Potential IRS Examination Areas

Potential IRS Examination Areas

If the Internal Revenue Service should choose your tax return for an audit, there are several areas they are likely to scrutinize because taxpayers usually don’t have the proper records to substantiate these deductions. The IRS agent can then make an easy adjustment, assess additional taxes, and close the case.

The purpose of this section is to alert you to some areas that are often audited and inform you as to what documentation is required by the IRS. It is easier to take a few seconds at the time of the transaction to make the necessary notes and keep the receipts than to try and substantiate your deductions the night before the audit.

Travel and Entertainment Expenses

The costs of business travel and entertainment (T&E) expenses are susceptible to IRS scrutiny because such expenditures may reflect personal as well as business objectives. Therefore, there are many requirements to be met in order to deduct these expenses.

Detailed record keeping is a must for travel and entertainment deductions. No deduction is allowed for any T&E item, which is not substantiated by adequate records. An “adequate record” is a contemporaneous diary, account book, log, expense statement or similar record. Additionally, in the following cases documentary evidence (e.g., receipts, paid bills, cancelled checks) must also be furnished: all expenditures for lodging while away from home and any other expenditure of $25 or more. You don’t need receipts for local transportation (e.g., taxis) where such receipts aren’t readily available. Minor incidental expenses, such as tips, may be approximated (but must be entered in your diary or log). Documentary evidence may be adequate by itself; a diary or log entry may not be necessary, if the document discloses the amount, date, place and character of the expenditure.

Business Meals & Entertainment

Only 50% of the cost of business meals and entertainment is deductible.
An employee’s meals/entertainment deductions must be aggregated with “miscellaneous deductions.”
The “quiet business meal” is no longer deductible.
No deduction is allowed for food and beverages, which are “lavish or extravagant under the circumstances.”
The taxpayer must be present when food or beverages are furnished.
Travel for investment purposes or for education cannot be deducted.

Travel costs

The taxpayer must prove, via diary, receipts, etc., all of the following: the amount of each separate expenditure for traveling away from home; the dates of the departure and return home for each trip, and the number of days spent on business away from home; the destination or locality of the travel; and
the business reason for the travel or the nature of the business benefit derived or expected to be derived as a result of the travel.

Business entertainment expenses

The taxpayer must prove all of the following: the amount of each separate expenditure for entertaining, except that incidental items like cab fares and telephone calls may be aggregated on a separate basis;
by the date the entertainment took place; the name, address or location, and the type of entertainment;
the reason for entertaining, or the nature of the business benefit derived or expected to be derived as a result of entertaining, and the nature of any business discussion or activity that took place; and
the occupation or other information relative to the person or persons entertained, including name, title or other designation, sufficient to establish his business relationship to the taxpayer.

Business gifts

The taxpayer must prove all of the following: cost; when the gift was made; the reason for making the gift or the nature of business benefit derived or expected to be derived as a result of the gift; occupation or other information about the person receiving the gift, including his name, title, or other designation sufficient to establish his business relationship to the taxpayer; and description of the gift. The cost of ordinary and necessary business gifts may be deducted up to $25 a year to any individual.

Travel Away from Home

Expenses incurred while traveling away from home for business purposes are deductible. Deductible travel expenses include meals and lodging enroute and at the destination, baggage charges, air, rail and bus fare, cost of transporting sample cases or display materials, expenses for sample rooms, costs of maintaining or operating a car, telephone and telegraph expenses, laundry and dry cleaning costs, cost of a public stenographer, cost of transportation by taxi, etc., from the airport or station to the hotel, from the hotel to the airport or station, from one customer or place of work to another, transportation from where meals and lodging are obtained to the temporary work assignment, and reasonable tips incident to any of these expenses.

Mixed business and pleasure trips

Transportation costs to and from your destination are deductible only if the trip is related primarily to the taxpayer’s business. If the trip is primarily for business, but the taxpayer extends his stay for personal reasons, makes side trips, or engages in other non-business activities, he may deduct only the expenses, such as meals and lodging, that he would have incurred if the trip had been totally for business, but no allocation is required for transportation costs to and from the business destination.

Foreign travel: Only the amount directly allocable to business is deductible in the case of a mixed purpose foreign trip. Even where the travel is primarily for business, a portion of transportation, meals, and lodgings, etc., expenses of the business part (as well as all the pleasure part) is nondeductible. The nondeductible part is computed on a time ratio, usually in the proportion of non-business days to all travel days.

This allocation and denial of deduction is not made if 1) the taxpayer, if an employee, isn’t related to his employer and isn’t a managing executive; 2) travel is for one week or less; 3) less than 25% of the time is spent in non-business activity; 4) the individual traveling had no substantial control over the arranging of the trip; or 5) a personal vacation was not a major consideration in making the trip.

Education, investment travel: The costs of travel as a form of education are not deductible, nor are the expenses of traveling for investment (as opposed to business) purposes.


Entertainment expenses are deductible if they are “ordinary and necessary” business expenses and strict substantiation requirements are met. But no deduction is allowed unless the taxpayer can show that the entertainment expenses are: 1) “directly related” to the active conduct of a trade or business, or 2) “associated” with the active conduct of a trade or business.

Taxpayers may entertain business associates or other persons with whom the taxpayer could reasonably expect to engage or deal in the active conduct of his trade or business. Examples of business associates are customers, suppliers, clients, employees, agents, partners, or professional advisors, whether established or prospective.

