture date is within thesecond full year after the date the vehiclewas placed in service.

• 331 / 3% if the recapture date is within thethird full year after the date the vehiclewas placed in service.

Recapture date. The recapture date isgenerally the date of the event that causesthe recapture. However, the recapture datefor item (3), earlier, is the first day of the yearin which the use occurs.

How to report. How you report the recaptureamount for clean-fuel vehicle property as in-come depends on how you claimed the de-duction for that property.

Nonbusiness use by individuals. In-clude the amount on line 21 of Form 1040.

Business use by employees. Includethe amount on line 21 of Form 1040.

Business use by sole proprietors. In-clude the amount on the Other income lineof either Schedule C (Form 1040) or Sched-ule F (Form 1040).

Partnerships and corporations (includ-ing S corporations). Include the amount onthe Other income line of the form you file.

Clean-Fuel VehicleRefueling PropertyYour clean-fuel vehicle refueling property nolonger qualifies if, at any time before the endof its depreciation recovery period, the prop-erty is:

1) No longer used to store or dispenseclean-burning fuel into the fuel tanks ofmotor vehicles propelled by the fuel, or

to recharge motor vehicles propelled byelectricity, whichever applies,

2) No longer used 50% or more in yourtrade or business, or

3) Is used—

a) Predominantly outside the UnitedStates,

b) Predominantly to furnish lodging orin connection with the furnishing oflodging,

c) By certain tax-exempt organiza-tions, or

d) By governmental units or foreignpersons or entities.

Sales or other dispositions. If you sell orotherwise dispose of the property and knowor have reason to know that it will be used ina manner described above, you are subjectto the recapture rules. In other sales or dis-positions, the recapture rules do not apply.

The deduction (minus any recaptureamount) is considered depreciation when fig-uring the part of the gain that is ordinary in-come upon its disposition. See Publication544 for more information on dispositions ofdepreciable property.

Recapture amount. Figure your recaptureamount by multiplying the deduction youclaimed by the following fraction.

How to report. How you report the recaptureamount for clean-fuel vehicle refueling prop-erty depends on how you claimed the de-duction for that property.

Business use by sole proprietors. In-clude the amount on the Other income lineof either Schedule C (Form 1040) or Sched-ule F (Form 1040).

Partnerships and corporations (includ-ing S corporations). Include the amount onthe Other income line of the form you file.

Basis AdjustmentYou must reduce the basis of your clean-fuelvehicle or clean-fuel vehicle refueling propertyby the amount of the deduction claimed. If, ina later year, you must recapture part or all ofthe deduction, increase the basis of theproperty by the amount recaptured.

If the property is depreciable property, youcan recover the additional basis over theproperty's remaining recovery period begin-ning with the tax year of recapture.

CAUTION!

If you were using the percentage ta-bles to figure your depreciation on theproperty, you will not be able to con-

tinue to do so. See Publication 946 for infor-mation on figuring your depreciation withoutthe tables.

Electric Vehicle CreditYou can choose to claim a tax credit for aqualified electric vehicle you place in serviceduring the year. You can make this choiceregardless of whether the property is used ina trade or business.

Total recovery period for _ Recovery years beforethe property the recapture year

Total recovery period for the property


Qualified Electric VehicleA vehicle is a qualified electric vehicle if itmeets all of the following requirements.

1) It has at least four wheels and is manu-factured primarily for use on publicstreets, roads, and highways.

2) It is powered primarily by an electricmotor drawing current from rechargeablebatteries, fuel cells, or other portablesources of electrical current.

3) You were the first person to use it.

4) You acquired it for your own use and notfor resale.

Generally, an electric vehicle is not qual-ified if it is:

1) Operated exclusively on a rail or rails,

2) Used predominantly outside the UnitedStates,

3) Used predominantly to furnish lodgingor in connection with the furnishing oflodging,

4) Used by certain tax-exempt organiza-tions, or

5) Used by governmental units or foreignpersons or entities.

Amount of the CreditThe credit is generally 10% of the cost ofeach vehicle you place in service during theyear. If your vehicle is a depreciable businessasset, you must reduce the cost of the vehicleby any section 179 deduction before figuringthe 10% credit. If you need information on thesection 179 deduction, get Publication 946.

Credit limits. The credit is limited to $4,000for each vehicle. The total credit is limited tothe excess of your regular tax liability, re-duced by certain credits, over your tentativeminimum tax. To figure the amount of credityou can take, complete Form 8834 and attachit to your tax return.

How To Claimthe CreditYou must complete and attach Form 8834 toyour tax return to claim the electric vehiclecredit. Enter your credit on your tax return asdiscussed next.

Individuals. Individuals claim the credit byentering the amount from line 19 of Form8834 on line 47 of Form 1040. Check box“d” and specify Form 8834.

Partnerships. Partnerships enter theamount from line 19 of Form 8834 on line 13of Schedule K (Form 1065). The partnershipthen allocates the credit to the partners online 13 of Schedule K–1 (Form 1065). See theinstructions for Form 1065.

S corporations. S corporations enter theamount from line 19 of Form 8834 on line 13of Schedule K (Form 1120S). The S corpo-ration then allocates the credit to the share-holders on line 13 of Schedule K–1 (Form1120S). See the instructions for Form 1120S.

Other corporations. Corporations otherthan S corporations claim the credit by en-tering the amount from line 19 of Form 8834

in the total for line 4c of Schedule J (Form1120) and checking the Form 8834 box to theleft of the entry. See the instructions for Form1120.

Recapture of the CreditThe electric vehicle credit is subject to re-capture if, within 3 years after the date youplace the vehicle in service, it ceases toqualify for the electric vehicle credit.

The vehicle ceases to qualify if it is:

1) Modified so that it is no longer primarilypowered by electricity,

2) Used predominantly outside the UnitedStates,

3) Used predominantly to furnish lodgingor in connection with the furnishing oflodging,

4) Used by certain tax-exempt organiza-tions, or

5) Used by governmental units or foreignpersons or entities.

Sales or other dispositions. If you sell ordispose of the vehicle and know or havereason to know that it will be used in a man-ner described above, you are subject to therecapture rules. In other sales or dispositions,the recapture rules do not apply.

If the vehicle was subject to depreciation,the credit (minus any recapture amount) isconsidered depreciation when figuring thepart of the gain that is ordinary income. SeePublication 544 for more information on dis-positions of depreciable property.

Recapture amount. Figure your recaptureamount by multiplying the credit by a recap-ture percentage. The percentages are as fol-lows.

• 100% if the recapture date is within thefirst full year after the date the vehiclewas placed in service.

• 662 / 3% if the recapture date is within thesecond full year after the date the vehiclewas placed in service.

• 331 / 3% if the recapture date is within thethird full year after the date the vehiclewas placed in service.

Recapture date. The recapture date isgenerally the date of the event that causesthe recapture. However, the recapture datefor items (2) through (5), earlier, is the firstday of the year in which the use occurs.

How to report. How you report the recaptureamount of the electric vehicle credit dependson how the credit was claimed.

Individuals. Include the amount on line56 of Form 1040. Write “QEVCR” on the dot-ted line next to line 56.

Partnerships. Include on line 25 ofSchedule K-1 (Form 1065) the information apartner needs to figure the recapture of thecredit.

S corporations. Include on line 23 ofSchedule K-1 (Form 1120S) the informationa shareholder needs to figure the recaptureof the credit.

Other corporations. Include the amounton line 8 of Schedule J (Form 1120), or line5 of Part I (Form 1120–A). Write “QEV re-capture” on the dotted line next to that entryspace.

Basis AdjustmentIf you claim a tax credit for a qualified electricvehicle you place in service during the year,you must reduce your basis in that vehicle bythe lesser of:

1) $4,000, or

2) 10% of the cost of the vehicle.

This basis reduction rule applies even if thecredit allowed is less than that amount.

If you must recapture part or all of thecredit, increase the basis of your vehicle bythe amount recaptured. If the qualified electricvehicle is depreciable property, you can re-cover the additional basis over the vehicle'sremaining recovery period beginning with thetax year of recapture.

CAUTION!

If you were using the percentage ta-bles to figure your depreciation on thevehicle, you will not be able to con-

tinue to do so. See Publication 946 for infor-mation on figuring your depreciation withoutthe tables.

16.Other Expenses

Important Changes for1998Standard mileage rate. The standard mile-age rate for the cost of operating your car,van, pickup, or panel truck in 1998 is 32.5cents per mile for all business miles. You canuse the standard mileage rate for a vehicleyou lease, as well as one you own.

Meal expense deduction increases forcertain individuals. Beginning in 1998, ifemployees are 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, see Meal expenses when subjectto “hours of service” limits later.

IntroductionThis chapter covers some expenses you asa business owner may have that are not ex-plained earlier.


• Travel, meals, and entertainment

• Bribes and kickbacks

• Charitable contributions

• Education expenses

• Franchises, trademarks, and tradenames

Chapter 16 Other Expenses

• Lobbying expenses

• Penalties and fines

• Repayments (claim of right)


Publication

m 463 Travel, Entertainment, Gift, andCar Expense

m 529 Miscellaneous Deductions

m 542 Corporations


m 1542 Per Diem Rates


m Sch A (Form 1040) Itemized Deduction

m 1099–MISC Miscellaneous Income

m 6069 Return of Excise Tax on ExcessContributions to Black Lung Ben-efit Trust Under Section 4953 andComputation of Section 192 De-duction


Travel, Meals, andEntertainmentTo be deductible, expenses incurred fortravel, meals, and entertainment must be or-dinary and necessary expenses of carryingon your trade or business. Generally, you alsomust show that entertainment expenses (in-cluding meals) are directly related to, or as-sociated with, the conduct of your trade orbusiness.

The following discussion explains how youdeduct any reimbursements or allowancesyou make for these expenses incurred byyour employees. If you are self-employed andincur these expenses yourself, see Publica-tion 463 for information on how you can de-duct them.

