When is Entertainment "Ordinary & Necessary?" by Karla Hopkins

Most business owners deduct expenses for entertaining clients, customers, or employees. Have you ever wondered what the letter of the law is when it comes to these deductions? Below are the requirements that you should consider when taking and documenting an entertainment deduction:
You can deduct entertainment expenses only if they are both ORDINARY AND NECESSARY AND meet ONE of the following tests:
• Directly-related test
• Associated test

An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be required to be considered necessary.

Directly-Related Test
To meet the directly-related test for entertainment expenses you must show that:
• The main purpose of the combined business and entertainment was the active conduct of business,
• You did engage in business with the person during the entertainment period, and
• You had more than a general expectation of getting income or some other specific business benefit at some future time.

It is not necessary to devote more time to business than to entertainment. However, if the business discussion is only incidental to the entertainment, the entertainment expenses do not meet the directly-related test. You do not have to show that business income or other business benefit actually resulted from each entertainment expense.

Clear business setting - If the entertainment takes place in a clear business setting and is for your business or work, the expenses are considered directly related to your business or work. The following situations are examples of entertainment in a clear business setting:
• Entertainment in a hospitality room at a convention where business goodwill is created through the display or discussion of business products.
• Entertainment that is mainly a price rebate on the sale of your products (such as a restaurant owner providing an occasional free meal to a loyal customer).
• Entertainment of a clear business nature occurring under circumstances where there is no meaningful personal or social relationship between you and the persons entertained. An example is entertainment of business and civic leaders at the opening of a new hotel or play when the purpose is to get business publicity rather than to create or maintain the goodwill of the persons entertained.

Expenses not considered directly related - Entertainment expenses generally are not considered directly related if you are not present or in situations where there are substantial distractions that generally prevent you from actively conducting business. The following are examples of situations where there are substantial distractions:
• A meeting or discussion at a nightclub, theater, or sporting event.
• A meeting or discussion during what is essentially a social gathering, such as a cocktail party.
• A meeting with a group that includes persons who are not business associates at places such as cocktail lounges, country clubs, golf clubs, athletic clubs, or vacation resorts.


Associated Test
Even if your expenses do not meet the directly-related test, they may meet the associated test.
To meet the associated test for entertainment expenses, you must show that the entertainment is:
• Associated with the active conduct of your trade or business, and
• Directly before or after a substantial business discussion.

Associated with trade or business - Generally, an expense is associated with the active conduct of your trade or business if you can show that you had a clear business purpose for having the expense. The purpose may be to get new business or to encourage the continuation of an existing business relationship.

Substantial business discussion - Whether a business discussion is substantial depends on the facts of each case. A business discussion will not be considered substantial unless you can show that you actively engaged in the discussion, meeting, negotiation, or other business transaction to get income or some other specific business benefit.

The meeting does not have to be for any specified length of time, but you must show that the business discussion was substantial in relation to the meal or entertainment. It is not necessary that you devote more time to business than to entertainment. You do not have to discuss business during the meal or entertainment.

Meetings at conventions - You are considered to have a substantial business discussion if you attend meetings at a convention or similar event, or at a trade or business meeting sponsored and conducted by a business or professional organization. However, your reason for attending the convention or meeting must be to further your trade or business. The organization that sponsors the convention or meeting must schedule a program of business activities that is the main activity of the convention or meeting.

Directly before or after business discussion - If the entertainment is held on the same day as the business discussion, it is considered to be held directly before or after the business discussion.

50% Limit - In general, you can deduct only 50% of your business-related meal and entertainment expenses. The 50% limit applies to employees or their employers, and to self-employed persons.

The 50% limit applies to business meals or entertainment expenses you have while:
• Traveling away from home (whether eating alone or with others) on business,
• Entertaining customers at your place of business, a restaurant, or other location, or
• Attending a business convention or reception, business meeting, or business luncheon at a club.

What Entertainment Expenses Are Deductible?
Entertainment - Entertainment includes any activity generally considered to provide entertainment, amusement, or recreation. Examples include entertaining guests at nightclubs; at social, athletic, and sporting clubs; at theaters; at sporting events; on yachts; or on hunting, fishing, vacation, and similar trips.

Entertainment also may include meeting personal, living, or family needs of individuals, such as providing meals, a hotel suite, or a car to customers or their families.

A meal as a form of entertainment - Entertainment includes the cost of a meal you provide to a customer or client, whether the meal is a part of other entertainment or by itself. A meal expense includes the cost of food, beverages, taxes, and tips for the meal. To deduct an entertainment-related meal, you or your employee must be present when the food or beverages are provided.

