2009 Pearson Education Inc Publishing as Prentice Hall
© 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -1
DEDUCTIONS AND LOSSES (1 of 2) ® Classifying deductions as for vs. from adjusted gross income ® Criteria for deducting business and investment expenses ® General restrictions on the deductibility of expenses ® Proper substantiation requirement © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -2
DEDUCTIONS AND LOSSES (2 of 2) ® When an expense is deductible ® Special disallowance rules ® Tax planning considerations ® Compliance and procedural considerations © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -3
Classifying Deductions as for vs. from Adjusted Gross Income (1 of 3) ® For AGI Taxpayer benefits from deduction even if he/she claims the standard deduction Reduces AGI: +/- benefits for taxpayer ¬+ Many deductions and credits phased out above certain AGI thresholds ¬+ Reduces AGI floors for certain categories of itemized deductions ¬- Reduces certain deduction ceilings © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -4
Classifying Deductions as for vs. from Adjusted Gross Income (2 of 3) ® Most common deductions for AGI Trade or business expenses IRAs Alimony Losses on sale of bus/invest property Moving expenses Interest paid on qualified education loans 1/2 of self-employment tax Health insurance paid by self-employeds © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -5
Classifying Deductions as for vs. from Adjusted Gross Income (3 of 3) ® From AGI Itemized deduction only will have tax benefit if total deductions exceed the taxpayer’s standard deduction ¬Deduct higher of standard deduction or sum of itemized deductions © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -6
Criteria for Deducting Business and Investment Expenses ® Business or investment requirement ® Ordinary expense ® Necessary expense ® Reasonable expense ® Expenses and losses must be incurred directly by the taxpayer © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -7
Business or Investment Requirement (1 of 2) ® Activity Use engaged in for profit facts and circumstances test ® Trade or business (To. B) vs. investment classification To. B losses are ordinary losses ¬To. B expenses are for AGI Investment losses are capital ¬Investment expenses are ªSubject to 2% of AGI floor from AGI © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -8
Business or Investment Requirement (2 of 2) ® Losses and expenses related to rents and royalties are for AGI deductions ® Legal and accounting fees For AGI deduction for To. B if incurred in ordinary course of business ¬Fees related to taxes also for AGI for To. B Nonbusiness fees related to taxes from AGI deduction subject to 2% of AGI floor © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -9
Ordinary Expense ® To be ordinary, an expense must be Reasonable in amount Bear reasonable proximate relationship to income-producing activity or property Must be customary or usual course of a particular industry or business community © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -10
Necessary Expense ® An expense is considered necessary if it is “appropriate and helpful” in the taxpayer’s business © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -11
Reasonable Expense ® Problems often occur with salaries for shareholder-employees of closely held businesses © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -12
Expenses and Losses Must Be Incurred Directly by the Taxpayer ® Generally, a taxpayer cannot take a deduction for a loss or expense of another person © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -13
General Restrictions on the Deductibility of Expenses ® Capitalization vs. expense deduction ® Expenses related to exempt income ® Expenditures that are contrary to public policy ® Other expenditures specifically disallowed © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -14
Capitalization vs. Expense Deduction ® General capitalization requirements ® Election to deduct currently E. g. , certain research and experimental expenditures, cost of qualified tangible personal property ® Capitalization of deduction items E. g. , carrying charges on unproductive unimproved real estate © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -15
Expenses Related to Exempt Income ® Deduction disallowed because income is not taxable © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -16
Expenditures that Are Contrary to Public Policy ® Cannot deduct illegal payments or payment resulting from an illegal act Fines and penalties Bribes and kickbacks ® Expenses from an illegal trade or business are deductible If taxpayer reports income from activity © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -17
Other Expenditures Specifically Disallowed ® Political contributions and lobbying expenses ® Business investigation and preopening expenses May elect to immediately expense up to $5, 000 Amortize remainder over 180 months beginning when business commences ¬No amortization if business not begun © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -18
Proper Substantiation Requirement (1 of 2) ® The taxpayer has the burden of proof ® The Cohan rule Certain expenses may be estimated ® More restrictive substantiation requirements for travel, entertainment, business gifts © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -19
