Home Office Issues - Home Office Deduction

Home Office Issues

HOME OFFICE DEDUCTION

Telecommuting and work from home offices is becoming more popular, but the IRS still likes to sniff out these deductions.

Take photographs of the house and the office area. This will serve two purposes: 

1.  It will show the proportion of the business area versus the personal living area to substantiate the amount of space claimed and 

2.  it will show that there is in fact a business area;

Know the rules. The home office must be your PRINCIPAL place of business and must be used exclusively and on a regular basis for business purposes.

Having your own business and working out of your residence affords you the possibility of taking an office in home deduction against qualified business net income.  The tax saving benefits of this deduction involve write-offs associated with this deduction.  If you qualify for it, you may be entitled to take a portion of your utilities, certain maintenance and repairs, residence insurance, property taxes, and mortgage interest.  If you rent, a portion of the rent may be deducted.  If you own, a portion of the house cost and house improvements may be deductible through an allowable depreciation write-off.

But you must qualify for this deduction; that is, you must meet certain tests.  These tests have changed, such that the home office deduction will be considerably easier to take.  

A home-office deduction can be taken by the professional if one uses a room(s) in their house or garage for doing the administrative work of their business regularly and exclusively for that purpose.  Under the old rules, to qualify, it had to be one’s principle place of business. In addition, there had to be no other place where one could do these chores.  In other words, if the home space was a second office away from the regular place of business, one couldn’t use a home-office deduction.

In a famous court case, an anesthesiologist, named Soliman,* who worked at three hospitals and conducted his administrative business at home (billing clients, studying client records, planning his workday), couldn’t take a home-office deduction because three hospitals could have given him office space to do his work, even though they didn’t. (It’s exactly this situation to which the expanded rules apply.)  

The Supreme Court denied Soliman's home office deduction setting forth a two consideration test for whether the home was the taxpayer's principal place of business: (1) the relative importance of the activities performed, and (2) time spent at each place.

Congress's reaction to this decision was to amend Section 280A(c) in Taxpayer's Relief Act of 1997 so that a home office could meet the "principal place of business" test if it is the only fixed location where administrative or management activities are performed. This effectively nullified the Supreme Court's decision ruling in the Soliman case. Under the new rules, a home office qualifies as a principle place of business if:

(1) the space is used by the owner to conduct substantial administrative activities, and
(2) there is no other fixed location where the owner conducts substantial administrative activities.

In addition, the space must be used exclusively and regularly for business. The critical word is ‘substantial.’  If an owner does most of his administrative work in a home office, regardless of whether he has an office at his place of business or not, is a sufficient requirement.  Now, any professional who has a home office and does substantial administrative work there qualifies.

In summary, the requirements are as follows:
You must use a part of your residence regularly and exclusively for business purposes.  Exclusively means a certain portion of the residence–a room, or a section–is used only for the business.  Thus, you can't write-off the dining room table, or any part of the residence which is also used for non-business purposes.  There is a possible exception here if you are using the residence for a daycare center.  In that case, the "exclusive area" qualification may be replaced with a "time-used" calculation formula.

The home office must be the PRINCIPAL place of business.  This is where it can get tricky.  It's not so tricky if this home office is where you meet or deal with your clients in the normal course of your business.  In that case, it definitely should qualify.  Similarly, if the space is used for inventory storage, or as a qualified day care business, or if the office is a separate structure on your property, then the IRS should accept this as the principal place.

However, it can be complicated beyond this.  The IRS position on principal place revolves around the amount of time spent in the home office compared to every place else.  Second, the "relative importance" of the activities performed in the office compared to every place else.

So, if your business involves visiting clients, potential clients, or any other activities where you leave the home office, the burden rests with you to prove you meet these two tests.

The amount of time spent in the home office vs outside of it involves a ratio of total hours in the home office compared to total working hours.  So, if you work 40 hours per week in your business, and spend 30 hours in your home office, and 10 hours outside, you meet the time test.  How you prove this in case of an IRS challenge is still not officially clear; the Supreme Court did not set any rules here.  Consequently, the proof most IRS districts seem to be accepting is a form of a time diary.  That is, designating the time spent in the home office and out of the office.

The second test can be the most frustrating, and it can even override the first test of time.  This test centers around your being able to prove the relative importance of your business activities both in the home office and out of it.  This test involves the actual nature of the business.  If the activities spent outside the home office are the true essence of the business, then even if you spend most of the time in the office, you will not get to take the deduction.

For example, a telemarketer spends 25 hours per week making sales phone calls from his home office, and 15 hours per week outside doing business errands.  In this case, since the essence of the business is telemarketing, and more than half the time was spent in the home office, the home office would qualify. In effect, the IRS has said that, if the activities being performed have equal relative importance both outside the home office, and inside the home office, then the time test is the determinant.  However, if the activities are unequal in terms of business essence, then the main test is where the most important, principal activities are being performed. 

Effective January 1, 1999, the "principal" place of business definition has been widened to include administrative use (such as paperwork).  Also, if there is no other fixed location, then the "relative importance" and "time test" determinants may be waived.  That means an office in home deduction may be easier to qualify for than has been the case in recent years.

Again, however, if clients come to the home office, or inventory storage is an important function, then the probability of a home office write-off is excellent.

How The Home Office Space Is Calculated
Assuming your business is eligible for the office in home deduction, let's review how the actual deduction is calculated.  The first step is to arrive at the allowable deductible space.  This can be done using two main methods for businesses other than a daycare facility.

The first option is to use a room to room comparison.  You add up the total number of rooms in the house(usually not including bathrooms) used exclusively by the business compared to the total number of rooms in the house altogether.  That gives you a percentage.  So if you use 1 room out of 6, the office in home deduction percentage is .1667, or 1/6 of the total.

The second main method involves square footage comparisons.  Add up the total square footage of space being used for the business compared to the total square footage of space in the entire residence, and you get a business use percentage.  If the business square footage is 250 square feet, and the entire house square footage is 2500 square feet, the home office percentage would be 10%.

Note that the more square feet of business space you use, the bigger the deduction.  So don't forget to consider all the usable, qualified business space, including attic, garage, and basement.  In some unusual cases, businesses run out of the home can take up a majority of the usable square footage, thus creating a significantly large write-off.

This home office percentage is then used to determine the amount of deduction for the allowable expenses.  You would add up the allowable utilities, insurance, maintenance costs, and any other similar operating expense, plus the allowable property taxes and mortgage interest.  You then take the calculated office in home percentage to arrive at the allowable business write-off for this portion of the home office.