ReimbursementsHow you deduct a reimbursement or allow-ance arrangement (including per diem allow-ances, discussed later) for travel, meals, andentertainment expenses incurred by youremployees depends on whether you have anaccountable plan or a nonaccountable plan.A reimbursement or allowance arrangementis a system by which you pay advances, re-imbursements, and charges for your employ-ees' business expenses and they substantiatetheir expenses to you so you can substantiateyour deduction of the advance, reimburse-ment, or charge. If you make a single pay-ment to your employees and it includes bothwages and an expense reimbursement, youmust specify the amount of the reimburse-ment.

If you reimburse these expenses underan accountable plan, deduct them as travel,meal, and entertainment expenses. If youreimburse these expenses under a nonac-countable plan, you must report the re-imbursements as wages on Form W–2 and

Table 16-1. Reporting Reimbursements

IF the type of reimbursement (or otherexpense allowance) arrangement isunder: Then the employer reports on Form W-2:

An accountable plan with:

Actual expense reimbursement:Adequate accounting made and excessreturned

No amount.

Actual expense reimbursement:Adequate accounting and return of excessboth required but excess not returned

The excess amount as wages in box 1.

Per diem or mileage allowance up to thefederal rate:Adequate accounting and excess returned

Per diem or mileage allowance exceeds thefederal rate:Adequate accounting up to the federal rateonly and excess not returned

The excess amount as wages in box 1. Theamount up to the federal rate is reportedonly in box 13—it is not reported in box 1.

A nonaccountable plan with:

Either adequate accounting or return ofexcess, or both, not required by plan

The entire amount as wages in box 1.

No reimbursement plan The entire amount as wages in box 1.

No amount.

Per diem or mileage allowance up to thefederal rate:Adequate accounting and return of excessboth required but excess not returned

The excess amount as wages in box 1. Theamount up to the federal rate is reportedonly in box 13—it is not reported in box 1.

deduct them as wages. See Table 16-1, Re-porting Reimbursements.

Accountable PlansTo be an accountable plan, your reimburse-ment or allowance arrangement must requireyour employees to meet all of the followingrules.

1) They must have paid or incurreddeductible expenses while performingservices as your employees.

2) They must adequately account to you forthese expenses within a reasonable pe-riod of time.

3) They must return any excess re-imbursement or allowance within a rea-sonable period of time.

TIPA reasonable period of time dependson the facts and circumstances.Generally, you can consider the pe-

riod reasonable if your employees adequatelyaccount for the expenses within 60 days afterthey pay or incur them and if they return anyexcess reimbursement within 120 days afterthey pay or incur the expense. Also, the pe-riod is considered reasonable if you give youremployees a periodic statement (at leastquarterly) that asks them to either return oradequately account for outstanding amountsand they do so within 120 days of the state-ment.

If any expenses reimbursed under thisarrangement are not substantiated, or are anexcess reimbursement that is not returnedwithin a reasonable period of time by an em-ployee, you cannot treat these expenses asreimbursed under an accountable plan. In-

stead, treat the reimbursed expenses as paidunder a nonaccountable plan, discussedlater.

How to deduct. You can take a deductionfor travel, meals, and entertainment if youreimburse your employees for these ex-penses under an accountable plan. Theamount you deduct for meals and enter-tainment, however, may be subject to a 50%limit, discussed later. If you are a sole pro-prietor, deduct the reimbursement on line 24of Schedule C (Form 1040). If you file a cor-poration income tax return, include the re-imbursement in the amount claimed on the“Other deductions” line of Form 1120 or Form1120–A. If you file any other income tax re-turn, such as a partnership or S Corporationreturn, deduct the reimbursement on the ap-propriate line of the return, as provided in theinstructions for that return.

Per Diem and Car AllowancesYou may reimburse your employees underan accountable plan based on travel days,miles, or some other fixed allowance. Inthese cases, your employee is considered tohave accounted to you for the amount of theexpense that does not exceed the rates es-tablished by the federal government. Youremployee must actually substantiate to youthe other elements of the expense, such astime, place, and business purpose.

Car allowance. Your employee is consid-ered to have accounted to you for car ex-penses that do not exceed the standardmileage rate. For 1998, the standard mileagerate is 32.5 cents for all business miles. Thestandard mileage rate is considered to be thefederal rate. If the car allowance you pay is


equal to or less than 32.5 cents a mile, seePer diem allowance LESS than or EQUAL tothe federal rate, later. If the car allowance youpay is more than 32.5 cents per mile, see Perdiem allowance MORE than the federal rate,later.

You can choose to reimburse your em-ployees using a fixed and variable rate(FAVR) allowance. This is an allowance thatincludes a combination of payments coveringfixed and variable costs, such as a cents-per-mile rate to cover your employees' vari-able operating costs (such as gas, oil, etc.)plus a flat amount to cover your employees'fixed costs (such as depreciation, insurance,etc.). For information on using a FAVR al-lowance, see Revenue Procedure 97–58 inthe 1997–52 Internal Revenue Bulletin. Youcan read Revenue Procedure 97–58 at manypublic libraries.

Per diem allowance. If your employee ac-tually substantiates to you the other elements(discussed earlier) of the expenses reim-bursed using the per diem allowance, howyou report and deduct the allowance dependson whether the allowance is for lodging andmeal expenses or for meal expenses only andwhether the allowance is more than the fed-eral rate. For allowances for lodging and mealexpenses, the federal rate can be figuredusing either of the following two methods:

1) The regular federal per diem rate (dis-cussed later), or

2) The high-low method (discussed later).

For an allowance for meal expenses only,the federal rate is the standard meal allow-ance (see chapter 1 in Publication 463). Youmay pay an allowance for meal expensesonly if, for example, you reimburse actuallodging expenses or do not reimburse lodgingexpenses because there are none.

Per diem allowance LESS than orEQUAL to the federal rate. If your per diemallowance for the employee is less than orequal to the appropriate federal rate, that al-lowance is not part of the employee's pay.Deduct the allowance as travel expenses (in-cluding meals that may be subject to the 50%limit, discussed later). See How to deductunder Accountable Plans, discussed earlier.

Per diem allowance MORE than thefederal rate. If your employee's per diemallowance is more than the appropriate fed-eral rate, you must report the allowance astwo separate items.

You include the allowance amount up tothe federal rate in box 13 (code L) of theemployee's Form W–2. Deduct it as travelexpenses (as explained above). This part ofthe allowance is treated as reimbursed underan accountable plan.

You include the allowance amount that ismore than the federal rate in box 1 (and inboxes 3 and 5 if they apply) of the employee'sForm W–2. Deduct it as wages subject to in-come tax withholding, social security, Medi-care, and federal unemployment taxes. Thispart of the allowance is treated as reimbursedunder a nonaccountable plan as explainedlater under Nonaccountable Plans.

Regular federal per diem rate. Theregular federal per diem rate is the highestamount that the federal government will payto its employees for lodging, meal, and inci-dental expenses (or meal and incidental ex-penses only) while they are traveling awayfrom home in a particular area. The rates are

different for different locations. Publication1542 lists the rates in the continental U.S.

The federal rates for meal and incidentalexpenses are the same as those rates dis-cussed under Standard Meal Allowance inchapter 1 in Publication 463.

High-low method. This is a simplifiedmethod of computing the federal per diemrate for lodging and meal expenses for trav-eling within the continental United States. Iteliminates the need to keep a current list ofthe per diem rate in effect for each city in thecontinental United States.

Under the high-low method, the per diemamount for travel during 1998 is $180 forcertain locations. All other areas have a perdiem amount of $113. The areas eligible forthe $180 per diem amount under the high-lowmethod are listed in Publication 1542.

Meals and EntertainmentUnder an accountable plan, you can generallydeduct only 50% of any otherwise deductiblebusiness-related meal and entertainment ex-penses that you reimburse your employees.The deduction limit applies even if you reim-burse them for 100% of the expenses.

Application of the 50% limit. The 50% de-duction limit applies to reimbursements youmake to your employees for expenses theyincur while traveling away from home onbusiness and for entertaining business cus-tomers at your place of business, a restau-rant, or other location. It applies to attendinga business convention or reception, businessmeeting, or business luncheon at a club. Thededuction limit may also apply to meals youfurnish on your premises to your employees(discussed in chapter 3).

Related expenses. Taxes and tips relat-ing to a meal or entertainment activity that youreimburse to your employee under an ac-countable plan are included in the amountthat is subject to the 50% limit. Reimburse-ments you make for expenses, such as covercharges for admission to a nightclub, rentpaid for a room to hold a dinner or cocktailparty, or the amount you pay for parking at asports arena, are all subject to the 50% limit.However, the cost of transportation to andfrom a business meal or entertainment activitythat is otherwise allowable is not subject tothe 50% limit.

How to apply the 50% limit. If you provideyour employees with a per diem allowance(discussed earlier) only for meal and inci-dental expenses, the amount treated as anexpense for food and beverages is the lesserof:

1) The per diem allowance, or

2) The federal meal and incidental expenserate (M & IE).

If you provide your employee with a per diemallowance that covers lodging, meals, andincidental expenses, you must treat anamount equal to the federal M & IE rate forthe area of travel as an expense for food andbeverages. If you use the high-low method,the federal M & IE rate is treated as $40 fora high-cost locality and $32 for any other lo-cality. If the per diem allowance you providefor a full day of travel is less than the federalper diem rate for the area of travel, you cantreat 40% of the per diem allowance as theamount for food and beverages.

Drilling rigs. The 50% limit does not applyto the food or beverages an employer pro-vides on an oil or gas platform or drilling riglocated offshore or in Alaska. This exceptionalso applies to food and beverages providedby an employer at a support camp that is nearand integral to an oil or gas drilling rig locatedin Alaska.