Trade association meetings - You can deduct entertainment expenses that are directly related to and necessary for attending business meetings or conventions of certain exempt organizations if the expenses of your attendance are related to your active trade or business. These organizations include business leagues, chambers of commerce, real estate boards, trade associations, and professional associations.

Entertainment tickets - Generally, you cannot deduct more than the face value of an entertainment ticket, even if you paid a higher price. For example, you cannot deduct service fees you pay to ticket agencies or brokers or any amount over the face value of the tickets you pay to scalpers.

What Entertainment Expenses Are Not Deductible?
Club dues and membership fees - You cannot deduct dues (including initiation fees) for membership in any club organized for:
• Business,
• Pleasure,
• Recreation, or
• Other social purpose.
You cannot deduct dues paid to:
• Country clubs,
• Golf and athletic clubs,
• Airline clubs,
• Hotel clubs, and
• Clubs operated to provide meals under circumstances generally considered to be conducive to business discussions

The IRS does pay attention to meals and entertainment expenses so it is important for taxpayers to understand the rules regarding what is deductible and what is not and also to maintain adequate records of the cost and business purpose of all meals and entertainment expenses.

Avoid Paying Taxes Twice on Reinvested Dividends by Karla Hopkins & Carolyn Flaherty

Many taxpayers get tripped up on this issue and end up unnecessarily paying tax on the same earnings twice. The key to avoiding double taxation on reinvested dividends is to keep track of the tax basis of your mutual fund investments. Your initial basis is what you pay for shares and your basis increases with each subsequent investment and each time dividends are reinvested in additional shares, (most mutual funds are set to automatically reinvest your dividends).

Some taxpayers neglect to increase the basis of their investment for dividends reinvested over time and therefore pay tax when the dividend is issued and again when the shares are sold, (when the reinvested dividends are not accounted for, the basis used to calculate tax is lower than it should be and therefore the taxable gain claimed is higher).

Many mutual fund companies now track an average tax basis for investors, however maintaining your own records can give you more flexibility to control your tax gains and losses. Average cost is only one method that can be used to determine your cost basis upon sale of shares. You can also specifically identify shares; choose the oldest shares in a "first in first out" method or newest shares, ("Last in first out"). Once you select a method to identify shares you must be consistent in its application. Specific identification gives you the most flexibility but also requires the most record keeping.

The flexibility of specific identification can be valuable for tax planning. For example, in a year that you have other gains, you may wish to offset the gains with losses and vice versa. If you sell a portion of the mutual fund, choosing those shares with the highest basis would lower your gain and selling those with lowest basis will increase your gain.

The general period of time that the IRS can audit your return is three years. However, you must be able to support amounts claimed on your return. Therefore, you must keep records until the actual liquidation of your investment without regard to the three year audit period. In other words, maintain records from the date of your original investment until the date you liquidate all shares in a mutual fund and then for an additional three year period in case you are selected for audit. Documentation and organization is imperative.

We suggest that you create an investment folder for each mutual fund and at a minimum keep the year-end statement for the fund that includes the share activity, purchases, sales and reinvestments for the whole year. Better still, maintain and update a spreadsheet or personal financial package like Quicken with your investment records. This way, in 10 years when you are liquidating shares, it is not overwhelming to determine your cost basis. Moreover you will have the information available to ascertain, with the assistance of your tax advisor, the most tax effective method for cost identification.

Inherited IRA's by Karla Hopkins

When an owner of an IRA dies, the monies in the IRA must be distributed to the owner's beneficiaries. Post-death distributions made to beneficiaries are subject to the general income tax treatment of all IRA distributions. Therefore, maximizing the deferral period that could be available for the distribution of an IRA can be an important tax savings tool.

The options available for deferring post-death distributions depend on the beneficiary's relationship to the deceased owner and whether the death occurred before or after the decedent had began their minimum required distributions (age 70 1/2). There is greater flexibility if the owner dies before reaching 70 1/2.

IRA beneficiaries are divided into two categories; a surviving spouse or all other beneficiaries (non-spousal).

A nonspousal beneficiary is either a "designated beneficiary" or a beneficiary of a decedent's will. A nonspousal beneficiary does not have the option of treating an IRA as their own. Therefore, the beneficiary may not make contributions into the account or roll the account into another IRA account. The title of the account must remain in the decedent's name throughout the entire distribution period.

