E ae EMPLOYEE EXPENSES AND DEFERRED COMPENSATION LEARNING OBJECTIVES After studying this chapter, you should be able to Determine the proper classification and deductibility of travel and, transportation expenses Determine the proper deductible amount for entertainment expenses under the 50% disallowance rule P> Identify deductible moving expenses and determine the amount and year of deductibility D> Describe the requirements for deducting education expenses B> Determine whether the expenses of an office in hore meet the requirements for deductibility and apply the gross income limitations D> Discuss the tax treatment and requirements for various deferred ‘compensation arrangements9-2 Individuals ¥ Chapter 9 CHAPTER OUTLINE —_ This chapter discusses the tax consequences from two types of expenditures: ‘asifation and Limitations of | Expenditures incurred by an employee in connection with his or her job Employee Expenses92 eee sa > Deferred compensation payments made to employees ‘ansportation Expenses.29 Employees routinely incur expenses in connection with their jobs, such as travel, enter- Entertainment Expenses.8-12 __gainment, professional journals, etc. The tax law considers employee expenses to be Reimburseg Employee Business incurred in connection with a trade or business and, therefore are deductible under Sec. aoe 162. However, employee expenses are subject to a myriad of special rules and limitations. Education Expenses .21 Because of the large number of taxpayers who are employees and the importance of the Office inHome Expenses..24 topic, this chapter discusses the rules as well as tax planning opportunities. Deferred Compensation. 9:25 Deferred compensation refers to methods of compensating employees that are based on Tax Planning Consderations.944 their current service, bur the actual payments are deferred until future periods. Deferred com- eapianar on Srececuret pensation arrangements are very popular and widely used in business. The two principal types of deferred compensation methods are qualified plans and nongualified plans. Qualified plans, such as pension and profit-sharing plans, have very favorable tax benefits but also impose strict eligibility and coverage requirements. Nonqualified plans, while not as tax advantageous as qualified plans, are very useful for highly compensated employees. Both of these types of deferred compensation arrangements are discussed later in this chapter. (NG La ssiricatIon AND LIMITATIONS OF EMPLOYEE EXPENSES ADDITIONAL Employee expenses, for purposes of the tax law, are divided into two classifications: reim- ‘COMMENT bbursed employee expenses and wnreimbursed employee expenses. Reimbursed employee ‘heincome tas hasmade more expenses are expenses incurred by the employee that are reimbursed by the employer. IRC fas out ofthe American people Seccion 62(a)(2) provides that an employee may deduct reimbursed employee expenses for make a tax form onthe fevel,you AGI. This presumes, of course, that the employee has included the reimbursement in his gontknow when ts woush gross income. Unreimbursed employee expenses are generally deductible by employees, but “watReges| are deductible from AGI. A more detailed discussion of the proper treatment of employee ‘expenses under accountable and nonaccountable plans is presented later in this chapter. Some of the more frequently encountered employee expenses discussed in this chapter include: Travel ‘Transportation Moving Entertainment Education Office in home Each of these types of employee expenses are discussed later in this chapter. vryvyyy KEY POINT NATURE OF THE EMPLOYMENT RELATIONSHIP ‘The busines expenses of ase: An individual who provides services for another person or entity may be classified either ‘employed individual andthe as an employee or as a self-employed individual (also referred to as an independent con- reece ucGadarbeie — tactor). Ifthe individual is classified as self-employed, expenses are deductible for AGL AciTheterembunedboines under Se. 162, and ate reported on Schedule G of Form 1040, Conversely, expenses of upensesofan employee are” employees are deductible either or or from AGI depending on whether such expenses are saesicible om AE reimbursed of unreimbursed. In addition to the deductibility of expenses, the proper clas- sification is also important due to employment taxes, such as Social Security taxes. As is discussed below, self-employed taxpayers must pay both the employee's and employer's shares of social security taxes. EMPLOYER-EMPLOYEE RELATIONSHIP DEFINED. ‘The Treasury Regulations pro- vide that an employer-employee relationship generally exists where the employer has theEXAMPLE 19-1 > EXAMPLE ADDITIONAL COMMENT ‘Anyone in a trade or business making