US Internal Revenue Service: p535--2000

8/14/2019 US Internal Revenue Service: p535--2000

1/55

ContentsIntroduction ........................................ 1

Important Changes for 2000 ............. 1

1. Deducting Business Expenses .. 2

2. Employees' Pay ........................... 5

3. Retirement Plans ......................... 8

4. Rent Expense .............................. 13

5. Interest ......................................... 15

6. Taxes ............................................ 20

7. Insurance ..................................... 22

8. Costs You Can Deduct orCapitalize ...................................... 24

9. Amortization ................................ 29

10. Depletion ...................................... 36

11. Business Bad Debts ................... 40

12. Electric and Clean-Fuel Vehicles 43

13. Other Expenses ........................... 46

14. How To Get Tax Help .................. 53

Index .................................................... 54

IntroductionThis publication discusses common businessexpenses and explains what is and is notdeductible. The general rules for deductingbusiness expenses are discussed in theopening chapter. The chapters that followcover specific expenses and list other publi-cations and forms you may need.

Comments and suggestions. We welcomeyour comments about this publication andyour suggestions for future editions.

You can e-mail us while visiting our website at www.irs.gov/help/email2.html.

You can write to us at the following ad-dress:

Internal Revenue ServiceTechnical Publications BranchW:CAR:MP:FP:P1111 Constitution Ave. NWWashington, DC 20224

We respond to many letters by telephone.Therefore, it would be helpful if you would

include your daytime phone number, includ-ing the area code, in your correspondence.

Important Changesfor 2000The following items highlight some changesin the tax law for 2000.

New Publication 15B. Information on thefollowing topics, previously contained in thispublication, has been moved to new Publica-tion 15B, Employer's Tax Guide to FringeBenefits.

Departmentof theTreasury

InternalRevenueService

Publica tion 535Cat. No. 15065Z

BusinessExpenses

For use in preparing

2000 Returns


2/55

Meals and lodging furnished to employ-ees.

Fringe benefits.

Employee benefit programs.

Standard mileage rate. The standard mile-age rate for the cost of operating your car,van, pickup, or panel truck in 2000 is 321/2cents a mile for all business miles. Seechapter 13.

Health insurance deduction for the self-employed. For 2000, this deduction is 60%of the amount you paid for health insurancefor yourself and your family. See chapter 7.

Meal expense deduction subject to hoursof service limits. For 2000, this deductionincreases to 60% of the reimbursed mealsyour employees consume while they aresubject to the Department of Transportation'shours of service limits. See chapter 13.

Marginal production of oil and gas. Thesuspension of the taxable income limit onpercentage depletion from the marginal pro-duction of oil and natural gas that wasscheduled to expire for tax years beginning

after 1999 has been extended to tax yearsbeginning before 2002. For more informationon marginal production, see section 613A(c)of the Internal Revenue Code.

Paid preparer authorization. Beginning withyour return for 2000, you can check a box andauthorize the IRS to discuss your Form 1040with your paid preparer who signed it. If youcheck the Yes box in the signature area ofyour return, the IRS can call your paidpreparer to answer any questions that mayarise during the processing of your return.Also, you are authorizing your paid preparerto perform certain actions. See your incometax package for details.

Photographs of missing children. TheInternal Revenue Service is a proud partnerwith the National Center for Missing and Ex-ploited Children. Photographs of missingchildren selected by the Center may appearin this publication on pages that would other-wise be blank. You can help bring thesechildren home by looking at the photographsand calling 1800THELOST (18008435678) if you recognize a child.

1.

DeductingBusinessExpenses

IntroductionThis chapter covers the general rules for de-ducting business expenses. Business ex-penses are the costs of carrying on a trade

or business. These expenses are usuallydeductible if the business is operated to makea profit.

TopicsThis chapter discusses:

What you can deduct

How much you can deduct

When to deduct

Not-for-profit activities

Useful ItemsYou may want to see:

Publication

334 Tax Guide for Small Business

463 Travel, Entertainment, Gift, andCar Expenses

525 Taxable and Nontaxable Income

529 Miscellaneous Deductions

536 Net Operating Losses (NOLs) forIndividuals, Estates, and Trusts

538 Accounting Periods and Methods 542 Corporations

547 Casualties, Disasters, and Thefts(Business and Nonbusiness)

587 Business Use of Your Home(Including Use by Day-Care Pro-viders)

925 Passive Activity and At-Risk Rules

936 Home Mortgage InterestDeduction

946 How To Depreciate Property

Form (and Instructions)

Sch A (Form 1040)Itemized De-ductions

5213 Election To PostponeDetermination as To Whether thePresumption Applies That anActivity Is Engaged in for Profit

See chapter 14 for information about get-ting publications and forms.

What Can I Deduct?To be deductible, a business expense mustbe both ordinary and necessary. An ordinaryexpense is one that is common and acceptedin your trade or business. A necessary ex-

pense is one that is helpful and appropriatefor your trade or business. An expense doesnot have to be indispensable to be considerednecessary.

It is important to separate business ex-penses from the following expenses.

The expenses used to figure the cost ofgoods sold.

Capital expenses.

Personal expenses.

TIPIf you have an expense that is partlyfor business and partly personal,separate the personal part from the

business part.

Cost of Goods SoldIf your business manufactures products orpurchases them for resale, some of your ex-penses are for the products you sell. You usethese expenses to figure the cost of the goodsyou sold during the year. You deduct thesecosts from your gross receipts to figure yourgross profit for the year. You must maintaininventories to be able to determine your costof goods sold. If you use an expense to figurethe cost of goods sold, you cannot deduct itagain as a business expense.

The following are types of expenses thatgo into figuring cost of goods sold.

The cost of products or raw materials inyour inventory, including the cost of hav-ing them shipped to you.

The cost of storing the products you sell.

Direct labor costs (including contributionsto pension or annuity plans) for workerswho produce the products.

Factory overhead expenses.

Under the uniform capitalization rules, youmay have to include certain indirect costs ofproduction and resale in your cost of goodssold. Indirect costs include rent, interest,

taxes, storage, purchasing, processing, re-packaging, handling, and administrativecosts. This rule on indirect costs does notapply to personal property you acquire forresale if your average annual gross receipts(or those of your predecessor) for the pre-ceding 3 tax years are not more than $10million.

For more information, see the followingsources.

Cost of goods soldchapter 6 of Publi-cation 334.

InventoriesPublication 538.

Uniform capitalization rulessection263A of the Internal Revenue Code and

the related regulations.

Capital ExpensesYou must capitalize, rather than deduct, somecosts. These costs are a part of your invest-ment in your business and are called capitalexpenses. There are, in general, three typesof costs you capitalize.

1) Going into business.

2) Business assets.

3) Improvements.

Recovery. Although you generally cannottake a current deduction for a capital ex-

pense, you may be able to take deductionsfor the amount you spend through depreci-ation, amortization, or depletion. These allowyou to deduct part of your cost each year overa number of years. In this way you are ableto recover your capital expense. SeeAmortization (chapter 9) and Depletion(chapter 10) in this publication. For informa-tion on depreciation, see Publication 946.

Going Into BusinessThe costs of getting started in business, be-fore you actually begin business operations,are capital expenses. These costs may in-clude expenses for advertising, travel, orwages for training employees.

Page 2 Chapter 1 Deducting Business Expenses


3/55

If you go into business. When you go intobusiness, treat all costs you had to get yourbusiness started as capital expenses.

Usually you recover costs for a particularasset through depreciation. Generally, youcannot recover other costs until you sell thebusiness or otherwise go out of business.However, you can choose to amortize certaincosts for setting up your business. See GoingInto Business in chapter 9 for more informa-tion on business start-up costs.

If you do not go into business. If you arean individual and your attempt to go intobusiness is not successful, the expenses youhad in trying to establish yourself in businessfall into two categories.

1) The costs you had before making a de-cision to acquire or begin a specificbusiness. These costs are personal andnondeductible. They include any costsincurred during a general search for, orpreliminary investigation of, a businessor investment possibility.

2) The costs you had in your attempt toacquire or begin a specific business.These costs are capital expenses andyou can deduct them as a capital loss.

If you are a corporation and your attemptto go into a new trade or business is notsuccessful, you may be able to deduct allinvestigatory costs as a loss.

The costs of any assets acquired duringyour unsuccessful attempt to go into businessare a part of your basis in the assets. Youcannot take a deduction for these costs. Youwill recover the costs of these assets whenyou dispose of them.

Business AssetsThe cost of any asset you use in your busi-ness is a capital expense. There are manydifferent kinds of business assets, such asland, buildings, machinery, furniture, trucks,patents, and franchise rights. You must capi-

talize the full cost of the asset, includingfreight and installation charges.

If you produce certain property for use inyour trade or business, capitalize the pro-duction costs under the uniform capitalizationrules. See section 1.263A2 of the regu-lations for information on those rules.

ImprovementsThe costs of making improvements to abusiness asset are capital expenses if theimprovements add to the value of the asset,appreciably lengthen the time you can use it,or adapt it to a different use. You can deductrepairs that keep your property in a normalefficient operating condition as a businessexpense.