If an IRA owner dies before reaching 70 1/2 the beneficiary that is not a "designated beneficiary" must withdraw the IRA over a five year period of time. If the beneficiary is a "designated beneficiary" they have the option to take distributions out over their own life expectancy.

A spouse has two options for an inherited IRA. The first is identical to the above rules for a nonspouse. The second is to treat the IRA as their own and redetermine the distribution period based on their own life expectancy which could potentially be significantly longer than the decedent's.

If an IRA owner dies after reaching 70 1/2 and has begun their required distributions, the IRA that is inherited is not afforded any flexibility regarding the starting date for the minimum distributions. The rules maximize the deferral period by allowing the longest life expectancy to be employed in the distribution period.

If the beneficiary is the spouse, the distributions must continue based on the longer of the surviving spouse's life expectancy or the deceased owner's life expectancy as of the year of death from the Single Life Expectancy Table. The five year rule of distribution is not available.

If there is no designated beneficiary, distributions continue using the deceased owner's life expectancy in the year of death using the Single Life Expectancy Table which is shorter than the Uniform Life Table. The five year rule of distribution is not available.


If there is a nonspouse designated beneficiary the required distributions continue over the longer of the fixed life expectancy of the designated beneficiary or the life expectancy of the deceased over a shorter Single Life Expectancy Table. The five year rule of distribution is not available.

Understanding the IRA distribution rules can be an important tax planning step. Not naming a beneficiary presents missed opportunities to defer distributions over longer life expectancies. Certain estate planning measures will be critical to extending the required distribution period. The most important is naming the beneficiary which is especially crucial when the owner dies before before the required distribution date. In addition to the above alternatives regarding the distribution period, there may be opportunities to delay the start date of a distribution cycle.

We recommend that you take the time to review your beneficiary options for your IRA accounts periodically to ensure that you and your beneficiaries will receive the most tax advantaged options for distributions.

Early Retirement Distributions by Carolyn Flaherty

During difficult economic times such as those we have been experiencing in recent years, it is not uncommon for people to obtain funds by borrowing from or cashing out their retirement accounts. Based on your personal financial circumstances, there may be no choice in the matter of tapping into these assets. However, there are tax consequences in addition to the obvious dilemma of diminishing savings for your future.

The facts:

• Distributions from a retirement account are taxable
• Any payments from a retirement account before you have reached age 59 and 1/2 are considered early or premature distributions and therefore are subject to an additional 10% tax
• Early distributions are required to be reported to the IRS
• Unless specifically instructed, distributions will not necessarily withhold for expected state and federal taxes. This can result in an unexpectedly large tax bill with potential for interest and penalty on April 15th. If you are withdrawing due to economic difficulty this will be an especially unpleasant outcome.

Is any portion of the distribution non-taxable?

• Non-deductible contributions to a retirement plan are not taxable to you upon distribution (we thank the government for not double dipping)
• Distributions that are rolled into another qualified plan within 60 days are not taxed. Note therefore, that if your need for cash is brief and you know with absolute certainty that you can replenish the cash into another plan within 60 days: an early distribution may provide a means to obtain temporary funds.
• The portion of an early distribution from a ROTH IRA that represents your contributions is not taxable, (again: no double dipping even if you are executing an early withdrawal).

The exceptions:

The government allows for certain specific exceptions to the application of the 10% additional tax BUT NOT to the income tax. The exceptions are listed below.

• Purchase of a first home
• Certain medical expenses
• Certain educational expenses
• Your disability
• Distributions after you reach age 59 1/2

Note that on the flip-side, upon reaching the age of 70 and 1/2, you MUST take minimum mandatory withdrawals from your individual retirement accounts. The first must be taken by April 1 of the year after you turn 70 and 1/2 and again in December of the same year. Your minimum withdrawal is determined by a formula based on your account values and life expectancy. The financial service firms that manage your retirement accounts will report the minimum distribution amount to you and to the IRS every year. Your minimum distribution changes every year. Failure to take the minimum distribution will result in a tax penalty of 50% of the amount that you did not withdraw.

For additional information on retirement distribution issues: visit IRS.gov to find IRS Publication 575, Pension and Annuity Income, and IRS Publication 590, Individual Retirement Arrangements, or contact your tax advisor.

Going Paperless by John Ratcliffe

In the age of Iphones, Ipads, instant messaging, text messaging, email, video streaming, cloud computing etc. our society demands information in real time. Most of our children have grown up during this evolution. So the need to access data anytime, anywhere is not just a convenience it is expected and considered a critical business function.