In addition, the same home office percentage is used to calculate the portion of the rent you are paying(if you rent), or the deductible portion of the depreciable basis of the house itself (if you own it).  If you own the residence, the calculation involves taking depreciation on the house based on IRS allowed write-off periods.  Even if the house is going up in value–or appreciating–you can do this.  The theory here is that "wear and tear" is occurring to the physical part of the house so the business should be allowed to factor it in as an expense.

Some Caveats
Although the office in home can generate some terrific 2000 tax deductions, and save you a significant amount of money, there are some possible drawbacks.

First, the office in home is a possible "red flag" in terms of audit possibilities.  The deduction on the tax return does indeed stand out "like a sore thumb." Naturally, you should never fail to consider taking a legitimate deduction out of fear of an audit.  However, this particular deduction may indeed increase your chances of an audit, especially in certain professions.

Second, parts of the office in home deduction may be subject to recapture down the road.  The depreciation taken on the residence over time may be recapturable.  This could increase your potential capital gains on the property upon sale.  For decision-making purposes, this means you are comparing the dollar amount of tax savings by taking the office in home against possible tax "give-backs" upon the sale of the property.  So, the effective tax bracket you are in while taking the current office in home deduction compared with what it will be when you sell becomes an important issue.

Conclusion
Taking an office in home deduction can make for some significant tax savings.  For an unincorporated business it can mean tax savings for both income tax and self-employment taxes–a double whammy so to speak.  At the upper brackets, this can be a savings in excess of 50% of every dollar spent in this regard.

So it's worth serious consideration.  Similarly, if the deduction is taken, it's important to keep adequate records for the use of space comparisons, actual expenses, and relative importance of the business activities inside and out of the office in home.  If done properly, it can be a great "loophole."
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*Commissioner v. Soliman, 506 U.S. 168 (1993), was a case heard before the United States Supreme Court in which the court decided whether a portion of a dwelling unit exclusively used as a principal place of business for any trade or business of a taxpayer would allow a deduction to the taxpayer's income taxes under IRC §280A(c)(1)(A).

IRC §280A(c)(1) now allows a home office deduction if taxpayer performs the "majority" of her administrative or managerial activities in her home.  It is no longer defined as a place where taxpayer performs the most important aspects of her trade or business.  Thank you Dr. Soliman! 
Source:  1997 amendment to IRC §280A(c)(1)

Reference: Practice Enhancers, Able & Co.

Checklist for Partnership - Start-up Issues for New Business

Checklist for Partnership: Start-up Issues for New Business

Below is a checklist of actions that should be considered for the organization and operations of your partnership.

• Determine partnership name
• Record Partners names, ID#'s, record of ownership
• Set up partnership agreements
• Set up buy/sell - change in partnership interest agreements
• Do assumed (fictitious) business name registration
• Apply for required operating permits, licenses, bonds, etc.
• Register for Federal SS-4 Tax ID#
• Register for State Income Tax ID#
• Register for State Sales Tax ID#
• Register for State Unemployment, Withholding Tax ID#
• Establish appropriate accounting methods (tax year, cash vs. accrual, etc.)
• Set up acceptable bookkeeping system
• Establish appropriate travel and entertainment procedures and record keeping reports
• Set up bank / checking accounts
• Contact insurance company regarding various coverages needed (business liability, key person insurance, medical, buy/sell, errors and omissions, workers comp)
• If Employees will be hired: Consider a personnel manual
• If Employees will be hired: Have W-4's, I-9 forms, state employee registration forms ready
• If Subcontractors will be used: Consider subcontractor agreement
• If Subcontractors will be used: Have W-9 forms ready
• Establish association with loan officer
• Establish association with attorney
• Set up tax filing calendar of due dates
• Plan for estimated tax payment filings for partners
• Consider a business pension plan
• Consider any necessary tradename registration

Notes:

Reference: Practice Enhancers, Able & Co.

Family Members on Payroll

Family Members on Payroll
HIRING FAMILY MEMBERS
Putting family members on your business payroll can create some significant tax savings.  Naturally, the IRS expects these family members to perform services for the business to justify the tax deductions.  But the various IRS and state laws governing employees and tax obligations are much more liberal when you employ family members as opposed to outsiders, especially for certain forms of business organizations.

Is it possible you could employ your 12 year old child to help you clean up your office, do filing, etc. and write off this as a tax deduction in your unincorporated business?  Yes.  If you were to pay that child $4,300 for the year, and your marginal federal/state tax bracket (including self-employment tax) were 28%, that could translate into a tax savings to you of $1,204  per year.

If you have a corporation, could you hire your spouse, include the spouse in various fringe benefit and pension plans, and take a tax write-off for these business expenses?  The answer again is Yes.

These are some of the possibilities that exist for a business owner.  Properly handled, the hiring of family members can greatly reduce taxes in your business.  Naturally, there are some variables that must be considered to determine overall tax saving possibilities.  The three main ones are:  the type of business entity you have; the relationship and/or age of the potential family member employee; and, whether or not certain types of business deductions are being used.

Type Of Business Entities
For the most part, the two main business types that have the most impact on the possible benefits of employing family members are sole proprietorships and corporations.

Sole Proprietorship
A sole proprietorship–that is, an unincorporated business–can create some interesting tax-saving opportunities in the case where the business owner has children who could help out.  In order to understand the possible tax savings, you should first know several "loopholes" that exist on the federal level in this regard.

Basically, a sole proprietor is allowed to hire his or her children even if the children are not of "legal" working age.  In other words, is it possible you could hire your 9 year old to help out if it were feasible?  According to federal law, it would be perfectly acceptable.  Second, the law also states that the sole proprietor does not have to pay social security taxes on his/her children's wages if the children are under 18 years old–nor do the children have to pay it either.

Let's see how this could save you some significant tax dollars.  Let's assume Business Owner A is currently paying income taxes at the rate of 28%.  In addition, a sole proprietor must pay self-employment taxes on the profits as well.  For the current year, that rate is 15.3% before adjustments–and approximately 14% in round numbers after adjustments. Thus, the overall marginal federal tax bracket in this case is 42%.  That means 42 cents of taxes are being paid for every additional dollar being earned.  From a tax write-off standpoint, it also means 42 cents of taxes would be saved for every additional dollar of deductions.

Thus, if Business Owner A were to hire his/her child for the year, and pay that child a reasonable wage, the savings could be as high as 42 cents on every dollar paid out.  Let's assume the child was paid $2,000 for the year.  The savings would be $840. per year, every year the child was paid.

Will the child have to pay taxes on the money?  It depends on how much the child is paid, and how much other income the child has for the year.  Current tax law allows the dependent child to earn up to at least $4,400 without paying tax.  Thus, for this scenario, the child will not have to pay any federal taxes on the money.  For other situations, the child's tax bracket would probably still be significantly lower than the sole proprietor, so there would still be sizeable potential tax savings.