Meal expenses when subject to “hours ofservice” limits. Beginning in 1998, you candeduct 55% of the reimbursed meals youremployees consume while away from theirtax home on business during or incident toany period subject to the Department ofTransportation's hours of service limits. Thepercentage remains 55% for 1999, and itgradually increases to 80% by the year 2008.

Individuals subject to the Department ofTransportation's hours of service limits in-clude the following:

1) Certain air transportation workers (suchas pilots, crew, dispatchers, mechanics,and control tower operators) who areunder Federal Aviation Administrationregulations,

2) Interstate truck operators and bus driv-ers who are under Department ofTransportation regulations,

3) Certain railroad employees (such as en-gineers, conductors, train crews, dis-patchers, and control operations per-sonnel) who are under Federal RailroadAdministration regulations, and

4) Certain merchant mariners who are un-der Coast Guard regulations.

De minimis (minimal) fringe benefit. The50% limit does not apply to an expense forfood or beverage that is excluded from thegross income of an employee because it is ade minimis fringe benefit. See chapter 4 foradditional information on de minimis fringebenefits.

Company cafeteria or executive diningroom. You can deduct the cost of food andbeverages you provide primarily to your em-ployees on your business premises. This in-cludes the cost of maintaining the facilities forproviding the food and beverages. These ex-penses are subject to the 55% limit unlessthey qualify as de minimis fringe benefits,discussed in chapter 4.

Employee activities. You can deduct theexpense of providing recreational, social, orsimilar activities (including the use of a facil-ity) for your employees. The benefit must beprimarily for your employees who are nothighly compensated employees. The defi-nition of highly compensated employee is thesame as the one given in chapter 4 underExclusion of Certain Fringe Benefits, with thefollowing exceptions.

• An employee owning less than a 10%interest in your business is not consid-ered a shareholder or other owner.

• An employee is treated as owning anyinterest owned by a family member.Family members include brothers, sis-ters, a spouse, ancestors, and lineal de-scendants.

These expenses are not subject to the50% limit. For example, the expenses forfood, beverages, and entertainment for a


company-wide picnic are not subject to the50% limit.

Nonaccountable PlansA nonaccountable plan is an arrangementthat does not meet the requirements for anaccountable plan. All amounts paid, or treatedas paid, under a nonaccountable plan arereported as wages on Form W–2. The pay-ments are subject to income tax withholding,social security, Medicare, and federal unem-ployment taxes. You can deduct the re-imbursement as compensation or wages onlyto the extent it meets the deductibility tests foremployees' pay in chapter 2. Deduct the al-lowable amount as compensation or wageson the appropriate line of your income taxreturn, as provided in its instructions.

Other Reimbursed ExpensesYou may provide meals and entertainmentexpenses to individuals who are not youremployees. These expenses may or may notbe subject to the 50% limit, depending on thecircumstances.

Nonemployee. If you provide a person whois not your employee with meals, goods, ser-vices, or the use of a facility and the item youprovide is considered entertainment, you candeduct the expense only to the extent it isincluded in the gross income of the recipientas compensation for services or as a prizeor award. If you are required to include theseexpenses on an information return (Form1099–MISC), you cannot claim a deductionfor them unless you file the necessary infor-mation return. For more information aboutwhen to file Form 1099–MISC, see the sepa-rate Instructions for Forms 1099, 1098, 5498,and W–2G. These expenses are not subjectto the 50% limit.

Director, stockholder, or employeemeetings. You can deduct entertainmentexpenses directly related to businessmeetings of your employees, partners, stock-holders, agents, or directors. You can providesome minor social activities, but the mainpurpose of the meeting must be your com-pany's business. These expenses are subjectto the 50% limit.

Trade association meetings. You can de-duct expenses directly related to and neces-sary for attending business meetings or con-ventions of certain exempt organizations.These organizations include businessleagues, chambers of commerce, real estateboards, and trade and professional associ-ations. These expenses are subject to the50% limit.

Sale of meals or entertainment. You candeduct the cost of providing meals, enter-tainment, goods and services, or use of facil-ities that you sell to the public. For example,if you run a nightclub, your expense for theentertainment you furnish to your customers,such as a floor show, is a business expense.These expenses are not subject to the 50%limit.

Advertising to promote goodwill. You candeduct the cost of providing meals, enter-tainment, or recreational facilities to the gen-eral public as a means of advertising or pro-moting goodwill in the community. Forexample, the expense of sponsoring a tele-

vision or radio show is deductible. You canalso deduct the expense of distributing freefood and beverages to the general public.These expenses are not subject to the 50%limit.

Charitable sports event. The 50% limitdoes not apply to the expenses covered bya package deal that includes a ticket to acharitable sports event if the event meetscertain conditions. See Entertainment ticketsin chapter 2 of Publication 463 for a list of theconditions a charitable sports event mustmeet.

MiscellaneousExpensesIn addition to travel, meal, and entertainmentexpenses, there are other expenses that youcan deduct. This section briefly covers someof these expenses (listed in alphabetical or-der).

Advertising expenses. You generally candeduct reasonable advertising expenses ifthey relate to your business activities. Gen-erally, you cannot deduct the cost of adver-tising to influence legislation. See Lobbyingexpenses, later.

You can usually deduct as a businessexpense the cost of institutional or “goodwill” advertising to keep your name before thepublic if it relates to business you reasonablyexpect to gain in the future. For example, thecost of advertising that encourages people tocontribute to the Red Cross, to buy U.S.saving bonds, or to participate in similarcauses is usually deductible.

Foreign expenses. You cannot deductthe costs of advertising on foreign radio andtelevision (including cable) where the adver-tising is primarily for a market in the UnitedStates. However, this rule only applies to ad-vertising expenses in countries that deny adeduction for advertising on a United Statesbroadcast primarily for that country's market.

Anticipated liabilities. Anticipated liabilitiesor reserves for anticipated liabilities are notdeductible. For example, assume you soldone-year TV service contracts this year total-ing $50,000. From experience, you know youwill have expenses of about $15,000 in thecoming year for these contracts. You cannotdeduct any of the $15,000 this year bycharging expenses to a reserve or liabilityaccount. You can deduct your expenses onlywhen you actually pay or accrue them, de-pending on your accounting method.

Black lung benefit trust contributions. Ifyou, as a coal mine operator, make a contri-bution to a qualified black lung benefit trust,you may be able to deduct your contribution.To be deductible, you must make your con-tribution during the tax year or pay it to thetrust by the due date for filing your federalincome tax return (including extensions). Youmust make the contribution in cash or inproperty the trust is permitted to hold.

Figure your allowable deduction for con-tributions to a black lung benefit trust onSchedule A of Form 6069.

Bribes and kickbacks. You cannot deductbribes, kickbacks, or similar payments if theyare either of the following.

1) Payments directly or indirectly to an offi-cial or employee of any government oran agency or instrumentality of any gov-ernment in violation of the law. If thegovernment is a foreign government, thepayments are not deductible if they areunlawful under the Foreign CorruptPractices Act of 1977.

2) Payments directly or indirectly to a per-son in violation of any federal or statelaw (but only if that state law is generallyenforced) that provides for a criminalpenalty or for the loss of a license orprivilege to engage in a trade or busi-ness.

Meaning of “generally enforced.” Astate law is considered generally enforcedunless it is never enforced or enforced onlyfor infamous persons or persons whose vio-lations are extraordinarily flagrant. For exam-ple, a state law is generally enforced unlessproper reporting of a violation of the law re-sults in enforcement only under unusual cir-cumstances.

Kickbacks. A kickback includes a pay-ment for referring a client, patient, or cus-tomer. The common kickback situation occurswhen money or property is given to someoneas payment for influencing a third party topurchase from, use the services of, or other-wise deal with the person who pays thekickback. In many cases, the person whosebusiness is being sought or enjoyed by theperson who pays the kickback does not knowof the payment.

Example 1. Mr. Green, an insurancebroker, pays part of the insurance commis-sions he earns to car dealers who refer in-surance customers to him. The car dealersare not licensed to sell insurance. Mr. Greencannot deduct these payments if they are inviolation of any federal or state law as ex-plained previously in (2).

Example 2. The Yard Corporation is inthe business of repairing ships. It returns10% of the repair bills as kickbacks to thecaptains and chief officers of vessels it re-pairs. It considers kickbacks necessary to getbusiness. The owners of the ships do notknow of these payments.

In the state where the corporation oper-ates, it is unlawful to attempt to influence theactions of any employee, private agent, orfiduciary in relation to the principal's or em-ployer's affairs by giving or offering anythingof value without the knowledge and consentof the principal or employer. The state gen-erally enforces the law. The kickbacks paidby the Yard Corporation are not deductible.

Medicare or Medicaid. Kickbacks,bribes, and rebates paid in Medicare orMedicaid programs are not deductible.

Form 1099–MISC. If you pay kickbacksduring your tax year, whether or not they aredeductible on your return, include them whenfiguring if you must file an information return,Form 1099–MISC. For more informationabout when to file Form 1099–MISC, see theseparate Instructions for Forms 1099, 1098,5498, and W–2G.

Car and truck expenses. You can deductthe cost of operating a car, truck, or othervehicle in your business. These costs includegas, oil, repairs, license tags, insurance, anddepreciation. Only the expenses for businessuse are deductible. Traveling between your


home and your place of business is not busi-ness use.

Under certain conditions, you can use thestandard mileage rate instead of deductingthe actual expenses for your vehicle. Thestandard mileage rate for 1998 is 32.5 centsa mile for all business miles put on a car, van,pick-up, or panel truck you own or lease. Formore information on how to figure your de-duction, see Publication 463.

Charitable contributions. Cash paymentsto charitable, religious, educational, scientific,or similar organizations may be deductible asbusiness expenses if the payments are notcharitable contributions or gifts. If the pay-ments are charitable contributions or gifts,you cannot deduct them as business ex-penses. However, corporations can deductcharitable contributions on their income taxreturns. See Charitable Contributions in Pub-lication 542 for more information. Individuals,partners in a partnership, or shareholders inan S corporation may be able to deductcharitable contributions made by their busi-ness on their individual income tax returns.

