Understanding Shareholder Expenses in Corporate Taxation

When it comes to managing business expenses, corporations and S-corporations face specific rules and limitations, particularly concerning the expenses incurred by shareholders. This blog post will delve into why these entities cannot directly deduct shareholder expenses such as home office and vehicle expenses on the corporate return. Additionally, we will explore the importance of accountable plans for reimbursing personal expenses of owner-employees and provide guidance on how to establish such a plan.

The Limitation on Direct Deduction of Shareholder Expenses

Corporations and S-corporations are separate legal entities from their shareholders. This separation means that the expenses incurred by shareholders for personal use, even if related to business activities, cannot be directly deducted on the corporate tax return. Here are the primary reasons for this limitation:

1. Separation of Entity and Individual: The IRS treats corporations and their shareholders as distinct entities. Expenses incurred by shareholders are considered personal unless reimbursed by the corporation under an accountable plan.
2. Compliance with Tax Laws: Allowing direct deductions of shareholder expenses could lead to misuse and non-compliance with tax regulations. The IRS requires clear documentation and substantiation of business expenses to ensure they are legitimate and necessary for the business.
3. Avoidance of Double Dipping: If shareholders were allowed to deduct their expenses directly on the corporate return, it could result in double deductions—once on the corporate return and again on the individual return. This would lead to unfair tax advantages.

The Role of Accountable Plans

To address the issue of reimbursing personal expenses of owner-employees, corporations must use accountable plans. An accountable plan is a reimbursement arrangement that meets specific IRS requirements, ensuring that the expenses are legitimate business expenses and are properly documented.

Key Requirements of an Accountable Plan:

1. Business Connection: The expenses must have a direct business connection. This means the expenses must be incurred while performing services as an employee of the corporation.
2. Adequate Accounting: Employees must adequately account for their expenses within a reasonable period. This involves providing documentary evidence such as receipts, mileage logs, and detailed expense reports.
3. Return of Excess Reimbursements: Any excess reimbursement or allowance must be returned to the employer within a reasonable period.

Examples of Common Shareholder Expenses and Their Treatment With Accountable Plans

Let’s consider a scenario where a shareholder uses their personal vehicle for both personal and business purposes. Without an accountable plan, they might be tempted to deduct the entire vehicle expense on the corporate tax return. However, this is not permissible under IRS regulations. Instead, with an accountable plan in place, the shareholder would track the mileage specifically related to business activities and submit this documentation to the corporation for reimbursement. The corporation can then deduct this reimbursed amount as a business expense, while the shareholder properly excludes it from their income, ensuring compliance and avoiding any double deductions.

Before and After Accountable Plan:

Imagine an S-corporation owner who regularly works from home but has not set up an accountable plan. They might deduct their home office expenses directly on the corporate return, leading to potential IRS scrutiny. By establishing an accountable plan, they instead submit their documented home office expenses to the corporation, which then reimburses them. The corporation gets a valid deduction, and the owner avoids the pitfalls of improper deductions. This clear separation of personal and corporate expenses not only aligns with IRS guidelines but also simplifies the tax process for both the corporation and the shareholder.

What Can You Deduct Through an Accountable Plan?

Here’s a list of items that can be deducted via an accountable plan:

1. Business Travel Expenses
• Airfare, train, or bus tickets
• Hotel accommodations
• Meals (subject to IRS limits)
• Transportation costs (taxis, rideshares, rental cars)
• Tips related to travel
2. Vehicle Expenses
• Mileage for business use (using the standard mileage rate)
• Parking fees and tolls for business travel
• Maintenance and repairs (if using actual expense method)
• Gasoline costs (if using actual expense method)
• Lease payments (if applicable and prorated for business use)
3. Home Office Expenses
• Portion of rent or mortgage interest attributable to the business-use portion of the home
• Utilities (electricity, gas, water) proportionate to the home office space
• Internet service and telephone expenses (related to business use)
• Homeowners or renters insurance (portion related to the home office)
• Depreciation on home office space
4. Business Supplies and Equipment
• Office supplies (paper, pens, printer ink, etc.)
• Computer hardware and software
• Office furniture (desks, chairs, filing cabinets)
• Tools and equipment necessary for business operations
5. Professional Development and Education
• Tuition for business-related courses or certifications
• Registration fees for conferences, seminars, and workshops
• Subscriptions to business-related publications and journals
6. Meals and Entertainment (with limitations)
• Meals directly related to business meetings or client entertainment
• Event tickets and entertainment expenses (subject to IRS limits and requirements)
7. Work-Related Clothing
• Uniforms or protective clothing required for the job
• Specialized work attire that is not suitable for everyday wear
8. Communication Expenses
• Business-related phone calls
• Business portion of cell phone plans
• Business-related internet usage
9. Professional Fees
• Legal, accounting, or consulting fees related to the business
• Tax preparation fees for the business
10. Insurance Premiums
• Business liability insurance
• Professional malpractice insurance

These expenses must be properly documented, and only the portion that is directly related to business activities is deductible under an accountable plan.