Will this technique also work for a sole proprietor's spouse?  The answer is no, for two reasons.  First, the exception regarding not paying self employment taxes does not apply for a spouse.  Second, the spouse's marginal tax bracket is normally the same as that of the sole proprietor since a joint tax return is usually filed, so there would be no tax savings here either.

Does that mean there is no tax saving benefit to employing a spouse in a sole proprietorship?  Not necessarily.  There may be some ways to save taxes using other possible angles.  Here are some possible tax savings scenarios if a spouse is hired:

Possible 6.2% tax savings on social security taxes:  If the spouse of a sole proprietor is already paying the maximum in social security tax from other earnings, and the sole proprietor is not paying the maximum, then a possible tax savings exists here.  The sole proprietor would be able to deduct the spouse's wages, and save the self-employment tax on the deduction amount. Since the spouse has already "maxed out" on paying social security from another source of earnings, no extra social security tax would be due.  Hence, a possible 6.2% tax savings.

Possible 100% medical insurance/reimbursement plan write-offs:  Sole proprietors are normally not allowed to write-off 100% of their health insurance like certain "C-type" corporations are; they are also not allowed to set up a medical reimbursement plan for themselves to write-off the medical expenses that their insurance company won't cover.

However, if the sole proprietor hires his/her spouse properly, both of these write-offs could be achieved.  Under federal rules for employee benefit programs, a spouse does qualify under health insurance coverage and deductions for said coverage.  Thus, the sole proprietor could hire the spouse, cover the spouse under a "family plan" health insurance policy (instead of having a sole proprietor coverage plan), and take a full deduction for it.  In effect, the sole proprietor has now covered everyone in the family, and gets a full tax write-off for the cost of the insurance.

Increasing your deductible retirement plan contributions:  Employing a spouse can result in extra retirement plan deductions which results in extra tax savings.  Under certain conditions, the spouse could be eligible to participate in various pension plans, such as IRAs in which more money could be put away than before.  If the sole proprietor is already putting away the maximum $2000 into a "working spouse" IRA, there is a possible scenario where the hired spouse could set up his/her own "working spouse" IRA, resulting in an additional $2000 IRA deduction yearly.

While much too complicated to go into here, the same kind of techniques may be possible for other types of retirement plans, especially customized types a sole proprietor may use in the business.

Creating a deductible office in home write-off:  This is viewed by the IRS as a bit aggressive, but it survives challenge if done properly.  The sole proprietor hires the spouse to do all the recordkeeping for the business.  The spouse then uses a portion of the residence to perform these duties on an "exclusive and regular" basis.  This could then qualify for office in home deductions where it previously didn't qualify under the current IRS rules for deducting a home office.  The tax savings here would revolve around deductions for writing off a portion of the utilities, maintenance, and depreciation of the residence, or a portion of the rent being paid.  This could save a considerable amount of taxes.

Similarly, under federal employee guidelines, a spouse as an employee can be covered under a medical reimbursement plan.  This allows the employer–in this case the sole proprietor–to pay for (and deduct) the medical costs that the health insurance won't pay for.  So if the health insurance had a high deductible, or if there were medical or dental expenses not being covered under the plan, a properly set-up medical reimbursement plan could result in large tax write-off for a sole proprietor.  Like all "fringe benefit" planning, a number of other issues have to be considered, such as other employees, reporting requirements, and tax brackets, but the use of a hired spouse does create interesting tax write-off possibilities in this area.

There are other fringe benefit plans that could be set up for a spouse/employee to generate significant tax deductions and tax free or tax favored benefits, including such things as life insurance, pre-tax savings plans, and the use of a vehicle, to name a few.

Corporation
There are both similarities and differences in employing family members in a corporate structure compared to a sole proprietorship.  A corporation cannot exclude children under 18 from social security/medicare taxes.  Consequently, there would be no savings on social security/medicare tax like there would be with a sole proprietorship.

However, the other options generally exist.  Children could still be paid up to $5,950 without any federal income tax liability, so this could save the corporation and owner/employees.  

When Are Kids Required To File a Tax Return?
Generally, children who can be claimed on another person's taxes must file their own return if:
• They have wages of $5,950 or higher (this is the standard deduction amount for 2012, the amount for 2011 was $5,800)
• They have unearned income (investment income from interest, dividends, etc.) of $950 in 2012 ($950 in 2011)
• They have total income (both earned and unearned) greater than the larger of $950 or their earned income plus $300.

The child's tax bracket would probably be lower, so money paid in this way could save significant corporate taxes.  A spouse could also be hired to take advantage of various fringe benefits and retirement plans(providing the highly compensated tests are met), and might qualify for the home office write-off as well.

Another benefit to hiring family members is to avoid IRS challenge on excess compensation or accumulated earnings issues.  Believe it or not, a corporation is not supposed to retain its earnings over certain acceptable levels or it could be hit with an IRS accumulated earnings tax penalty.  In effect, the IRS wants the corporation to distribute these earnings in the form of dividends instead of retaining them.  This is not a tremendous tax saving option.  The corporation cannot deduct dividend distributions, but the recipients must pay tax on them.  It is a form of double taxation, since the corporation already paid income tax on the original earnings.

Now, if a corporation facing this problem of excess accumulated earnings can justify hiring family members, it is a way of getting the money out in other than dividend distributions–a sizeable tax savings and a way of avoiding the double taxation issue.

Similarly, certain corporations can be penalized for paying out excess compensation to the owner/employee.  The IRS can take the position it is excessive and/or a form of a disguised dividend.  Thus, putting family members on the payroll may help to defend this type of IRS challenge.

Conclusion
Hiring family members can result in dramatic tax savings for a business.  First, the deduction itself may save certain types of taxes, especially for sole proprietors.  Second, if there is a significant tax-bracket differential between the family member and the business or business owner, this can also be used as an important tax-saving device.

Family members can benefit from various tax favored fringe benefits which the business can deduct.  On the corporate level, they can be employed to alleviate certain IRS threats regarding excessive compensation or earnings, and save on taxes as well.  All in all, there can be a number of attractive options in this area.

Reference: Practice Enhancers, Able & Co.

Hobby Loss vs. Business Loss

Hobby Loss vs. Business Loss
TURNING HOBBY LOSS INTO BUSINESS LOSS
It happens on more than one occasion that a person turns a hobby into a business and makes money.  After all, if it is something you like doing, you tend to do it better, and spend time learning, improving, and mastering the activity.  These are all some of the basics tenets of success in business.

Your government loves this.  A hobby that starts producing profits means taxable income which translates into more taxes.  Why wouldn't this be well received?