Example. You paid $15 to a local churchfor a half-page ad in a program for a concertit is sponsoring. The purpose of the ad wasto encourage readers to buy your products.Since your payment is not a contribution, youcannot deduct it as such. However, you candeduct it as an advertising expense.

Inventory. You can take a charitablecontribution deduction for inventory items do-nated to a qualified charitable organization.Your deduction is limited to the fair marketvalue of the property on the date of the con-tribution less any gain you would have real-ized if you had sold the property at its fairmarket value. You must remove from openinginventory (for the year you make the contri-bution) any costs for the donated propertyincluded from prior years. These costs are notpart of the cost of goods sold for determininggross income for the year of the contribution.Use them in figuring the basis of the donatedproperty. However, you can include (as partof the cost of goods sold) costs in the yearof the contribution if you treat them as partof the cost of goods sold under your ac-counting method. Do not use these costs toincrease the basis of the donated property.

Example 1. You own an auto repair shopand in 1998 you donated auto parts to yourlocal school for its auto repair class. The fairmarket value of the parts at the time of thecontribution was $600 and you had included$400 for the parts in your opening inventoryfor 1998. Your charitable contribution is $400,determined as follows:

You reduce your opening inventory by the$400 for the donated property.

Example 2. Assume the same facts asExample 1, except you purchased the autoparts in 1998 for $400 (not part of the openinginventory). The $400 is included as part of thecost of goods sold for 1998 but not in figuringthe basis of the property. Your charitablecontribution is $0, determined as follows:

Damages recovered. Special rules apply tocompensation you receive for damages sus-tained as a result of patent infringement,breach of contract or fiduciary duty, or anti-trust violations. You must include this com-pensation in your income. However, you maybe able to take a special deduction. The de-duction applies only to amounts recovered foractual injury, not any additional amount. Thededuction is the smaller of:

1) The amount you received or accrued fordamages in the tax year reduced by theamount you paid or incurred in the yearto recover that amount, or

2) Your losses from the injury you have notdeducted.

Demolition expenses or losses. You can-not deduct any amount paid or incurred todemolish a structure or any loss for the un-depreciated basis of a demolished structure.Add these amounts to the basis of the landwhere the demolished structure was located.

Depreciation. If property you buy to use inyour business has a useful life longer thanone year, you generally cannot deduct theentire cost as a business expense in the yearyou buy it. You must spread the cost overmore than one tax year and deduct part of iteach year. This method of deducting the costof business property is called depreciation.

However, you can choose to deduct alimited amount of the cost of certain depre-ciable property in the year you place it inservice in your business. This is referred toas a “section 179 deduction.”

For information on depreciation and thesection 179 deduction, see Publication 946.

Dues and subscriptions. Generally, youcannot deduct amounts you pay or incur formembership in any club organized for busi-ness, pleasure, recreation, or any other socialpurpose. This includes country clubs, athleticclubs, luncheon clubs, sporting clubs, airlineclubs, and hotel clubs.

Exception. Unless a main purpose is toconduct entertainment activities for membersor their guests or to provide members or theirguests with access to entertainment facilities,the following organizations will not be treatedas clubs organized for business, pleasure,recreation, or other social purpose.

1) Boards of trade.

2) Business leagues.

3) Chambers of commerce.

4) Civic or public service organizations.

5) Professional organizations such as barassociations and medical associations.

6) Real estate boards.

7) Trade associations.

You can deduct as a business expensesubscriptions to professional, technical, andtrade journals that deal with your businessfield.

Donations to business organizations. Youcan deduct donations to business organiza-tions as business expenses if all the followingconditions are met.

• The donation relates directly to your tradeor business.

• You reasonably expect a financial returnin line with your donation.

• The donation is not a nondeductible lob-bying expense as discussed later underLobbying expenses.

For example, a donation you make to acommittee organized by the Chamber ofCommerce to bring a national convention toyour city may be deductible.

Education expenses. You can deduct theordinary and necessary expenses you pay forthe education and training of your employees.For more information, see Education Ex-penses in chapter 2.

You can also deduct your own educationexpenses (including certain related travel)that are related to your trade or business. Youmust be able to show the education maintainsor improves skills required in your trade orbusiness, or it is required by law or regu-lations for keeping your pay, status, or job.

You cannot deduct education expensesyou incur to meet the minimum requirementsof your present trade or business, or thosethat qualify you for a new trade or business.This is true even if the education maintainsor improves skills presently required in yourbusiness.

Example 1. Dr. Carter, who is a psychi-atrist, begins a program of study at an ac-credited psychoanalytic institute to qualify asa psychoanalyst. She can deduct the cost ofthe program because the study maintains orimproves skills required in her profession anddoes not qualify her for a new one.

Example 2. Herb Jones owns a repairshop for electronic equipment. The bulk ofthe business is television repairs, but occa-sionally he fixes tape decks and disc players.To keep up with the latest technical changes,he takes a special course to learn how to re-pair disc players. Since the course maintainsand improves skills required in his trade, hecan deduct its cost.

Example 3. Peter Green, an architect inNew York, decided to take a special 2-weekcourse in Los Angeles on the latest buildingtechniques. While there, he spent an extra 8weeks on personal activities. The time hespent on personal activities indicates his mainreason for going to Los Angeles was to takea vacation. He can deduct his education ex-penses and meals and lodging for the 2weeks he attended the course. He cannotdeduct his round trip transportation expenseto Los Angeles or any of the expenses for the8 weeks spent on personal activities.

Environmental cleanup costs. You candeduct certain costs to clean up land and totreat groundwater that you contaminated withhazardous waste from your business oper-ations. You can deduct the costs you incur torestore your land and groundwater to thesame physical condition that existed prior tocontamination. You cannot deduct costs forthe construction of groundwater treatment fa-cilities. You must capitalize those costs andyou can recover them through depreciation.

Franchise, trademark, trade name. If youbuy a franchise, trademark, or trade name,you can deduct the amount you pay or incurfor the transfer as a business expense onlyif the payments are part of a series of pay-ments that are:

Fair market value ............................................ $600Minus: Gain if sold ($600 − $400 basis) ........ 200

Charitable contribution ................................ $400

Fair market value ............................................ $600Minus: Gain if sold ($600 − $0 basis) ............ 600

Charitable contribution ................................ $0


1) Contingent on productivity, use, or dis-position of the item,

2) Payable at least annually for the entireterm of the transfer agreement, and

3) Substantially equal in amount (or paya-ble under a fixed formula).

When determining the term of the transferagreement, include all renewal options andany other period for which you and thetransferor reasonably expect the agreementto be renewed.

A franchise includes an agreement thatgives one of the parties to the agreement theright to distribute, sell, or provide goods, ser-vices, or facilities within a specified area.

Property acquired after August 10,1993 (or after July 25, 1991, if elected). Anyamounts you pay or incur for the transfer thatare not described in (1) through (3) abovemust be charged to a capital account. Theseare “section 197 intangibles” and are amor-tized over 15 years. See chapter 12 for moreinformation on amortization.

You can also elect to apply this sametreatment to any franchise, trademark, ortrade name acquired after July 25, 1991. Thiselection is binding and cannot be revokedwithout consent from the IRS.

Property acquired before August 11,1993. For a transfer not treated as a sale orexchange of a capital asset, you can deducta lump-sum payment of an agreed uponprincipal amount ratably over the shorter of:

1) 10 years, or

2) The period of the transfer agreement.

For a transfer not treated as a sale or ex-change of a capital asset, you can deduct, inthe year made, a payment that is one of aseries of approximately equal payments pay-able over:

1) The period of the transfer agreement, or

2) A period of more than 10 years, regard-less of the period of the agreement.

CAUTION!

The above business deductions donot apply to transfers after October2, 1989, and before August 11, 1993,

if the principal sum is over $100,000.

Charge any payment not deductible be-cause of these rules to a capital account.However, you can deduct the paymentscharged to a capital account over the life ofthe asset if you can determine the useful lifeof the asset. Otherwise, you can amortize thepayment over a 25-year period beginning withthe tax year the transfer occurs.

Contracts entered into before October3, 1989. For contracts to buy a franchise,trademark, or trade name entered into beforeOctober 3, 1989, you can deduct paymentscontingent on productivity, use, or disposition.The rules discussed earlier for annual andsubstantially equal payments do not apply.

Recapture. You must recapture the pay-ments as ordinary income if you transfer, sell,or otherwise dispose of a franchise, trade-mark, or trade name for which payments werededucted as:

1) A lump-sum or serial payment of a prin-cipal amount not treated as a sale orexchange of an asset,

2) An amortized payment deducted over 25years, or

3) The amortization claimed on section 197intangibles.

Interview expense allowances. Re-imbursements you make to job candidates fortransportation or other expenses related tointerviews for possible employment are notwages. They are not subject to social securityand Medicare taxes (FICA), federal unem-ployment taxes (FUTA), or the withholding ofincome tax. You can deduct the reimburse-ments as a business expense. However, ex-penses for food, beverages, and enter-tainment are subject to the 50% limitdiscussed earlier under Meals and Enter-tainment.

Legal and professional fees. Legal andprofessional fees, such as fees charged byaccountants, that are ordinary and necessaryexpenses directly related to operating yourbusiness are deductible as business ex-penses. However, you usually cannot deductlegal fees you pay to acquire business assets.Add them to the basis of the property.

If the fees include payments for work of apersonal nature (such as making a will), youtake a business deduction only for the partof the fee related to your business. The per-sonal portion of legal fees for producing orcollecting taxable income, doing or keepingyour job, or for tax advice may be deductibleon Schedule A (Form 1040) if you itemizedeductions. See Publication 529.