Improvements include new electric wiring,a new roof, a new floor, new plumbing,bricking up windows to strengthen a wall, andlighting improvements.

Restoration plan. Capitalize the cost of re-conditioning, improving, or altering yourproperty as part of a general restoration planto make it suitable for your business. Thisapplies even if some of the work would byitself be classified as repairs.

Replacements. You cannot deduct the costof a replacement that stops deterioration andadds to the life of your property. Capitalizethat cost and depreciate it.

Treat amounts paid to replace parts of amachine that only keep it in a normal operat-ing condition like repairs. However, if yourequipment has a major overhaul, capitalizeand depreciate the expense.

Capital or Deductible ExpensesTo help you distinguish between capital anddeductible expenses, several different itemsare discussed below.

Business motor vehicles. You usuallycapitalize the cost of a motor vehicle you buyto use in your business. You can recover itscost through annual deductions for depreci-ation.

There are dollar limits on the depreciationyou can claim each year on passenger auto-mobiles used in your business. See Publica-tion 463.

Repairs you make to your business vehi-cle are deductible expenses. However,amounts you pay to recondition and overhaula business vehicle are capital expenses.

Roads and driveways. The costs of buildinga private road on your business property andthe cost of replacing a gravel driveway with

a concrete one are capital expenses you maybe able to depreciate. The cost of maintain-ing a private road on your business propertyis a deductible expense.

Tools. Unless the uniform capitalization rulesapply, amounts spent for tools used in yourbusiness are deductible expenses if the toolshave a life expectancy of less than 1 year.

Machinery parts. Unless the uniform cap-italization rules apply, the cost of replacingshort-lived parts of a machine to keep it ingood working condition and not add to its lifeis a deductible expense.

Heating equipment. The cost of changing

from one heating system to another is a cap-ital expense and not a deductible expense.

Personal ExpensesGenerally, you cannot deduct personal, living,or family expenses. However, if you have anexpense for something that is used partly forbusiness and partly for personal purposes,divide the total cost between the businessand personal parts. You can deduct as abusiness expense only the business part.

For example, if you borrow money anduse 70% of it for business and the other 30%for a family vacation, generally you can de-duct as a business expense only 70% of theinterest you pay on the loan. The remaining

30% is personal interest that is not deductible.See chapter 5 for information on deductinginterest and the allocation rules.

Business use of your home. If you use partof your home in your business, you may beable to claim part of the expenses of main-taining your home as a business expense.These expenses include mortgage interest,insurance, utilities, repairs, and depreciation.

The business use of your home must meetspecific requirements before you can take anyof these expenses as business deductions.

To qualify to claim expenses for the busi-ness use of your home, you must meet thefollowing tests.

1) The business part of your home must beused exclusively and regularly for yourtrade or business.

2) The business part of your home must beone of the following.

a) Your principal place of business.

b) A place where you meet or dealwith patients, clients, or customersin the normal course of your tradeor business.

c) A separate structure (not attachedto your home) you use in con-nection with your trade or business.

You do not have to meet the exclusive usetest for the part of your home that you regu-larly use in either of the following ways.

For the storage of inventory or productsamples.

As a day-care facility.

Your home office qualifies as your princi-pal place of business if you meet the followingrequirements.

You use the office exclusively and regu-larly for administrative or management

activities of your trade or business.

You have no other fixed location whereyou conduct substantial administrative ormanagement activities of your trade orbusiness.

For more information, see Publication 587.

Business use of your car. If you use yourcar in your business, you can deduct car ex-penses. If you use your car for both businessand personal purposes, you must divide yourexpenses based on mileage. Only your ex-penses for the miles you drove the car forbusiness are deductible as business ex-penses.

You can deduct actual car expenses,

which include depreciation (or lease pay-ments), gas and oil, tires, repairs, tune-ups,insurance, and registration fees. Instead offiguring the business part of these actual ex-penses, you may be able to use the standardmileage rate to figure your deduction. For2000, the standard mileage rate is 321/2 centsa mile for all business miles driven.

If you are self-employed, you can alsodeduct the business part of interest on yourcar loan, state and local personal property taxon the car, parking fees, and tolls, whetheror not you claim the standard mileage rate.You can use the nonbusiness part of thepersonal property tax to determine your de-duction for taxes on Schedule A (Form 1040)if you itemize your deductions.

For more information on car expenses andthe rules for using the standard mileage rate,see Publication 463.

How MuchCan I Deduct?You cannot deduct more for a business ex-pense than the amount you actually spend.There is usually no other limit on how muchyou can deduct if the amount is reasonable.However, if your deductions are large enoughto produce a net business loss for the year,the tax loss may be limited.

Chapter 1 Deducting Business Expenses Page 3


4/55

Recovery of amount deducted. If you re-cover part of an expense in the same tax yearfor which you would have claimed a de-duction, reduce your expense deduction bythe amount of the recovery. If you have a re-covery in a later year, include the recoveredamount in income. However, if part of thededuction for the expense did not reduce yourtax, you do not have to include all the recov-ery in income. Exclude the part that did notreduce your tax.

For more information on recoveries andthe tax benefit rule, see Publication 525.

Payments in kind. If you provide servicesto pay a business expense, the amount youcan deduct is the amount you spend to pro-vide the services. It is not what you wouldhave paid in cash.

Similarly, if you pay a business expensein goods or other property, you can deductonly the amount the property costs you. Ifthese costs are included in the cost of goodssold, do not deduct them as a business ex-pense.

Limits on losses. If your deductions for aninvestment or business activity are more than

the income it brings in, you have a net loss.There may be limits on how much, if any, ofthe loss you can use to offset income fromother sources.

Not-for-profit limits. If you do not carryon your business activity with the intention ofmaking a profit, you cannot use a loss fromit to offset other income. See Not-for-ProfitActivities, later.

At-risk limits. Generally, a deductibleloss from a trade or business or otherincome-producing activity is limited to the in-vestment you have at risk in the activity. Youare at risk in any activity for the followingitems.

1) The money and adjusted basis of prop-

erty you contribute to the activity.

2) Amounts you borrow for use in the ac-tivity if:

a) You are personally liable for repay-ment, or

b) You pledge property (other thanproperty used in the activity) as se-curity for the loan.

For more information, see Publication 925.Passive activities. Generally, you are in

a passive activity if you have a trade or busi-ness activity in which you do not materiallyparticipate during the year, or a rental activity.

Deductions from passive activities can gen-erally offset your income from only passiveactivities. You cannot use any excess de-ductions to offset your other income. In addi-tion, you can take passive activity credits onlyfrom tax on net passive income. Any excessloss or credits are carried over to later years.For more information, see Publication 925.

Net operating loss. If your deductionsare more than your income for the year, youmay have a net operating loss. You can usea net operating loss to lower your taxes inother years. See Publication 536 for more in-formation. See Publication 542 for informationabout net operating losses of corporations.

When Can IDeduct an Expense?When you deduct an expense depends onyour accounting method. An accountingmethod is a set of rules used to determinewhen and how income and expenses are re-ported. The two basic methods are the cashmethod and an accrual method.

For more information on accounting

methods, see Publication 538.

Cash method. Under the cash method ofaccounting, you deduct business expenses inthe tax year you actually paid them, even ifyou incur them in an earlier year.

Accrual method. Under an accrual methodof accounting, you generally deduct businessexpenses when you become liable for them,whether or not you pay them in the sameyear. All events that set the amount of theliability must have happened, and you mustbe able to figure the amount of the expensewith reasonable accuracy.

Economic performance rule. Under anaccrual method, you generally cannot deduct

or capitalize business expenses until eco-nomic performance occurs. If your expenseis for property or services provided to you, oryour use of property, economic performanceoccurs as the property or services are pro-vided, or the property is used. If your expenseis for property or services you provide to oth-ers, economic performance occurs as youprovide the property or services.

Example. Your tax year is the calendaryear. In December 2000, the Field PlumbingCompany did some repair work at your placeof business and sent you a bill for $150. Youpaid it by check in January 2001. If you usean accrual method of accounting, deduct the$150 on your tax return for 2000 because allevents occurred to fix the fact of liability andeconomic performance occurred in that year.If you use the cash method of accounting, youcan deduct the expense on your 2001 return.

Prepayment. You cannot deduct expensesin advance, even if you pay them in advance.This rule applies to both the cash and accrualmethods. It applies to prepaid interest, pre-paid insurance premiums, and any other ex-pense paid far enough in advance to, in ef-fect, create an asset with a useful lifeextending substantially beyond the end of thecurrent tax year.

Example. In 2000, you sign a 10-yearlease and immediately pay your rent for thefirst 3 years. Even though you paid the rent

for 2000, 2001, and 2002, you can deductonly the rent for 2000 on your current tax re-turn. You can deduct on your 2001 and 2002tax returns the rent for those years.

