Individual Income Taxes C6-1 Chapter 6 Deductions and Losses: In General Copyright ©2009 Cengage Learning Individual Income Taxes

C6-2 Deductions Exclusive definition of deductions –Deductions are allowed based on legislative grace and defined narrowly –Substantiation requirements Taxpayer has burden of proof for substantiating all expenses deducted on return Thus, adequate records of expenses must be maintained Exclusive definition of deductions –Deductions are allowed based on legislative grace and defined narrowly –Substantiation requirements Taxpayer has burden of proof for substantiating all expenses deducted on return Thus, adequate records of expenses must be maintained

Individual Income Taxes C6-3 Deductions FOR and FROM AGI (slide 1 of 3) Deductions FOR AGI –Can be claimed even if taxpayer does not itemize –Important in determining the amount of certain itemized deductions Certain itemized deductions are limited to amounts in excess of specified percentages of AGI –e.g., Medial expenses (7.5% of AGI), misc. itemized deductions ( 2% of AGI) Deductions FOR AGI –Can be claimed even if taxpayer does not itemize –Important in determining the amount of certain itemized deductions Certain itemized deductions are limited to amounts in excess of specified percentages of AGI –e.g., Medial expenses (7.5% of AGI), misc. itemized deductions ( 2% of AGI)

Individual Income Taxes C6-4 Deductions FOR and FROM AGI (slide 2 of 3) Deductions FROM AGI: –In total, must exceed the standard deduction to provide any tax benefit –Called “below the line” or itemized deductions Deductions FROM AGI: –In total, must exceed the standard deduction to provide any tax benefit –Called “below the line” or itemized deductions

Individual Income Taxes C6-5 Deductions FOR and FROM AGI (slide 3 of 3) Comparison of deductions FOR and FROM AGI (2008 tax year) –Single taxpayer has gross income of $45,000 and a $6,000 deduction For AGIFrom AGI Gross income $45,000 $45,000 Less: for AGI ded. 6,000 0 AGI $39,000 $45,000 Less: from AGI ded. 5,450 6,000 Less: personal exempt. 3,500 3,500 Taxable income $30,050 $35,500 Comparison of deductions FOR and FROM AGI (2008 tax year) –Single taxpayer has gross income of $45,000 and a $6,000 deduction For AGIFrom AGI Gross income $45,000 $45,000 Less: for AGI ded. 6,000 0 AGI $39,000 $45,000 Less: from AGI ded. 5,450 6,000 Less: personal exempt. 3,500 3,500 Taxable income $30,050 $35,500

Individual Income Taxes C6-6 Deductions for AGI (slide 1 of 3) Partial list includes: –Trade or business expenses –Reimbursed employee business expenses –Deductions from losses on sale or exchange of property –Deductions from rental and royalty property –Alimony –One-half of self-employment tax paid Partial list includes: –Trade or business expenses –Reimbursed employee business expenses –Deductions from losses on sale or exchange of property –Deductions from rental and royalty property –Alimony –One-half of self-employment tax paid

Individual Income Taxes C6-7 Deductions for AGI (slide 2 of 3) Partial list includes: –100% of health insurance premiums paid by a self-employed individual –Contributions to pension, profit sharing, annuity plans, IRAs, etc. –Penalty on premature withdrawals from time savings accounts or deposits –Moving expenses Partial list includes: –100% of health insurance premiums paid by a self-employed individual –Contributions to pension, profit sharing, annuity plans, IRAs, etc. –Penalty on premature withdrawals from time savings accounts or deposits –Moving expenses

Individual Income Taxes C6-8 Deductions for AGI (slide 3 of 3) Partial list includes: –Interest on student loans –Qualified tuition and related expenses under § 222 –Up to $250 for teacher supplies for elementary and secondary school teachers Partial list includes: –Interest on student loans –Qualified tuition and related expenses under § 222 –Up to $250 for teacher supplies for elementary and secondary school teachers

