us internal revenue service: p535--1998

8/14/2019 US Internal Revenue Service: p535--1998

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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 business

expenses 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, 18777774778. Persons who have access toTTY/TDD equipment can call 18008294059 and ask for the Taxpayer Advo-cate. If you prefer, you can write to the Tax-

Departmentof theTreasury

InternalRevenueService

Publica tion 535Cat. No. 15065Z

BusinessExpenses

For use in preparing

1998 Returns


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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 employer

can 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 your

convenience (for substantial business rea-sons other than to provide additional pay).Also, under a special rule enacted in 1998

for any tax year, you can treat allmeals 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 of

other 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

334 Tax Guide for Small Business

463 Travel, Entertainment, Gift andCar Expenses

529 Miscellaneous Deductions

536 Net Operating Losses

538 Accounting Periods and Methods

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

551 Basis of Assets

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

925 Passive Activity and At-Risk Rules

936 Home Mortgage Interest De-duction

946 How To Depreciate Property

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Form (and Instructions)

Sch A (Form 1040) Itemized De-ductions

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.

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If 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 your

gross 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 soldchapter 6 of Publi-cation 334.

InventoriesPublication 538.

Uniform capitalization rulessection1.263A 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 Businessin 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 business

or 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 Tax

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

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

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

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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 be

able 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 beoneof 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 much

you 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 and

the 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 ina 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

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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 the

current 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 the

liability (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 RelatedPersonsin Publication 538.

Not-for-ProfitActivitiesIf you do not carry on your business or in-vestment activity to make a profit, there is alimit on the deductions you can take. Youcannot use a loss from the activity to offsetother income. Activities you do as a hobby,or mainly for sport or recreation, come underthis limit. So does an investment activity in-

tended only to produce tax losses for the in-vestors.The limit on not-for-profit losses applies to

individuals, 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 itemize

them on Schedule A (Form 1040).

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

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

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

Category 3. Business deductions that de-crease the basis of property are allowed last,but only to the extent the gross income fromthe activity is more than deductions you take(or could take) for it under the first two cate-gories. The deductions for depreciation,amortization, and the part of a casualty lossan individual could not deduct in category (1)belong in this category. Where more than oneasset is involved, divide depreciation andthese other deductions proportionally amongthose assets.

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

(Form 1040). They are subject to 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

$300 = $225 depreciation for the automobile$800

$200 $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 are

reflected 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 various

undertakings 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.

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

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

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

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

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

Loss $500

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

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

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

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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 Form

5213. 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.

TIP

Form 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 Change

for 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

15 Circular E, Employer's Tax Guide

15A Employer's Supplemental TaxGuide

521 Moving Expenses

551 Basis of Assets

946 How To Depreciate Property

Form (and Instructions)

W2 Wage and Tax Statement

3800 General Business Credit


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 likely

to 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 unpaid

at 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 also

must 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.

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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 following

tests.

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 on

the 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 personalpropertythat 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 deductionsline of your tax return or business schedule.

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

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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 RateLoansin 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 in

the 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 is

the 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 actually

owned 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 next

year 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) under

terms 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 planin 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 planin the compensation youpay your employees and deduct it aswages on your return.

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

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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 if

he or she paid or incurred them.Deduct as wages any reimbursement that

is not for a qualified moving expense re-imbursement (that is, an expense the em-ployee cannot deduct).

Form W2. You must show any reimburse-ment paid directly to an employee for movingexpenses on the employee's Form W2.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 W2 or Form 1099MISC(even if the recipient is a corporation) to takethe deduction. However, You do not have toreport if the transfer:

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

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

3.

Meals andLodging

Furnished toEmployees

Important Changefor 1998

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 the

meals 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 allmeals 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 2For 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 Page 9


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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 the

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

premises.

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

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

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 meal

period 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 half

of 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 3Lodging Re-quired As a Condition of Employment, do nottreat the value of any meal you furnish on thebusiness premises as wages.

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

If you furnish meals for which you chargethe employees a flat amount 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 3Lodging RequiredAs a Condition of

EmploymentThis 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 tax

withholding.

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 service

employee 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

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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 in

addition 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 1998

Meals 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 1.6121 of the Income Tax Reg-ulations.

Topics

This chapter discusses:

General information

The general valuation rule

Special valuation rules

Exclusion of certain fringe benefits fromemployee income


Publication


521 Moving ExpensesSee chapter 17 for information about get-

ting publications and forms.

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 use

the 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.

TIP

Nonemployee 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 1099MISC,Miscellaneous Income, and you may have towithhold income tax under the backup with-holding rules. See the Instructions for Forms1099, 1098, 5498, and W2G 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

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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 value

of benefits you provide in the first 10 monthsof the next year.Benefits you actually provide. Only the

benefits 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 market

valueof 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 a

cents-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 a

special 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 the

same 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 1.6121(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.

Benefi

us internal revenue service: p535--1998

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