payments of $600 or more to an independent contrac: {or during a year must fle Form o99.aasc RECENT, DEVELOPMENT In November, 2006, in conjunction ‘with IRS Form 35-8, the RS inte ‘grated the 20 factors into twee main categories: Behavioral Control, Financial Control, and Relationship of the Parties. This new fest while not introducing ew factors, represents a more concise way to look atthe many, factors of determining 2 worker's satus, KEY POINT Even f the employee expenses ‘exceed 2% of AGL, the employee tay not derive a tax benefit it the deductible employee ‘expenses, when added tothe ther itemized deductions, do not ‘exceed the standard deduction § Reg, Sc. 31.3401} 16). Employee Expenses and Deferred Compensation ¥ Individuals 9-3 right to control and direct the individual who provides services with regard to the end result and the means by which the result is accomplished.! Carmen is a nurse who assists a group of doctors in a clinic. Carmen is under the direct supervi- sion of the doctors and is told what procedures to perform and when to perform them, Therefore, Carmen is classified as an employee. < Carol is a registered nurse who provides in-home services to several elderly patients. She receives instructions from the patients’ doctors regarding such items as medications and diet. arol is directly responsible for the delivery of nursing care and is in control of the end result. Thus, Carol is self-employed. < IMPORTANCE OF PROPER CLASSIFICATION. As mentioned above, proper classifi- cation is important both to employers and employees. If an individual is classified as an employee, the employer must match the Social Security and Medicare taxes that are paid by the employee. In addition, employers are generally liable for unemployment taxes for their employees. Thus, an employer must pay these employment taxes to the federal and/or state governments in addition to the wages, which means that the cost of an ‘employee generally is higher than for a non-employee. If an individual is determined to ‘not be an employee, the individual is considered to be self-employed (also called an inde- pendent contractor). Amounts paid to a self-employed individual are not considered to be ‘wages and the payor is not responsible for any employment taxes. However, the self- employed individual must pay both the employee and employer portions of Social Security and Medicare taxes. This tax is referred to as the self-employment tax. As can be seen from the above discussion, employment taxes are shifted from the employer to the self-employed individual if the individual is not considered to be an employee. Individuals may prefer to be classified as employees because the employee portion of the Social Security and Medicare taxes (7.65% in 2008) is only one-half of the self- ‘employment tax rate (15.3% in 2008). Of the 7.65%, 6.2% (12.4% for self-employed individuals) is for the old age, survivors and disability insurance (OASDI) portion of the FICA tax and is assessed on a maximum income amount of $102,000 (2008). The remaining 1.45% (2.9% for self-employed individuals) portion of the FICA tax is for hos- pital insurance and has no ceiling limitation? LITIGATION ISSUES AND ADMINISTRATIVE ENFORCEMENT. The determination as to whether an individual who performs services is either an employee or an indepen- dent contractor has been a major area of contention between the IRS and taxpayers. In Rev, Rul. 87-41, 1987-1 CB 296, the IRS enumerated 20 factors as guides for determining, whether an individual is an employee or an independent contractor. These factors are designed to help determine whether the person or persons for whom the services are per- formed exercises sufficient control over the individual for such an individual to be classi- fied as an employee. Some of the factors include instructions, set hours of work, work on ‘employer's premises, and method of payment (hourly versus commission, for example). Substantial litigation has occurred in the interpretation of these factors. For example, truck drivers who were owner-operators and were engaged under contract by an inter- state trucking company were considered independent contractors because they selected their own routes and were paid a percentage of the company’s receipts for shipment.> However, drivers for a moving van company were considered employees because the com- pany exercised control over their assignments.4 LIMITATIONS ON UNREIMBURSED EMPLOYEE EXPENSES 2% NONDEDUCTIBLE FLOOR. Section 67 imposes a nondeductible floor of 2% of AGI to the following types of itemized deductions: > Row, Rul. 76.226, 1976-1 CB 332 2 Fora more deiled discussion ofthe selemployment tax, (se Chaper L14). RN. Smith « US, 78-1 USTC 19263 (CA-S, 1978).