Our firm began the paperless journey in 2005 primarily to address a few areas of concern as follows: efficiency, client service and disaster recovery. Before we began the process we identified these as the key areas that we would benefit most from our efforts and then began researching solutions. Your needs may vary based upon your business type and size, but the overall benefits of the paperless concept are relatively standard.

For our firm the first area that we felt we wanted to address was our accounting and auditing engagements. We chose to focus on these activities because doing so actually touched upon each of our areas of concern.

Before paperless, the process involved an inordinate amount of paper required for each engagement including copies of client documents, checklists and worksheets. Each time we went to a client site we would lug in large briefcases of paper and leave with even more. Sometimes we even had a trunk full of paper! Then all of this information would be collated and manually referenced with tick marks and page references: an "accounting" work of art!

When a client requested a historical workpaper we would first have to determine where the client binder was being stored, (on site in our offices or in the offsite storage units rented to house all our paper). We would then have to dig thru the binders, take a copy out and either mail or fax the document to the client. The response time was usually more than a day depending upon the location of the files and who was available to retrieve it.

The process from start to finish of the audit and accounting engagements was labor intensive and inefficient. Even more disconcerting, although we had all this paper, we had only one copy of the client workpapers in our storage. What happened if documents were lost or damaged by fire or flood?

Fast forward six years…
Efficiency: We no longer go to a client with a large briefcase of paper but simply our laptops. The workpapers and data are electronically organized and the days of staff spending hours at a copy machine, red pencils, tick marks and the droning sound of an adding machine are history.

Client Service: Today if a client calls requesting information the data is usually available within an hour or sooner, (minutes even) depending upon where we are. We can not only transmit the data quickly but also securely, (there are no longer workpapers sitting out on a general fax machine). We can now satisfy the need and expectation of clients to access data anytime, anywhere.

Data Security: Most of our data resides in electronic format on our file servers that are backed up daily and archived offsite. We retain multiple copies of the backup and have built redundancy in the storage of the data. All client data is required to be kept in an encrypted format and is to be removed from the laptops once we are back in the office.

Our engagements have become more efficient, our client service enhanced and we can sleep better at night knowing that if a disaster were to hit our business would not experience a major disruption. And, as time does actually equal money; we are saving in labor hours as well.

So what does this mean for your business? Identify the areas that concern you the most and design your process around that. Some people think that getting a scanner is all that is required to go paperless. Actually, a scanner is only one component of the entire process. In my opinion, the most important part of the process is making sure you have a good disaster recovery plan that is tested on a regular basis. As for hardware and software requirements, I suggest the following:

1) Scanner - depending upon the volume of paper you will digitize, I suggest a production level scanner with a sufficient scanning tray to handle stacks of documents.
2) Document storage - also depending upon the volume of paper you will digitize, I suggest you purchase a server with enough capacity and redundancy built in to handle five times your current storage requirements. We were pleasantly surprised as to how little space our data required if they were stored in Adobe format.
3) Backup - have multiple backup media and build redundancy into the process. These days utilizing online backup services such as Mozy, Iron Mountain and others is something you should seriously consider. The key is to not rely on just one form of media and test your process regularly.
4) Document management software - depending upon your process, it is a good idea to consider some form of document management software to organize and retrieve your data. Not only will it be easier to find but most document management software allows you to build in an archive date to remove data from your system based upon your record retention policy. There are many systems out there and some are industry specific.
5) Virus software - if you make the leap to digital you certainly want to make sure your data is virus free. Depending upon the size of your business an enterprise version of the virus software might best suite your needs.
6) Network Firewall - the more data that is accessible in digital format the more important it will be to keep that data safe from outsiders. Invest in a good network firewall and spend the time properly configuring it for your business. Appliances such as SonicWall and Cisco offer reasonably priced options with excellent customer support.
7) Remote access - what good is all this data if you need to be in the office to get to it? Look into software that will allow you to remotely access your data. If you have a mobile workforce this will enhance productivity and quality of life.
8) Adobe Software - we utilize Adobe Standard as one of our main tools. This version allows you greater flexibility with your documents including one of my favorite features which is the ability to type into an existing Adobe document (filling in forms being my favorite).

As you can see there are many things to consider as you move to a paperless (or more likely less paper) environment. The key is to remember that it is a process that involves research and planning. I can assure you that once you have made the leap you will be asking yourself why you didn't do it sooner. Pavento, Ratcliffe, Renzi & Co., LLC is available for guidance on developing a paperless system.

