Per Diem - 50% Meals Disallowance on Out-Of-Town Travel
Meals paid for out-of-town travel are subject to the 50% travel and entertainment limitation per IRC § 274(n). Employers may be paying their out-of-town employees a per diem rate with nothing being applied to meals, and deducting the total as lodging
expense. Revenue Procedure 2003-80, however, sets forth the rules for per diem allowances. Generally, a portion of the allowance must be treated as paid for meals. Depreciation of Automobiles and SUV’s
For passenger automobiles, the total depreciation deduction (including the Section 179 deduction) that can be claimed is limited.
Passenger automobile defined: A passenger automobile is any four-wheeled vehicle made primarily for use on public streets, roads, and highways and rated at 6,000
pounds or less of unloaded gross vehicle weight. However, in the case of a truck or van gross vehicle weight is substituted for unloaded gross vehicle weight. It includes any part, component, or other item physically attached to the automobile or usually included in the purchase price of an automobile. I.R.C. § 280F(d)(5)(A)
SUVs (Sport Utility Vehicles) are commonly used within the construction industry. Revenue Procedure 2003-75 defines the term “trucks and vans” as passenger automobiles that are built on a truck chassis, including minivans and sport utility
vehicles (SUVs) that are built on a truck chassis. If the taxpayer is depreciating SUVs, research (via internet or the manufacturer/dealership) may be necessary to determine the gross vehicle weight to determine if the passenger automobile depreciation
limitation is applicable.
Personal Use of Business Assets
Contractors in closely held businesses sometimes deduct expenses for improvements to a personal residence. These expenses are frequently deducted through cost of sales, along with other contract costs. If the taxpayer is a corporation and the expenses are incurred to improve a shareholder's residence, a potential dividend issue exists, and the expenses are not deductible. If improvements are made to an employee's residence, then a possible employment tax issue exists. Being able to understand the contractor’s billing and job cost records is crucial to the examination of a contractor. Sampling invoices for deliveries to the contractor’s residence or for excess building supplies charged to a job is an example of audit techniques for this issue.
Unreasonable Compensation
Officer/owner compensation often fluctuates significantly. An argument may be made that the present-year compensation is due to artificially low compensation in earlier years. This argument may be valid, and will be sustained where the early years of the operation were used to build capital. However, if the operation is well established, and the profits of a high-volume year are being reduced through high compensation, the examiner should seriously consider raising the issue. Industry averages are also available through Web sites such as Bizstats.com. This issue is dependent upon the facts and circumstances of each case.
Double Deductions
Double deductions can occur when the contractor uses a single-entry bookkeeping system. Some job costs may be both capitalized and expensed in the current period. Since the single entry bookkeeping system will allow duplications to occur, the auditor should consider using
in-depth investigative techniques. Interest Expense – Cash Method
For a contractor on the cash method of accounting, interest expense on a construction loan is not deductible until it is paid. A construction loan differs from a conventional loan in that a construction loan usually does not require interim payments. Even the loan origination fees may be financed. These expenses are not deductible until the payments are made. The loan documents should be examined to determine the terms for making principal and interest payments, as well as verifying the actual payments made during the year.
See Heyman v. Commissioner, 70 T.C. 482 (1978), aff'd, 652 F.2d 598 (6th Cir. 1980).
Capitalization of Pre-development Costs
A developer may purchase a parcel of property for future development. Pre-
development costs must be capitalized and are not currently deductible. Several judicial decisions support this position:
John J. Reichel, 112 TC 14 - A real estate developer who purchased properties for development was required to capitalize related real estate taxes as indirect production expenses.
Lee D. Hustead, T.C. Memo 1994-374 - A developer was required to capitalize costs incurred to challenge the zoning of property.
Von-Lusk, 104 TC 207 - Property taxes and preliminary costs associated with the contemplated construction were required to be capitalized per IRC § 263A.
Contributions of Land and Facilities
Land developers and building contractors often donate land, buildings, or other assets to state or local governments, charitable organizations, or civic organizations. These assets usually have appreciated in value, due to the passage of time and/or the development activity by the builder. Be alert to deductions of the fair market value of the donated property as a charitable contribution.
Examiners should consider the “donative intent” of the builder. A common practice is for state and local government agencies having control of zoning and building permits to require the developer/builder to set aside and donate land and facilities for some of the following uses: schools, parks, police and fire stations, government offices, medical facilities, community centers, water and sewer plants, roads, and maintenance buildings. If the developer/builder donated the asset due to a requirement of a government agency or the facility was used as a promised improvement in selling efforts to customers, then the requisite “donative intent” for a contribution deduction is missing. Without this intent, the non-deductible donation is a part of the cost of
developing lots. In addressing this issue, examiners should inspect the builder’s correspondence and legal files, zoning and permit documents, minutes of government agency meetings, corporate minutes of the builder, newspaper articles, and the builder’s sales literature.
