On January 1, the IRS ended its monthly employment tax deposit requirements for many small businesses, allowing them, instead, to make such payments quarterly.

Businesses now can make employment tax payments every three months if the amount is under $2,500. Previously, the IRS permitted quarterly payments only for businesses whose payments were less than $1,000. The threshold, which had been $500, was raised to $1,000 in 1998. After further study, the IRS increased the threshold to the current $2,500. Small businesses that are above the new threshold level still have to make monthly payments. The change in deposit requirements affects approximately one million small businesses, which make tax payments of $6.6 billion, or about 13% of the $52.7 billion total.

Not only will the change mean less paperwork for small businesses and the IRS, but it also will create a number of other advantages:

IRS notices to small businesses are expected to decrease about 70% because there will be fewer deposits.

Because deposits will be less frequent, small businesses will make fewer mistakes and will incur fewer penalties.

Making payments quarterly instead of monthly will help ease small businesses’ cash flow.

Small businesses with employment tax deposits of less than $2,500 per quarter may pay them when they file Form 941, Employer’s Quarterly Federal Tax Return.

Employers now can distribute tax-free mass-transit passes to their employees more than one month in advance. IRS Announcement 2000-78 changed the distribution requirement in proposed regulations that would have exempted transit passes from taxes only for the month in which they were actually distributed to employees.

Employers now may distribute transit passes (valued at $65 per month for 2001), as qualified transportation fringe benefits, for more than one month without negating the tax-free status of the passes. For example, an employer may distribute transit passes quarterly. However, if the employee holding advance passes terminates his or her employment before using all of them, and the employer does not recover their value, the employee will be liable for taxes on the remaining passes.

The IRS announced that employers will use a new code in box 12 of the 2001 form W-2. Box 12 states the amount of benefits includable as wages on which the employee’s share of taxes has been paid. Code V will identify the amount of compensation related to the exercise of employer-provided nonstatutory stock options that are included in box 1—wages, tips and other compensation; box 3—Social Security wages (up to the SS wage base); and box 5—Medicare wages and tips. Currently, the IRS does not require employers to separately identify any taxable fringe benefits that are included in box 1.

The IRS and the Treasury Department have launched a pilot program designed to address issues that are common to large or midsize business taxpayers.

According to Larry Langdon, commissioner of the Large and Mid-Size Business (LMSB) Division, the aim of the industry issue resolution (IIR) program is to establish a consistent IRS position on industry issues, which will eliminate the uncertainty with respect to tax treatment and reduce costs for both taxpayers and the service. He has requested that tax practitioners, businesses, trade groups and others submit specific problems for consideration.

The IRS will focus on issues affecting a significant number of taxpayers where the appropriate tax treatment is uncertain, the problem has been repeatedly examined and factual determination is a major component. While the resulting guidance may vary, the IRS is most likely to issue it in the form of a revenue procedure that will permit taxpayers to adopt the recommended treatment on future tax returns.

Submissions must reach the LMSB office no later than February 28. Notice 2000-65 issued in December provides additional information on the IIR pilot and describes how to submit an issue.

For specifics on the IIR project, call Richard Druk of the LMSB Pre-filing and Technical Guidance Office at 202-283-8387. Details are also available on the IRS Web site at www.irs.gov .

The IRS closely scrutinizes all related party transactions. In addition to verifying that the items involved are stated at fair market value, it checks to make sure the transaction is properly classified. Recently, the Tax Court considered the correct classification of a corporation/shareholder transaction.

Lenward Hood created Hood’s Institutional Foods (HIF) in 1978 as a sole proprietorship. In 1988 he incorporated the business and became the sole shareholder and principal employee. In 1990 Hood was indicted for criminal tax evasion with respect to HIF’s income before its incorporation. He was acquitted on all counts in 1991. The corporation paid—and deducted—$103,188 for Hood’s legal fees. The IRS denied the deduction and reclassified the payment as a constructive dividend to Hood. He appealed.

Result. For the IRS. Hood argued that HIF was entitled to the deduction based on the Tax Court’s decision in Jack’s Maintenance Contractors, TC Memo 1981-349. In that case—on almost identical facts—the court held that the corporation could deduct the legal fees it paid for an indispensable shareholder-employee based on Lohrke, 48 TC 679. In Lohrke, the court held that one taxpayer can deduct the expenses of another if it can show the expenditure was necessary to assure its continuation as a business. The IRS argued the expenditure was a constructive dividend based on the Fifth Circuit Court of Appeals reversal of the Tax Court decision in Jack’s.