However, the reverse is not always true.  Losses that emanate from a business which could be construed as a hobby-type activity are frequently subject to government challenge in an audit.  This is because these losses can be used to offset other taxable income you may have, resulting in your paying less taxes.  So, there is a form of polarization here.  The taxpayer may be happy with the losses which could save up to 40% in taxes for some.  Obviously, the government may not be as happy with these results.

The key here is to work within the system to be able to use hobby-type losses to save taxes.  The way to do it is to make sure the hobby-type activity qualifies as a business, not a hobby, under the current IRS guidelines.  In terms of IRS tax code, you want to qualify under Code Section 162 (Trade or Business Expenses), or Code Section 212 (Expenses for Production of Income) which refer to a trade or business and/or the production of income.

You don't want to get categorized under Code Section 183 which is an "activities not engaged in for profit," since this makes the net losses non-deductible.

To help your cause in being able to deduct these losses, there are a number of issues, or tests that are considered under current audit guidelines.  The successful qualification within these parameters goes a long way toward the allowance of these losses against other forms of income.  This isn't to say ALL of the guidelines must be met.  It is a matter of the relativity of these guidelines compared to the specific activity in question.  Let's look at the guidelines that are used to establish the activity as a business rather than a hobby.

The main parameters that are currently used as guides to the deductibility of hobby-type business losses are as follows:

1. Amount of profits earned, and occasion of such profits:  Obviously, if the activity produces consistent profits, there is no problem.  There are no losses of concern.  If the profits are only occasional and the losses are more frequent, the tests here are twofold.  First, a relatively large profit, even if only occasional, would tend to support the idea that it is a business more than a hobby.  Second, if the losses are relatively larger than the occasional small profits, and consistently so, then it tends to be viewed more as a hobby.

2. Reason for, or history of losses:  Losses in the early phases of a business are common, and aren't necessarily held against you.  Similarly, losses due to circumstances beyond your control (such as from disease, casualty, weather, market conditions, etc.) are taken into positive reference.  So continued losses without profits in this case would not necessarily be a detriment.

3. The degree of personal pleasure in the activity:  The more this factors in, the more suspect the activity with the IRS.  Model train collecting, horse breeding, art painting, etc., where the business owner or family members participate heavily in the recreational aspects, causes more problems than perhaps other activities.

4. Degree of benefit of losses:  The economic status of the taxpayer enters in here.  The more you have income from other sources besides the hobby-type activity, and the more you benefit from the losses tax-wise, the more it may be challenged.  If you are deriving the bulk of your income from the activity, or if the losses are not saving you much in taxes, it becomes more of a moot issue to challenge.

5. Experience, or expertise of the taxpayer:  Those with significant expertise in the related field, or those who can prove they are making continued efforts to become knowledgeable stand a better chance.  If you use advisers in the activity, if you go to school, trade shows, or buy books, to name a few possibilities, you reinforce that you are trying to make positive efforts to understand the market, and eventually overcome the current losses.

6. Time spent on the activity:  If you spend a significant amount of time in the running of this activity compared to other income-producing activities, it helps show you view this hobby-type activity as more of a business with income potential.  If you spend 3 hours a week on stamp collecting vs 37 hours a week earning money elsewhere, it could be difficult writing-off losses year-by-year from this activity.

7. The "business-like" nature of the activity:  This is perhaps the most frequently-used major test.  One difference between a business and a hobby is in how the activity is run.  If good financial records are maintained, a proper bookkeeping/ recordkeeping system is used, and possibly a separate checking account is kept, then a better case can be made that it is a business, not a hobby.  Similarly, if you can prove you made reasonable attempts to market or advertise this activity to generate revenues, it supports your case.

Is there a Loophole for all of this?
A possible general "loophole" exists where you can show that a reasonable profit occurred in two out five consecutive years of operations.  If this is the case the IRS tends to assume the activity was done for profit, hence the loophole since no challenge may be in order.  Note however, that the degree of profit is important compared to the degree of loss.  Very small profits for two years vs large losses for the other 3 years may not be enough to keep the IRS from trying to challenge.

Since the challenge is done "after-the-fact," the IRS has the benefit of hindsight.  It's too late for you to go back in time to shore up your position.  If you lose this challenge, these losses, both future and past (within the appropriate statute of limitations), can be disallowed resulting in a possible hefty tax bill for you to pay– plus interest and possible penalties.  So contemporaneous recordkeeping and marketing activities are the watchwords here.

However, if you do your homework and the loss-producing activity is handled correctly, this can be a wonderful tax-saving opportunity.  You or members of your family may have the chance to enjoy a fun activity, write-off its expenses, and reduce your taxes all at the same time.  So it is worth the consideration.

Reference: Practice Enhancers, Able & Co.

Estate Planning Primer

Estate Planning Primer
Your Potential Federal Estate Tax Liability
The purpose of the accompanying analysis is give you an idea of your potential federal estate tax liability based on your current "net worth." The effects of any state succession or inheritance taxes will not be taken into account.

The federal estate tax is based on the net difference between your various taxable assets and your allowable debts/liabilities at date of death.  In effect, this is a form of "net worth" calculation.  Under the current rates, this graduated tax can reach as high as 35% for certain size estates!  Thus, calculating your potential estate tax–and planning how to reduce it–shouldn't be taken lightly.

Under the present laws, married individuals can leave an unlimited estate to their surviving spouse, assuming that spouse is a US citizen.  No tax problem here.  But it is at other levels where the tax liability can come into play.  That is, when the surviving spouse dies, or if there is no qualified spouse, or if the estate exceeds a value of  (higher if the estate involves a family-owned business.)  At this point, federal estate taxes–like a shark–can come charging into the picture to take huge bites out of your assets.

A brief rundown on some basic techniques that people use to do estate tax planning is enclosed.  When it comes to estate tax planning it's always a good idea to know two things.  One, where you stand tax-wise; that is, how much you have potentially to lose.  Two, what tax-saving avenues are open to you to cut down on these taxes.  That's because: Three, if you don't take advantage of these tax-saving techniques before certain events occur, you lose the opportunity.  So please review the accompanying text in addition to the estimated estate tax calculation, based on your situation.

Basics Of Estate Planning
Most people assume that only the wealthy need estate tax planning.  This is not so, because it doesn't take a great deal to reach the taxable levels; not when you start adding up all the components the IRS uses to determine what's taxable.  Keep in mind that such items as life insurance proceeds, annuities, value of your company retirement plan, and real estate are only some of the taxable components.  Also, when the estate tax does kick in, it starts furiously, with an opening 2012 marginal tax bracket of 35% after your unified credit exemption.

But an estate plan also fulfills other important functions.  Properly done, it can also insure that your remaining assets at death go exactly as you wish, to exactly whom you want, in as little time as possible, and at the smallest cost.  Failure on your part to do the proper–and legal–estate planning will mean that the courts will decide what to do with your assets, and who will handle it.

