If you're one of those company owners who routinely deducts unreimbursed business expenses -- meals, entertainment, travel -- on your personal income-tax form, you may want to reconsider this year. The 1986 Tax Reform Act has changed the rules in ways that could cost you, as well as any of your employees who deduct business expenses on their personal tax returns.
These are the new rules: all of your miscellaneous itemized deductions are stuffed into one basket, and included in the basket are such items as tax-preparation fees, investment advice, and unreimbursed business expenses. The total basket is deductible only after you subtract a "floor" equal to 2% of your adjusted gross income -- and that's the hitch.
Say your adjusted gross income for 1987 is $100,000, and your miscellaneous itemized deductions total $5,500 -- $5,000 in unreimbursed employee business-travel expenses and $500 for tax advice. You can deduct only $3,500, calculated as follows:
Misc. itemized deductions $5,500
Floor ($100,000 X 2%) 2,000
Deductible amount $3,500
The solution is to have your company reimburse you for all of the business expenses you pay out of your own pocket. The reimbursement ($5,000 in the above example) is tax free to you, and your company gets a deduction for the full amount. The floor will take away your remaining $500 deduction, but better to lose that than the $2,000.
As you probably know, under the new law only 80% of business meals and entertainment expenses are deductible. If $4,000 of your expenses in the example had been for meals and entertainment, the deductible amount on Form 1040 would be reduced by another $800 (20% of $4,000). When, on the other hand, you or your employees are reimbursed for meal and entertainment expenses, the 20% disallowance is passed to the company.
Your tax course is clear. Reimburse yourself 100% for every dollar you spend on the corporation's business as its employee. Most employers, after reviewing the situation with a professional tax adviser, are also reimbursing employees -- at least key employees -- 100% for business expenses. The company can deduct the full amount -- less the 20% on meals and entertainment, which somebody is going to have to absorb in any case -- and the employee avoids the 2% trap.
While it's true that you can deduct only the business use of your car on your personal tax form, you may be missing out on a way to increase the amount of that deduction.
The law says that if you drive your car 20,000 miles a year and only 8,000 miles are for business, you can deduct only 40% (8,000 divided by 20,000) of your car expenses and depreciation. But say you have two cars, one a new Porsche and the other an old clunker. You could keep the clunker at home, use it on weekends, and drive it to and from your office (commuting is considered personal mileage). The idea is to park the Porsche at work and mushroom the business miles -- while almost eliminating commuting miles -- on it.
If we use our example of driving 20,000 miles in a year, with 8,000 of those on business, here's how you'd benefit. Assume that each car is driven 10,000 miles. Since the Porsche is used 80% for business (8,000 divided by 10,000), you can deduct 80% of the related expenses and depreciation, probably a tidy sum over the life of the car.
To keep track of your business deduction, keep a log of business miles, record expenses, and keep receipts.
Rumor has it that long-term gains don't matter anymore. True enough, under the new tax law, long-term capital gains are taxed as ordinary income -- but that doesn't take effect completely until 1988. You've got some room to maneuver in 1987.
It's to your advantage to think about long-term capital gains or losses in terms of the phasing in of the new rules. This year, the highest personal tax rate is 38.5%, compared with a 28% ceiling for capital gains. Starting in 1988, for a married couple filing a joint return, the rates will be 28% for taxable incomes in the $29,750-to-$71,900 range and for incomes over $171,090 (including exemptions); 33% for incomes in the $71,900-to-$171,090 range. And bear in mind that you can deduct only $3,000 of net capital losses against other ordinary income in any one year, although excess losses can be carried forward until used up.
Here are the most important strategies to help you combine the old law with the new law for the balance of 1987:
For gains, in general:
Take the gains in 1987 at the 28% capital-gains rate if your tax rate will be 33% next year. Also, if your rate is lower than 28% this year, take the gain in 1987.
For losses, in general:
Take losses to offset gains. Then take up to $3,000 to reduce ordinary income, and carry forward the balance.
If you already have long-term gains, should you take long-term losses in 1987?
It depends on what your 1988 tax rate will be: 28% and below, or 33%. The answer is no if the 1987 gains will cost you only 28% and the losses will offset ordinary income at 33% in 1988. The answer is yes if the losses will offset income at only 28% or less in 1988.
For other situations, use the same logic to determine if the transaction should be completed in 1987 or deferred to 1988.