The Tax Court decided to follow the Fifth Circuit decision rather than its own prior decision because, at the time, it had failed to properly evaluate the possibility of a constructive dividend in Jack’s. If a corporation pays a shareholder’s expenses, the payment first must be examined for constructive dividend treatment. If the shareholder is the primary beneficiary of the payment, as was so in this case, the IRS will reclassify it as a constructive dividend and deny the corporation a deduction.

Even if the expenditure is not a constructive dividend, it will be deductible only if the taxpayer can prove it is an ordinary and necessary expense. In other words, the expenditure must be necessary to protect or promote the payer’s business. According to the Fifth Circuit—and now the Tax Court—paying a shareholder’s medical or legal expenses is never necessary for a corporation’s survival—even if the shareholder performs critical services. Therefore the corporation cannot deduct them. Applying these rules to the current case, the shareholder must report as income a constructive dividend equal to the legal fees paid and the corporation is not permitted to deduct or capitalize the expenditure.

Lohrke is easily distinguishable from the current case. In Lohrke it was the shareholder who paid corporate expenses when the corporation was insolvent and unable to pay the amounts due. As a result of the decision in Hood, taxpayers will find it more difficult to claim a corporate deduction for any shareholder expenses. On the other hand, a shareholder may be able to deduct corporate expenses if the corporation is insolvent and he or she can prove the payment is necessary to continue the business.

Lenward C. Hood v. Commissioner, 115 TC no. 14.

In general, personal expenditures such as food and lodging are not tax deductible. However, a taxpayer may deduct these costs while he or she is away from home overnight for business purposes. Instead of deducting actual expenditures, taxpayers can use the per diem amounts for food and lodging in revenue procedure 93-50. The applicability of this revenue procedure to self-employed individuals recently came before the courts.

Paul Duncan was an independent over-the-road truck driver who lived in Tazewell, Tennessee. He contracted all his cargo-hauling assignments from Knox Cartage in Knoxville. In 1994 he traveled 130,000 miles. On his 1994 tax return, he deducted food and lodging expenses for away-from-home travel based on the per diem amounts in revenue procedure 93-50. He also deducted the cost of meals for days he stayed in Knoxville to obtain a cargo. The IRS denied the deductions.

Result. For the IRS. IRC section 162(a)(2) permits taxpayers a deduction for travel expenses such as food and lodging when they are away from home overnight. Section 274(d) limits the deduction to amounts for which a taxpayer has the necessary substantiation. Therefore, a taxpayer may not rely on the “Cohan rule,” which allows him or her to estimate expenditures. While taxpayers can use the per diem amounts found in revenue procedure 93-50 to ease their administrative burden, they must otherwise comply with all of the code’s substantiation requirements.

The revenue procedure limits the use of per diem amounts for lodging to cases where an employer reimburses an employee with a fixed daily amount. That means self-employed individuals may not use this method for lodging expenditures. Instead, they must prove actual expenses based on the rules of section 274(d). Duncan could not deduct any lodging expenditures because he did not have the required proof. Self-employed individuals may use the per diem amounts for meals since the revenue procedure specifically authorizes them to do so. In this case Duncan was allowed to deduct such per diem amounts.

Duncan deducted meals in Knoxville on days he stayed over to obtain a cargo the next day. The law requires truckers to rest 8 hours in a 24-hour period. Duncan argued he needed to stay in Knoxville to meet this requirement and to obtain a cargo. Had he taken the time to drive to his house, he would not have been able to leave as early the next morning and the cargo would have gone to another trucker. The Tax Court rejected Duncan’s “need to rest” argument. For tax purposes, your home is where your principal business takes place, not your residence. In this case Knoxville, not Tazewell, was Duncan’s home. Since he was not away from home, he could not deduct the cost of meals while he was in Knoxville.

Self-employed individuals must carefully substantiate all out-of-town travel expenses. They may use the listed per diem amounts only for food. Lodging deductions must be for the actual amount spent. Failure to comply will result in a complete denial of the deduction.

Paul H. Duncan, TC Memo 2000-269.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.