Individual Income Taxes C6-9 Deductions from AGI Itemized deductions include: –Medical expenses (in excess of 7.5% of AGI) –Certain state and local taxes –Contributions to qualified charitable organizations –Personal casualty losses (in excess of 10 % of AGI and a $100 floor per casualty) –Certain personal interest expense (e.g., mortgage interest on a personal residence) –Miscellaneous itemized deductions (in excess of 2% of AGI) Itemized deductions include: –Medical expenses (in excess of 7.5% of AGI) –Certain state and local taxes –Contributions to qualified charitable organizations –Personal casualty losses (in excess of 10 % of AGI and a $100 floor per casualty) –Certain personal interest expense (e.g., mortgage interest on a personal residence) –Miscellaneous itemized deductions (in excess of 2% of AGI)

Individual Income Taxes C6-10 Trade or Business Deductions (slide 1 of 2) Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including: –Reasonable salaries paid for services –Expenses for the use of business property –One-half of self-employment taxes paid Such expenses are deducted for AGI Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including: –Reasonable salaries paid for services –Expenses for the use of business property –One-half of self-employment taxes paid Such expenses are deducted for AGI

Individual Income Taxes C6-11 Trade or Business Deductions (slide 2 of 2) In order for expenses to be deductible, they must be: –Ordinary: normal, usual, or customary for others in similar business, and not capital in nature –Necessary: prudent businessperson would incur same expense –Reasonable: question of fact –Incurred in conduct of business In order for expenses to be deductible, they must be: –Ordinary: normal, usual, or customary for others in similar business, and not capital in nature –Necessary: prudent businessperson would incur same expense –Reasonable: question of fact –Incurred in conduct of business

Individual Income Taxes C6-12 Section 212 Expenses (slide 1 of 2) Section 212 allows deductions for ordinary and necessary expenses paid or incurred for the following: –The production or collection of income –The management, conservation, or maintenance of property held for the production of income –Expenses paid in connection with the determination, collection, or refund of any tax Section 212 allows deductions for ordinary and necessary expenses paid or incurred for the following: –The production or collection of income –The management, conservation, or maintenance of property held for the production of income –Expenses paid in connection with the determination, collection, or refund of any tax

Individual Income Taxes C6-13 Section 212 Expenses (slide 2 of 2) § 212 expenses that are deductions for AGI include: –Expenses related to rent and royalty income –Expenses paid in connection with the determination, collection, or refund of taxes related to the income of sole proprietorships, rents and royalties, or farming operations All other § 212 expenses are itemized deductions (deductions from AGI) –For example, investment-related expenses (e.g., safe deposit box rentals) are deductible as itemized deductions attributable to the production of investment income § 212 expenses that are deductions for AGI include: –Expenses related to rent and royalty income –Expenses paid in connection with the determination, collection, or refund of taxes related to the income of sole proprietorships, rents and royalties, or farming operations All other § 212 expenses are itemized deductions (deductions from AGI) –For example, investment-related expenses (e.g., safe deposit box rentals) are deductible as itemized deductions attributable to the production of investment income

Individual Income Taxes C6-14 Business And Nonbusiness Losses Deductible losses of individual taxpayers are limited to those: –Incurred in a trade or business, –Incurred in a transaction entered into for profit Individuals may also deduct casualty losses from fire, storm, shipwreck, and theft Deductible losses of individual taxpayers are limited to those: –Incurred in a trade or business, –Incurred in a transaction entered into for profit Individuals may also deduct casualty losses from fire, storm, shipwreck, and theft

Individual Income Taxes C6-15 Methods of Accounting The method of accounting affects when deductions are taken –Cash: expenses are deductible only when paid –Accrual: expenses are deductible when incurred Apply the all events test and the economic performance test –Exception to the economic performance test for recurring items The method of accounting affects when deductions are taken –Cash: expenses are deductible only when paid –Accrual: expenses are deductible when incurred Apply the all events test and the economic performance test –Exception to the economic performance test for recurring items