Contested liability. Under the cash method,you can deduct a contested liability only in theyear you pay the liability. Under an accrualmethod, you can deduct contested liabilities,such as taxes (except foreign or U.S. pos-session income, war profits, and excess pro-fits taxes), in the tax year you pay the liability(or transfer money or other property to satisfythe obligation) or in the tax year you settle thecontest. However, to take the deduction in theyear of payment or transfer, you must meet

certain conditions. See Contested Liability inPublication 538 for more information.

Related person. Under an accrual methodof accounting, you generally deduct expenseswhen you incur them, even if you have notpaid them. However, if you and the personyou owe are related and the person uses thecash method of accounting, you must pay theexpense before you can deduct it. The de-duction by an accrual method payer is al-lowed when the corresponding amount isincludible in income by the related cashmethod payee. See Related Personsin Pub-lication 538.

Not-for-ProfitActivitiesIf you do not carry on your business or in-vestment activity to make a profit, there is alimit on the deductions you can take. Youcannot use a loss from the activity to offsetother income. Activities you do as a hobby,or mainly for sport or recreation, come underthis limit. So does an investment activity in-tended only to produce tax losses for the in-

vestors.The limit on not-for-profit losses applies toindividuals, partnerships, estates, trusts, andS corporations. It does not apply to corpo-rations other than S corporations.

In determining whether you are carryingon an activity for profit, all the facts are takeninto account. No one factor alone is decisive.Among the factors to consider are whether:

1) You carry on the activity in a business-like manner,

2) The time and effort you put into the ac-tivity indicate you intend to make it prof-itable,

3) You depend on income from the activityfor your livelihood,

4) Your losses are due to circumstancesbeyond your control (or are normal in thestart-up phase of your type of business),

5) You change your methods of operationin an attempt to improve profitability,

6) You, or your advisors, have the knowl-edge needed to carry on the activity asa successful business,

7) You were successful in making a profitin similar activities in the past,

8) The activity makes a profit in someyears, and how much profit it makes, and

9) You can expect to make a future profitfrom the appreciation of the assets used

in the activity.

Limit onDeductions and LossesIf your activity is not carried on for profit, takedeductions only in the following order, only tothe extent stated in the three categories, and,if you are an individual, only if you itemizethem on Schedule A (Form 1040).

Category 1. Deductions you can take forpersonal as well as for business activities areallowed in full. For individuals, all nonbusi-ness deductions, such as those for homemortgage interest, taxes, and casualty losses,

Page 4 Chapter 1 Deducting Business Expenses


5/55

belong in this category. Deduct them on theappropriate lines of Schedule A (Form 1040).You can deduct a casualty loss on propertyyou own for personal use only to the extentit is more than $100 and all these losses aremore than 10% of your adjusted gross in-come. See Publication 547 for more informa-tion on casualty losses. For the limits thatapply to mortgage interest, see Publication936.

Category 2. Deductions that do not result in

an adjustment to the basis of property areallowed next, but only to the extent your grossincome from the activity is more than the de-ductions you take (or could take) for it underthe first category. Most business deductions,such as those for advertising, insurance pre-miums, interest, utilities, wages, etc., belongin this category.

Category 3. Business deductions that de-crease the basis of property are allowed last,but only to the extent the gross income fromthe activity is more than deductions you take(or could take) for it under the first two cate-gories. The deductions for depreciation,amortization, and the part of a casualty lossan individual could not deduct in category (1)

belong in this category. Where more than oneasset is involved, divide depreciation andthese other deductions proportionally amongthose assets.

TIPIndividuals must claim the amounts incategories (2) and (3) as miscella-neous deductions on Schedule A

(Form 1040). They are subject to the2%-of-adjusted-gross-income limit. See Pub-lication 529 for information on this limit.

Example. Ida is engaged in a not-for-profit activity. The income and expenses ofthe activity are as follows.

Ida must limit her deductions to $3,200,the gross income she earned from the activ-ity. The limit is reached in category (3), asfollows.

The $300 for depreciation is divided be-tween the automobile and machine as fol-lows.

$600 $300 = $225 depreciation for the automobile

$800

$200 $300 = $75 depreciation for the machine

$800

The basis of each asset is reduced ac-cordingly.

The $1,600 for category (1) is deductiblein full on the appropriate lines for taxes and

interest on Schedule A (Form 1040). Ida addsthe remaining $1,600 (the total of categories(2) and (3)) to her other miscellaneous de-ductions on Schedule A (Form 1040) that aresubject to the 2%-of-adjusted-gross-incomelimit.

Partnerships and S corporations. If apartnership or S corporation carries on anot-for-profit activity, these limits apply at thepartnership or S corporation level. They arereflected in the individual shareholder's or

partner's distributive shares.

More than one activity. If you have severalundertakings, each may be a separate activityor several undertakings may be one activity.The following are the most significant factsand circumstances in making this determi-nation.

The degree of organizational and eco-nomic interrelationship of various under-takings.

The business purpose that is (or mightbe) served by carrying on the variousundertakings separately or together in abusiness or investment setting.

The similarity of various undertakings.

The IRS will generally accept your char-acterization of several undertakings as oneactivity, or more than one activity, if supportedby facts and circumstances.

TIPIf you are carrying on two or moredifferent activities, keep the de-ductions and income from each one

separate. Figure separately whether each isa not-for-profit activity. Then figure the limiton deductions and losses separately for eachactivity that is not for profit.

Presumption of ProfitAn activity is presumed carried on for profit ifit produced a profit in at least 3 of the last 5tax years, including the current year. Activitiesthat consist primarily of breeding, training,showing, or racing horses are presumed car-ried on for profit if they produced a profit inat least 2 of the last 7 tax years, including thecurrent year. You have a profit when thegross income from an activity is more than thedeductions for it.

If a taxpayer dies before the end of the5-year (or 7-year) period, the period ends onthe date of the taxpayer's death.

If your business or investment activitypasses this 3- (or 2-) years-of-profit test, pre-sume it is carried on for profit. This means itwill not come under these limits. You can take

all your business deductions from the activity,even for the years that you have a loss. Youcan rely on this presumption in every case,unless the IRS shows it is not valid.

Using the presumption later. If you arestarting an activity and do not have 3 (or 2)years showing a profit, you may want to takeadvantage of this presumption later, after youhave the 5 (or 7) years of experience allowedby the test.

You can choose to do this by filing Form5213. Filing this form postpones any deter-mination that your activity is not carried on forprofit until 5 (or 7) years have passed sinceyou started the activity.

The benefit gained by making this choiceis that the IRS will not immediately questionwhether your activity is engaged in for profit.Accordingly, it will not restrict your de-ductions. Rather, you will gain time to earna profit in 3 (or 2) out of the first 5 (or 7) yearsyou carry on the activity. If you show 3 (or2) years of profit at the end of this period, yourdeductions are not limited under these rules.If you do not have 3 (or 2) years of profit, thelimit can be applied retroactively to any yearin the 5-year (or 7-year) period with a loss.

Filing Form 5213 automatically extendsthe period of limitations on any year in the5-year (or 7-year) period to 2 years after thedue date of the return for the last year of theperiod. The period is extended only for de-ductions of the activity and any related de-ductions that might be affected.

TIPYou must file Form 5213 within 3years after the due date of your returnfor the year in which you first carried

on the activity, or, if earlier, within 60 daysafter receiving written notice from the InternalRevenue Service proposing to disallow de-ductions attributable to the activity.

2.

Employees' Pay

IntroductionYou can generally deduct the pay you giveyour employees for the services they performfor your business. The pay may be in cash,property, or services. It may include wages,salaries, vacation allowances, bonuses,commissions, and fringe benefits. This chap-ter provides information about deductions al-lowed for various kinds of pay.

For information about determining who isan employee and about employment taxeson your employees' wages, see Publication15, Circular E, Employer's Tax Guide, Publi-cation 15A, Employer's Supplemental TaxGuide, and Publication 15B, Employer's TaxGuide to Fringe Benefits. For informationabout deducting employment taxes paid onyour employees' wages, see chapter 6.

TIPYou can claim the following employ-ment credits if you hire individualswho meet certain requirements.

Empowerment zone employment credit.

Indian employment credit.

Welfare-to-work credit.

Work opportunity credit.

However, you must reduce your deduction foremployee wages by the amount of any em-ployment credits you claim. For more infor-mation about these credits, see Publication954, Tax Incentives for Empowerment Zonesand Other Distressed Communities.

Gross income ............................................... $3,200

Minus expenses:Real estate taxes ........................... $700Home mortgage interest ................ 900Insurance ........................................ 400Utilities ............................................ 700Maintenance ................................... 200Depreciation on an automobile ...... 600Depreciation on a machine ............ 200 3,700

Loss ............................................................. $ 500

Limit on deduction ....................................... $3,200

Category 1: Taxes and interest ...... $1,600Category 2: Insurance, utilities, andmaintenance .................................... 1,300 2,900

Available for Category 3 ........................... $ 300

Chapter 2 Employees' Pay Page 5


6/55


Tests for deducting pay

Kinds of pay


Publication

15 Circular E, Employer's Tax Guide

15A Employer's Supplemental TaxGuide

15B Employer's Tax Guide to FringeBenefits


Tests for DeductingPayTo be deductible, your employees' pay must

be an ordinary and necessary expense andyou must pay or incur it in the tax year. Theseand other requirements that apply to all busi-ness expenses are explained in chapter 1.

