2009 Pearson Education Inc Publishing as Prentice Hall

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -1

© 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -1

DEDUCTIONS AND LOSSES (1 of 2) ® Classifying deductions as for vs. from adjusted

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

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

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

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

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

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

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

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

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”

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

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

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

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.

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 ©

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

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

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

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.

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

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

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

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

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

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

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 ®

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

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

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

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

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

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

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 ®

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

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

Comments or questions about Power. Point Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard. [email protected] Duh. com © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 -36