So, basically good estate planning will do all of the following: Cut federal and state taxes, minimize red tape for the transition, allow you to enjoy your money while you are still alive, and make it easy for your survivors to handle your estate after you pass on.

Normally, most people do not do their own estate planning.  They use lawyers, tax accountants, financial advisors and planners.  But, the biggest mistake made by a majority of people is that they don't even know enough to decide if they need help, what kind of help to get, when to get it, and what the trade-offs will be for all this planning.  In fact, to most people, all this estate planning is a confusing, scary area (no one likes to even think about dying, much less plan for it).  So how do they respond?  They do nothing!

Big mistake.  Especially since, once you understand some basic tax-savings possibilities in this area, you will quickly realize how easy it is to implement.  You see, basic estate planning is not complicated so much as it is a timing consideration and a decision as to trade-offs.  All you have to do is decide on which trade-offs make sense for you.  The rest is done by the lawyers, financial advisors, and so forth.

Consequently, what follows is a brief outline of certain basic estate tax planning techniques that may come into play some time in your financial history.  These techniques can be divided into five main areas as follows.

1 - Outright Gifts to Charities
There are two ways this can be done: before or after death.  If you give to qualified religious, educational, scientific, charitable, or literary organizations before death, you achieve dual functions.  First, you may qualify for an itemized deduction on your income tax return to save on taxes; second, it reduces the size of your taxable estate.

After death, the taxable estate is reduced by the fair market value of any gifts bequeathed.  Thus, if it is property or stocks, bonds, etc., the fair market value at date of death is used as the deductible amount.

Remainder Interests
In this scenario, the donor retains life use of the property, and agrees to have the property pass to a charity upon death.  An income tax deduction based on the fair market value of the property less the so-called "lifetime-use" value is received by the donor, and the estate is reduced upon death.

Easement donations also fall into this category.  You may have a piece of property in which you grant an "easement"–or a right to use the property for a specified period of time.  This has a value to it under current IRS rules.  As an example, you may allow a charity to use part of the woods on your property for a bird sanctuary.  This easement can create a deduction from your taxable estate, as well as a current income tax deduction.

Charitable Trusts
There are two main types of trusts most people use for charities:  
• Charitable Remainder Trusts, and 
• Charitable Lead Trusts.

CHARITABLE REMAINDER TRUST: In this type, the donor gives property over to an irrevocable trust.  However, the income generated by this property is still retained by the donor and/or the donor's beneficiaries.  Upon death of donor and/or beneficiaries, the charity gets the property in full, income and all.

This creates a current income tax deduction based on the value of the remainder interest donated, reduces the taxable estate, and can shift taxable income to lower-bracket beneficiaries.

It's also a great way to convert a non-income producing asset into an income producing one, tax-free.  If you have a property that has highly appreciated value compared to your cost basis (like a stock, or building), you can set up this trust such that the charity will sell the property, invest the proceeds in income-producing assets, and you get this income.  If you had done this yourself, you would have had to pay capital gains tax on the sale of the property first, so you would have had less principal to re-invest on your own, and, therefore, possibly less income being generated.

CHARITABLE LEAD TRUST: This is the opposite of the above.  The income from the investment is gifted to the charity, and the property itself is kept in the estate.  The donor gets a deduction for the "present value" of the income stream gifted to the charity.  The charity gets this income until the donor's death when the property is passed to the beneficiaries.

2 - Use Of Gifts To Individuals
You can reduce the size of your taxable estate by making gifts to individuals while you are still alive.  While this will not give you a current income tax deduction, it obviously lowers your taxable estate.

However, you are limited to how much you can give per year per person to take advantage of this.  You are allowed to give up to $14,000 (2013 amount) per year per person.  A couple can jointly give $14,000 each per person; thus, a husband and wife (gift-splitting) could give their child up to $28,000 per year.  Beyond this amount, you can be held liable for gift taxes as the donor.  There are a few exceptions to this dollar value limitation.  Any payments made directly to a qualified secondary level educational institution, or any qualified medical payments made directly to the source are not subject to the $14,000 limitation.

A caveat: Any gifts that parents make to minors to reduce their estate must usually be made under the Uniform Gifts To Minors Act, or to the Uniform Transfer To Minors Act, or to qualified trusts to preserve this estate tax planning technique.

3 - Use Of Marital Deduction
Although a spouse can leave an unlimited size estate to the surviving spouse who is a US citizen, it is different if it is being left to anyone else.  For other-than-a spouse who is a US citizen, the maximum size estate currently exempt from federal taxes is $5,120,000 per individual (higher if the estate involves a family-owned business).  This refers to the "unified credit" allowance.

Thus, if your total taxable estate is under $5,120,000 you may need little federal estate tax planning.  But if your estate is higher than $5,120,000 and you are concerned with estate taxes even after your surviving spouse passes on, then you can use this Per Individual unified credit exemption in your favor and save taxes on a combined estate of up to $10,240,000.

To do this, you would leave $5,120,000 to your spouse (since the law allows you to leave any amount to a qualified spouse with no immediate federal estate tax consequences) and set up a "credit-shelter" trust to hold the remaining $5,120,000 which you have designated as your allowable unified credit exemption.  According to a loophole in the laws, your spouse is still allowed to receive the income from this trust, but the principal would pass on to the next level of beneficiaries upon the spouse's death.

What you have done here is to make use of both your $5,120,000 unified credit, and your spouse's, so you can shield up to $10,240,000 using this relatively simple estate tax planning technique.  For this to work effectively however, the title to your assets must be allocated properly before the death of either spouse.  Any jointly held property may not work properly in this maneuver.  So some "asset shifting" may be needed in order to set this up.

US CITIZEN VS NON US CITIZEN: Under certain tax provisions enacted, only spouses who are US citizens can receive an unlimited estate.  All others–including Resident Aliens–can only receive a maximum of $60,000.  Under the new law, the exemption amount for non-U.S. domiciliaries remains at only $60,000. Non-U.S. residents have only a $60,000 exemption from the Federal estate tax, unless a treaty provides a greater exemption. Thus, if your estate is over this amount, your non-US citizen spouse can get hit with a heavy estate tax under certain scenarios.

For a non-US citizen, the marital deduction is available only if certain requirements are met. Code §2056(d)(2)(A). The property must be left to the surviving noncitizen spouse in the form of a qualified domestic trust (QDOT), which pays all income to the spouse for life, has at least one US trustee, and may make principal distributions only to the surviving spouse. Code §§2056(d)(2), 2056A. If the trust has more than $2 million in assets, there must be a US corporate trustee, unless a letter of credit or a bond is posted.

