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- FAQ: What are above-the-line deductions?

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How to Deduct Business-Travel Expenses the RIGHT Way - Watch Out for the "True Lease" Trap!



Question 1 of 2: I am trying to get my arms around the North American trip rules, specifically the 51/49 primary purpose test.

 

If my trip in the IRS-defined North American area is for seven days or less and includes one business day, does that one business day make for a deductible business trip?

Answer - It makes for deductions meaning your word "trip" defines what you think you've done, but tax law breaks the word trip or travel into two components, as shown in the chart below:
 

TRAVEL EXPENSES

Transportation (costs of getting to and from the business destination)
Business-day costs (meals, lodging, and other costs of sustaining life on business days)


Yes. With one business day on this seven-day trip, you pass the 51/49 test, and that qualifies you to deduct the entire cost of getting to and from this business destination.

Question 2 of 2:  Originally, this question was intertwined with the first question. We broke this apart to facilitate understanding. Here's the second question.

So the 51/49 rule makes my trip a business trip, and I deduct 100 percent of the airfare and lodging. And then I deduct meals and expenses on the business days as though the entire trips is business. Yes?

Answer - No. First, you deduct the cost of getting to and from the business destination under the 51/49 test. This includes airfares, taxis, rental cars, and lodging en route.

Once you arrive at the destination, you deduct your business-day expenses for meals, lodging, and other costs of sustaining business life. You deduct nothing for the personal days.

Example. You travel to St John in the U.S. Virgin Islands. This is a foreign destination under the business travel rules; thus, the 51/49 rule applies to your transportation if your trip is for 7 days or less, excluding the day of departure.

Including travel, your trip involves three business days and four personal days. You deduct all costs of getting to and from St. John and all food, lodging, and other costs of sustaining life during your business days. You deduct nothing for your personal days.

Planning note. On this trip, if a personal day is sandwiched by two business days, the rules convert the personal day into a business day.
 



Trap to Avoid: Leasing When You Thought You Were Buying-or Vice Versa
 

In 2004, a gentleman named Arthur Boyce walked into an Idaho Ford dealership and purchased a new Expedition truck for his business. Or so he thought.

 

The IRS found that the arrangement didn't really transfer an ownership interest to Mr. Boyce.

 

Result: The court agreed with the IRS and ruled that Mr. Boyce had actually leased the truck and denied him a Section 179 deduction for its cost.

Moral - It doesn't matter what you call it. It doesn't matter what you intend. It matters what is.


You need to make sure you don't accidentally lease the vehicle you think you're buying or buy the vehicle you think you're leasing. This article will help you do what you want to do by showing you the trap and how to avoid it. But first, let examine why it's important to get this right.

Why Getting the Transaction Right Matters

Ensuring that vehicle "leases" are true leases and "purchases' are true purchases isn't just a formality. At stake is a lot of money in or out of your pocket. That's because leases and purchases often have significantly different tax consequences.

The catch: The lease must be a "true lease." For the IRS (and the courts), it's a matter of substance over form. In other words, it's not what you call it, it's not what the lessor calls it, but it's the "objective economic realities of the transaction" that determine whether your transaction is a purchase or a lease for tax purposes.

If a lease isn't a true lease, the IRS will re-characterize the arrangement as a purchase and will not let you claim the rent payments as business deductions under IRe Section 162(a)(3).

 

Of course, the same thing can happen in reverse when the IRS re-characterizes a purchase as a lease and disallows the deductions for purchasing the vehicle under IRS Section 179. This is what happened to Mr. Boyce.


What's a "True Lease"-the IRS's Five Red Flags

A "true lease" is one in which you pay to use the vehicle and not to obtain ownership of it. There are five red flags of ownership the IRS looks for in determining whether a lease is really a sale in disguise.

1. Rent Payments Build Equity

To be a true lease, no part of the required "rent" payment can count as equity.

Example. The IRS said and the court agreed that you have a purchase and not an equipment lease when a portion of the rent payments made in Year 1 count as equity in the formula to calculate rent for Year 2.

2. You Get Title after Making Rent Payments

Another red flag against the lease is a provision that purports to give you ownership of the vehicle after you pay a designated amount/percentage of rent due.