Entertainment expenses are deductible if they are “directly related” to the active conduct of the taxpayer’s trade or business. This test is met if the entertainment is 1) involved in an active discussion aimed at getting immediate revenue, 2) occurred in a clear business setting such as a hospitality room or 3) the expenditure must be reported as compensation for services performed by an individual other than employee.

Entertainment expenses that do not meet the “directly related” test but that are “associated” with the active conduct of the taxpayer’s business are deductible if the entertainment directly “precedes or follows” a substantial and bona fide business discussion.

Entertainment facilities: No deduction is allowed for any expense paid or incurred with respect to “an entertainment facility” used in conjunction with an activity that is of a type generally considered to constitute entertainment, amusement or recreation. A deduction is now specifically not allowed in the case of social, athletic, sporting and other clubs dues even when the taxpayer establishes that the facility was used primarily to further the taxpayer’s business and that the item was directly related to the active conduct of that business.

Expenses incurred with regard to entertainment facilities that are disallowed include yachts; hunting lodges, fishing camps, swimming pools, tennis courts, and bowling alleys. Fees paid to any social, athletic, or sporting club or organization is treated as expenditure for an entertainment facility.

Automobile Expenses

The owner of a small business often uses a car or truck for both business and personal purposes. The extent to which the company can claim depreciation deductions, any investment tax credit, or lease payments depends on the extent to which the owner (or other employee) uses car or truck for business purposes. In addition, the value of a closely held corporations stockholder’s personal use of a corporate-owned car or truck is a taxable fringe benefit.

Listed property includes any passenger automobile; other transportation vehicles, e.g. boats; computers and related equipment, and cellular telephone equipment. If your listed property is not used more than 50% for business during any tax year, Section 179 deductions are not allowed and you must depreciate the property using the ADS method.

Luxury Car and Listed Property Limitations

The definition of a “luxury automobile” is a passenger automobile or light truck with an unloaded gross weight of 6,000 lbs or less.

If an car or truck is placed in service after December 31, 1986, its cost must be recovered over at least five years using 200% declining balance depreciation with a switch to straight-line. The luxury car limitations place a special dollar limit on the depreciation and Section 179 deduction you can claim each year. Although the dollar amounts change, as an illustration, for a car placed into service in 1992, your total Section 179 and depreciation deduction in the first year cannot exceed $2,760; the second year cannot exceed $4,400; $2,650 the third year, and $1,575 each later year.

To the extent that business use of the automobile (“luxury” or otherwise) is less than 100% the allowable tax benefits and depreciation deductions must be reduced proportionately.

An automobile-related deduction for depreciation, lease payments or other expenses must be substantiated by adequate corroborative records that evidence the extent to which the vehicle has been driven for business purposes. The rule requiring adequate substantiation extends to “listed property” which includes passenger cars; other transportation vehicles; computer equipment; and property used for entertainment, recreation, or amusement.

Tax Return Reporting

A business claiming car and light truck related deductions must, on its tax return, provide certain information about the use of the vehicle. This information pertains to mileage (total, business, commuting, and other personal mileage), the percentage of business use, the date the vehicle was placed in service, and the existence of adequate records to support the business use being claimed on the return.

A business that provides more than five vehicles to its employees does not have to provide detailed information on its tax return. However, it must obtain relevant information from its employees and indicate that such data are in its possession.

Use of a company car for business purposes qualifies as a working condition fringe benefit, and the value of that business-related use is not included in income. But to the extent the car is driven for non-business purposes, the value of such personal use is taxable (unless the employee reimburses the company for value of that use). The value of an employee’s personal use of the car is still considered to be taxable income that must be reported on the employee’s Form W-2. The company can assume that all use of the car by the employee was personal use and report 100% of the car’s annual lease value as income. The employee can calculate the value of any business use on Form 2106, Employee Business Expenses, and report the resulting amount on his or her personal tax return.

Insurance Premiums

Insurance premiums are ordinarily deductible in the tax year to which they apply. If you make an advance payment of the premium for an insurance policy that covers more than one tax year, even a cash basis taxpayer must prorate the premium and only deduct that amount which applies to the current tax year. The balance may be deducted in any later tax year to which it applies.

Generally, you may deduct insurance premiums paid on business insurance policies. Medical insurance paid by a proprietor and life insurance premiums require additional consideration. Split-dollar Insurance – if the officers or employees designate their own beneficiary, the employer retains no incidents of ownership and is not directly or indirectly the beneficiary, then the premiums are deductible. If more than $50,000 of insurance is purchased, the officer or employee may have to include as income the premium on the excess amount.

The medical insurance premiums paid by a self-employed person were only deductible on his personal tax return. However, the amount does not reduce the net earnings from self-employment for the self-employment tax computation.

Certain insurance premiums that are not deductible include any self-insurance premiums, or any premium paid on a policy that pays you for your lost earnings due to sickness or disability. This is not to be confused with overhead or business interruption insurance which are deductible.Split-dollar Insurance – if the officers or employees designate their own beneficiary, the employer retains no incidents of ownership and is not directly or indirectly the beneficiary, then the premiums are deductible. If more than $50,000 of insurance is purchased, the officer or employee may have to include as income the premium on the excess amount.
Key-person Insurance – life insurance covering any officer, employee or other financially interested party is deductible only if: 1) the payment is in the nature of additional compensation, 2) the total amount of compensation is reasonable, and 3) the policy is not beneficial to you either directly or indirectly. Key-person insurance are wages subject to withholding.