In addition, the pay must meet both thefollowing tests.

Test 1. The pay must be reasonable.

Test 2. The pay must be for servicesperformed.

If these tests are met, the form or method offiguring the pay does not affect its deductibil-ity. For example, bonuses and commissionsbased on sales or earnings and paid underan agreement made before the services wereperformed are generally deductible.

Employee-shareholder salaries. If a cor-poration pays an employee who is also ashareholder a salary that is unreasonablyhigh considering the services actually per-formed, the excessive part of the salary maybe treated as a constructive distribution ofearnings to the employee-shareholder. Formore information on corporate distributions toshareholders, see Publication 542, Corpo-rations.

Test 1ReasonableDetermine the reasonableness of pay by thefacts. Generally, reasonable pay is theamount that like enterprises ordinarily would

pay for the services under similar circum-stances.You must be able to prove the pay is

reasonable. Base this test on the circum-stances that exist when you contract for theservices, not those existing when the rea-sonableness is questioned. If the pay is ex-cessive, you can deduct only the part that isreasonable.

Factors to consider. To determine if pay isreasonable, consider the following items andany other pertinent facts.

The duties performed by the employee.

The volume of business handled.

The character and amount of responsi-bility.

The complexities of your business.

The amount of time required.

The general cost of living in the locality.

The ability and achievements of the indi-vidual employee performing the service.

The pay compared with the gross and netincome of the business, as well as withdistributions to shareholders if the busi-

ness is a corporation. Your policy regarding pay for all your

employees.

The history of pay for each employee.

Individual salaries. You must base the testof whether a salary is reasonable on eachindividual's salary and the service performed,not on the total salaries paid to all officers orall employees. For example, even if the totalamount you pay to your officers is reason-able, you cannot deduct an individual officer'sentire salary if it is not reasonable based onthe items listed above.

Test 2For Services

PerformedYou must be able to prove the payment wasmade for services actually performed.

Kinds of PaySome of the ways you may provide pay toyour employees are discussed next.

AwardsYou can generally deduct, as wages,amounts you pay to your employees asawards, whether paid in cash or property.(For awards paid in property, see Property,

later.) However, if you give property to anemployee as an employee achievementaward, your deduction may be limited.

Achievement awards. An achievementaward is an item of tangible personal propertythat meets all the following requirements.

It is given to an employee for length ofservice or safety achievement.

It is awarded as part of a meaningfulpresentation.

It is awarded under conditions and cir-cumstances that do not create a signif-icant likelihood of disguised pay.

Length-of-service award. An award willnot qualify as a length-of-service award if ei-ther of the following applies.

The employee receives the award duringhis or her first 5 years of employment.

The employee received another length-of-service award (other than one of verysmall value) during the same year or inany of the prior 4 years.

Safety achievement award. An awardwill not qualify as a safety achievement awardif it is given to either of the following.

1) A manager, administrator, clerical em-ployee, or other professional employee.

2) More than 10% of your employees dur-ing the year, excluding those listed in (1).

Deduction limit. Your deduction for thecost of employee achievement awards givento any one employee during the tax year islimited to the following amounts.

$400 for awards that are not qualifiedplan awards.

$1,600 for all awards, whether or notqualified plan awards.

Claim the deduction as a nonwage businessexpense on your return or business schedule.

A qualified plan award is an achievementaward given as part of an established writtenplan or program that does not favor highlycompensated employees as to eligibility orbenefits.

A highly compensated employee for 2000is an employee who meets either of the fol-lowing tests.

1) The employee was a 5% owner at anytime during the year or the precedingyear.

2) The employee received more than$85,000 in pay for the preceding year.

You can choose to ignore test (2) if the em-ployee was not also in the top 20% of em-ployees when ranked by pay for the preced-ing year.

An award is not a qualified plan award ifthe average cost of all the employeeachievement awards given during the tax year(that would be qualified plan awards exceptfor this limit) is more than $400. To figure thisaverage cost, do not take into account awardsof very small value.

TIPYou may be able to exclude the valueof achievement awards you provideto an employee from the employee's

wages. See Publication 15B.

BonusesYou can generally deduct a bonus paid to anemployee as wages if you intended the bonusas additional pay for services, not as a gift,and the services were actually performed.However, the total bonuses, salaries, andother pay must be reasonable for the servicesperformed. If the bonus is paid in property,see Property, later.

Gifts of nominal value. If, to promote em-ployee goodwill, you distribute turkeys, hams,or other merchandise of nominal value to youremployees at holidays, you can deduct thecost of these items as a nonwage businessexpense. Your deduction for gifts of food ordrink are not subject to the 50% deduction

limit that generally applies to meals. For moreinformation on this deduction limit, see Mealsand lodging, later.

Education ExpensesIf you pay or reimburse education expensesfor an employee, you can deduct the pay-ments. Deduct payments for education that isnot related to the employee's job or that isnonqualifying education as wages. Deductpayments for education that is job related andis not nonqualifying education as a nonwagebusiness expense. Regardless of the natureof the education, deduct the payments on theemployee benefit programs line of your taxreturn or business schedule if they are part

Page 6 Chapter 2 Employees' Pay


7/55

of a qualified educational assistance program.For information on educational assistanceprograms, see Educational Assistance inchapter 2 of Publication 15B.

Nonqualifying education is education that:

1) Is needed to meet the minimum educa-tion requirements for the employee's job,or

2) Is part of a program of study that canqualify the employee for a different typeof job.

For a discussion on nonqualifying education,see Publication 508, Tax Benefits for Work-Related Education.

Fringe BenefitsA fringe benefit is a form of pay provided toany person for the performance of servicesby that person. The following are examplesof fringe benefits.

Benefits under qualified employee benefitprograms.

Meals and lodging.

The use of a car.

Flights on airplanes. Discounts on property or services.

Memberships in country clubs or othersocial clubs.

Tickets to entertainment or sportingevents.

You can generally deduct the cost offringe benefits you provide on your tax returnor business schedule in whatever categorythe cost falls. For example, if you allow anemployee to use a car or other property youlease, deduct the cost of the lease as a rentor lease expense. If you own the property,include your deduction for its cost or otherbasis as a section 179 deduction or a depre-

ciation deduction.

TIPYou may be able to exclude all or partof the fringe benefits you provide fromyour employees' wages. For more in-

formation about fringe benefits and the ex-clusion of benefits, see Publication 15B.

Employee benefit programs. Employeebenefit programs include the following.

Accident and health plans.

Adoption assistance.

Cafeteria plans.

Dependent care assistance.

Educational assistance.

Group-term life insurance coverage. Welfare benefit funds.

You can generally deduct amounts youspend on employee benefit programs on theemployee benefit programs line of your taxreturn or business schedule. However, if youprovide dependent care by operating a de-pendent care facility for your employees, de-duct your costs in whatever categories theyfall (depreciation, utilities, salaries, etc.).

Group-term life insurance coverage.You cannot deduct the cost of group-term lifeinsurance coverage if you are directly or in-directly the beneficiary of the policy. SeeNondeductible Premiumsin chapter 7.

Welfare benefit funds. A welfare benefitfund is a funded plan (or a funded arrange-ment having the effect of a plan) that provideswelfare benefits to your employees, inde-pendent contractors, or their beneficiaries.Welfare benefits are any benefits other thandeferred compensation or transfers of re-stricted property.

Your deduction for contributions to a wel-fare benefit fund is limited to the fund's qual-ified cost for the tax year. If your contributionsto the fund are more than its qualified cost,you can carry the excess over to the next taxyear.

Generally, the fund's qualified cost is thetotal of the following amounts, reduced by theafter-tax income of the fund.

The cost you would have been able todeduct using the cash method of ac-counting if you had paid for the benefitsdirectly.

The contributions added to a reserve ac-count that are needed to fund claims in-curred but not paid as of the end of theyear for supplemental unemploymentbenefits, severance pay, or disability,medical, or life insurance benefits.

For more information, see sections 419(c)

and 419A of the Internal Revenue Code andthe related regulations.

Meals and lodging. You can usually deductthe cost of furnishing meals and lodging toyour employees. However, you can generallydeduct only 50% of the cost of furnishingmeals.

Deduct the cost on your tax return orbusiness schedule in whatever category theexpense falls. For example, if you operate arestaurant, deduct the cost of the meals youfurnish to your employees as part of the costof goods sold. If you operate a nursing home,motel, or rental property, deduct the cost offurnishing lodging to an employee as ex-penses for utilities, linen service, salaries,

depreciation, etc.Deduction limit on meals. You cangenerally deduct only 50% of the cost of fur-nishing meals to your employees. However,you can deduct the full cost of the followingmeals.

Meals whose value you must include inan employee's wages.

