With the extension given for our tax returns this year because of COVID-19 ,you could still be working on your taxes or just preparing for next year. Either way, boaters are using, or some are considering using, their houseboat to conduct a business enterprise. What a great way to claim a tax deduction for defraying some of those expenses associated with it, right?
Navigating the Internal Revenue Code is daunting and terms of depreciation for business property, amortization, expensing limitations—well, it all make the eyes glaze over, but here’s an overview of selected tax regulations along with suggested ways to keep track of expenses properly attributable to the business, red flags that can trigger an audit, and tips on how best to avoid this unpleasant occurrence.
First, many boaters have known for years that recreational boats could, and still may, qualify for the second home tax deduction (tax form 1098) with interest paid on boat loans being deductible. Boats used for business purposes also come with deductions if meeting certain requirements which need to be understood to decrease the chance of audit. (As an aside, experienced tax professionals advise not claiming the well known “home office” deduction if your residence is a target for auditors and particularly if it provides only minimal tax savings.)
According to the American Institute of CPAs, improved overall financial reporting and enhanced transparency has become the norm in the business world, and the IRS computers certainly have them on their radar. And just as large corporate yachts operators must prove business-related expenses in a manner acceptable to the IRS, so must individuals keep accurate records of use of their recreational boat for business purposes.
Write Offs—Real Company Examples
One boat owner takes customers of his small, yet prosperous, electric company out on fishing excursions along with doing extensive wiring jobs on docks in marinas and resorts in the area. At tax time the cost of mooring, fuel, crew (when used), insurance, legal fees (if any), financing costs, repairs, equipment and other legitimate business expenses are subtracted from company earnings. Vessel depreciation further lowers his taxable business income.
Buddies who aren’t customers that he takes for short fishing cruises pay a fee for the angling trip (for food and fuel) which covers those expenses and makes sure income can be shown against expenses. The tax advantage is that all expenses are tax deductible against your other income, he explains. That includes depreciation. It cost $23,000 just to paint the boat.
Whether a sole proprietorship or, for instance, held as a limited liability company (and mainly owned by individuals), U.S. Treasury Department officials advise the law requires the ‘company’ produce records establishing business use of the boat, and any personal use by an individual must be reported as personal income. They also readily admit luxury houseboats and yachts can catch the attention of auditors the way a Rolls-Royce would draw attention versus a less luxurious car.
Another example of business use is a houseboater who uses his vessel to research marinas and hidden bays for a cruising guide publisher, his vessel being the primary tool of his business under an independent contract for services. And yet another real estate seller utilizes his 92-footer which enables him to deduct insurance, repairs, maintenance and other operational expenses (see IRS Pub.535 Other Business Expenses). So far both businesses have passed IRS muster with both individuals noting that all allowable and appropriate expenses are written off in conjunction with IRS regulations, the latter owner adding, “The boat makes money because the boat makes money.”
Business Entertainment Expense
This category of expense is a frequent topic of inquiry. (See IRS Pub.463.) What expenses are deductible is not an easy question to answer as what are deductible is often determined by the kind of business and particular activities. Plus an expense must be “reasonable considering the facts and circumstances.” A business purpose must be served among business acquaintances.
If entertaining for example, a combination of business and non-business persons at the same onboard occasion, the entertaining expense must be divided pro rata subject to the 50 percent allowable only limitation. The IRS legal tests are the expenses must be “directly related” test and the “associated-with” test. And an expense for hosting a client or customer with a dinner aboard must be separated from say tickets to a dance or auction at the local yacht club.
Logging in your designated log book, diary or notebook (along with on your computer having backup disk regularly updated on hand), grouping certain “expenses of a similar nature” is acceptable to the IRS. Substantiation by the best evidence possible is the requirement. Receipts, cancelled checks, bills and invoices, showing the amount, date, place and essential character of the expense are generally considered adequate documentary evidence to satisfy recordkeeping rules. Think timely and accurate.
Depreciation Deduction On Business Property
Only property used in a trade or profession or other income-producing activity can be depreciated on your tax return. Depreciation can’t be claimed on property held for personal purposes such as your boat if not used for business. Some kinds of business property that depreciate include machinery, equipment and furniture. I write this with the caveat that ‘depreciation’ and the rules relating are a very complex subject in tax law.
For our discussion, IRS Code Section 179 allows taxpayers to write-off a fixed amount of capital expenditures on their return each year ($500,000 for 2010) rather than depreciate them over multiple tax years. One limitation, however, is that Section 179 expenses shouldn’t be greater than the net income generated by the business for which the property was acquired. (Goodwill, information databases, customer lists, licenses and other intangibles can’t be depreciated but could be amortizable over 15 years on your return.)
Avoiding An Audit
Finally, the IRS has a standard tax auditing program. It advises that most people are picked based on a computer analysis (that’s based upon a closely-guarded formula) to determine which returns are most likely to be in error. Most filings singled out for audit are what they have basically always been—types of deductions claimed, deductions that appear too high in relationship to income, erroneous tax items, items that require proof or an explanation, or are on the tax man’s list of hot tax issues.
Recalling our previous boat use examples, chances for audit are greater if: the business receives cash in the ordinary course of business; there are complex business expenses listed on the return; expenses are large in relation to the income reported; a prior IRS audit resulted in a tax deficiency; a dockmate or other informant has given information to the IRS; and unreported taxable income pops up when the computers match with information gathered from banks and others sources. (A common red flag are the traditional ‘self-employed.’)
To learn if your floating enterprise is listed on guides the government publishes for auditors, call the IRS Freedom of Information Act Reading Room at 202-622-5164 or write to Box 793, Ben Franklin Station, Washington, D.C. 20044. These can help pinpoint what auditors are looking for and how to best protect yourself. As with any information, visit a tax professional for your specific situation.
The author is a long-time East Coast boater with a law degree. Questions or comments are welcomed at email@example.com.