By Karen E. Klein
Q: A year ago, I founded a cell-phone recycling company with three partners. We set up as an limited-liability company (LLC) and have no employees. I have personally paid for travel, meal, and entertainment expenses this year because the company cannot afford to pay them. How do I claim these expenses? Do I list them on my personal tax return or on the company's return? -- K.C., Fremont, Calif.
A:Before we get into tax-return specifics, experts advise that all small-business owners make absolutely certain that the expenses they deduct are legitimate and properly documented. Business expenses need to pass strict IRS tests, no matter what kind of business entity you're operating.
Things like meals and entertainment must be substantiated with receipts and notations that explain how the expense is directly related to or associated with an active business. In order to be deducted, entertainment expenditures must directly precede or follow a bona fide business discussion, says Brad Hall, managing director of Hall & Co., an Irvine (Calif.) accounting firm (www.hallcpas.com).
"These requirements are rarely met, from our experience," Hall says. "Most of the time, we see businesses fail to maintain entertainment documentation to substantiate the expense or what was discussed."
Are you sure the expenses in question can be legitimately deducted? Good. Now, the answer to your question about how to do that depends on what kind of tax return your LLC plans to file.
For both federal and California state tax purposes, an LLC is considered a "flexible entity" -- it doesn't have a specific tax profile and can be treated either as a partnership or a corporation for tax purposes.
If your LLC files a partnership tax return, you may deduct out-of-pocket expenses directly on your personal tax return as unreimbursed member business expenses (use Schedule E) -- as long as your company has some documentation in writing defining what acceptable expenses are and stating that such expenses will not be reimbursed by the business but should be personally deducted, says Danielle Hewitt, president of The Invisible Accountant in Irvine, Calif.
Your LLC agreement should spell out this kind of information. Remember: If you deduct the expenses on your own tax return as an offset to your partnership income or loss, you cannot submit the expense reports for company reimbursement later, Hewitt says.
HIRE AN ACCOUNTANT.
What if your LLC agreement specifies that members are supposed to be reimbursed for business expenses they pay themselves? You should submit an expense report directly to the LLC for reimbursement, Hall says.
If your company cannot reimburse you in the same tax year and your LLC is operating on a cash basis for tax purposes, the outfit cannot claim the expenses. If you're operating on the accrual basis, your company could deduct accrued expenses eventually, whether or not they are reimbursed in the same year they are incurred, he says.
If your company plans to file taxes as a corporation (either S or C), you should submit the expense reimbursements to the enterprise and wait for reimbursement. If you were to deduct corporate expenses on your personal return, you'd have to use Schedule A, and the expenses would be subject to a 2% itemized deduction threshold -- meaning that you'd probably lose the benefit of the deduction, says Jan Zobel, an enrolled agent in Oakland, Calif., and the author of Minding Her Own Business: The Self-Employed Woman's Essential Guide to Taxes and Financial Records.
Confused yet? Well, this is just one small situation that business owners have to puzzle out when it comes to finances. You and your partners would do well to hire an accountant who has experience dealing with small businesses -- not only to do your taxes but also to advise you on company financial matters.
MAKE A LOAN.
Don Lucove, of Lucove, Say & Co. in Calabasas, Calif., is one such accountant, and he says he often sees startup clients in your position. "We advise [that they] advance funds to their businesses and have the business reimburse the partners for these expenses," he says. "The proper place for expenses of this type is on the business tax return, not the individual tax return. The Internal Revenue Service tends to question the deduction of expenses of this type if they appear on a 1040."
Affordability should not be an issue for you and your partners, since you obviously have personal funds to pay for these expenses out-of-pocket. Rather than do that next time, simply loan funds to the LLC to cover these kinds of expenses. "Payment by the LLC directly to the credit-card company (assuming you're charging these expenses on a card) is the best suggestion I can provide," Lucove says.
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Karen E. Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues
Edited by Rod Kurtz