Tax preparation fees. You can deductas a trade or business expense the cost ofpreparing that part of your tax return relatingto your business as a sole proprietor. Theremaining cost is deductible on Schedule A(Form 1040) if you itemize your deductions.

You can also take a business deductionfor the amount you pay or incur in resolvingasserted tax deficiencies for your businessas a sole proprietor.

Licenses and regulatory fees. Licensesand regulatory fees for your trade or businesspaid each year to state or local governmentsgenerally are deductible. Some licenses andfees may have to be amortized. See chapter12 for more information.

Lobbying expenses. Generally, you cannotdeduct lobbying expenses. Lobbying ex-penses include amounts paid or incurred forany of the following activities.

• Influencing legislation.

• Participating, or intervening, in any poli-tical campaign for, or against, any candi-date for public office.

• Attempting to influence the general pub-lic, or segments of the public, aboutelections, legislative matters, or referen-dums.

• Communicating directly with coveredexecutive branch officials (defined later)in any attempt to influence the officialactions or positions of such officials.

• Researching, preparing, planning, or co-ordinating any of the preceding activities.

Your expenses for influencing legislationand communicating directly with a coveredexecutive branch official include a portion ofyour labor costs and general and administra-tive costs of your business. For informationon making this allocation, see section1.162-28 of the income tax regulations.

You cannot take a charitable deductionor business expense for amounts paid to anorganization described in section 170(c) ofthe Internal Revenue Code if:

1) The organization conducts lobbying ac-tivities on matters of direct financial in-terest to your business, and

2) A principal purpose of your contributionis to avoid the rules discussed earlierthat prohibit a business deduction forlobbying expenses.

If a tax-exempt organization, other than asection 501(c)(3) organization, provides youwith a notice on the portion of dues that areallocable to nondeductible lobbying and poli-tical expenses, you cannot deduct that portionof the dues.

Covered executive branch official. Forpurposes of this discussion, a covered exec-utive branch official includes:

1) The President,

2) The Vice President,

3) Any officer or employee of the WhiteHouse Office of the Executive Office ofthe President, and the two most seniorlevel officers of each of the other agen-cies in the Executive Office,

4) Any individual who:

a) Is serving in a position in Level I ofthe Executive Schedule under sec-tion 5312 of title 5, United StatesCode,

b) Has been designated by the Presi-dent as having Cabinet-level status,or

c) Is an immediate deputy of an indi-vidual listed in items (a) or (b)above.

Exceptions to denial of deduction. Thegeneral denial of the deduction does not ap-ply to:

1) Expenses of appearing before, or com-municating with, any local council orsimilar governing body concerning itslegislation (local legislation) if the leg-islation is of direct interest to you or toyou and an organization of which youare a member. An Indian tribal govern-ment is treated as a local council orsimilar governing body.

2) Any in-house expenses for influencinglegislation and communicating directlywith a covered executive branch officialif those expenses for the tax year do notexceed $2,000 (excluding overhead ex-penses).

3) Expenses incurred by taxpayers en-gaged in the trade or business of lobby-ing (professional lobbyists) on behalfof another person (but does apply topayments by the other person to thelobbyist for lobbying activities).

Impairment-related expenses. If you aredisabled, you can deduct expenses neces-sary for you to be able to work (impairment-related expenses) as a business expense,rather than as a medical expense.

You are disabled if you have:

1) A physical or mental disability (for ex-ample, blindness or deafness) that func-tionally limits your being employed, or


2) A physical or mental impairment thatsubstantially limits one or more of yourmajor life activities.

You can deduct the expense as a busi-ness expense if:

1) Your work clearly requires the expensefor you to satisfactorily perform the work,

2) The goods or services purchased areclearly not needed or used, other thanincidentally, in your personal activities,and

3) Their treatment is not specifically pro-vided for under other tax law provisions.

Example. You are blind. You must usea reader to do your work, both at and awayfrom your place of work. The reader's ser-vices are only for your work. You can deductyour expenses for the reader as a businessexpense.

Moving machinery. Generally, the cost ofmoving your machinery from one city to an-other is a deductible expense. So is the costof moving machinery from one plant to an-other, or from one part of your plant to an-other. You can deduct the cost of installingthe machinery in the new location. However,you must capitalize the costs of installing ormoving newly purchased machinery.

Outplacement services. You can deduct thecosts of outplacement services you provideto your employees to help them find newemployment (such as career counseling, re-sume assistance, skills assessment, etc.).

The costs of outplacement services maycover more than one deduction category. Forexample, deduct as a utilities expense thecost of telephone calls made under this ser-vice, and deduct as rental expense the costof renting machinery and equipment for thisservice.

Penalties and fines. Penalties you pay forlate performance or nonperformance of acontract are generally deductible. For in-stance, if you contracted to construct a build-ing by a certain date and had to pay anamount for each day the building was notfinished after that date, you can deduct theamounts paid or incurred.

On the other hand, you cannot deductpenalties or fines you pay to any governmentagency or instrumentality because of a vio-lation of any law. These fines or penalties in-clude the following amounts.

1) Paid because of a conviction for a crimeor after a plea of guilty or no contest ina criminal proceeding.

2) Paid as a penalty imposed by federal,state, or local law in a civil action, in-cluding certain additions to tax and ad-ditional amounts and assessable penal-ties imposed by the Internal RevenueCode.

3) Paid in settlement of actual or possibleliability for a fine or penalty, whether civilor criminal.

4) Forfeited as collateral posted for a pro-ceeding that could result in a fine orpenalty.

Examples of nondeductible penalties andfines include the following.

1) Fines for violating city housing codes.

2) Fines paid by truckers for violating statemaximum highway weight laws and airquality laws.

3) Civil penalties for violating federal lawsregarding mining safety standards anddischarges into navigable waters.

A fine or penalty does not include the fol-lowing.

1) Legal fees and related expenses to de-fend yourself in a prosecution or civilaction for a violation of the law imposingthe fine or civil penalty.

2) Court costs or stenographic and printingcharges.

3) Compensatory damages paid to a gov-ernment.

Nonconformance penalty. You can de-duct a nonconformance penalty assessed bythe Environmental Protection Agency for fail-ing to meet certain emission standards.

Political contributions. You cannot deductcontributions or gifts to political parties orcandidates as business expenses. In addi-tion, you cannot deduct expenses you pay orincur to take part in any political campaign ofa candidate for public office.

Indirect political contributions. Youalso cannot deduct indirect political contribu-tions and costs of taking part in political ac-tivities as business expenses. Examples ofnondeductible expenses include the following.

1) Advertising in a convention program ofa political party, or in any other publica-tion if any of the proceeds from thepublication are for, or intended for, theuse of a political party or candidate.

2) Admission to a dinner or program (in-cluding, but not limited to, galas, dances,film presentations, parties, and sportingevents) if any of the proceeds from thefunction are for, or intended for, the useof a political party or candidate.

3) Admission to an inaugural ball, gala,parade, concert, or similar event if iden-tified with a political party or candidate.

Repairs. The cost of repairing or improvingproperty used in your trade or business is ei-ther a deductible or capital expense. You candeduct repairs that keep your property in anormal efficient operating condition, but thatdo not add to the value or usefulness ofproperty or appreciably lengthen its life. If therepairs add to the value or usefulness of yourproperty or significantly increase its life youmust capitalize them. Although you cannotdeduct capital expenditures as current ex-penses, you can usually deduct them over aperiod of time as depreciation.

TIPThe cost of repairs includes the costsof labor, supplies, and certain otheritems. You cannot deduct the value

of your own labor.

The following are examples of repairs.

• Patching and repairing floors.

• Repainting the inside and outside of abuilding.

• Repairing roofs and gutters.

• Mending leaks.

You cannot deduct the cost of repairs thatyou added to the cost of goods sold as aseparate business expense.

Repayments (claim of right). If you had torepay an amount that you had included inyour income in an earlier year because at thattime you thought you had an unrestricted rightto it, you can deduct the amount repaid fromyour income in the year in which you repayit.

Type of deduction. The type of deductionyou are allowed in the year of repayment de-pends on the type of income you included inthe earlier year. For instance, if you repay anamount that you previously reported as acapital gain, deduct the repayment as a cap-ital loss.

Repayment—$3,000 or less. If the amountyou repaid was $3,000 or less, deduct it fromyour income in the year you repaid it. If youreported it as wages, unemployment com-pensation, or other ordinary income, enter iton line 22 of Schedule A (Form 1040). If youreported it as a capital gain, deduct it onSchedule D (Form 1040).

Repayment—over $3,000. If the amount yourepaid was more than $3,000, you can takea deduction for the amount repaid (Method1) or you can take a credit against your tax(Method 2). Figure your tax under bothmethods and use the method that results inless tax.

Method 1. Figure your tax for 1998claiming a deduction for the repaid amount.

Method 2. Follow these steps.

1) Figure your tax for 1998 without de-ducting the repaid amount.

2) Refigure your tax from the earlier yearwithout including in income the amountyou repaid in 1998.

3) Subtract the tax in (2) from the tax shownon your return for the earlier year. Thisis the credit.

4) Subtract the answer in (3) from the taxfor 1998 figured without the deduction(step 1).

If the amount from Method 1 is less tax,deduct the amount repaid on the same formor schedule on which you previously reportedit. For example, if you reported it as self-employment income, deduct it as a businessdeduction on Schedule C or Schedule C-EZ(Form 1040). If you reported it as wages, de-duct it as an individual deduction on line 27of Schedule A (Form 1040).

If using Method 2 results in less tax, claimthe credit on line 63 of Form 1040, and write“I.R.C. 1341” next to line 63.

Example. For 1997 you filed a return andreported your income on the cash method. In1998 you repaid $5,000 included in your 1997gross income under a claim of right. Your fil-ing status in 1998 and 1997 is single. Yourincome and tax for both years are as follows:


Your tax under method (1) is $9,298. Your taxunder method (2) is $9,948, figured as fol-lows:

Because you pay less tax under method (1),you should take a deduction for the repay-ment in 1998.