Examiners should be aware that developers/builders often allocate development costs only to the properties that will generate sales revenue. Thus, the donated property may only have the cost of raw land charged to it. The allocation of costs usually takes place in the early stages of development, while donations of property are made in the latter stages. You should be alert to ensure that a double recovery of cost is not allowed. Losses
There may be an improper inclusion of the total loss on a contract that is still in progress. Financial reporting (GAAP) requires the contractor to recognize the full amount of any anticipated loss in the current period, regardless of the degree of completion. However, for tax purposes, the loss is not deductible until the job is determined to be complete for taxpayers using the completed contract method. The loss incurred to date (not the total loss) is deductible for taxpayers using the PCM. Abandonment Losses
If a taxpayer abandons an asset, the loss is generally deductible to the extent of the taxpayer's adjusted basis in the abandoned property. To support an abandonment loss, the taxpayer must establish an intent to abandon the asset and must make some
affirmative act of abandonment. The loss is deductible in the year the abandonment is sustained with regard to non-depreciable property.
In general, abandonment losses occur with "spec" homebuilders, real estate developers, and related-party entities more frequently than with other types of
contractors. Some reasons for abandonment losses are due to lack of financing, lack of bonding, disapproval of zoning changes, cost overruns or, in the case of related parties, possible tax avoidance.
A contractor or subcontractor may incur expenses for improvements to his personal residence (or that of a friend or relative) or build a home for his personal use (or that of a friend or relative). These expenses might be applied to another job to disguise the costs, or the taxpayer might report the job separately, but “sell” the residence for cost. Potential issues are disallowance of personal expenses and/or dividend issues, if a corporation. The difference between the FMV and the actual “sales” price to the shareholder would be subject to constructive dividend rules.
Also, allocation of indirect costs not “charged” to the taxpayer/relative would result in a nondeductible loss per IRC § 267.
Severed Contracts
For tax purposes, losses are not deductible until incurred. Under the completed contract method, none of the loss may be deducted until the contract is completed. Under the percentage of completion method, the loss is deducted as the job
progresses. By improperly severing a contract, the taxpayer is recognizing the loss prematurely.
See Treas. Reg. § 1.460-1(e).
Bad Debts and Cancellation of Debt Income
The typical bad debt issue must be reviewed when there are related party transactions involved. If one party has a legitimate bad debt, the other related party should have cancellation, or forgiveness, of debt income. Bad debts are deductible under IRC § 166, and cancellation of debt is income pursuant to IRC § 108. Be aware that the facts of bankruptcy or insolvency may impact the recognition of forgiveness of debt income. Also, net operating losses may have to be reduced if bankruptcy limits the recognition of forgiveness of debt income.
Bad debts require an inquiry into the following: 1. Debt or equity investment?
2. Whose debt is it? (Related party?) 3. Business or non-business?
4. Have the funds actually been transferred, or have only adjusting journal entries been made?
5. Has interest been charged and reported?
6. Do documents exist that support the transactions? Warranty Reserves or Contingent Liabilities
An accrual basis taxpayer may be deducting estimated warranty costs from a reserve account established to reflect a liability for future services:
• Reg. §1.446-1(c)(1)(ii) - Under the accrual method a liability is incurred in the taxable year in which all the events have occurred that establish the fact of the liability, the amount can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.
• IRC § 461(h)(1) - In determining whether an amount has been incurred, the all events test shall not be met any earlier than when economic performance occurs. Economic performance occurs when service or property is provided by the
taxpayer.
Economic performance has not occurred with respect to estimated warranty costs, and contingent liabilities are nondeductible. The examiner should be aware that for GAAP these items are reportable, so there should be an M-1 adjustment for these items. Model Homes
The taxpayer is in the business of building and selling residential houses. To assist in its sales activity, the taxpayer may use certain houses as models and/or sales offices temporarily. Such use generates no rental income to the taxpayer. Revenue Ruling 75- 538 provides guidance. It holds that a vehicle is not property used in the business (thus subject to depreciation) if it is used merely for demonstration purposes or is temporarily withdrawn from stock-in-trade. Model homes/sales offices are used for a small fraction of their expected useful lives, and the taxpayer ultimately expects to sell these houses. Although the taxpayer may be reluctant or unwilling to sell the houses while they are being used as a model home or sales office, they remain property held primarily for sale to customers and may not be depreciated.
See Rev. Rul. 89-25.