A Qualified Domestic (QDOT) Trust is a very specific trust designed to address a somewhat common situation: what happens when the spouse of a non-US citizen dies while leaving significant assets to the non-citizen survivor. Properly set up, a QDOT trust makes it so that, upon your death, your assets pass into the hands of the trust, with the surviving non-citizen receiving the benefits from the trust. Then, upon the death of your non-citizen surviving spouse, the assets pass to your relatives as normal and the estate tax is paid then, much like it would with two citizens.

4 - Using Life Insurance
Using life insurance may be a valuable estate tax planning tool.  It is divided into two areas: Using life insurance to pay estate taxes and using life insurance trusts to avoid paying estate taxes.

Using Life Insurance To Pay Estate Taxes
In its simplest form life insurance can be a cheap way to do estate tax planning.  If your estate tax bracket is high, and if you do not outlive your statistical lifespan, the cost of having life insurance can be a great deal cheaper than the estate tax you will owe.  Thus, life insurance may be a good investment in this context.

So, life insurance can provide the liquidity needed to pay the estate taxes.  This can be valuable especially if you have little cash in the estate, but a lot of property that you don't want to be sold at death.  The life insurance proceeds can be used to pay the taxes, thus preserving the character of the estate.

A cheaper way to go for a married couple doing estate planning is to buy a "second to die" policy.  This is especially true if one of the spouses is considerably older than the other and/or has health problems.  The policy is cheaper because the insurance companies are spreading the statistical "mortality rate" calculation over two combined life spans instead of separate ones.

For some people, a decent life insurance policy may be the easiest form of estate tax planning.  While you are not saving estate taxes, you are planning for their payment without reducing your other taxable assets.  So, this is still a form of estate tax planning.

Using an Irrevocable Life Insurance Trust (ILIT)
Normally, life insurance proceeds paid to anyone other than a spouse who is a US citizen are included in one's taxable estate.  While these proceeds are not subject to income tax chargeable to the beneficiaries, the proceeds do get added to the rest of the taxable estate.  Thus, once the total value of the estate exceeds $5,120,000 including the value of the life insurance, estate tax headaches can occur down the road.

There is a loophole to this, however.  The present law states that life insurance proceeds are taxable in one's estate only if the insured OWNED the contract.  Legally, owning a policy means paying for it, and having the power to exercise various rights such as the right to change beneficiaries, change the policy terms, or cancel the contract.  So, if you legally disavow ownership by having some other individual or a trust own the policy, these proceeds will not be included in your taxable estate even though you are still the one insured.  In short, you are making an irrevocable election to give up control over the policy.  You can do this by having another person own the policy. Example: Your beneficiary for the policy could take over ownership, and make the premium payments.

Or, you can set up an Irrevocable Life Insurance Trust to own the policy.  This works great in the situation where you want your spouse to benefit from the policy without it going into your estate, and still have some control over the principal amount while the spouse is alive.  This trust can also be allowed to pay your spouse the income from investing the life insurance proceeds.  The life insurance proceeds themselves go to another beneficiary(such as a child) upon the death of your spouse.

This technique may be applied even to life insurance policies from your job by transferring the incidence of ownership of this policy and naming your heirs as beneficiaries.

Some Caveats: If you transfer any insurance policies that have "cash surrender value" this amount may be considered as a gift, so the gift tax rules may come into play if this value exceeds $14,000.  There is also a three year rule which applies.  If you die within three years of transferring over any existing policies, this estate tax planning technique may be disqualified.  To beat this problem, however, you can consider canceling an existing policy and starting fresh with a new one, everything else being equal.

5 -  Use Of Trusts
As previously mentioned, some trusts can be valuable estate planning tools.  The Charitable Trusts to allocate property and/or income, the Credit Shelter Trust for taking advantage of the $5,120,000 unified credit, and the Irrevocable Life Insurance Trust we just discussed are good examples.  But there are a few more to outline as well.

Note that trusts can fulfill other purposes besides estate tax planning.  Proper use of a trust can greatly reduce the costs and time associated with the probate process; they can save or at least stabilize income taxes; and they can provide for control, continuity, and clarity of management even after death.  In fact, trusts have so many uses, that entire books and careers are based solely on the use of these interesting "creatures of the tax codes."

However, the purpose of this text is to concentrate only on the estate tax planning benefits of certain trusts that may apply to the majority of taxpayers like you.  Again, this is to give you a basic overview so that you know what's out there.

First, what is a trust?  From a legal and tax standpoint, a trust is a separate entity to which a grantor has transferred legal ownership of property of some type(including cash) for the benefit of one or more beneficiaries.  This trust has a legal life of its own.

For estate tax planning purposes, the other trusts to review besides the ones already discussed in the other sections are the Minor's Trust, the Generation Skipping Trust, and the Grantor Retained Income Trust.

Minor's Trust
This trust is used in conjunction with estate tax and income tax planning for the situation in which someone wants to make a gift to a minor but still wants some control over the property.  Most of these trusts are the so-called "2503(b)" trusts.  The property can be managed by a trustee for the benefit of the beneficiary.  By making this an irrevocable trust, the donor effectively removes the principal from the taxable estate, and the trust can continue indefinitely.

Variations on this theme can be done in which the trust can have a scheduled termination date.  A 2503(c) trust does this.  In this one, it ends when the minor reaches age 21.  If done properly, it also effectively removes assets from the donor's taxable estate.

Generation Skipping Trust
GST’s are not as tax free as other trusts. The IRS levies a Generation Skipping Transfer Tax on all transfers of property over more than one generation. This tax rate mirrors the estate tax rate (35% in 2012). Fortunately, there is a GSTT exemption which also mirrors the estate tax exemption ($5.12 million per individual in 2012).

A GST is created on the death of the grantor. The first $5.12 million of his estate will pass to whomever he chooses, tax free. After that, he will pay estate taxes on the rest of his estate, including the property which will go into the GST. Up to $5.12 million worth of property will be placed in the GST (financially it does not make sense to place more than the exemption amount in the GST). The property in the GST will then be used to provide income to the life beneficiaries (the first generation after the grantor) for the remainder of their lives. On their death, the property in the GST passes to the next generation, without estate taxes (since they were assessed at the time of the creation of the GST). This trust allows the assets to grow over a long period of time, while only being assessed taxes for their value at the creation of the trust.

Concerns with regard to a GST
This trust is only a good choice for grantors if they are sure that the generation which becomes the life beneficiaries are able to provide for themselves without the use of the property in the trust (since the life beneficiaries will not have access to the trust property).

It is possible to create a GST for someone who is not a family member. Also, each individual is allowed the GST exemption at their death. Therefore, a couple with a large estate may create two separate GSTs for their beneficiaries. It is also possible that someone may want to create multiple GSTs by splitting up their exemption into separate trusts.