Repayment does not apply. This discussiondoes not apply to the following.

1) Deductions for bad debts.

2) Deductions from sales to customers,such as returns and allowances, andsimilar items.

3) Deductions for legal and other expensesof contesting the repayment.

Year payment deducted. If you use thecash method, you can take the deduction forthe tax year in which you actually make therepayment. If you included the amount in in-come because of the rule of constructive re-ceipt, but never received it, you can deductthe amount in the tax year you must give upyour right to receive it. If you use any otheraccounting method, you can deduct the re-payment only for the tax year in which it is aproper deduction under your accountingmethod. For example, if you use an accrualmethod, you are entitled to the deduction inthe tax year in which the obligation for therepayment accrues.

Accounting for repayments. If you usethe cash method of accounting, you can claimthe deduction only in the year the income itemis repaid. If you included the amount in in-come because of the rule of constructive re-ceipt, but never received it, you can deductthe amount in the tax year you must give upyour right to receive it. If you use any otheraccounting method, you can deduct the re-payment only in the proper tax year under thataccounting method.

Supplies and materials. Unless you havededucted the cost in any earlier year, yougenerally can deduct the cost of materials andsupplies actually consumed and used duringthe tax year.

If you keep incidental materials and sup-plies on hand, you can deduct the cost of theincidental materials and supplies you boughtduring the tax year if all three of the followingrequirements are met.

1) You do not keep a record of when theyare used.

2) You do not take an inventory of theamount on hand at the beginning andend of the tax year.

1997With Income

1997Without Income

3) This method does not distort your in-come.

You can also deduct the cost of books,professional instruments, equipment, etc., ifyou normally use them up in less than a year.

Utilities. Your business expenses for heat,lights, power, and telephone are deductible.However, any part due to personal use is notdeductible.

Telephone. If you have an office in yourhome, even though you are in business, youcannot deduct the cost of basic local tele-phone service (including any taxes) for thefirst telephone line you have in your home.

Cellular telephone. Generally, any cel-lular telephone or similar telecommunicationsequipment is listed property. If listed propertyis not used more than 50% for qualified busi-ness use during any tax year, special rulesapply to the section 179 deduction and thedepreciation deduction. See chapter 4 ofPublication 946.

17.How To GetMoreInformation

You can order free publications and forms,ask tax questions, and get more informationfrom the IRS in several ways. By selecting themethod that is best for you, you will havequick and easy access to tax help.

Free tax services. To find out what servicesare available, get Publication 910, Guide toFree Tax Services. It contains a list of free taxpublications and an index of tax topics. It alsodescribes other free tax information services,including tax education and assistance pro-grams and a list of TeleTax topics.

Personal computer. With your per-sonal computer and modem, you canaccess the IRS on the Internet at

www.irs.ustreas.gov . While visiting our WebSite, you can select:

• Frequently Asked Tax Questions to findanswers to questions you may have.

• Fill-in Forms to complete tax forms on-line.

• Forms and Publications to downloadforms and publications or search publi-cations by topic or keyword.

• Comments & Help to e-mail us withcomments about the site or with taxquestions.

• Digital Dispatch and IRS Local News Netto receive our electronic newsletters onhot tax issues and news.

You can also reach us with your computerusing any of the following.

• Telnet at iris.irs.ustreas.gov

• File Transfer Protocol atftp.irs.ustreas.gov

• Direct dial (by modem) 703–321–8020

TaxFax Service. Using the phoneattached to your fax machine, you canreceive forms, instructions, and tax

information by calling 703–368–9694. Followthe directions from the prompts. When youorder forms, enter the catalog number for theform you need. The items you request will befaxed to you.

Phone. Many services are availableby phone.

• Ordering forms, instructions, and publi-cations. Call 1–800–829–3676 to ordercurrent and prior year forms, instructions,and publications.

• Asking tax questions. Call the IRS withyour tax questions at 1–800–829–1040.

• TTY/TDD equipment. If you have accessto TTY/TDD equipment, call 1–800–829–4059 to ask tax questions or to orderforms and publications.

• TeleTax topics. Call 1–800–829–4477 tolisten to pre-recorded messages coveringvarious tax topics.

Evaluating the quality of our telephoneservices. To ensure that IRS representativesgive accurate, courteous, and professionalanswers, we evaluate the quality of our tele-phone services in several ways.

• A second IRS representative sometimesmonitors live telephone calls. That persononly evaluates the IRS assistor and doesnot keep a record of any taxpayer's nameor tax identification number.

• We sometimes record telephone calls toevaluate IRS assistors objectively. Wehold these recordings no longer than oneweek and use them only to measure thequality of assistance.

• We value our customers' opinions.Throughout this year, we will be survey-ing our customers for their opinions onour service.

Walk-in. You can pick up certainforms, instructions, and publicationsat many post offices, libraries, and

IRS offices. Some libraries and IRS officeshave an extensive collection of productsavailable to print from a CD-ROM or photo-copy from reproducible proofs.

Mail. You can send your order forforms, instructions, and publicationsto the Distribution Center nearest to

you and receive a response 7 to 15 workdaysafter your request is received. Find the ad-dress that applies to your part of the country.

• Western part of U.S.: Western Area Distribution CenterRancho Cordova, CA 95743–0001

• Central part of U.S.: Central Area Distribution Center

TaxableIncome $15,000 $10,000

TaxLiability $ 2,254 $ 1,504

1998Without Deduction

1998With Deduction

TaxableIncome $49,950 $44,950

TaxLiability $10,698 $ 9,298

Tax previously determined for 1997 ........ $2,254Less: Tax as refigured ............................. − 1,504Decrease in 1997 tax $750Regular tax liability for 1998 .................... $10,698Less: Decrease in 1997 tax ..................... − 750Refigured tax for 1998 $9,948

Chapter 17 How To Get More Information

P.O. Box 8903Bloomington, IL 61702–8903

• Eastern part of U.S. and foreign ad-dresses:Eastern Area Distribution CenterP.O. Box 85074Richmond, VA 23261–5074

CD-ROM. You can order IRS Publi-cation 1796, Federal Tax Products onCD-ROM, and obtain:

• Current tax forms, instructions, and pub-lications.

• Prior-year tax forms, instructions, andpublications.

• Popular tax forms which may be filled inelectronically, printed out for submission,and saved for recordkeeping.

• Internal Revenue Bulletins.

The CD-ROM can be purchased from Na-tional Technical Information Service (NTIS)for $25.00 by calling 1–877–233–6767 or for$18.00 on the Internet at www.irs.ustreas.gov/cdorders. The first release is availablein mid-December and the final release isavailable in late January.

Index

AAccident and health plans, self-

insured .................................. 20 Accident plans ........................... 19 Accountable plan ....................... 64 Achievement award ..................... 7

Adoption assistance programs .. 22 Advertising ................................. 66 Amortization:

Anti-abuse rule ..................... 50 Anti-churning rules ............... 49 Bond premium ...................... 53

Corporate organization costs 51Dispositions of section 197 in-

tangibles .......................... 49 Experimental costs ............... 53

Going into businessexpenses ......................... 51

How to amortize ................... 52How to deduct ...................... 48Incorrect amount deducted .. 50

Partnership organizationcosts ................................ 51

Pollution control facilities ...... 53 Recapture of ......................... 51 Reforestation expenses ....... 52 Related person ..................... 50 Research costs .................... 53

Section 197 intangiblesdefined ............................ 48 Start-up costs ....................... 51

Anticipated liabilities .................. 66 Assessments, local .................... 39

Assistance (See More information) Attorney fees ............................. 68 Awards:

Deduction limit ........................ 7 Employee achievement .......... 7 Length-of-service .................... 7 Safety ..................................... 7

B Bad debts .................................. 58

Black lung payments ................. 66 Bond premium ........................... 53 Bonuses:

Employee ............................... 7 Royalties ............................... 58

Bribes ........................................ 66Business meal expenses .......... 65Business use of your car .......... 66

Business: Assets ..................................... 3 Bad debts ............................. 58

Books and records ............... 48Use of car ............................... 4Use of home ........................... 4

C Cafeteria plans .......................... 22 Campaign contribution .............. 69 Capital expenses ......................... 3

Capitalization of interest ............ 37

Car and truck expenses .... 3, 4, 66 Carrying charges ....................... 43 Cellular telephone ..................... 70 Cents-per-mile rule .................... 14 Charitable:

Contributions ........................ 67 Sports event ......................... 66

Child care (dependent care pro-gram) .................................... 23

Circulation costs, newspapers andperiodicals ............................ 45 Clean-fuel property .................... 61

Cleanup costs, environmental ... 67 Club dues .................................. 67 Commitment fees ...................... 36 Computer software .................... 49 Constant-yield method .............. 36 Contested liabilities ..................... 5 Contributions:

Charitable ............................. 67 Political ................................. 69

Copyrights ................................. 48Corporate franchise taxes ......... 40

Cost depletion ........................... 54Cost of getting lease ........... 32, 53Cost of goods sold ...................... 3Covenant not to compete .......... 49Credit, electric vehicle ............... 62

DDay care (dependent care pro-

gram) .................................... 23De minimis rule, OID ................. 35

Death benefits ............................. 6 Debt-financed:

Acquisitions .......................... 35 Distributions .......................... 35

Definitions: Achievement award ................ 7

Business bad debt ............... 58 Clean-burning fuel ................ 61

Clean-fuel vehicle property .. 61Clean-fuel vehicle refueling

property ........................... 61 Fringe benefit ....................... 11 Necessary expense ................ 3 Ordinary expense ................... 3

Qualified electric vehicle ...... 63 Related person ....................... 8 Restricted property ................. 9

Section 197 intangibles ........ 48Dependent care assistance ....... 23

Depletion: Deduction ............................. 54 Mineral property ................... 54