DATA SECURITY by John Ratcliffe

On October 30, 2009 the Massachusetts Office of Consumer Affairs and Business Regulation filed its final amended regulation for 201 CMR 17.00 (aka "The Massachusetts Data Security Regulation"). The regulation requires persons (including out of state persons) who "own or license personal information about a resident of the Commonwealth" to comply with strict requirements to safeguard such personal information. Information includes:

• social security numbers
• drivers license or state-issued identification numbers
• financial account numbers, credit or debit card numbers, (with or without any security code that would permit access to a resident's financial account).

The regulation does not discriminate between a small business and a large business but must be implemented by all who store, transmit or have access to the aforementioned personal information. The regulation was required to be implemented in 2010.

In anticipation of the proposed regulation we at Pavento, Ratcliffe, Renzi & Co., LLC completed our implementation in 2009 and continue to refine the process. In my opinion regardless if you meet the criteria it is a good business practice to implement some of the key areas of the regulation, if for no other reason than to allow you to sleep better at night. There is not a week that goes by that you do not hear about another data security breach.

So for the small business what does the regulation entail? The first step in the process is to look at the data you maintain both in paper and electronic form to determine if are required to implement the data security regulation. Once you have identified the data, you must design procedures to ensure that data is secure. Most businesses have both paper and electronic records. Here are some areas that I feel are key areas to review:

1) Paper file storage and data destruction policies
2) Paper files in employee possession both inside and outside of the office
3) E-mail policies
4) Network password policies
5) Network security policies
6) Network firewall and related policies
7) Electronic file transmission policies
8) Electronic data storage and achieving policies
9) Laptop and Desktop security policies (passwords and encryption)
10) Smart phone data and e-mail policies

Next you begin the process of implementing a plan. Address the areas of highest risk first. As an example, if you allow remote access to your network and have an outdated firewall appliance, consider upgrading that first.

Then look at what types of data are being transmitted via e-mail. Data transmission is an area that everyone in our firm is very cautious about as tax returns include social security numbers. We have two ways that we transmit files 1) we utilize an email encryption service which is used for any transmission of files that meet the criteria that we have set forth as sensitive data; 2) we maintain a client portal with multi-layer security to allow for a secure exchange of data. Our clients seem to prefer the portal over the e-mail encryption as the portal does not slow their e-mail down with large file transmissions.

As you go through the process of implementing a solution for each area that impacts your business, document the process. Once you have all areas documented, write a formal data security plan and update it frequently as your situation changes.

Finally, the most important step in any plan is to monitor and test the policies you have implemented. As an auditor I cannot stress enough the importance of this step.

Whatever you decide to do is a personal business decision. Doing something is better than doing nothing and may very well prevent you from being the next company in the news! Pavento, Ratcliffe, Renzi & Co., LLC is available for guidance in the development of your data security plan.

6 Tax-Smart Ways to Help your Kids (or Grandkids) by Karla Hopkins

Uncle Sam (and some states) will reward you for helping your children or grandchildren. Several tax-smart ways are:

 Contribute to a 529 Plan. Money in a 529 Plan can be used tax-free for college costs. It is good idea for parents and grandparents to open separate accounts for a child. There is no limit on the number of 529 Accounts that can be open for one child.
 Get a gift tax break from 529 contributions. You can generally only gift up to $13,000 per person in 2011 but you can make 5 years' worth of 529 contributions all in one year without triggering the gift tax.
 Get a tax credit for tuition payments. The American Opportunity Credit can cut your tax bill by up to $2,500 per student. There are certain income limitations and other specifics for this credit but it is a dollar-for-dollar reduction in your tax liability.
 Pay tuition directly to a college. Direct payments to educational institutions are excluded from the annual $13,000 gift limit. This rule applies to anyone and is particularly popular with grandparents. Only tuition qualifies, NOT room and board.
 Help your kids or grandkids contribute to a ROTH IRA. As long as they have earned income, they qualify for a ROTH. Since most kids don’t want to stash away all their paychecks for the future, you can give them the money for their contributions. While there is no tax break to you, the kids will reap the benefit in the future.
 Open a custodial account for a child. This is not a big tax break strategy but is a great tool for teaching kids about money and savings. The child will take over the account when they turn 18 but until them, you can manage it together.

With all of these areas, it is important to consider the impact any or all of these have on various forms of financial aid and your ability to pay for college. Contact your tax and financial advisors to coordinate an effective savings plan.