A GST is most effective when coupled with other estate planning devices. To know which is the best combination for yourself, speak with an experienced estate planning attorney.

Grantor Retained Income Trust
Commonly referred to as a GRIT, this is a form of trust which may allow you to remove a substantial portion of the value of your residence from your taxable estate without losing the right to live in it for a designated period.

Basically, you turn your residence over to an irrevocable trust and your beneficiaries will receive the residence after a certain period.  But you retain the right to live in the house for this specified period of years before the title goes over to the heirs.

This saves estate taxes because the restriction you place to retain your right to live in the house has a value for tax purposes.  The longer you extend this right, the greater the value.  Thus, this value gets subtracted from the actual fair market value of the residence for estate tax purposes.   

In addition, any potential property appreciation after the house goes into the trust is effectively removed from estate taxes under current law.

One big catch, however.  If you do not outlive the original term of the trust you set up for your right to retain occupancy, the full value of the property–including any appreciation–goes back into your estate.

2011 and 2012 Changes to Estate Tax, Gift Tax, and Generation-Skipping Transfer Tax Laws
Here is a summary of what TRA 2010 provides for gifts made in 2011 and 2012 and the estates of decedents who die in 2011 or 2012, as well as some problems created with regard to state estate taxes and generation-skipping trusts:

1. Sets new and unified estate tax, gift tax and generation-skipping transfer tax exemptions and rates. For 2011, the federal estate tax exemption will be $5 million and the estate tax rate for estates valued over this amount will be 35%. The estate tax has also become unified with federal gift and generation-skipping transfer taxes such that in 2011 the lifetime gift tax exemption and generation-skipping transfer tax exemption will be $5 million each and the tax rate for both of these taxes will also be 35%.

2.  Indexes estate tax, gift tax and generation-skipping transfer tax exemptions for inflation in 2012. The estate tax, gift tax and generation-skipping transfer tax exemptions have been indexed for inflation for the 2012 tax year such that each will be increased from $5 million to $5.12 million beginning on January 1, 2012.

3.  Offers "portability" of the federal estate tax exemption between married couples. In 2009 and prior years, married couples could pass on up to two times the federal estate tax exemption by including "AB Trusts" or "ABC Trusts" in their estate plan. TRA 2010 eliminates the need for AB Trust planning or ABC Trust planning for federal estate taxes by allowing married couples to add any unused portion of the estate tax exemption of the first spouse to die to the surviving spouse's estate tax exemption. This will effectively allow married couples to pass $10 million on to their heirs free from federal estate taxes with absolutely no planning at all; however, note that the surviving spouse must file IRS Form 706, United States United States Estate (and Generation-Skipping Transfer) Tax Return, in order to take advantage of the deceased spouse's unused estate tax exemption. Also note that portability was not applied retroactively to January 1, 2010. Aside from this, as it now stands portability is only available for deaths that occur during the 2011 and 2012 tax years. In addition, without AB Trust or ABC Trust planning, state estate taxes may be due in states that collect them. See more on state estate tax issues below.

4.  State estate tax issues. For states that collect a separate state estate tax and have not adopted portability of the state estate tax exemption between spouses, AB Trust or ABC Trust planning may still be required in states that collect state estate taxes, particularly in states where the couple has a large estate, the state estate tax exemption is less than the federal estate tax exemption, and state law allows for a separate state QTIP election.  

5.  Generation-skipping trust issues. Unlike the estate tax exemption, the generation-skipping transfer tax exemption has not been made portable between spouses for the 2011 and 2012 tax years.  Therefore, couples who want to take advantage of passing on up to two times the generation-skipping transfer tax exemption to their heirs in generation-skipping trusts will still need to include AB Trust planning or ABC Trust planning in their estate plans.

Conclusion
Estate tax planning requires two components.  First, the knowledge of your specific situation to execute the trade-offs.  In effect, how much estate tax are you up for, and is this potential tax-savings worth it to you to make the necessary changes.  The second component is the timing factor.  You must do these things at certain times to qualify for the tax-saving features.

As you can see, effective estate tax planning is not a one-time thing.  It needs a periodic review of your financial situation and your marital status, as well as that of your potential beneficiaries.  This must be coupled with the ever-changing federal and state tax laws as they apply to estate tax planning.  Finally, you must coordinate all of this with your own cash flow situation.

However, with the right advisors, and with time on your hands, this can be some of the most effective planning you can do on a dollar-for-dollar tax-saving basis.

Reference: Practice Enhancers, Able & Co.

Automobile Use Rules/Recordkeeping - Business Use of a Vehicle

Automobile Use Rules/Recordkeeping
BUSINESS USE OF A VEHICLE
This is perhaps one of the most prevalent write-off issues a business owner faces.  Nearly every business uses a vehicle at one time or another for a business purpose.

Thus, a business may be able to deduct various expenses associated with this use of a vehicle.  Normally there are two major methods used:  a standard mileage rate or actual expenses method.  Both of these methods involve calculating the business portion of the allowable expenses which are then deducted against business revenues.  From a tax-savings standpoint, the allowable deduction saves an amount in taxes relative to the marginal tax rate for the business.  For example, if your tax bracket is 33%, you will save one-third in taxes for every dollar of deductible vehicle expense you paid out.

In addition to the methodology to be used, other issues that you, the business owner, must face include recordkeeping and substantiation requirements, and calculating the business use percentage.

First, an overview of the two main methods for deducting these business vehicle expenses is in order, based on current rules.

Actual Expense Method
This method is basically what it sounds like.  You deduct the business portion of the various expenses associated with operating a vehicle.  These costs may include the following:  
• fuel
• insurance
• repairs
• maintenance
• tires
• registrations
• garage rental
• parking fees
• tolls
• lease fees
• property tax
• loan interest expense
• washing & waxing
• depreciation
• etc.

While most of these ordinary expenses are self-explanatory, a couple of them merit further detail, specifically depreciation and leasing expenses which are at opposite ends of the deduction spectrum.  Basically, a vehicle can be either owned or leased for business purposes.  Depending on which option you select determines whether you will be taking a depreciation expense for a portion of the cost of the vehicle, or taking a leasing cost write-off instead.  You can't do both at the same time.

Depreciation Write-off:  The business cost basis of a vehicle can be written-off over an allowable time frame as opposed to all at once.  This is a form of depreciation expense.  For most passenger type and non-exempt vehicles, the depreciation amount and method is governed by the IRS, and generally involves the use of MACRS rules.  This is a hybrid depreciation calculation combining a declining balance and straight line methodology.  You are not always required to use this method, however.  Under certain instances you can also elect a straight line method, or a different declining balance method instead.