Oil and gas wells .................. 55 Percentage table .................. 57 Timber .................................. 58

Depreciation .............................. 67Development costs, miners ....... 45

Disabled:Dependent care program ..... 23

Improvements for ................. 45Drilling and development costs . 44

Dues, membership .................... 67

E Economic performance ............... 4 Education expenses .............. 9, 67 Educational assistanceprograms .............................. 24

Elderly, improvements for ......... 45Electric vehicle credit ................ 62Employee benefit programs:

Accident and health plans .... 19 Adoption assistance ............. 22 Cafeteria plans ..................... 22

Dependent care assistance . 23 Educational assistance ........ 24

Group-term life insurance .... 24Welfare benefit funds ........... 26 Employees' pay ........................... 6 Employment taxes ..................... 40 Entertainment tickets ................. 66

Environmental cleanup costs .... 67 Excise taxes .............................. 40 Experimentation costs ......... 44, 53 Exploration costs ....................... 44

F Fees:

Commitment ......................... 36Legal and professional ......... 68

Loan origination .................... 35 Regulatory ............................ 68

Tax return preparation ......... 68 Fines .......................................... 69 Franchise ............................. 49, 67 Franchise taxes ......................... 40

Free tax services ....................... 70 Fringe benefit:

Definitions ............................. 11 Exclusions ............................ 16 Nondiscrimination rules ........ 16 Valuation rules ..................... 12

Fuel taxes .................................. 40Fund, welfare benefit ................. 26

G Gas wells ................................... 57 Geothermal wells ................. 44, 57

Gifts, nominal value ..................... 7Going into business ............... 3, 51

Goodwill ..................................... 48Group health plans:

Continuation-of-coverage ..... 20 Other requirements .............. 20

Group-term life insurance .......... 24Guaranteed annual wage ............ 8

HHealth insurance, deduction for

self-employed ....................... 41 Health plans .............................. 19

Health plans, group ................... 20Help (See More information) Highly compensated employee . 16Hobby losses, not for profit ......... 5

How to deduct amortization ...... 48

I Improvements:

By lessee .............................. 33For disabled and elderly ...... 45To business assets ................ 3 Income taxes ............................. 40

Incorrect amount of amortizationdeducted ............................... 50

Individual retirement arrange-ments (IRAs) ........................ 31

Injury, pay for .............................. 8 Insurance:Accident and health plans .... 19

Capitalizing premiums .......... 43 Deductible premiums ........... 41 Group-term life ..................... 24 Nondeductible premiums ..... 42 Self-employed individuals .... 41

Intangible drilling costs .............. 44 Intangibles, amortization ........... 48

Interest you cannot deduct ........ 36 Interest:

Allocation of .......................... 33 Below-market ....................... 38

Business expense for ........... 33 Capitalized ...................... 36, 37 Carrying charge .................... 43 Deductible ............................ 35

Life insurance policies .......... 36 Refunds of ............................ 37

Interview expenses .................... 68Investment interest expense limit 37

IRAs ........................................... 31

K Keogh plans .............................. 28 Kickbacks .................................. 66

L Leases:Cost of getting ................ 32, 53Improvements by lessee ...... 33

Leveraged ............................ 32 Mineral .................................. 58

Oil and gas ........................... 58 Sales distinguished .............. 31 Taxes on .............................. 32

Legal and professional fees ...... 68 Licenses .............................. 49, 68 Loans:Below-market interest rate ... 38

Discounted ........................... 37 Origination fees .................... 35 To employees ......................... 7

Lobbying expenses ................... 68Lodging and meals ...................... 8

Lodging, employee ...................... 9Long-term care insurance ......... 41

Losses: Limits ...................................... 4 Not-for-profit rules .................. 5

MMaterials and supplies .............. 70Meals and entertainment ........... 65Meals and lodging ....................... 8

Meals, employee ......................... 9Medical expenses, business or

personal ................................ 68Medical reimbursement plans ... 19Medical savings accounts ......... 22

Mining: Depletion .............................. 57 Development costs ............... 45 Exploration costs .................. 44

Money purchase pension plan .. 28 More information ....................... 70 Mortgages:Cost of acquiring .................. 35

Interest ................................. 35 Moving expenses:

Employees .............................. 9 Machinery ............................. 69 Reimbursements .................. 19

N Natural gas ................................ 57 Necessary expense ..................... 3 Nonaccountable plan ................. 66 Nonqualifying intangibles .......... 49 Not-for-profit activities ................. 5

OOffice in home ............................. 4Oil and gas wells:

Depletion .............................. 55 Drilling costs ......................... 44 Partnerships ......................... 56 S corporation ........................ 57

Ordinary expense ........................ 3 Organization costs:

Corporate ............................. 51 Partnership ........................... 51

Outplacement services .............. 69

P Parking ...................................... 18 Payments:

In kind ..................................... 4 Restricted property ................. 9

Penalties: Deductible ............................ 69 Nondeductible ...................... 69 Prepayment .......................... 35

Percentage depletion ................ 54Personal property tax ................ 40

Points ......................................... 35 Political contributions ................. 69

Pollution control facilities ........... 53 Prepaid expenses:

General rule ........................... 5 Insurance .............................. 43 Interest ................................. 37 Rent ...................................... 31

Prepayment penalty .................. 35Problem Resolution Program ...... 1

Profit-sharing plans ................... 28Publications (See More information)

RReal estate taxes ...................... 39

Recapture: Amortization ......................... 51 Clean-fuel deductions .......... 62

Electric vehicle credit ........... 63 Exploration expenses ........... 44 Timber property .................... 53

Recordkeeping .................... 56, 57Recovery of amount deducted .... 4

Reforestation expenses ............. 52 Regulatory fees ......................... 68 Reimbursements:

Accountable plan .................. 64 Mileage ................................. 64 Moving expense ................... 19 Nonaccountable plan ........... 66 Per diem ............................... 64 Qualifying requirements ....... 64

Related persons: Anti-churning rules ............... 50

Clean-fuel vehicle deduction 61 Definition ................................ 8 Refiners ................................ 55 Unpaid salaries ...................... 8 Unreasonable rent ................ 31

Relatives as employees .............. 6Rent expense, capitalizing ........ 33

Repairs ...................................... 69Repayments (claim of right) ...... 69

Replacements .............................. 3 Research costs .................... 44, 53 Restricted property ...................... 9 Retirement plans:

Defined benefit ..................... 28 Defined contribution ............. 28 IRAs ...................................... 31 Keogh ................................... 28

Money purchase pension ..... 28 Nonqualified ......................... 31 Profit-sharing ........................ 28 Qualified ......................... 26, 27

Salary reduction arrangement 29Simplified employee pension

(SEP) ............................... 29Small business owners ........ 28

Stock bonus ......................... 28

SSalaries and wages ..................... 6

Sales taxes ................................ 40Self-employed, health insurance

deduction .............................. 41 Self-employment tax .................. 40 Self-insurance:Medical reimbursement plans 19

Reserve for ........................... 42 SIMPLE plans ............................ 30

Simplified employee pension(SEP) .................................... 29

Standard mileage rate ............... 64 Standby charges ....................... 36 Start-up costs ............................ 51

Stock bonus plan ....................... 28Stockholders as employees ........ 6

Subscriptions ............................. 67

Supplies and materials .............. 70

TTax help (See More information) Tax preparation fees ................. 68

Taxes: Carrying charge .................... 43 Corporate franchise .............. 40 Employment ......................... 40 Excise ................................... 40 Franchise .............................. 40 Fuel ...................................... 40 Income .................................. 40 Leased property ................... 32 Personal property ................. 40 Real estate ........................... 39 Sales .................................... 40 Unemployment fund ............. 40

Taxpayer Advocate ..................... 1Telephone, deducting cost ........ 70

Timber ................................. 52, 58Trademark, trade name ....... 49, 67

Travel ......................................... 64 TTY/TDD information ................ 70

UUnemployment fund taxes ........ 40Uniform capitalization rules ......... 6Unpaid expenses, related per-

sons .................................. 5, 38Unpaid salaries, related persons 8

Utilities ....................................... 70

V Vacation pay ................................ 8

WWages and salaries ..................... 6Welfare benefit funds ................ 26

�

Tax Publications for Business Taxpayers

General Guides

Commonly Used Tax Forms

Spanish Language Publications

Your Rights as a TaxpayerYour Federal Income Tax (ForIndividuals)Farmer’s Tax GuideTax Guide for Small BusinessTax Calendars for 1999Highlights of 1998 Tax Changes

Guide to Free Tax Services

Employer’s Tax Guide (Circular E)Employer’s Supplemental Tax GuideAgricultural Employer’s Tax Guide(Circular A)Federal Tax Guide For Employers inthe U.S. Virgin Islands, Guam,American Samoa, and theCommonwealth of the NorthernMariana Islands (Circular SS)

Household Employer’s Tax Guide

Guía Contributiva Federal ParaPatronos Puertorriqueños(Circular PR)

Travel, Entertainment, Gift, and CarExpensesTax Withholding and Estimated TaxExcise Taxes for 1999Withholding of Tax on NonresidentAliens and Foreign CorporationsSocial Security and OtherInformation for Members of theClergy and Religious WorkersResidential Rental PropertySelf-Employment TaxDepreciating Property Placed inService Before 1987Business ExpensesNet Operating LossesInstallment SalesAccounting Periods and Methods

CorporationsSales and Other Dispositions ofAssetsBasis of AssetsExamination of Returns, AppealRights, and Claims for RefundRetirement Plans for Small Business(SEP, SIMPLE, and Keogh Plans)Determining the Value of DonatedPropertyStarting a Business and KeepingRecords

Understanding the Collection Process

Information on the United States-Canada Income Tax Treaty

Bankruptcy Tax GuideDirect SellersPassive Activity and At-Risk RulesHow To Depreciate Property

Reporting Cash Payments of Over$10,000The Problem Resolution Programof the Internal Revenue Service

Derechos del ContribuyenteCómo Preparar la Declaración deImpuesto Federal

English-Spanish Glossary of Wordsand Phrases Used in PublicationsIssued by the Internal RevenueService

Tax on Unrelated Business Incomeof Exempt Organizations

Wage and Tax Statement

Itemized Deductions & Interest andOrdinary Dividends*

Profit or Loss From Business*Net Profit From Business*

Capital Gains and Losses*Supplemental Income and Loss*Profit or Loss From Farming*

Credit for the Elderly or the Disabled*

Estimated Tax for Individuals*Self-Employment Tax*

Amended U.S. Individual Income Tax Return*

Capital Gains and LossesPartner’s Share of Income,Credits, Deductions, etc.