Meals that qualify as a de minimis fringebenefit, as discussed in chapter 2 ofPublication 15B.

Meals you furnish to your employees atthe work site when you operate a res-taurant or catering service.

Meals you furnish to your employees as

part of the expense of providing recre-ational or social activities, such as acompany picnic.

Meals you must furnish to crew membersof a commercial vessel under a federallaw. This includes meals furnished tocrew members of commercial vesselsoperating on the Great Lakes, the SaintLawrence Seaway, or any U.S. inlandwaterway if the meals would be requiredunder federal law had the vessel beenoperated at sea. This does not includemeals you furnish on vessels primarilyproviding luxury water transportation.

Meals you furnish on an oil or gas plat-form or drilling rig located offshore or in

Alaska. This includes meals you furnishat a support camp that is near and inte-gral to an oil or gas drilling rig located inAlaska.

Loans or AdvancesYou generally can deduct as wages a loanor advance you make to an employee thatyou do not expect the employee to repay if itis for personal services actually performed.The total must be reasonable when you add

the loan or advance to the employee's otherpay. However, if the employee performs noservices, treat the amount you advanced tothe employee as a loan, which you cannotdeduct unless it becomes a bad debt. For in-formation on the deduction for bad debts, seechapter 11.

Below-market interest rate loans. On cer-tain loans you make to an employee orshareholder, you are treated as having re-ceived interest income and as having paidcompensation or dividends equal to that in-terest. See Below-Market Loan in chapter 5for more information.

PropertyIf you transfer property (including your com-pany's stock) to an employee as payment forservices, you can generally deduct it aswages. The amount you can deduct is its fairmarket value on the date of the transfer minusany amount the employee paid for the prop-erty.

You can claim the deduction only for thetax year in which your employee includes theproperty's value in income. Your employee isdeemed to have included the value in incomeif you report it on Form W2 in a timelymanner.

You treat the deductible amount as re-ceived in exchange for the property, and youmust recognize any gain or loss realized onthe transfer. Your gain or loss is the difference

between the fair market value of the propertyand its adjusted basis on the date of transfer.

CAUTION

!A corporation recognizes no gain orloss when it pays for services with itsown stock.

These rules also apply to property trans-ferred to an independent contractor, generallyreported on Form 1099MISC.

Restricted property. If the property youtransfer for services is subject to restrictionsthat affect its value, you generally cannot de-duct it and do not report gain or loss until itis substantially vested in the recipient. How-ever, if the recipient pays for the property, you

must report any gain at the time of the trans-fer up to the amount paid.Substantially vested means the property

is not subject to a substantial risk of forfeiture.The recipient is not likely to have to give uphis or her rights in the property in the future.

Reimbursementsfor Business ExpensesYou can generally deduct the amount you payor reimburse employees for business ex-penses they incur for you for items such astravel and entertainment. However, your de-duction for meal and entertainment expensesis usually limited to 50% of the payment.

Chapter 2 Employees' Pay Page 7


8/55

If you make the payment under an ac-countable plan, deduct it in the category ofthe expense paid. For example, if you pay anemployee for travel expenses incurred onyour behalf, deduct this payment as a travelexpense on your tax return or businessschedule. See the instructions for the formyou file for information on which lines to use.

If you make the payment under a nonac-countable plan, deduct it as wages on yourtax return or business schedule.

See Travel, Meals, and Entertainment inchapter 13 for more information about de-ducting reimbursements and an explanationof accountable and nonaccountable plans.

Sick PayYou can deduct amounts you pay to youremployees for sickness and injury, includinglump-sum amounts, as wages. However, yourdeduction is limited to amounts not compen-sated by insurance or other means.

Vacation PayVacation pay is an amount you pay to anemployee while the employee is on vacation.It includes an amount you pay an employee

for unused vacation leave. Vacation pay doesnot include any sick pay or holiday pay.

You can ordinarily deduct vacation payonly in your tax year in which the employeeactually receives it. This rule applies regard-less of whether you use the cash method oran accrual method of accounting.

However, you can deduct vacation pay inyour tax year in which the employee earns itif it is vested by the end of that year and theemployee actually receives it within 21/2months after the end of that year. Generally,vacation pay is vested if it is payable underan oral or written vacation pay plan that youtold your employees about before the tax yearand its amount and your liability for it arecertain.

3.

RetirementPlans

IntroductionThis chapter discusses retirement plans youcan set up and maintain for yourself and youremployees. Retirement plans are savingsplans that offer you tax advantages to setaside money for your own and your employ-ees' retirement.

In general, a sole proprietor or a partneris treated as an employee for participating ina retirement plan.

SEP, SIMPLE, and qualified plans offeryou and your employees a tax favored wayto save for retirement. You can deduct con-tributions you make to the plan for your em-ployees. If you are a sole proprietor, you candeduct contributions you make to the plan for

yourself. You can also deduct trustees' feesif contributions to the plan do not cover them.Earnings on the contributions are generallytax free until you or your employees receivedistributions from the plan in later years.

Under certain plans, employees can haveyou contribute limited amounts of theirbefore-tax pay to a plan. These amounts (andthe earnings on them) are generally tax freeuntil your employees receive distributionsfrom the plan in later years.

In general, individuals who are employedor self-employed can also set up and con-tribute to individual retirement arrangements(IRAs).


Simplified employee pension (SEP)

SIMPLE retirement plan

Qualified plan

Individual retirement arrangement (IRA)


Publication

560 Retirement Plans for Small Busi-ness (SEP, SIMPLE, and Qual-ified Plans)

590 Individual Retirement Arrange-ments (IRAs) (Including RothIRAs and Education IRAs)

Form (and Instructions)

W2 Wage and Tax Statement


Simplified EmployeePension (SEP)A simplified employee pension (SEP) is awritten plan that allows you to make deduct-ible contributions toward your own and youremployees' retirement without getting in-volved in more complex retirement plans. Acorporation also can have a SEP and makedeductible contributions toward its employ-ees' retirement. But certain advantagesavailable to qualified plans, such as the spe-cial tax treatment that may apply to lump-sumdistributions, do not apply to SEPs.

Under a SEP, you make the contributionsto a traditional individual retirement arrange-ment (called a SEP-IRA) set up for each eli-gible employee.

SEP-IRAs are set up for, at a minimum,each eligible employee. A SEP-IRA mayhave to be set up for a leased employee, butneed not be set up for an excludable em-ployee. For more information, see Publication560.

Form 5305SEP. You may be able to useForm 5305SEP, Simplified EmployeePension-Individual Retirement AccountsContribution Agreement, in setting up yourSEP.

Contribution LimitsContributions you make for a year to a com-mon-law employee's SEP-IRA are limited tothe lesser of $30,000 or 15% of the employ-ee's compensation. Compensation generallydoes not include your contributions to theSEP, but does include certain elective defer-rals unless you choose not to include them.

Annual compensation limit. You generallycannot consider the part of an employee'scompensation over $170,000 when you figureyour contribution limit for that employee.

More than one plan. If you also contributeto a defined contribution retirement plan (de-fined later), annual additions to all a partic-ipant's accounts are limited to the lesser of$30,000 or 25% of the participant's compen-sation. When you figure this limit, you mustadd your contributions to all defined contri-bution plans. A SEP is considered a definedcontribution plan for this limit.

Contributions for yourself. The annuallimits on your contributions to a common-lawemployee's SEP-IRA also apply to contribu-tions you make to your own SEP-IRA.

Deduction LimitThe most you can deduct for employer con-tributions for a common-law employee is 15%of the compensation paid to him or her duringthe year from the business that has the plan.

Deduction of contributions for yourself.When figuring the deduction for employercontributions made to your own SEP-IRA,compensation is your net earnings from self-employment minus the following amounts.

1) The deduction for one-half your self-employment tax.

2) The deduction for contributions to yourown SEP-IRA.

The deduction for contributions to yourown SEP-IRA and your net earnings dependon each other. For this reason, you determinethe deduction for contributions to your ownSEP-IRA indirectly by reducing the contribu-tion rate called for in your plan. Use the RateWorksheet for Self-Employed shown underQualified Plan, later, to figure the rate.

SEP and profit-sharing plan. If you alsocontributed to a qualified profit-sharing plan,you must reduce the 15% deduction limit forthat plan by the allowable deduction for con-tributions to the SEP-IRAs of those partic-ipating in both the SEP plan and the profit-sharing plan.

SEP and another qualified plan. If you alsocontributed to any other type of qualified plan,treat the SEP as a separate profit-sharingplan when applying the overall 25% deductionlimit described in section 404(h)(3) of theInternal Revenue Code.

TIPIf your SEP contribution is more thanthe deduction limit (nondeductiblecontribution), you can carry over and

deduct the difference in later years. However,the contribution carryover, when combinedwith the contribution for the later year, issubject to the deduction limit for that year.

Page 8 Chapter 3 Retirement Plans


9/55

Employee contributions. Employees canalso make contributions of up to $2,000 totheir SEP-IRAs independent of the employer'sSEP contributions. However, the employee'sdeduction for IRA contributions may be re-duced or eliminated because the employee iscovered by an employer retirement plan (theSEP plan). See Publication 590 for details.