Proper Substantiation Requirement (2 of 2) ® Documentation requirements for travel, entertainment, gifts, etc. Amount Time and place (T&E) Date and description of gift Business purpose Business relationship © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -20
When an Expense is Deductible Cash Method (1 of 2) ® Generally deductible when actually paid ® Prepaid expenses No current deduction if expenditure creates an asset with a life substantially beyond end of tax year © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -21
When an Expense is Deductible Cash Method (2 of 2) ® Prepaid interest Amortize over period of loan to which interest charge is allocated Points deductible over life of loan ¬Points paid in connection with purchase of principal residence currently deductible © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -22
When an Expense is Deductible Accrual Method (1 of 2) ® Allowed to deduct expenses in period in which expenses accrue under allevents test & economic performance test All-events test met ¬When amount of liability is established ¬Amount of liability is determined with reasonable accuracy © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -23
When an Expense is Deductible Accrual Method (2 of 2) Economic performance test is met ¬When economic performance is deemed to occur ¬See Table I 6 -1 © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -24
Special Disallowance Rules ® Wash sales ® Transactions between related parties ® Hobby losses ® Vacation home ® Expenses of an office in the home © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -25
Wash Sales ® Wash sales occurs when “substantially identical” stock or securities acquired by taxpayer within a 61 -day period Extends from 30 days before date of sale to 30 days after date of sale ® Loss on wash sale disallowed Disallowed loss added to basis of recently purchased stock or securities © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -26
Transactions between Related Parties (1 of 2) ® § 267 defines related parties ® Loss on transaction between related parties disallowed Disallowed loss may be used to offset gain from subsequent sale to unrelated party © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -27
Transactions between Related Parties (2 of 2) ® Unpaid expenses Accrual basis taxpayer cannot deduct expense to cash basis related party until cash basis party recognizes payment as income © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -28
Hobby Losses (1 of 2) ® Activity has more personal attributes than profit motive IRS factors to determine profit motive ¬Activity conducted in businesslike manner ¬Time and effort expended ¬Expected asset appreciation ¬Taxpayer’s success in similar activities ¬Profits earned and profit history ¬Taxpayer’s financial status © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -29
Hobby Losses (2 of 2) ® Profit motive assumed if activity profitable in 3 of 5 years ® Deductible hobby expenses Hobby-related expenses deductible up to gross income of hobby activity Deductible as miscellaneous itemized deductions subject to 2% of AGI floor ¬Special order of the deductions © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -30
Vacation Home ® Deductions on vacation home may be limited or disallowed ® Vacation home if personal use greater of 14 days, or 10% of # of days property used as rental ® Expenses allocated based on days of use ® Property rented < 15 days No taxable income and no deductions © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -31
Expenses of an Office in the Home ® Office in the home expenses deductible only if office regularly and exclusively used for business AND Principal place of taxpayer’s business, Place where taxpayer meets with clients, OR a separate structure from house ® Employees must also use office for convenience of employer © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -32
Tax Planning Considerations ® Hobby losses Control timing of hobby losses ® Unreasonable Compensation If IRS feels that a salary payment to an officer is excessive ¬Often recharacterize excess portion as a dividend ® Timing of deductions © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -33
Compliance and Procedural Considerations (1 of 2) ® Schedule C for sole proprietorship ® Schedule E for rents and royalties ® Other investment expenses reported on Schedule A Proper substantiation IRS scrutiny Statutory requirements ® Travel and entertainment are of particular interest to the IRS © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -34
Compliance and Procedural Considerations (2 of 2) ® Business vs. hobby Form 8829 to claim home office deduction on Schedule C Form 2106 to claim home office deduction by employees Taxpayer may be willing to extend statute of limitation’s period to prove profit motive by filing Form 5231 © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -35
Comments or questions about Power. Point Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard. newmark@Ph. Duh. com © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -36
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