U.S. Corporation Income Tax Return

U.S. Income Tax Return for an S Corporation

Employee Business Expenses*Unreimbursed Employee BusinessExpenses*

Power of Attorney and Declaration ofRepresentative*

Child and Dependent Care Expenses*

General Business Credit

Application for Automatic Extension of Time ToFile U.S. Individual Income Tax Return*

Moving Expenses*

Additional Taxes Attributable to IRAs, OtherQualified Retirement Plans, Annuities, ModifiedEndowment Contracts, and MSAs*Installment Sale Income*Noncash Charitable Contributions*

Change of Address*Expenses for Business Use of Your Home*

Tax Highlights for CommercialFishermen

910

595553509334225

171

Nondeductible IRAs*Passive Activity Loss Limitations*

1515-A

51

80

179

926

378

463

505510515

517

527533534

535536537

541538

542Partnerships

544

551556

560

561

583

594

597

598

901

911925946947

908

1544

1546

1SP

850

579SP

Comprendiendo el Proceso de Cobro594SP

10134

Sch A & B

Sch CSch C-EZSch DSch ESch FSch H Household Employment Taxes*

Sch RSch SE

1040-ES1040X

Sch DSch K-1

1120

1120S

1065 U.S. Partnership Return of Income

21062106-EZ

24412848

3800

4868

3903

5329

62528283

8582860688228829

Specialized Publications

Fuel Tax Credits and Refunds

Employee’s Withholding Allowance Certificate*W-4Employer’s Annual Federal Unemployment(FUTA) Tax Return*

940

940EZ

U.S. Individual Income Tax Return*1040

Employer’s Annual Federal Unemployment(FUTA) Tax Return*

Business Use of Your Home(Including Use by Day-CareProviders)

587

U.S. Tax Treaties

Practice Before the IRS and Powerof AttorneyInternational Tax Information forBusinesses

Employer’s Guides

Certification for Reduced Tax Ratesin Tax Treaty Countries

686

953

Capital Gains and Losses and Built-In GainsShareholder’s Share of Income, Credits,Deductions, etc.

Sch DSch K-1

Underpayment of Estimated Tax byIndividuals, Estates, and Trusts*

2210

Report of Cash Payments Over $10,000Received in a Trade or Business*

8300

Depreciation and Amortization*4562Sales of Business Property*4797

Informe de Pagos en Efectivo enExceso de $10,000 (Recibidos enuna Ocupación o Negocio)

1544SP

U.S. Corporation Short-FormIncome Tax Return

1120-A

See How To Get More Information for a variety of ways to get publications,including by computer, phone, and mail.

See How To Get More Information for a variety of ways to get forms, including by computer, fax,phone, and mail. Items with an asterisk are available by fax. For these orders only, use the catalognumbers when ordering.

Form Number and TitleCatalogNumber

W-21022011234

10983

170011132011330

113341437411338113441134612187

113581134011360

Employer’s Quarterly Federal Tax Return941

11359Sch J Farm Income Averaging* 25513

11510

CatalogNumber

20604

11744

1186211980

1239212490129061308613141

13329

1360162299

639661208113232

63704

62133113901139311394

1145011456

11700

1152011516

Form Number and Title

Tax Publications for Individual Taxpayers

General Guides

Your Rights as a TaxpayerYour Federal Income Tax (ForIndividuals)Farmer’s Tax GuideTax Guide for Small BusinessTax Calendars for 1999Highlights of 1998 Tax Changes

Guide to Free Tax Services

Specialized Publications

Armed Forces’ Tax GuideFuel Tax Credits and RefundsTravel, Entertainment, Gift, and CarExpensesExemptions, Standard Deduction,and Filing InformationMedical and Dental ExpensesChild and Dependent Care ExpensesDivorced or Separated IndividualsTax Withholding and Estimated TaxEducational ExpensesForeign Tax Credit for IndividualsU.S. Government Civilian EmployeesStationed AbroadSocial Security and OtherInformation for Members of theClergy and Religious WorkersU.S. Tax Guide for AliensScholarships and FellowshipsMoving ExpensesSelling Your HomeCredit for the Elderly or the DisabledTaxable and Nontaxable IncomeCharitable ContributionsResidential Rental Property

Commonly Used Tax Forms

Miscellaneous Deductions

Tax Information for First-TimeHomeownersReporting Tip IncomeSelf-Employment TaxDepreciating Property Placed inService Before 1987Installment SalesPartnershipsSales and Other Dispositions ofAssetsCasualties, Disasters, and Thefts(Business and Nonbusiness)Investment Income and ExpensesBasis of AssetsRecordkeeping for IndividualsOlder Americans’ Tax GuideCommunity PropertyExamination of Returns, AppealRights, and Claims for RefundSurvivors, Executors, andAdministratorsDetermining the Value of DonatedPropertyMutual Fund DistributionsTax Guide for Individuals WithIncome From U.S. PossessionsPension and Annuity IncomeNonbusiness Disaster, Casualty, andTheft Loss WorkbookBusiness Use of Your Home(Including Use by Day-CareProviders)Individual Retirement Arrangements(IRAs) (Including Roth IRAs andEducation IRAs)Tax Highlights for U.S. Citizens andResidents Going AbroadUnderstanding the Collection ProcessEarned Income CreditTax Guide to U.S. Civil ServiceRetirement Benefits

Tax Highlights for Persons withDisabilitiesBankruptcy Tax GuideDirect SellersSocial Security and EquivalentRailroad Retirement BenefitsIs My Withholding Correct for 1999?Passive Activity and At-Risk RulesHousehold Employer’s Tax GuideTax Rules for Children andDependentsHome Mortgage Interest DeductionHow To Depreciate PropertyPractice Before the IRS and Powerof AttorneyIntroduction to Estate and Gift TaxesIRS Will Figure Your Tax

Per Diem RatesReporting Cash Payments of Over$10,000The Problem Resolution Programof the Internal Revenue Service

Derechos del ContribuyenteCómo Preparar la Declaración deImpuesto Federal

Crédito por Ingreso del TrabajoEnglish-Spanish Glossary of Wordsand Phrases Used in PublicationsIssued by the Internal RevenueService

U.S. Tax Treaties

Spanish Language Publications

Tax Highlights for CommercialFishermen

910

595553509334225

171

3378463

501

502503504505508514516

517

519520521523524525526527529

530

531533534

537

544

547

550551552554

541

555556

559

561

564570

575584

587

590

593

594596721

901907

908

915

919925926929

946

911

936

950

1542

967

1544

1546

596SP

1SP

850

579SP

Comprendiendo el Proceso de Cobro594SP

947

Tax Benefits for Adoption968

Informe de Pagos en Efectivo enExceso de $10,000 (Recibidos enuna Ocupación o Negocio)

1544SP

See How To Get More Information for a variety of ways to get forms, including by computer,fax, phone, and mail. For fax orders only, use the catalog numbers when ordering.

U.S. Individual Income Tax ReturnItemized Deductions & Interest andOrdinary Dividends

Profit or Loss From BusinessNet Profit From Business

Capital Gains and LossesSupplemental Income and Loss

Earned Income CreditProfit or Loss From Farming

Credit for the Elderly or the Disabled

Income Tax Return for Single and Joint Filers With No Dependents

Self-Employment TaxU.S. Individual Income Tax Return

Interest and Ordinary Dividends forForm 1040A FilersChild and Dependent CareExpenses for Form 1040A FilersCredit for the Elderly or the Disabled for Form 1040A Filers

Estimated Tax for IndividualsAmended U.S. Individual Income TaxReturn

Unreimbursed Employee BusinessExpenses

Underpayment of Estimated Tax byIndividuals, Estates and Trusts

Power of Attorney and Declarationof Representative

Child and Dependent Care Expenses

Moving ExpensesDepreciation and AmortizationApplication for Automatic Extension of TimeTo File U.S. Individual Income Tax ReturnInvestment Interest Expense DeductionAdditional Taxes Attributable to IRAs, OtherQualified Retirement Plans, Annuities,Modified Endowment Contracts, and MSAsAlternative Minimum Tax–IndividualsNoncash Charitable Contributions

Change of AddressExpenses for Business Use of Your Home

Nondeductible IRAsPassive Activity Loss Limitations

1040Sch A & B

Sch CSch C-EZSch DSch ESch EICSch FSch H Household Employment Taxes

Sch RSch SE

1040EZ

1040ASch 1

Sch 2

Sch 3

1040-ES1040X

2106 Employee Business Expenses2106-EZ

2210

24412848

390345624868

49525329

6251828385828606

88228829

Form Number and TitleCatalogNumber

Sch J Farm Income Averaging

Additional Child Tax Credit8812

Education Credits8863

CatalogNumber

1170020604

11744

1186211980

124901290613141

1317713329

1360062294637046396610644120811323225379

11320

Form Number and Title

11330

113341437411338113441133911346121872551311359113581132712075

10749

12064

11329

1134011360

See How To Get More Information for a variety of ways to get publications,including by computer, phone, and mail.

970 Tax Benefits for Higher Education971 Innocent Spouse Relief

1998 publication 535 - internal revenue service › pub › irs-prior › p535--1998.pdf ·...

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