Salary ReductionSimplified EmployeePension (SARSEP)

CAUTION

!An employer is no longer allowed toset up a SARSEP. However, partic-ipants in a SARSEP set up before

1997 (including employees hired after 1996)can continue to have their employer contrib-ute part of their pay to the plan.

A SARSEP is a SEP set up before 1997that included a salary reduction arrangement.Under the arrangement, employees canchoose to have you contribute part of theirpay to their SEP-IRAs rather than receive itin cash. This contribution is called an electivedeferral because employees choose (elect)

to set aside the money and the tax on themoney is deferred until it is distributed.This choice is available only if all the fol-

lowing requirements are met.

The SARSEP was set up before 1997.

At least 50% of the eligible employeeschoose the salary reduction arrangement.

You had 25 or fewer eligible employees(or employees who would have been eli-gible if you had maintained a SEP) at anytime during the preceding year.

Each eligible highly compensated em-ployee's deferral percentage each year isno more than 125% of the average

deferral percentage (ADP) of all non-highly compensated employees eligibleto participate (the ADP test). See Publi-cation 560 for the definition of a highlycompensated employee and informationon how to figure the deferral percentage.

Limit on elective deferrals. In general, thetotal income an employee can defer under aSARSEP and certain other elective deferralarrangements for 2000 is limited to the lesserof $10,500 or 15% of the employee's com-pensation (as defined in Publication 560).This limit applies only to amounts that reducethe employee's pay, not to any contributionsfrom employer funds.

Employment taxes. Elective deferrals thatmeet the ADP test are not subject to incometax in the year of deferral, but they are in-cluded in wages for social security, Medicare,and federal unemployment (FUTA) tax.

Reporting SEPContributions on Form W2Your contributions to an employee's SEP-IRAare excluded from the employee's income.Unless there are contributions under a salaryreduction arrangement, do not include thesecontributions in your employee's wages onForm W2 for income, social security, or

Medicare tax purposes. Your SEP contribu-tions under a salary reduction arrangementare included in your employee's wages forsocial security and Medicare tax purposesonly.

Example. Jim's salary reduction ar-rangement calls for 10% of his salary to becontributed by his employer as an electivedeferral to Jim's SEP-IRA. Jim's salary for theyear is $30,000 (before reduction for thedeferral). The employer did not choose to

treat deferrals as compensation under thearrangement. To figure the deferral, the em-ployer multiplies Jim's salary of $30,000 by9.0909%, the reduced rate equivalent of 10%,to get the deferral of $2,727.27. (This methodis the same one you, as a self-employedperson, use to figure the contributions youmake on your own behalf. See Rate Work-sheet for Self-Employed under QualifiedPlan.)

On Jim's Form W2, his employer showstotal wages of $27,272.73 ($30,000 $2,727.27), social security wages of $30,000,and Medicare wages of $30,000. Jim reports$27,272.73 as wages on his individual incometax return.

If his employer chooses to treat deferralsas compensation under the salary reductionarrangement, Jim's deferral would be $3,000($30,000 x 10%). In this case, the employeruses the rate called for under the arrange-ment (not the reduced rate) to figure thedeferral and the ADP test. On Jim's FormW2, the employer shows total wages of$27,000 ($30,000 $3,000), social securitywages of $30,000, and Medicare wages of$30,000. Jim reports $27,000 as wages onhis return.

In either case, the maximum deductiblecontribution would be $3,913.05 ($30,000 x13.0435%).

More information. For more information onemployer withholding requirements, see

Publication 15.For more information on SEPs, see Pub-

lication 560.

SIMPLERetirement PlansA Savings Incentive Match Plan for Employ-ees (SIMPLE plan) is a written arrangementthat provides you and your employees with asimplified way to make contributions to pro-vide retirement income. Under a SIMPLEplan, employees can choose to make salary

reduction contributions to the plan rather thanreceiving these amounts as part of their reg-ular pay. In addition, you will contributematching or nonelective contributions.

SIMPLE plans can only be maintained ona calendar-year basis.

A SIMPLE plan can be set up in either ofthe following ways.

Using SIMPLE IRAs (SIMPLE IRA plan).

As part of a 401(k) plan (SIMPLE 401(k)plan).

See Publication 560 for information onSIMPLE 401(k) plans.

TIPMany financial institutions will helpyou set up a SIMPLE plan.

SIMPLE IRA PlanA SIMPLE IRA plan is a retirement plan thatuses SIMPLE IRAs for each eligible em-ployee. Under a SIMPLE IRA plan, a SIMPLEIRA must be set up for each eligible em-ployee. For the definition of an eligible em-ployee, see Who Can Participate in a SIMPLEIRA Plan?, next.

Who Can Set Upa SIMPLE IRA Plan?You can set up a SIMPLE IRA plan if youmeet both the following requirements.

You meet the employee limit.

You do not maintain another qualifiedplan unless the other plan is for collectivebargaining employees.

Employee limit. You can set up a SIMPLEIRA plan only if you had 100 or fewer em-ployees who earned $5,000 or more in com-pensation during the preceding year. Under

this rule, you must take into account allem-ployees employed at any time during the cal-endar year regardless of whether they areeligible to participate. Employees includeself-employed individuals who receivedearned income, and leased employees.

Once you set up a SIMPLE IRA plan, youmust continue to meet the 100-employee limiteach year you maintain the plan.

Grace period for employers who ceaseto meet the 100-employee limit. If youmaintain the SIMPLE IRA plan for at least 1year and you cease to meet the100-employee limit in a later year, you will betreated as meeting it for the 2 calendar yearsimmediately following the calendar year forwhich you last met it.

A different rule applies if you do not meetthe 100-employee limit because of an acqui-sition, disposition, or similar transaction. Un-der this rule, the SIMPLE IRA plan will betreated as meeting the 100-employee limit forthe year of the transaction and the 2 followingyears if both the following conditions are sat-isfied.

Coverage under the plan has not signif-icantly changed during the grace period.

The SIMPLE IRA plan would have cont-inued to qualify after the transaction if youhad remained a separate employer.

CAUTION

!The grace period for acquisitions,dispositions, and similar transactions

also applies if, because of these typesof transactions, you do not meet the rulesexplained underOther qualified plan orWhoCan Participate in a SIMPLE IRA Plan?, be-low.

Other qualified plan. The SIMPLE IRA plangenerally must be the only retirement plan towhich you make contributions, or benefitsaccrue, for service in any year beginning withthe year the SIMPLE IRA plan becomes ef-fective.

Exception. If you maintain a qualifiedplan for collective bargaining employees, youare permitted to maintain a SIMPLE IRA planfor other employees.

Chapter 3 Retirement Plans Page 9


10/55

Who Can Participatein a SIMPLE IRA Plan?

Eligible employee. Any employee who re-ceived at least $5,000 in compensation duringany 2 years preceding the current calendaryear and is reasonably expected to earn atleast $5,000 during the current calendar yearis eligible to participate. The termemployee includes a self-employed individ-ual who received earned income.

You can use less restrictive eligibility re-

quirements (but not more restrictive ones) byeliminating or reducing the prior year com-pensation requirements, the current yearcompensation requirements, or both. For ex-ample, you can allow participation for em-ployees who received at least $3,000 incompensation during any preceding calendaryear. However, you cannot impose any otherconditions on participating in a SIMPLE IRAplan.

Excludable employees. The following em-ployees do not need to be covered under aSIMPLE IRA plan.

Employees who are covered by a unionagreement and whose retirement benefits

were bargained for in good faith by theemployees' union and you.

Nonresident alien employees who havereceived no U.S. source wages, salaries,or other personal services compensationfrom you.

Compensation. Compensation for employ-ees is the total wages required to be reportedon Form W2. Compensation also includesthe salary reduction contributions made underthis plan, compensation deferred under asection 457 plan, and the employees' electivedeferrals under a section 401(k) plan, aSARSEP, or a section 403(b) annuity con-tract. If you are self-employed, compensation

is your net earnings from self-employment(line 4 of Short Schedule SE (Form 1040))before subtracting any contributions made tothe SIMPLE IRA plan for yourself.

How To Set Up a SIMPLE IRA PlanYou can use Form 5304SIMPLE or Form5305SIMPLE to set up a SIMPLE IRA plan.Each form is a model savings incentive matchplan for employees (SIMPLE) plan document.Which form you use depends on whether youselect a financial institution or your employeesselect the institution that will receive the con-tributions.

Use Form 5304SIMPLE if you allow eachplan participant to select the financial institu-tion for receiving his or her SIMPLE IRA plan

contributions. Use Form 5305SIMPLE if yourequire that all contributions under theSIMPLE IRA plan be deposited initially at adesignated financial institution.

The SIMPLE IRA plan is adopted whenyou (and the designated financial institution,if any) have completed all appropriate boxesand blanks on the form and you have signedit. Keep the original form. Do not file it with theIRS.

