Legitimate business expenses?

[silversopp]

While not as comical or interesting as most of the TP stuff, I have a question about certain business practices, and whether or not it would be tax fraud/evasion.

Here's what's going on.

A small business in the Detroit area that employs under 50 people is directly paying for the living expenses of the owner. The owner has an apartment in his name in a different state, and the company pays the owner a good deal of the cost in order to use it for business purposes. The business also leases a home in the Detroit area for corporate housing. The owner and his family are the only ones who use the house. The company also leases cars for the owner and his wife, who is not an employee of the company. Utilities, groceries, clothing, and such are also paid for by the company for the owner.

I'm curious whether this is legitimate business expenses, or if the owner is simply avoiding the double taxation (first the business pays taxes, then he would pay personal income tax on those earnings when it becomes a salary) by having his business own everything.

How thin is the fine line between business expense and personal income tax avoidance?

[Judge Roy Bean]

While not as comical or interesting as most of the TP stuff, I have a question about certain business practices, and whether or not it would be tax fraud/evasion.

Here's what's going on.

A small business in the Detroit area that employs under 50 people is directly paying for the living expenses of the owner. The owner has an apartment in his name in a different state, and the company pays the owner a good deal of the cost in order to use it for business purposes. The business also leases a home in the Detroit area for corporate housing. The owner and his family are the only ones who use the house. The company also leases cars for the owner and his wife, who is not an employee of the company. Utilities, groceries, clothing, and such are also paid for by the company for the owner.

I'm curious whether this is legitimate business expenses, or if the owner is simply avoiding the double taxation (first the business pays taxes, then he would pay personal income tax on those earnings when it becomes a salary) by having his business own everything.

How thin is the fine line between business expense and personal income tax avoidance?

Not enough information and I'm no tax guru, but without knowing the company structure (sole proprietorship? corp? LLC? LLP?) and seeing the returns being filed it's difficult to say. IMHO, the question hinges on whether there is a valid business purpose for the expenditures.

[Nikki]

A small business in the Detroit area that employs under 50 people is directly paying for the living expenses of the owner. The owner has an apartment in his name in a different state, and the company pays the owner a good deal of the cost in order to use it for business purposes.
Probably justifiable if (1) there's adequate documentation as to the business use of the apartment AND the owner can show that he has reimbursed the company for any personal use of it.

The business also leases a home in the Detroit area for corporate housing. The owner and his family are the only ones who use the house. The company also leases cars for the owner and his wife, who is not an employee of the company. Utilities, groceries, clothing, and such are also paid for by the company for the owner.
Bells! Alarms! People have gone to jail for this. Personal expenses of an employee are only legitimate business expenses if there is a string, documented business-related requirement for them -- such as if the employee resides a distance from the business and is required to travel and stay at the business for the convenience of the employer. For the OWNER, this would be extremely hard to justify. For a non-employee, such as the wife, it is dead in the starting gate.

I'm curious whether this is legitimate business expenses, or if the owner is simply avoiding the double taxation (first the business pays taxes, then he would pay personal income tax on those earnings when it becomes a salary) by having his business own everything.

How thin is the fine line between business expense and personal income tax avoidance?

If this person or business is ever audited, he will be extremely lucky to only get hit for taxes, penalties and interest without the big gross-up for fraud.

[Famspear]

Silversopp, you're right to question this. A personal living expense is a personal living expense, and is generally non-deductible for federal income tax purposes (section 262). A common misconception that some people have is that merely "incorporating" or having something paid by a corporation or LLC, etc., somehow makes the expense deductible.

EDIT: Oh, and welcome back, silversopp. We've been missing your posts.

[Mr. Mephistopheles]

Silversopp, you're right to question this. A personal living expense is a personal living expense, and is generally non-deductible for federal income tax purposes (section 262). A common misconception that some people have is that merely "incorporating" or having something paid by a corporation or LLC, etc., somehow makes the expense deductible.

EDIT: Oh, and welcome back, silversopp. We've been missing your posts.

Out of curiosity, how should personal expenses paid by a corporation be handled? Should it be counted as personal income?

[Nikki]

If the personal expenses of an employee fall into the closely-defined category of legitimate business expenses AND they are paid by the employer AND they are not already addessed by the tax code such as employer portion of health insurance or commuting expenses within the allowable limit, there are at least three basic ways of handling them.

First, the employer can reimburse the employee for out-of-pocket expenses such as meals, lodging, transportation, etc. This does not represent income to the employee.

Second, the employer can increase the employee's salary by an amount sufficient to cover expenses. This is income to the employee, but can be offset by the allowable deduction for well-documented employee business expenses. This gets iffy due to the potentially increased cost to the employer for Social Security and other salary-based costs AND to the employee who might be in a high enough income bracket to suffer from reductions in deductions.

Also, for things like employer-provided cars, the employee must declare as income the difficult-to-compute value of his personal use of the vehicle.

[Famspear]

See Nikki's post, above.

Also, the term "personal expenses" is something of a term of art. If it is truly a "business" expense (deductible under section 162), then it's not a "personal expense" in the sense of a "personal, living or family expense" (generally non-deductible, but sometimes deductible) as that term is used in section 262. For example, the cost of an employee meal that is deductible by the employer under section 162 is not a "personal expense" at all, as defined in section 262. So, there's really no overlap there.

And, as noted above, under section 262, it's possible for a "personal, living or family expense" to be deductible in certain limited situations: where another code provision makes it deductible. One example we don't even normally think about would be the home mortgage interest expense deduction under section 163(a) and section 163(h). If section 163 did not exist, then interest expense on the debt secured by your home would be just another "personal, living or family expense" that, under section 262, would be non-deductible. Notice that under section 163(h)(2), the home mortgage interest expense is essentially "carved out" of what would otherwise be "personal interest" as defined in section 163(h)(1).

Here's the sequence:

1. Section 262 theoretically makes the home mortgage interest expense (and all other personal, living and family expenses) non-deductible -- except as otherwise provided.

2. Section 163(a) then theoretically carves out an exception -- by (theoretically) making all interest expense deductible.

3. Section 163(h)(1) then theoretically carves out an exception to the exception, by making personal interest expense non-deductible again.

4. Section 163(h)(2) (D) then carves out an exception to the exception to the exception, by making SOME but NOT ALL home mortgage interest expense (called "qualified residence interest") deductible.

5. Section 163(h)(3) then defines what is meant by "qualified residence interest," dividing it into two broad categories: "aquisition indebtedness" and "home equity indebtedness."

This is one of the reasons I love the Internal Revenue Code.

[Judge Roy Bean]

See Nikki's post, above.

Also, the term "personal expenses" is something of a term of art. ....

This is one of the reasons I love the Internal Revenue Code.

Defining and authorizing a "legitimate business purpose" is not just an art form, it's trench warfare in some businesses. All heads in the board meeting turn to the bean counter/CFO who either capitulates ("we'll find a way to make that work") or looks at the CEO and mentions something about auditors, DOJ subpoenas and stockholder suits.

Of course, in a small business, "the board" may be a handful of willing accomplices who hold all the stock in a privately-held company.

Whenever there is room to maneuver, there will be creative maneuvers.