Individual Income Taxes C6-16 Disallowance Possibilities The tax law disallows the deduction of certain types of expenses for a variety of reasons –e.g., May restrict taxpayer attempts to deduct certain items that, in reality, are personal expenditures Certain disallowance provisions are a codification or extension of prior court decisions –e.g., After courts denied deductions for payments in violation of public policy, tax law was changed to provide specific authority for the disallowance The tax law disallows the deduction of certain types of expenses for a variety of reasons –e.g., May restrict taxpayer attempts to deduct certain items that, in reality, are personal expenditures Certain disallowance provisions are a codification or extension of prior court decisions –e.g., After courts denied deductions for payments in violation of public policy, tax law was changed to provide specific authority for the disallowance

Individual Income Taxes C6-17 Expenditures Contrary To Public Policy Deductions are disallowed for certain specific types of expenditures that are considered contrary to public policy –Examples: penalties, fines, illegal bribes or kickbacks, two-thirds of treble damage payments for violation of anti-trust law Deductions are disallowed for certain specific types of expenditures that are considered contrary to public policy –Examples: penalties, fines, illegal bribes or kickbacks, two-thirds of treble damage payments for violation of anti-trust law

Individual Income Taxes C6-18 Legal Expenses Incurred In Defense Of Civil Or Criminal Penalties To deduct legal expenses –Must be directly related to a trade or business, an income producing activity, or the determination, collection, or refund of a tax e.g., Corporate officer’s legal fees in defending against price-fixing charges e.g., Landlord’s legal fees associated with eviction of tenant To deduct legal expenses –Must be directly related to a trade or business, an income producing activity, or the determination, collection, or refund of a tax e.g., Corporate officer’s legal fees in defending against price-fixing charges e.g., Landlord’s legal fees associated with eviction of tenant

Individual Income Taxes C6-19 Expenses Relating To An Illegal Business Usual expenses of operating an illegal business are deductible –However, deduction for fines, bribes to public officials, illegal kickbacks, and other illegal payments are disallowed Trafficking in controlled substances: only cost of goods sold can reduce gross income Usual expenses of operating an illegal business are deductible –However, deduction for fines, bribes to public officials, illegal kickbacks, and other illegal payments are disallowed Trafficking in controlled substances: only cost of goods sold can reduce gross income

Individual Income Taxes C6-20 Political Contributions And Lobbying Activities Generally, no business deduction is allowed for payments made for political purposes or for lobbying –Exceptions are allowed for lobbying: To influence local legislation, To monitor legislation, and De minimis in-house expenses (limited to $2,000) –If greater than $2,000, none can be deducted Generally, no business deduction is allowed for payments made for political purposes or for lobbying –Exceptions are allowed for lobbying: To influence local legislation, To monitor legislation, and De minimis in-house expenses (limited to $2,000) –If greater than $2,000, none can be deducted

Individual Income Taxes C6-21 Excessive Executive Compensation For publicly held corporations: –Deduction for compensation of CEO and four other highest compensated executives is limited to $1 million each –Does not include: Performance-based compensation and commissions Payments to qualified retirement plans Payments excludible from gross income For publicly held corporations: –Deduction for compensation of CEO and four other highest compensated executives is limited to $1 million each –Does not include: Performance-based compensation and commissions Payments to qualified retirement plans Payments excludible from gross income

Individual Income Taxes C6-22 Investigation Of A Business (slide 1 of 3) Investigation expenses - incurred to determine the feasibility of entering a new business or expanding an existing business –Include costs such as travel, engineering, architectural surveys, marketing reports, various legal and accounting services Tax treatment of these expenses depends on: –The current business, if any, of the taxpayer –The nature of the business being investigated –The extent to which the investigation has proceeded –Whether or not the acquisition actually takes place Investigation expenses - incurred to determine the feasibility of entering a new business or expanding an existing business –Include costs such as travel, engineering, architectural surveys, marketing reports, various legal and accounting services Tax treatment of these expenses depends on: –The current business, if any, of the taxpayer –The nature of the business being investigated –The extent to which the investigation has proceeded –Whether or not the acquisition actually takes place