Other uses of the forms. If you set up aSIMPLE IRA plan using Form 5304SIMPLEor Form 5305SIMPLE, you can use the formto satisfy other requirements, including thefollowing.

Meeting employer notification require-ments for the SIMPLE IRA plan. Page 3of Form 5304SIMPLE and Page 3 ofForm 5305SIMPLE contain a ModelNotification to Eligible Employeesthatprovides the necessary information to theemployee.

Maintaining the SIMPLE IRA plan recordsand proving you set up a SIMPLE IRAplan for employees.

Deadline for setting up a SIMPLE IRA plan.

You can set up a SIMPLE IRA plan effectiveon any date between January 1 and October1 of a year, provided you did not previouslymaintain a SIMPLE IRA plan. If you previ-ously maintained a SIMPLE IRA plan, youcan set up a SIMPLE IRA plan effective onlyon January 1 of a year. This requirement doesnot apply if you are a new employer thatcomes into existence after October 1 of theyear the SIMPLE IRA plan is set up and youset up a SIMPLE IRA plan as soon as ad-ministratively feasible after you come intoexistence. A SIMPLE IRA plan cannot havean effective date that is before the date youactually adopt the plan.

Setting up a SIMPLE IRA. SIMPLE IRAs

are the individual retirement accounts or an-nuities into which the contributions are de-posited. A SIMPLE IRA must be set up foreach eligible employee. Forms 5305S,SIMPLE Individual Retirement Trust Account,and 5305SA, SIMPLE Individual RetirementCustodial Account, are model trust and cus-todial account documents the participant andthe trustee (or custodian) can use for thispurpose.

A SIMPLE IRA cannot be designated asa Roth IRA. Contributions to a SIMPLE IRAwill not affect the amount an individual cancontribute to a Roth IRA.

Deadline for setting up a SIMPLE IRA.A SIMPLE IRA must be set up for an em-ployee before the first date by which a con-

tribution is required to be deposited into theemployee's IRA. See Time limits for contrib-uting fundslater under Contribution Limits.

Notification RequirementIf you adopt a SIMPLE IRA plan, you mustnotify each employee of the following infor-mation before the beginning of the electionperiod.

1) The employee's opportunity to make orchange a salary reduction choice undera SIMPLE IRA plan.

2) Your choice to make either reducedmatching contributions or nonelectivecontributions (discussed later).

3) A summary description and the locationof the plan. The financial institutionshould provide you with this information.

4) Written notice that his or her balance canbe transferred without cost or penalty ifyou use a designated financial institu-tion.

Election period. The election period is gen-erally the 60-day period immediately preced-ing January 1 of a calendar year (November2 to December 31 of the preceding calendaryear). However, the dates of this period aremodified if you set up a SIMPLE IRA plan inmid-year (for example, on July 1) or if the

60-day period falls before the first day anemployee becomes eligible to participate inthe SIMPLE IRA plan.

A SIMPLE IRA plan can provide longerperiods for permitting employees to enter intosalary reduction agreements or to modify prioragreements. For example, a SIMPLE IRAplan can provide a 90-day election period in-stead of the 60-day period. Similarly, in addi-tion to the 60-day period, a SIMPLE IRA plancan provide quarterly election periods duringthe 30 days before each calendar quarter,other than the first quarter of each year.

Contribution LimitsContributions are made up of salary reductioncontributions and employer contributions.You, as the employer, must make eithermatching contributions or nonelective contri-butions, defined later. No other contributionscan be made to the SIMPLE IRA plan. Thesecontributions, which you can deduct, must bemade timely. See Time limits for contributingfunds, later.

Salary reduction contributions. Theamount the employee chooses to have youcontribute to a SIMPLE IRA on his or herbehalf cannot be more than $6,000 for 2000.These contributions must be expressed as apercentage of the employee's compensationunless you permit the employee to expressthem as a specific dollar amount. You cannotplace restrictions on the contribution amount(such as limiting the contribution percentage),except to comply with the $6,000 limit.

If an employee is a participant in any otheremployer plan during the year and has elec-tive salary reductions or deferred compen-sation under those plans, the salary reductioncontributions under a SIMPLE IRA plan alsoare elective deferrals that count toward theoverall $10,500 annual limit on exclusion ofsalary reductions and other elective deferrals.

If the other plan is a deferred compen-sation plan of a state or local government or

a tax-exempt organization, the limit on elec-tive deferrals is $8,000.

Employer matching contributions. You aregenerally required to match each employee'ssalary reduction contributions on a dollar-for-dollar basis up to 3% of the employee'scompensation. This requirement does notapply if you make nonelective contributionsas discussed later.

Example. In 2000, your employee, JohnRose, earned $25,000 and chose to defer 5%of his salary. You make a 3% matching con-tribution. The total contribution you can makefor John is $2,000, figured as follows.

Lower percentage. If you choose amatching contribution less than 3%, the per-centage must be at least 1%. You must notifythe employees of the lower match within areasonable period of time before the 60-dayelection period (discussed earlier) for thecalendar year. You cannot choose a per-centage less than 3% for more than 2 yearsduring the 5-year period that ends with (andincludes) the year for which the choice is ef-fective.

Salary reduction contributions($25,000 .05) ............................................ $1,250Employer matching contribution($25,000 .03) ............................................ 750Total contributions .................................... $2,000

Page 10 Chapter 3 Retirement Plans


11/55

Nonelective contributions. Instead ofmatching contributions, you can choose tomake nonelective contributions of 2% ofcompensation on behalf of each eligible em-ployee who has at least $5,000 of compen-sation (or some lower amount of compen-sation that you select) from you for the year.If you make this choice, you must make non-elective contributions whether or not the em-ployee chooses to make salary reductioncontributions. Only $170,000 of the employ-ee's compensation can be taken into accountto figure the contribution limit.

If you choose this 2% contribution formula,you must notify the employees within a rea-sonable period of time before the 60-dayelection period (discussed earlier) for thecalendar year.

Example 1. In 2000, your employee,Jane Wood, earned $36,000 and chose tohave you contribute 10% of her salary. Youmake a 2% nonelective contribution. The totalcontributions you can make for her are$4,320, figured as follows.

Example 2. Using the same facts as inExample 1, above, the maximum contributionyou can make for Jane if she earned $75,000is $7,500, figured as follows.

Time limits for contributing funds. Youmust make the salary reduction contributionsto the SIMPLE IRA within 30 days after theend of the month in which the amounts wouldotherwise have been payable to the employeein cash. You must make matching contribu-

tions or nonelective contributions by the duedate (including extensions) for filing your fed-eral income tax return for the year.

When To Deduct ContributionsYou can deduct SIMPLE IRA contributions inthe tax year with or within which the calendaryear for which contributions were made ends.You can deduct contributions for a particulartax year if they are made for that tax year andare made by the due date (including exten-sions) of your federal income tax return forthat year.

Example 1. Your tax year is the fiscalyear ending June 30. Contributions under aSIMPLE IRA plan for the calendar year 2000

(including contributions made in 2000 beforeJuly 1, 2000) are deductible in the tax yearending June 30, 2001.

Example 2. You are a sole proprietorwhose tax year is the calendar year. Contri-butions under a SIMPLE IRA plan for thecalendar year 2000 (including contributionsmade in 2001 by April 16, 2001) are deduct-ible in the 2000 tax year.

Where To Deduct ContributionsDeduct contributions you make for your com-mon-law employees on your tax return. Forexample, sole proprietors deduct them onSchedule C (Form 1040) or Schedule F (Form

1040), partnerships deduct them on Form1065, and corporations deduct them on Form1120, Form 1120A, or Form 1120S.

Sole proprietors and partners deduct con-tributions for themselves on line 29 of Form1040. (If you are a partner, contributions foryourself are shown on the Schedule K1(Form 1065) you receive from the partner-ship).

Tax Treatment of ContributionsYou can deduct your contributions and your

employees can exclude these contributionsfrom their gross income. SIMPLE IRA contri-butions are not subject to federal income taxwithholding. However, salary reduction con-tributions are subject to social security, Med-icare, and federal unemployment (FUTA)taxes. Matching and nonelective contributionsare not subject to these taxes.

Reporting on Form W2. Do not includeSIMPLE IRA contributions in the Wages, tips,other compensation box of Form W2.However, salary reduction contributions mustbe included in the boxes for social securityand Medicare wages. Also include the propercode in Box 13. For more information, see theinstructions for Forms W2 and W3.

Distributions (Withdrawals)Distributions from a SIMPLE IRA are subjectto IRA rules and generally are includible inincome for the year received. Tax-freerollovers can be made from one SIMPLE IRAinto another SIMPLE IRA. A rollover from aSIMPLE IRA to another IRA can be made taxfree only after a 2-year participation in theSIMPLE IRA plan.

Early withdrawals generally are subject toa 10% additional tax. However, the additionaltax is increased to 25% if funds are withdrawnwithin 2 years of beginning participation.

More information. See Publication 590 forinformation about IRA rules, including thoseon the tax treatment of distributions, rollovers,required distributions, and income tax with-holding.