Example. The IRS says that your lease is a purchase agreement when you get title to the property when total monthly rent payments equal a stated amount.6

3. Amount You Pay to Lease Is About the Same as the Amount You'd Pay to Buy

Since you're paying for use of the vehicle over a relatively short period, the expectation is that total rent payments will be much less than what you'd pay to buy the vehicle. So it's hard to justify as a true lease an arrangement where total rent is anywhere near what you would pay to buy the vehicle outright.

Example. In Revenue Ruling 55-540, the IRS cites Bov.en, in which the court ruled that when six months' worth of rental payments equaled the value of the leased equipment, the lease was a sham and the lessee bought the equipment

4. Rent Amount Is Much Higher than Fair Market Rent

A corollary to number 3 above is the principle that you can't have a true lease where rental payments are way above the current fair rental value.

Example. Say that fair rent is $300 a month, but you pay $900 a month. The IRS says that excess rent indicates fishy business, likely a purchase rather than a lease.

5. Buy for a Song

Another way to taint the integrity of the true lease is to allow the lessee to buy the vehicle at lease-end for a nominal amount. The obvious suggestion: the rental payments were actually made to buy the vehicle.

Example. You rent equipment with an expected useful life of 10 to 15 years. You do not have a true lease when after five years of renting you can renew the lease for up to 10 years for $1 a year.

True Lease and Option to Purchase

If, like most vehicle leases, your lease includes an option to purchase, it's important to note that such options are not on the IRS's red flag list. In other words, a true lease can include an option to purchase as long as the price you pay reflects the vehicle's fair market value.

One way to make sure of this is for the purchase option to reflect the vehicle's "clean value" (i.e., the value listed in the National Auto Research Black Book).'

True Lease Rules for Closed-End Leases

In this form of lease, the purchase price of the vehicle is set at the time you sign the lease.

Rule. The option price is considered fair market value for true lease purposes if you can buy the vehicle at its projected end-of-lease residual value."  You negotiate and set the residual value and corresponding option price when you sign the lease.

True Lease Rules for Open-End Leases

With this type of lease, you estimate the vehicle's residual value when you sign the lease and wait until the lease actually ends to determine the vehicle's actual residual value--and your liability:

• If actual residual value is higher than the estimate, you pay the difference.
• If actual residual value is lower than the estimate, you get a refund.

In other words, in open-ended leases you (not the lessor) bear the risk of decline in vehicle value. Taking on the decline in vehicle value is like owning the vehicle, not leasing it. But lawmakers created an exception for this type of lease.

In 1982, 1984, and 1986, lawmakers enacted laws saying open-ended vehicle leases that include clauses adjusting the rental price up or down based on the amount that the lessor can sell the vehicle for at the end of the lease (the way open-ended leases do) can be considered true leases when all of the following five conditions are met:

1. You lease a car, truck, or trailer.
2. You certify in writing to the leasing company under penalty of perjury that you'll use the vehicle more than 50 percent of the time for business.
3. The leasing company certifies in writing that it told you that you're not the owner of the vehicle for tax purposes.
4. The leasing company has no knowledge that your certification is false.
5. The leasing company has a tax-law-defined liability in the vehicle.

Conclusion

There's more to the lease versus buy conundrum than choosing between them. Once you decide whether to buy or lease, you face the challenge of ensuring that the transaction is really a purchase or a lease.

If what you intended as a lease turns out to be a purchase or vice versa, you could end up not only losing out on the valuable tax benefits you thought you were getting but also owing the IRS interest and penalties.

If you don't believe it, just ask Mr. Boyce.

 


 

   

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As always you can call me at 714-619-0667 if you have any questions about investing, retirement or any other tax & accounting related issues. 

 

Regards, Monica Rebella, CPA/IAR

President, Rebella Accountancy

 
Disclaimer:  The opinions contained herein are not intended to be investment advice or a solicitation to buy or sell any securities. With any investment you should carefully consider the investment objectives, potential risks, management fees, and charges and expenses before investing.  Past performance is not a guarantee of future results. The investment return and principle value of any investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.

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Monica Rebella, CPA/IAR | President - Rebella Accountancy | Certified Public Accountants
507 E. First Street, Suite A | Tustin, CA 92780 | Phone: 714-619-0667 | Fax: 714-544-0236
Email: mrebella@rebellacpa.com | www.RebellaCPA.com | www.MyDentalCPA.com