BUSINESS MEALS AND ENTERTAINMENT

The IRS generally will closely scrutinize any amount an entity includes in its tax return that relates to meals and/or entertainment.  The Service requires the entity and/or the employees incurring the expense to “jump through hoops” with regard to supporting documentation before it will allow a deduction for them.  A deduction will be allowed for these expenses if:

• The expense is ordinary and necessary to the business.  Any expense incurred, to be deductible, must be “ordinary and necessary” in carrying on the business.  This term has been broadly defined to include any item that is customary or usual, appropriate, or helpful in assisting the entity meet its business objectives.  Thus, if it is reasonable for the business to entertain clients or other business contacts or associates, the entity should be able to pass this test.
• The expense must be “directly related” or “associated with” the business.   This second test, specifically applicable to meals and entertainment expenses, must also be satisfied. Under it, the business meal or entertainment activity must be either “directly related to” or “associated with” the business.

Passing the “directly related” test requires an “active” discussion of issues with an ultimate goal of achieving increased revenues.  A specific benefit, not just general goodwill from having a favorable meeting with a client or associate, must be identified; the principal purpose of the event must be related to the taxpayer’s business.  This test is also substantiated if the event takes place in an obvious business setting.  Generally, meetings taking place at sporting events, night clubs, or cocktail parties— essentially social events— would not meet this test.

If the “directly related” test cannot be met, the expense may also qualify as “associated with” the active conduct of a business if the meal or entertainment event precedes or follows a substantial and bona fide business discussion (e.g. an event that occurs following a business meeting).  This test generally will be easier to satisfy in that “goodwill” events such as shows, sporting events, etc. can qualify.  This type of event will be considered associated with the active conduct of the business if its purpose is to get new business or to support a continuing business relationship.

• The expense incurred must be supported by documentation. Once the expense passes muster under the above tests, there is still no deduction available for it if the event is not properly documented.

Any “event” expense incurred by an entity or its employees requires corroborating information to support its deductibility.  The expenses must not be “lavish or extravagant.”  This is generally a “reasonableness” test and does not impose fixed dollar limits on the cost of the event.  Documentation of the expense must include the amount spent, the time and place of the event, its business purpose, and the business relationship of the individuals involved.  Any amount paid in excess of $75 or more requires a receipt or other documentary proof.  Using reasonable estimates will not survive an IRS challenge.

• Once all other requirements for deductibility are met, generally only 50 percent of the amount qualifies as a deduction.  This general rule applies whether clients are being entertained or the expenses are incurred while traveling away from home.

 There are exceptions to this general rule, allowing full deductions by the company for:

• Refreshment stations on the employer’s premises
• Employee parties, including recreational, social, or entertainment gatherings primarily for the benefit of rank and file employees (as opposed to highly compensated employees)
• Meals served on the employer’s premises.  These will be fully deductible if they are 
• They are provided for a valid business reason
• On or near the employer’s businesses premises
• Primarily for the convenience of the employer
• Items available to the general public, such as free food for potential customers, free hot dogs at a promotion, etc.
• Any amounts that are billed to a third party
• The cost of a ticket to a charity event that includes a meal

 BUSINESS TRAVEL EXPENSES

• In general, all business travel costs are deductible if documented.  This applies to costs incurred by an employee while he/she is away from his/her “tax home.”  Like other expenses, a deduction is not available if documentation is insufficient.

An employee’s tax home refers to the city or area that includes his main place of business.  If an employee is away, receipts submitted must state the reason for the trip, and all associated costs and lodging are deductible.  Travel is fully deductible, but meals are only 50 percent deductible as discussed above.  As previously mentioned, lodging is fully deductible to the extent the expense is not “lavish or extravagant.”