More Informationon SIMPLE IRA PlansIf you need more help to set up and maintaina SIMPLE IRA plan, see the following IRSnotice and revenue procedure.

Notice 984. This notice contains questionsand answers about the implementation andoperation of SIMPLE IRA plans, including theelection and notice requirements for theseplans. Notice 984 is in Cumulative Bulletin19981.

Revenue Procedure 9729. This revenueprocedure provides guidance to drafters ofprototype SIMPLE IRAs on obtaining opinionletters. Revenue Procedure 9729 is in Cu-mulative Bulletin 19971.

Qualified PlanA qualified retirement plan is a written planyou can set up for the exclusive benefit ofyour employees and their beneficiaries. It issometimes called a Keogh or H.R.10 plan.

You, or you and your employees, canmake contributions to the plan. If your plan

meets the qualification requirements, you cangenerally deduct your contributions to theplan. For more information, see Publication560.

Your employees generally are not taxedon your contributions or increases in theplan's assets until they are distributed. How-ever, certain loans made from qualified plansare treated as taxable distributions. For moreinformation, see Publication 575.

Qualification requirements. To be a qual-

ified plan, the plan must meet many require-ments. They include requirements that de-termine the following.

Who must be covered by the plan.

How contributions to the plan are to beinvested.

How contributions to the plan and bene-fits under the plan are to be determined.

How much of an employee's interest inthe plan must be guaranteed (vested).

For more information, see Publication 560.

More than one job. If you are self-employedand also work for someone else, you can

participate in retirement plans for both jobs.Generally, your participation in a retirementplan for one job does not affect your partici-pation in a plan for the other job. However,if you have an IRA, you may not be allowedto deduct part or all of your IRA contributions.See Publication 590.

Kinds of Qualified PlansThere are two basic kinds of qualified retire-ment plans: defined contribution plans anddefined benefit plans.

Defined Contribution PlanThis plan provides for a separate account for

each person covered by the plan. Benefits arebased only on amounts contributed to or al-located to each account.

There are two types of defined contribu-tion plans: profit-sharing and money purchasepension.

Profit-sharing plan. This plan lets your em-ployees or their beneficiaries share in theprofits of your business. The plan must havea definite formula for allocating the contribu-tion among the participating employees andfor distributing the accumulated funds in theplan.

Money purchase pension plan. Under thisplan, contributions fixed and are not based

on your business profits. For example, if theplan requires contributions be 10% of eachparticipating employee's compensation re-gardless of whether you have a profit, theplan is a money purchase pension plan.

Defined Benefit PlanThis is any plan that is not a defined contri-bution plan. In general, contributions to aqualified defined benefit plan are based onwhat is needed to provide definitely determi-nable benefits to plan participants. Your con-tributions to the plan are based on actuarialassumptions. Generally, you will need con-tinuing professional help to administer a de-fined benefit plan.

Salary reduction contributions($36,000 .10) ............................................ $3,6002% nonelective contributions($36,000 .02) ............................................ 720Total contributions .................................... $4,320

Salary reduction contributions(maximum amount) ...................................... $6,0002% nonelective contributions($75,000 .02) ............................................ 1,500Total contributions .................................... $7,500

Chapter 3 Retirement Plans Page 11


12/55

Setting Up a PlanYou must adopt a written plan. The plan canbe an IRS-approved master or prototype planoffered by a sponsoring organization. Or itcan be an individually designed plan.

Master or prototype plans. The followingsponsoring organizations generally can pro-vide IRS-approved master or prototype plans.

Trade or professional organizations.

Banks (including savings and loan asso-ciations and federally insured credit un-ions).

Insurance companies.

Mutual funds.

Adoption of a master or prototype plan doesnot mean your plan is automatically qualified.It must still meet all the qualification require-ments stated in the law.

Individually designed plan. If you prefer,you can set up an individually designed planto meet specific needs. Although advanceIRS approval is not required, you can applyfor approval by paying a fee and requesting

a determination letter. You may need profes-sional help with this. Revenue Procedure20006 in Internal Revenue Bulletin 20001can help you decide whether to apply for ap-proval.

Deduction LimitThe deduction limit for contributions to aqualified plan depends on the kind of plan youhave.

CAUTION

!In figuring the deduction for contribu-tions to these plans, you cannot takeinto account any contributions or

benefits that are more than the limits dis-cussed under Limits on Contributions andBenefits in Publication 560.

Defined contribution plans. The deductionlimit for a defined contribution plan dependson whether it is a profit-sharing plan or amoney purchase pension plan.

Profit-sharing plan. Your deduction forcontributions to a profit-sharing plan cannotbe more than 15% of the compensation paid(or accrued) during the year to the eligibleemployees participating in the plan. You mustreduce this limit in figuring the deduction forcontributions you make for your own account.See Deduction of contributions for yourself,later.

Money purchase pension plan. Yourdeduction for contributions to a money pur-chase pension plan is generally limited to

25% of the compensation paid during the yearto a participating eligible employee. You mustreduce this limit in figuring the deduction forcontributions you make for yourself, as dis-cussed later.

Defined benefit plans. An actuary must fig-ure the deduction for contributions to a de-fined benefit plan since it is based on actuarialassumptions and computations.

Deduction of contributions for yourself.To take a deduction for contributions youmake to a plan for yourself, you must havenet earnings from the trade or business forwhich the plan was set up.

Limit on deduction. If the qualified planis a profit-sharing plan, your deduction foryourself is limited to the lesser of $30,000 or13.0435% (15% reduced as discussed below)of your net earnings from the trade or busi-ness that has the plan. If the plan is a moneypurchase plan, the deduction is limited to thelesser of $30,000 or 20% (25% reduced asdiscussed later) of your net earnings.

Net earnings. Your net earnings mustbe from self-employment in a trade or busi-ness in which your personal services are amaterial income-producing factor. Your netearnings do not include items excluded fromincome (or deductions related to that income),other than foreign earned income and foreignhousing cost amounts.

Your net earnings are your business grossincome minus the allowable business de-ductions from that business. Allowable busi-ness deductions include contributions to SEPand qualified plans for common-law employ-ees and the deduction for one-half your self-employment tax.

Net earnings include a partner's distribu-tive share of partnership income or loss (otherthan separately stated items such as capitalgains and losses) and any guaranteed pay-ments. If you are a limited partner, netearnings include only guaranteed payments

for services rendered to or for the partnership.For more information, see Partners underWho Must Pay Self-Employment Tax in Pub-lication 533.

Net earnings do not include incomepassed through to shareholders of S corpo-rations.

Adjustments. You must reduce your netearnings by the deduction for one-half yourself-employment tax. Also, net earnings mustbe reduced by the deduction for contributionsyou make for yourself. This reduction is madeindirectly, as explained next.

Net earnings reduced by adjustingcontribution rate. You must reduce netearnings by your deduction for contributionsfor yourself. The deduction and the net

earnings depend on each other. You makethe adjustment indirectly by reducing thecontribution rate called for in the plan andusing the reduced rate to figure your maxi-mum deduction for contributions for yourself.

Annual compensation limit. You gen-erally cannot take into account more than$170,000 of your compensation in figuringyour contribution to a defined contributionplan.

Figuring Your DeductionUse the following worksheet to find the re-duced contribution rate for yourself. Make noreduction to the contribution rate for anycommon-law employees.

Now that you have figured your self-employed rate, you can figure your maximumdeduction for contributions for yourself bycompleting the following steps.

Example. You are a self-employedfarmer and you have employees. The termsof your plan provide that you contribute 81/2%(.085) of your compensation (defined earlier)and 81/2% of your participants' compensation.Your net earnings from line 36, Schedule F(Form 1040) are $200,000. In figuring this,you deducted your participants' pay of

$100,000 and contributions for them of$8,500 (81/2% x $100,000). You figure yourself-employed rate and maximum deductionfor contributions on behalf of yourself as fol-lows.

When to make contributions. To take adeduction for contributions for a particularyear, you must make the contributions notlater than the due date (generally, April 15 forcalendar year taxpayers), plus extensions, ofyour tax return for that year.

More information. See Publication 560 formore information on retirement plans for smallbusiness owners, including the self-employed. Publication 560 also discusses

Step 2Enter your net earnings (net profit) fromline 31, Schedule C (Form 1040); line3, Schedule CEZ (Form 1040); line36, Schedule F (Form 1040); or line15a, Schedule K1 (Form 1065) .........

Step 3Enter your deduction for self-employ-ment tax from line 27, Form 1040 .......

Step 4Subtract step 3 from step 2 and enterthe result ..............................................

Step 5Multiply step 4 by step 1 and enter theresult ....................................................

Step 6Multiply $170,000 by your plan contri-bution rate. Enter the result, but notmore than $30,000 .... .................. ........

Step 7Enter the lesser of step 5 or step 6.This is your maximum deductiblecontribution. Enter your deduction online 29, Form 1040 ................ ..............

Rate Worksheet fo

Documents

US Internal Revenue Service: p535--2000