Individual Income Taxes C6-23 Investigation Of A Business (slide 2 of 3) If the taxpayer is in a business the same as or similar to that being investigated –Investigation expenses are deductible in the year paid or incurred The tax result is the same whether or not the taxpayer acquires the business being investigated If the taxpayer is in a business the same as or similar to that being investigated –Investigation expenses are deductible in the year paid or incurred The tax result is the same whether or not the taxpayer acquires the business being investigated

Individual Income Taxes C6-24 Investigation Of A Business (slide 3 of 3) When the taxpayer is not in a business the same as or similar to that being investigated –Tax result depends on whether new business is acquired If not acquired –All investigation expenses generally are nondeductible If acquired –Investigation expenses must be capitalized –May elect to deduct the first $5,000 of expenses currently –Any excess expenses can be amortized over a period of not less than 180 months (15 years) –In arriving at the $5,000 immediate deduction allowed, a dollar-for-dollar reduction must be made for those expenses in excess of $50,000 When the taxpayer is not in a business the same as or similar to that being investigated –Tax result depends on whether new business is acquired If not acquired –All investigation expenses generally are nondeductible If acquired –Investigation expenses must be capitalized –May elect to deduct the first $5,000 of expenses currently –Any excess expenses can be amortized over a period of not less than 180 months (15 years) –In arriving at the $5,000 immediate deduction allowed, a dollar-for-dollar reduction must be made for those expenses in excess of $50,000

Individual Income Taxes C6-25 Hobby Losses (slide 1 of 8) Hobby defined –Activity not entered into for profit Personal pleasure associated with activity Examples: raising horses, fishing boat charter If an activity is not engaged in for profit, the hobby loss rules apply –Hobby expenses are deductible only to the extent of hobby income Hobby defined –Activity not entered into for profit Personal pleasure associated with activity Examples: raising horses, fishing boat charter If an activity is not engaged in for profit, the hobby loss rules apply –Hobby expenses are deductible only to the extent of hobby income

Individual Income Taxes C6-26 Hobby Losses (slide 2 of 8) Profit activity –If activity is entered into for profit, taxpayer can deduct expenses FOR AGI even in excess of income from the activity At-risk and passive loss rules may apply Often it is difficult to determine if an activity is profit motivated or a hobby Regulations provide nine factors to consider in making this determination Profit activity –If activity is entered into for profit, taxpayer can deduct expenses FOR AGI even in excess of income from the activity At-risk and passive loss rules may apply Often it is difficult to determine if an activity is profit motivated or a hobby Regulations provide nine factors to consider in making this determination

Individual Income Taxes C6-27 Hobby Losses (slide 3 of 8) Presumptive rule of § 183 –If activity shows profit 3 out of 5 years (2 out of 7 years for horses), the activity is presumed to be a trade or business rather than a personal hobby –Rebuttable presumption, shifts burden of proof to IRS –Otherwise, taxpayer has burden to prove profit motive Presumptive rule of § 183 –If activity shows profit 3 out of 5 years (2 out of 7 years for horses), the activity is presumed to be a trade or business rather than a personal hobby –Rebuttable presumption, shifts burden of proof to IRS –Otherwise, taxpayer has burden to prove profit motive

Individual Income Taxes C6-28 Hobby Losses (slide 4 of 8) YearIncome (loss)Hobby? 2002$500Yes 2003(1,500)Yes Yes 2005(1,000)Yes No, profit 3 of 5 years 2007(500)Yes, profit only 2 of 5 years 20081,200No, profit 3 of 5 years

Individual Income Taxes C6-29 Hobby Losses (slide 5 of 8) If an activity is deemed to be a hobby –Can only deduct expenses to extent of income from activity (i.e., cannot deduct hobby losses) If an activity is deemed to be a hobby –Can only deduct expenses to extent of income from activity (i.e., cannot deduct hobby losses)

