The basics of an often-misunderstood tax topic
If you are an employee with expenses related to your job, these expenses are not taxable income. If your employer reimburses these expenses separately from your wages then these amounts are not taxed and you need to take no further action. But if the amounts were included in your total taxable wages then you need to take additional steps to avoid taxation of these amounts.
The following explanation is how to deduct employee business expenses from your reported taxable earned income. Examples of common missteps by taxpayers are included to help illustrate the topics.
There are two universal requirements for excluding employment-related expenses from your taxable income. You must meet both requirements to exclude expenses from your taxable income:
1. The expense must be ordinary and necessary.
Here’s the catch: the employer, not you, determines what is an ordinary and necessary business expense. Just because you think it is ordinary and necessary does not mean that the employer takes the same position. For example, you read The Wall Street Journal to keep up on essential information about your company’s competitors. You consider the subscription price to be an employee business expense. The IRS and your state taxing authorities may not agree. As another example, you take each employee in your department out to lunch on their birthday. It’s likely a brilliant leadership strategy but may not qualify as a tax-deductible expense. It makes sense to have documentation in writing, in advance, about the expenses that the employer requires you to incur as a condition of your employment. If a letter from the employer is not available to prove the business necessity of business expenses, a tax auditor may refuse the tax deduction.
2. You must keep adequate documentation.
These records must be a format prescribed by the taxing authority. Be careful that what you think is adequate proof of an expense may not be so to a tax auditor. A credit card statement, for example, may seem like adequate proof but the IRS says that it does not contain enough information to prove that an expense restaurant meal is a deductible expenses. The IRS allows sampling of expense records but state tax authorities generally do not allow sampling. This means that for federal tax purposes you can keep an adequate record for parts of a tax year and use that record to prove the amount of business or investment use for the entire year. You must demonstrate by other evidence that the periods for which an adequate record is kept are representative of the use throughout the tax year. For state tax purposes, you may need to keep every receipt. IRS provides the following guidance on how to prove come types of expenses but again keep in mind that state tax authorities may use a more stringent criteria. I typically find that taxpayers have good records of the dates and amounts spent but poor records of the odometer readings for driving expenses, for example, and weak documentation of the destinations and business purpose of specific periods of driving travel.
| IF you have expenses for . . | THEN you must keep records that show details of the following elements . . . | |||
|---|---|---|---|---|
| Amount | Time | Place or Description |
Business Purpose Business Relationship |
|
| Travel | Cost of each separate expense for travel, lodging, and meals. Incidental expenses may be totaled in reasonable categories such as taxis, fees and tips, etc. | Dates you left and returned for each trip and number of days spent on business. | Destination or area of your travel (name of city, town, or other designation). | Business purpose for the expense or the business benefit gained or expected to be gained. |
| Entertainment | Cost of each separate expense. Incidental expenses such as taxis, telephones, etc., may be totaled on a daily basis. | Date of entertainment. | Name and address or location of place of entertainment. Type of entertainment if not otherwise apparent. | Business purpose for the expense or the business benefit gained or expected to be gained. For entertainment, the nature of the business discussion or activity. If the entertainment was directly before or after a business discussion: the date, place, nature, and duration of the business discussion, and the identities of the persons who took part in both the business discussion and the entertainment activity.Relationship: Occupations or other information (such as names, titles, or other designations) about the recipients that shows their business relationship to you. For entertainment, you must also prove that you or your employee was present if the entertainment was a business meal. |
| Gifts | Cost of the gift. | Date of the gift. | Description of the gift. | |
| Transportation | Cost of each separate expense. For car expenses, the cost of the car and any improvements, the date you started using it for business, the mileage for each business use, and the total miles for the year. | Date of the expense. For car expenses, the date of the use of the car. | Your business destination. | Business purpose for the expense. |
- Consider the practical accounting and audit aspects of claiming a deduction of employee business expenses on your tax returns. If the IRS or state decides to ask for your proof of these expenses – often involving hundreds of transactions – then the cost of responding to this audit request may well exceed the tax benefit you achieved by taking the deduction. For this reason I often suggest that taxpayers are taxing a calculated financial risk when they choose to exclude employee business expenses from their taxable income.
- The best way to avoid taxes employee business expenses is to have the employer set them up as an ‘accountable plan’ separate from taxable wages the payments can be made through the payroll company as usual, but without taxes. I consider the setup and management of these tax-free arrangements to be among the most valuable services I provide as a small business accountant.
- For more information, see IRS Publication 463 and similar guidance published by your state.
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