How to Establish an Accountable Plan

Creating an accountable plan involves several steps to ensure compliance with IRS regulations. Here’s a step-by-step guide:

1. Draft a Written Plan: The first step is to draft a written accountable plan that outlines the types of expenses that will be reimbursed, the documentation required, and the process for submitting and approving expenses.
2. Define Eligible Expenses: Clearly define which expenses are eligible for reimbursement. Common examples include travel expenses, home office expenses, and vehicle expenses used for business purposes.
3. Set Documentation Requirements: Specify the documentation employees must provide to substantiate their expenses. This typically includes receipts, invoices, mileage logs, and detailed descriptions of the business purpose of each expense.
4. Implement a Submission Process: Establish a process for employees to submit their expenses for reimbursement. This process should include deadlines for submission and a review procedure to ensure all expenses meet the plan’s requirements.
5. Monitor and Enforce Compliance: Regularly review the submitted expenses to ensure compliance with the accountable plan. Any excess reimbursements should be promptly returned by the employees.
6. Communicate the Plan to Employees: Ensure that all employees, including owner-employees, are aware of the accountable plan and understand the requirements for reimbursement.

Best Practices for Documenting Expenses

Record-Keeping Tips: Proper documentation is the cornerstone of compliance when deducting expenses through an accountable plan. Corporations should implement a robust record-keeping system that makes it easy to track, organize, and retrieve receipts and other supporting documents. Utilizing accounting software that allows for the attachment of digital copies of receipts can be particularly helpful. Additionally, shareholders and employees should be diligent in maintaining logs for mileage, keeping detailed records of travel expenses, and promptly submitting all required documentation to the corporation. By staying organized, corporations can ensure that they are prepared for any potential inquiries from the IRS and can easily substantiate their deductions.

Audit Preparation: To further safeguard against potential issues, corporations should regularly review their documentation practices to ensure they are audit-ready. This includes conducting periodic internal audits to check that all expenses submitted under the accountable plan are properly documented and meet IRS requirements. Establishing a checklist of required documents—such as receipts, invoices, and logs—can help ensure that nothing is overlooked. By preparing as if an audit could happen at any time, corporations can streamline the audit process and reduce the risk of penalties or disallowed deductions.

Potential Consequences of Non-Compliance

IRS Penalties: Failing to comply with IRS regulations regarding the deduction of shareholder expenses can result in significant penalties. If the IRS discovers that a corporation has improperly deducted shareholder expenses directly on its return, the corporation may face back taxes, interest on the underpaid taxes, and potentially steep penalties. For instance, the IRS could disallow the deductions, leading to a higher tax liability, and impose accuracy-related penalties of up to 20% of the underpayment if it determines that there was negligence or disregard of rules. Additionally, repeated non-compliance could flag the corporation for further audits, which can be costly and time-consuming.

Tax Audits: Improperly deducting shareholder expenses on a corporate return can significantly increase the likelihood of an IRS audit. The IRS is vigilant about ensuring that corporations and their shareholders maintain a clear distinction between personal and business expenses. An audit can be a stressful and intrusive process, involving extensive reviews of financial records, interviews with corporate officers, and even the examination of personal financial records. By adhering to the proper procedures, such as using accountable plans, corporations can minimize the risk of audits and the associated costs and disruptions.

Corporations and S-corporations must navigate specific tax regulations when it comes to deducting shareholder expenses. By using accountable plans, these entities can ensure that personal expenses of owner-employees are properly reimbursed and documented, maintaining compliance with IRS rules. Establishing a clear and comprehensive accountable plan is essential for managing business expenses effectively and avoiding potential tax issues.

For more detailed information on accountable plans and business expense deductions, you can refer to Publication 535 (2022), Business Expenses.

By adhering to these guidelines, corporations can maintain financial integrity and ensure that all business expenses are handled in a tax-efficient manner.

FAQs on Accountable Plans: 

To address some of the most frequently asked questions about accountable plans, consider the following:

• Can I retroactively apply an accountable plan? No, an accountable plan must be established and followed before the expenses are incurred. Retroactive application is not allowed, so it’s important to set up the plan as early as possible.
• What happens if I don’t return excess reimbursements? If excess reimbursements are not returned within a reasonable time, they must be included in the employee’s taxable income, which could lead to unintended tax consequences for both the employee and the corporation.
• Can I include personal expenses in an accountable plan? No, only expenses that are directly related to business activities and that are properly documented can be included in an accountable plan. Personal expenses must be excluded to avoid issues 

We understand that every business situation is unique, and you may have specific questions about how accountable plans apply to your corporation. Feel free to give us a call and we can help walk you through this process and how it applies to your unique circumstances so you can navigate these complex tax regulations with confidence.

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