Individual Income Taxes C6-30 Hobby Losses (slide 6 of 8) If an activity is a hobby: –Expenses are deductible FROM AGI Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation Exception: expenses that are deductible without regard to profit motive are deductible in full, such as –Home mortgage interest –Property taxes If an activity is a hobby: –Expenses are deductible FROM AGI Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation Exception: expenses that are deductible without regard to profit motive are deductible in full, such as –Home mortgage interest –Property taxes

Individual Income Taxes C6-31 Hobby Losses (slide 7 of 8) Order in which hobby expenses are deductible: –First: Those otherwise deductible: e.g., home mortgage interest and property taxes –Then: Expenses that do not affect adjusted basis: e.g., maintenance, utilities –Then: Expenses that affect adjusted basis: e.g., Depreciation (or cost recovery) Order in which hobby expenses are deductible: –First: Those otherwise deductible: e.g., home mortgage interest and property taxes –Then: Expenses that do not affect adjusted basis: e.g., maintenance, utilities –Then: Expenses that affect adjusted basis: e.g., Depreciation (or cost recovery)

Individual Income Taxes C6-32 Hobby Losses (slide 8 of 8) Example of hobby expenses: Taxpayer sells horses raised as a hobby for $15,500 AmountOrderAmount Income$15,500 Interest6,0001$ 6,000 Taxes3,0001 Vet Bills2,0002 Feed4,0002 Depreciation1,0003 Ltd. to 500 Total15,500

Individual Income Taxes C6-33 Rental Vacation Homes (slide 1 of 9) May have both personal and rental use of a vacation home Rental expenses may be limited to rental income if primarily used for personal purposes Determination of vacation home treatment is dependent on personal use vs. rental use May have both personal and rental use of a vacation home Rental expenses may be limited to rental income if primarily used for personal purposes Determination of vacation home treatment is dependent on personal use vs. rental use

Individual Income Taxes C6-34 Rental Vacation Homes (slide 2 of 9) Rental days –Less than 15 days: No gross income recognized from rentals and no deductible rental expenses Mortgage interest and property taxes treated as if on personal residence (generally deductible in full) –More than 14 days: Treatment depends on amount of personal use Rental days –Less than 15 days: No gross income recognized from rentals and no deductible rental expenses Mortgage interest and property taxes treated as if on personal residence (generally deductible in full) –More than 14 days: Treatment depends on amount of personal use

Individual Income Taxes C6-35 Rental Vacation Homes (slide 3 of 9) Primarily rental use –If rented for 15 days or more and personal use days NOT more than the greater of 14 days or 10 percent of fair rental days –Can deduct all expenses allocated to rental use even if loss results Rental loss subject to passive loss rules Primarily rental use –If rented for 15 days or more and personal use days NOT more than the greater of 14 days or 10 percent of fair rental days –Can deduct all expenses allocated to rental use even if loss results Rental loss subject to passive loss rules

Individual Income Taxes C6-36 Rental Vacation Homes (slide 4 of 9) Personal/rental use –If rented for 15 days or more and personal use days exceed the greater of 14 days or 10 percent of fair rental days –Treated similar to hobby Rental expenses deducted in three step process No rental loss allowed Carryforward of disallowed rental expenses Personal/rental use –If rented for 15 days or more and personal use days exceed the greater of 14 days or 10 percent of fair rental days –Treated similar to hobby Rental expenses deducted in three step process No rental loss allowed Carryforward of disallowed rental expenses

Individual Income Taxes C6-37 Rental Vacation Homes (slide 5 of 9) Example of personal use Rental days: 200 (10% = 20) Personal useNot SignificantSignificant 7 days X 18 days X 25 days X Example of personal use Rental days: 200 (10% = 20) Personal useNot SignificantSignificant 7 days X 18 days X 25 days X

