Is Your Tax Deduction Lacking “Economic Substance”?

Posted on March 3, 2014 by AAR

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Recently, social media sites frequented by Arizona real estate licensees have been abuzz over the IRS’s ability to disallow certain tax deductions on the basis that they lack “economic substance.” Because the deduction of business expenses is important to REALTORS®, AAR asked Tax Accountant Eric Viavattene of Dobbins Wealth Management to shed light on this issue.

Finding ways to limit your tax liability is critical to your business. The key to success lies in understanding the latest rules for what does, or does not, constitute economic substance.

As a judicial concept, the doctrine of economic substance has existed for about as long as people have tried to limit taxation from business pursuits. Economic substance refers to the reasoning behind a business transaction. It asks, “does the transaction have any merit beyond avoiding tax?”

In the past, courts have determined whether a transaction had economic substance based on precedent – with no specific rules involved. The advent of Section 1409 of the Health Care and Education Affordability Reconciliation Act of 2010 changed all this. It requires that a two-part test be run to determine if a transaction qualifies.

To be considered as having economic substance the transaction must:

1) change the taxpayer’s economic position in a meaningful way apart from any federal income tax effects; and

2) the taxpayer must have a substantial purpose for entering into the transaction apart from any federal income tax effects.

Additionally, the Act specifies a penalty of 40 percent of the liability for underpayments of tax from transactions that do not meet the qualifications. However, while the Act does create these tests and penalties, it doesn’t say exactly when they should be applied, leaving a wide opening for their application.

For the REALTOR® community, these changes require business owners to take more stringent accounting measures and increase the documentation retained for their transactions. All transactions, including payroll, need to show business and economic merit beyond simply lowering tax liability. Payroll amounts for shareholders must be based on work recorded in time sheets or logbooks, or some other verifiable means, with rates comparable to industry norms. Business expenses need to be reasonable and necessary – no trips to the grocery store on the company dime unless they’re really for company expenses, and even then, only with a receipt noting the reason for the expense.

Be sure to seek the advice of an accounting professional to learn what you can do to improve your process and reduce your liability.

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About the Author:
Eric Viavattene is a partner at Dobbins Wealth Management, PLLC where he specializes in Short Sale/Foreclosure tax analysis and financial planning. As a Registered Investment Advisor and senior Financial Advisor, Eric provides a
unique tax perspective during the planning process as he works with individuals and small to medium-sized businesses to help them meet their financial goals.

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