Personal entertainment while away is never deductible, but business-related costs (phone calls, computer access, etc.) are deductible.  If a trip combines business and pleasure, allocations between business and personal expenses will be required.  If an employee tacks a vacation period on to a business meeting, only the costs associated with the business days are deductible.  If the primary purpose of the trip is business, the travel is fully deductible without allocation.  If the trip involves only a convention, seminar, etc., the IRS will scrutinize the nature of the meetings to determine if they are disguised vacations.

The rules relating to a spouse’s travel costs are very restrictive.  Unless the spouse is also an employee taking part in the meeting, all costs related to him/her are non-deductible.  Even if the spouse is an employee, having the spouse perform incidental business services, such as typing meeting notes, etc. isn’t enough to establish a business purpose.  Having the spouse present to be “helpful” to your business pursuits is insufficient– it must be “necessary” to the business.   In most cases, a spouse’s participation in social functions, even as host or hostess, does not provide a business purpose.

Any costs that are incurred without additional cost, e.g. a car rental, taxi, etc. are deductible even if the spouse is present.  If the cost of lodging is 20 percent higher because of the spouse, only the incremental 20 percent is non-deductible; the other 80 percent would be a deductible business expense.

Please contact the BBD Tax Department at 215/567-7770 for additional information or with any questions you may have.

Although this requirement has been in place for years, the IRS has recently begun to step up enforcement in the reporting of this information (on Form 1099). Additionally, penalties for late filing (or non-filing) of the information returns have increased substantially, and could be as high as $200 per late or non-filed 1099.  When a 1099 is required, a copy must be filed with the IRS, and a copy must be given to the service provider.

 Various 1099s are required to report payments in excess of $600 made to individuals, trusts, partnerships, and LLCs and generally include payments for:

• Non-employee compensation, awards, bonuses, commissions and any other remuneration
• Punitive damages resulting from litigation
• Rents and royalties
• Sales proceeds from the sale of an asset, including stocks
• Current income (interest and dividends) from financial institutions
• Any other payment in excess of $600 made for service related transactions

The 1099s are generally required to be filed with the IRS by February 28, but copies should be provided to the recipient by January 31.  The reporting requirements can be complicated.  Part of this process is the need to obtain a W-9 (Request for Tax Identification Number) from any payee to which a 1099 may ultimately be issued.  This document requires a payee to furnish a taxpayer ID number and other information.  This also provides a certification to the payer that the payee is not subject to backup withholding.

Please contact the BBD Tax Department at 215/567-7770 for additional information or with any questions you may have.

Most Exchange Traded Funds (“ETFs”) file their registration statements on Form N-1A, and therefore compute and present Total Return based on net asset values as required by the instructions to Form N-1A.  However, ETFs contain characteristics of both open end and closed end funds, and therefore the net asset value total return is not representative of the return that most of the Fund’s shareholders would earn (please see previous post on the inadequacies of the two methods for computing total returns for ETFs.)  As a result, it is common practice for ETFs to present both net asset value (N-1A) returns and market price (N-2) returns.

As ETFs do not have dividend reinvestment plans, when calculating the market price (N-2) returns, it is normally assumed that distributions are reinvested at the market price on the distribution pay date.  Depending on the timing of the distributions, this can produce a Total Return that is not accurate.  Most ETFs are structured as Regulated Investment Companies (“RICs”) for tax purposes. IRS rules for RICs require them to distribute income earned in the calendar year, and capital gains earned in the 12-month period ending October 31, by the end of each calendar year.  Due to logistical difficulties in determining all of a Fund’s calendar year income and distributing such income in the same calendar year, the IRS allows such distributions to be paid in January, so long as the record and ex-dividend dates are in the calendar year.  Therefore, it is not uncommon for RICs, including ETFs, to make distributions with record and ex dates in December that are not paid until January.  According to the Total Return methodology described above for market price returns, distributions paid under this assumption would not be reflected in a Fund’s calendar year Total Return calculation, even though the Fund’s shareholders on the ex-dividend date would be entitled to receive the distribution, and the net asset value and market price per share would have been reduced by the amount on the distribution on the ex-dividend date.  Therefore, in such circumstances, it is necessary to assume the distribution was reinvested on the last day of the period in order to give an accurate portrayal of the Total Return an investor would have earned on an investment in the Fund’s shares during the period.

 Consider the following example:

1. Market price at the beginning of the period (January 1) is $10.
2. The Fund appreciates to $11.50 and declares a $1.00 dividend, ex-dividend date in December, payable in January
3. The market price of the Fund on December 31^st is $10.50

 Based on the facts above and according to the instructions in Form N-2, the total return of the Fund would be 5% as the distribution is not reinvested until the pay date in January.  This is clearly not an accurate portrayal as a shareholder who redeemed their shares on December 31 would still be entitled to receive the $1 per share distribution in January and would have effectively earned $1.50 per share or 15% total return ($1 per share dividend and $.50 per share price appreciation.)  Therefore, it is necessary to include the distribution in the calendar total return calculation.  Assuming reinvestment on the last day of the period is the most accurate way of reflecting this would produce a correct Total Return figure of 15%.

As a financial statement preparer or an auditor of financial statements, it is important to apply the “smell” test when analyzing figures in a financial statement.  There is a completely logical reason for assuming distributions are reinvested at the market price on the pay date when calculating market value returns.  Market price on the pay date does represent, after all, the earliest date the distributions can be reinvested and the price at which they can be reinvested.  However, one must assume the reinvestment of distributions on the pay date when the ex-dividend and pay dates straddle a reporting period will clearly produce an inaccurate total return figure.  Although not contemplated in the N-2 Total Return instructions, assuming distributions are reinvested at period-end in such circumstances is undoubtedly the correct approach and helps to highlight the need for ETFs to have their own set of rules.

In order to derive the maximum benefit of pre-enactment loss carryforwards, portfolio managers should consider realizing gains to the extent of the pre-enactment loss carryforwards.  One rule portfolio managers are often concerned with when it comes to harvesting losses is the wash sale loss rule.  The wash sale loss rule disallows losses on the sale of a security to the extent a substantially similar security is purchased within a period beginning 30 days before the sale or disposition of the loss shares and 30 days after such date.  Fortunately, there are no such rules with respect to sales that result in a gain.  Therefore, a portfolio manager could potentially sell shares to realize a gain, and utilize a pre-enactment loss carryforward, and immediately repurchase the same shares to maintain the same portfolio composition.  Of course, a cost/benefit analysis will need to performed on the transaction cost.  However, fiscal years ending in 2012 may be a unique time where such a strategy will be beneficial to funds and their shareholders.

On January 9,  the IRS announced it was reopening the voluntary disclosure program to allow people “hiding” (their word, not ours) offshore accounts to come into compliance with the reporting requirements and become current with their tax liabilities.  Two prior programs resulted in billions of dollars in cash collection for the Service, and taxpayers also received relief in that the penalties associated with non-reporting of income were substantially reduced and the possibility of criminal prosecution was generally abated.  The IRS Commissioner recently stated that “ . . . people need to come in and get it right with us before we find you.  We are following more leads and the risk for people who do not come in continues to increase.”

The program is open as to its duration, but it will not last forever.  The IRS has indicated that they reserve the right to terminate the program at any time without notice, or to increase the penalties further into the program.  It will have the same general parameters as prior programs, requiring the filing of amended returns for up to eight years. The penalties associated with prior FBAR non-filings are substantial (up to 27.5 percent of the highest value of the assets during this eight year period).  The penalties will be reduced to 12.5 percent if the taxpayer holds “smaller” offshore accounts (less than $75,000 in value in any calendar year).

Should a taxpayer enter the voluntary disclosure program?  Like the answer to any tax question, it depends.  Strictly from a numbers standpoint, an individual holding one foreign investment account with an average value of $1 million would not want to enter the program and write a $275,000 check up front when he could just pay the $10,000 penalty (albeit annually).  An individual with a $100,000 invested in six different offshore accounts would benefit from the program in that the annual penalty would be $60,000, not $10,000 per year (because of the six accounts).  The non-numeric considerations in entering the program relate to the tolling of the statute and the avoidance of criminal prosecution for tax evasion.

The decision to enter or ignore the program is not an easy one.  The IRS has said in its news release that the details are still to be worked out (probably within the next month).  We will keep you in the loop when they are released. If you have any offshore accounts that have not been reported, please call us to discuss the program.

1. Registered public accounting firms must disclose the name of the responsible “engagement partner” in the audit report of their public company audits.  This means that the name of partner who is leading the audit would be identified on the report.  Though the engagement partner must be identified, only the firm is required to actually sign the auditor’s report.  This new procedure is meant to compel greater integrity and responsibility in the engagement partners, leading to better quality audits.  Public company clients will also have the added benefit of being able to research engagement partners who have experience in their desired niche, and avoid those who have been linked with low quality audits.

1. An amendment would be made to Part IV, of page two, of the Board’s Annual Report Form. According to PCAOB Rule 2201, every registered firm is required to file an annual report on Form 2 by June of each year.  This report contains some basic information about the firm and its issuer-related practice over the last year. Detailed in section 4.1 of the form are any audit reports issued during the reporting period, along with the issuer’s name, the issuer’s CIK number, and the date of the audit report. Release No. 2011-007 would add one other item to section 4.1: the name of the engagement partner of each audit.  Although the audit reports themselves would already contain this information, the PCAOB feels that this medium would provide investors a more efficient way to search this information.

1. PCAOB Release No. 2011-007 would also require disclosure of any involved independent public accounting firms or persons supervised by the lead auditor.  The auditor’s report must also identify other independent auditors who conducted sections of the audit.  Although usually audits are completed by just one firm, often audits are more complicated.  The primary firm often outsources work to its subsidiaries, a foreign affiliate, or independent consultants.  These companies perform part of the audit, such as auditing the financial statements of a division of the public company, which the “engagement partner” will refer to in the report.  Investors are usually unaware of all the outside companies involved in an audit.  This new policy would increase transparency in the auditing process.

A similar policy was explored by the Public Company Accounting Oversight Board in 2009, but was eventually dismissed.  The policy had called for the engagement partner to sign off on their public-company audit reports.  This caused much outrage from many large auditing companies, who believed this policy would put too much liability on the single auditor, when in reality, the entire firm was involved.  The PCAOB’s new release is a bit more lenient, but its final outcome is yet to be determined.

And that can create a big problem, since excess benefit transactions can trigger steep intermediate sanctions (excise taxes). The IRS is in the middle of a three-year employment tax compliance initiative and has stated very clearly that it is paying “significant attention” to executive fringe benefit programs.

Excess Benefit Transactions
An excess benefit transaction occurs when a tax-exempt organization directly or indirectly provides an economic benefit to or for the use of a disqualified person and the value of the benefit exceeds the value of the services or other consideration the person provides. A disqualified person is anyone who is in a position to exercise substantial influence over the organization’s affairs, such as a major contributor or an officer, director, or trustee. (Family members of a disqualified person are also disqualified persons.)

Intermediate Sanctions
Intermediate sanctions are steep. For each excess benefit transaction, the excise tax equals 25% of the excess benefit. The tax is imposed on the disqualified person. If the disqualified person does not correct the excess benefit in a timely manner, an additional tax equal to 200% of the excess benefit is imposed. In addition, any organization manager who knowingly participates in an excess benefit transaction is liable for a tax equal to 10% of the excess benefit — not to exceed $20,000 in aggregate for a single transaction. Managers include officers, directors, or trustees of the organization, and other people who have the powers or responsibilities of those offices.

Include Benefits as Compensation
Unless specifically excluded under the tax code, fringe benefits are taxable compensation. When an organization provides a taxable perk or fringe benefit, the IRS requires “written contemporaneous substantiation,” which essentially means that the value of the benefit must be “timely reported” as compensation on the appropriate tax forms (of both the organization and the disqualified person).

Some perks and benefits tend to slip through the cracks — and that can draw the IRS’s attention. Not-for-profits should pay particular attention to amounts provided to executives for companion travel, first-class travel, discretionary spending allowances, unsubstantiated business expenses, housing allowances, personal services, personal cell phone use, and club memberships.

Check Your Reimbursement Plan
Reimbursing employee expenses can also result in an automatic excess benefit transaction if the organization’s reimbursement plan is not an “accountable plan.” An accountable plan requires that:

• Expenses have a clear business connection
• Proper and timely documentation be provided
• Any excess reimbursement or expense allowance be returned within a reasonable time

Review Compensation Practices
A step-by-step review of compensation practices can help an organization avoid excess benefit transactions and steer clear of the IRS. Some best practices include establishing:

• A transparent, documented process for reviewing compensation
• Policies and procedures that support the compensation process
• An independent compensation committee to make decisions

For more information about this article and BBD’s services for not-for-profit organizations, please contact Ron Scaramuzza or Adam Watson.

A budget is a valuable financial planning tool. On a broad level, it is an outline of the goals you’ve set for the year ahead and a projection of the financial resources needed to accomplish them. On a day-to-day level, a budget serves as an operational and financial guide for everyone in your organization, from board members and executives to staff members and even volunteers.

The Budget Process
If your organization has an effective budget, then the groundwork has been laid and the process is familiar. However, if your budget doesn’t provide the necessary financial structure, it’s time to revisit the budget process. The more effort you put into creating a budget, the more accurate — and effective — your budget will be.

Following are some suggestions for establishing a rigorous budget process. Be sure that you document everything, from the process in general down to the very data you collect. Having a strong, documented process in place will serve you well in future years.

• Decide who should be involved. The executive director, program directors, and any staff members who are involved with the organization’s finances and budget should be included from the beginning.
• Establish timelines, set deadlines, and schedule key meetings. Some adjustments may be necessary along the way, but having a general schedule will help people stay on track and keep things moving smoothly.
• Build in time for strategic, big-picture considerations.
• Allow plenty of time for the review and revision phases.
• Standardize definitions and write down any assumptions you make and/or formulas you use to arrive at your budget figures.
• Make sure everyone is on the same page. Spell out specific responsibilities and expectations. Keep in touch throughout the process to avoid duplicating efforts.
• Make sure that budget line items coordinate with accounting line items. Mismatches could result in budget shortfalls or overages and diminish the effectiveness of the organization’s financial reports.
• Gather information about income and expenses for each program and validate the data.
• Use worksheets and templates to standardize the process.
• Be conservative when estimating revenue.
• Build in reserves for unexpected expenses.
• Have your finance committee (and all other appropriate individuals) review and respond to the proposed draft budget.
• Give board members plenty of review time prior to voting on the budget. Along with the draft budget, provide program goals and relevant supporting documents well before the deadline for budget approval.
• Have the treasurer or finance committee present the actual budget proposal.

 A Working Budget
Going through the review process and finalizing a budget is a big step. But it’s just the beginning. How you use your budget is just as important as how you create it.

Compare actual expenses and revenue with budget amounts on a monthly basis (or more often) so you can track trends and foresee shortfalls. Document any changes that require budget revisions. Keeping detailed notes will help make next year’s budget process more accurate.

The Year Ahead
Once the budget is approved, review it with the appropriate staff members. Since most budgets are prepared annually, it’s an ideal time to also have a state-of-the-organization meeting to review all your goals for the year ahead.

For more information about this article and BBD’s services for not-for-profit organizations, please contact Ron Scaramuzza or Adam Watson.