In effect, though, all of these depreciation methods and rules set the time frame and dollar amount of depreciation that can be taken for the vehicle each year.  There are certain limitations/differences in the actual amount of the cost of the vehicle that can be written off under each of these rules for any given year.

This means that the cost of the vehicle does not necessarily impact the amount of depreciation that can be taken in a particular year once a certain price range is involved.  So if you buy a $15,000 car vs a $40,000 car, the amount of depreciation taken (at least for the first 5 years) may not be different between the two vehicles.

Leasing Expenses:  If you lease a car instead of buy it, you are not allowed to depreciate it.  Rather, you can take the business portion of the lease payments as a deduction–subject to certain limitations.  These limitations parallel the depreciation deduction limitation in that a portion of the lease payments may not be allowable as a net deduction if the value of the car exceeds certain government amounts.  This falls into the so-called "luxury vehicle" use rules and/or "lease inclusion amount" calculations.  It's a way for the IRS to limit the business write-off of vehicles that exceed certain dollar values.  Thus, if you lease a Cadillac vs a Ford Escort, the amount of the lease payment deduction may be limited as set forth in IRS tables associated with "luxury vehicles."

Standard Mileage Rate Method
This method uses an IRS mileage rate allowance instead of using actual expenses.  Note, however, that this method is not available to all.  It is not an allowable method for the following situations:
• Uses five or more cars at the same time for business (such as in fleet operations).
• You do not own the car (except for leasing).
• Most corporations and partnerships where more than one vehicle is being used.
• The vehicle has been previously depreciated using MACRS or ACRS methods in an earlier year.
• The vehicle was converted from personal use to business under certain controlled or related-party transactions.
• Rural mail carrier who received a qualified reimbursement

Beginning in 2011, the standard mileage rate method can be used for cars "for hire," such as a taxi.  For those who qualify, the most recent standard mileage rate allowance is 56.5 cents per business mile, effective for the 2013 year.  By choosing this method, you do not take actual operating expenses.  Instead, you get a business use deduction of 56.5 cents per business mile.

There are a few expenses that can be added to the standard mileage deduction, however.  You can also write-off the business portion of parking fees, tolls, business loan interest, and personal property taxes on the vehicle.

Note that this election to use the standard mileage method should generally be chosen in the first year you place the vehicle in service for business purposes to preserve this option.

From a substantiation viewpoint, the standard mileage allowance method is easier to use.  However, it may not provide the bigger deduction.  Some of the major variables that can affect the choice of standard mileage vs actual expense methods include: cost of vehicle for depreciation purposes, repair expenses, insurance coverage amounts, type of gas mileage, business use percentages, total miles driven, and lease payments.  In other words, whenever possible you should try to project out the actual costs of the vehicle to compare to the standard mileage method and pick the option best suited to you.

Calculating the Business Use Percentage
For situations where the vehicle is not being used 100% for business, the calculation for the deductible portion of the business expenses allowed for tax purposes is based on a ratio between personal and business use.  For example, if you drive the vehicle a total of 10,000 miles for the year and 6,000 of those miles were for allowable business purposes, the business use percentage is 60%.  That means you could claim 60% of the total operating expenses of the vehicle for business purposes.

If business use percentage is less than 50%: A special "wrinkle" develops in the situation where the business use is below 50% and you are using the actual expense method where depreciation is being taken.  In this case, the IRS requires a different depreciation calculation than MACRS.  An alternate MACRS system is used.  The net result is that you are allowed a smaller depreciation deduction– everything else being equal–for the year in which the business use is less than 50%.

Recordkeeping & Substantiation Requirements
The IRS has various requirements you should follow for validating the business use of a vehicle.  IRS not withstanding, if you have employees who will be using company vehicles, you would want them to provide you with adequate substantiation–both for your piece of mind, and for IRS purposes.

With that in mind, the recordkeeping recommendations are designed to be able to prove the following:

1) When you placed the vehicle into use
2) Adjusted cost basis of vehicle
3) Operating expenses(such as gas, insurance, etc.)
4) Total mileage verification and business mileage verification
5) Business purpose of business miles claimed

Recordkeeping should be done in a timely fashion; that is, the verification should be done at or near the time of the actual occurrence/expense. For the actual expenses that is fairly easy if you are paying by check, credit card, or cash where a receipt is given to you. For other situations, or for verification of mileage, the suggestion is to use a diary or business log to track the other expenses and miles driven. While this is not always required to survive an IRS audit(ref. the "Cohen" case in which reconstructive testimony was allowed as verification), it is certainly the best way.

The verification of mileage driven is usually handled by the use of a travel log in which the total miles are recorded periodically, and the business miles are identified within this framework.  While using exact odometer readings is the ideal, it is not always done this way.  A listing on a daily basis of the total miles driven can suffice for one part; a notation of the round trip miles driven that day for business purposes will suffice as well.

Some exemptions:  There are certain types of vehicles that may be exempt from some (or all) of the substantiation/recordkeeping rules, most notably:

Busses, moving vans, heavy specialty trucks, cranes, bucket trucks, fork-lifts, dump trucks, cement mixers, certain delivery vehicles, ambulances, hearses, garbage trucks, certain vehicles for hire where no personal use is possible, various farm vehicles, and so forth.

Basically, the major criteria on the bulk of the substantiation rules requirements is whether or not the vehicle is likely to be used for any personal purposes, and the nature of the vehicle.  A "passenger-type" vehicle where the major burden falls as to substantiation is considered one that weighs less than 6,000 pounds, is four-wheeled, and is designed for use on public roads.  The exempted vehicles usually differ from this definition, and are used directly in a trade or business for the purpose of carrying property or persons for hire.

How long to keep records:  For IRS purposes, it is usually necessary to keep substantiation records for at least three years from the date you last filed the tax return in question.

Conclusion
Using a vehicle for business purposes is a commonplace event.  The odds are you will be dealing with this issue one time or another whether it be for yourself, or for an employee situation.  In the situation where you have a choice between the two different methodologies, it sometimes requires a bit of detailed thinking. This is especially true if you are considering the actual expense method, and if the business use percentage may be low.

Since the business deduction increases as the business mileage increases, some pre-planning here could make a difference if you have more than one vehicle available for business use.  The higher the business use ratio, the higher the business deduction.

Recordkeeping is not terribly onerous.  While contemporary recordkeeping is always the best, it is not an absolute requirement for IRS purposes.  So you don't have to write down the particulars as soon as you stop the car!  However, the proof of the actual expenses being claimed is required.  Cancelled checks, and paid invoices will suffice.  There may be certain expenses where this type of substantiation is nearly impossible (gas, washing & waxing, etc.) at times .  In this case, the use of an expense log or other consistent recordkeeping may serve as adequate proof instead.

Reference: Practice Enhancers, Able & Co.