Individual Income Taxes C6-38 Rental Vacation Homes (slide 6 of 9) Example of personal use Rental days: 100 (10% = 10) Personal UseNot SignificantSignificant 7 days X 14 days X 18 days X Example of personal use Rental days: 100 (10% = 10) Personal UseNot SignificantSignificant 7 days X 14 days X 18 days X

Individual Income Taxes C6-39 Rental Vacation Homes (slide 7 of 9) Allocation of expenses between personal and rental –Mortgage interest and real estate taxes IRS requires allocation based on total days used Courts have allowed allocation based on days in year –Other expenses are allocated based on total days used Allocation of expenses between personal and rental –Mortgage interest and real estate taxes IRS requires allocation based on total days used Courts have allowed allocation based on days in year –Other expenses are allocated based on total days used

Individual Income Taxes C6-40 Rental Vacation Homes (slide 8 of 9) Tax treatment of income and expenses of a primarily rental vacation home –Rental income included in gross income –Rental expenses deductible FOR AGI –Rental income and expenses reported on Sch. E Tax treatment of income and expenses of a primarily rental vacation home –Rental income included in gross income –Rental expenses deductible FOR AGI –Rental income and expenses reported on Sch. E

Individual Income Taxes C6-41 Rental Vacation Homes (slide 9 of 9) Treatment of allocated personal portion of vacation home expenses –Primarily rental use: taxes deductible FROM AGI, mortgage interest nondeductible (personal interest) –Personal/rental use: mortgage interest and taxes deductible FROM AGI –Personal portion of other expenses (e.g., insurance, maintenance) nondeductible Treatment of allocated personal portion of vacation home expenses –Primarily rental use: taxes deductible FROM AGI, mortgage interest nondeductible (personal interest) –Personal/rental use: mortgage interest and taxes deductible FROM AGI –Personal portion of other expenses (e.g., insurance, maintenance) nondeductible

Individual Income Taxes C6-42 Expenditures Incurred for Taxpayer’s Benefit or Obligation No deduction is allowed for payment of another taxpayer’s expenses –Must be incurred for taxpayer’s benefit or arise from taxpayer’s obligation –Exception: Payment of medical expenses for a dependent No deduction is allowed for payment of another taxpayer’s expenses –Must be incurred for taxpayer’s benefit or arise from taxpayer’s obligation –Exception: Payment of medical expenses for a dependent

Individual Income Taxes C6-43 Personal Expenditures Unless otherwise provided in the Code, personal expenses are not deductible

Individual Income Taxes C6-44 Capital Expenditures Amounts are capitalized Asset may be subject to depreciation (or cost recovery), amortization, or depletion Amounts are capitalized Asset may be subject to depreciation (or cost recovery), amortization, or depletion

Individual Income Taxes C6-45 Transactions Between Related Parties (slide 1 of 2) Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties –Family and entity relationships apply –Constructive ownership rules apply –Loss disallowed may reduce gain on subsequent disposition to unrelated third party Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties –Family and entity relationships apply –Constructive ownership rules apply –Loss disallowed may reduce gain on subsequent disposition to unrelated third party

Individual Income Taxes C6-46 Transactions Between Related Parties (slide 2 of 2) Section 267 also requires the matching principle be applied for unpaid expenses and interest when different accounting methods used –Example: An accrual basis, closely held corporation, cannot deduct accrued, but unpaid, salary to cash basis related party employee/shareholder until it is actually paid Section 267 also requires the matching principle be applied for unpaid expenses and interest when different accounting methods used –Example: An accrual basis, closely held corporation, cannot deduct accrued, but unpaid, salary to cash basis related party employee/shareholder until it is actually paid

Individual Income Taxes C6-47 Expenses and Interest Relating to Tax-Exempt Income Expenses relating to production of tax- exempt income are nondeductible –Example: interest expense on loan where funds used to acquire municipal bonds Expenses relating to production of tax- exempt income are nondeductible –Example: interest expense on loan where funds used to acquire municipal bonds

Individual Income Taxes C6-48 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta