Individual Income Taxes C7-1 Chapter 7 Deductions and Losses: Certain Business Expenses and Losses Copyright ©2009 Cengage Learning Individual Income Taxes

C7-2 Bad Debts If an account receivable arising from credit sale of goods or services becomes worthless –A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income –No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected If an account receivable arising from credit sale of goods or services becomes worthless –A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income –No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected

Individual Income Taxes C7-3 Business Bad Debts (slide 1 of 4) Specific charge-off method must be used –Exception: Reserve method is allowed for some financial institutions Deduct as ordinary loss in the year when debt is partially or wholly worthless Specific charge-off method must be used –Exception: Reserve method is allowed for some financial institutions Deduct as ordinary loss in the year when debt is partially or wholly worthless

Individual Income Taxes C7-4 Business Bad Debts (slide 2 of 4) If a business bad debt previously deducted as partially worthless becomes totally worthless in a future year –Only the remainder not previously deducted can be deducted in the future year If a business bad debt previously deducted as partially worthless becomes totally worthless in a future year –Only the remainder not previously deducted can be deducted in the future year

Individual Income Taxes C7-5 Business Bad Debts (slide 3 of 4) In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless Deductible amount depends on basis in bad debt –If debt arose from sale of services or products and the face amount was previously included in income That amount is deductible –If the taxpayer purchased the debt Deduction is equal to amount paid for debt instrument In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless Deductible amount depends on basis in bad debt –If debt arose from sale of services or products and the face amount was previously included in income That amount is deductible –If the taxpayer purchased the debt Deduction is equal to amount paid for debt instrument

Individual Income Taxes C7-6 Business Bad Debts (slide 4 of 4) If a receivable has been written off –The collection of the receivable in a later tax year may result in income being recognized –Income will result if the deduction yielded a tax benefit in the year it was taken If a receivable has been written off –The collection of the receivable in a later tax year may result in income being recognized –Income will result if the deduction yielded a tax benefit in the year it was taken

Individual Income Taxes C7-7 Nonbusiness Bad Debts (slide 1 of 2) Nonbusiness bad debt –Debt unrelated to the taxpayer’s trade or business Deduct as short-term capital loss in year amount of worthlessness is known with certainty –No deduction is allowed for partial worthlessness of a nonbusiness bad debt Nonbusiness bad debt –Debt unrelated to the taxpayer’s trade or business Deduct as short-term capital loss in year amount of worthlessness is known with certainty –No deduction is allowed for partial worthlessness of a nonbusiness bad debt

Individual Income Taxes C7-8 Nonbusiness Bad Debts (slide 2 of 2) Related party (individuals) bad debts are generally suspect and may be treated as gifts –Regulations state that a bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money –Thus, individual circumstances must be examined to determine whether advances between related parties are gifts or loans Related party (individuals) bad debts are generally suspect and may be treated as gifts –Regulations state that a bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money –Thus, individual circumstances must be examined to determine whether advances between related parties are gifts or loans

Individual Income Taxes C7-9 Classification of Bad Debts Individuals will generally have nonbusiness bad debts unless: –In the business of loaning money, or –Bad debt is associated with the individual’s trade or business Determination is made either at the time the debt was created or when it became worthless Individuals will generally have nonbusiness bad debts unless: –In the business of loaning money, or –Bad debt is associated with the individual’s trade or business Determination is made either at the time the debt was created or when it became worthless

Individual Income Taxes C7-10 Worthless Securities (slide 1 of 2) Loss on worthless securities is deductible in the year they become completely worthless –These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless –Capital losses may be of limited benefit due to the $3,000 capital loss limitation Loss on worthless securities is deductible in the year they become completely worthless –These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless –Capital losses may be of limited benefit due to the $3,000 capital loss limitation

Individual Income Taxes C7-11 Worthless Securities (slide 2 of 2) Example of worthless securities –On December 1, 2007, Sally purchased stock for $10,000. The stock became worthless on June 1, Sally’s loss is treated as having occurred on December 31, The result is a long-term capital loss. Example of worthless securities –On December 1, 2007, Sally purchased stock for $10,000. The stock became worthless on June 1, Sally’s loss is treated as having occurred on December 31, The result is a long-term capital loss.

Individual Income Taxes C7-12 Section 1244 Stock (slide 1 of 3) Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals –Ordinary loss treatment (per year) is limited to $50,000 ($100,000 for MFJ taxpayers) Loss in excess of per year limit is treated as capital loss Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals –Ordinary loss treatment (per year) is limited to $50,000 ($100,000 for MFJ taxpayers) Loss in excess of per year limit is treated as capital loss

Individual Income Taxes C7-13 Section 1244 Stock (slide 2 of 3) Section 1244 loss treatment is limited to stock owned by original purchaser who acquired the stock from the corporation Corporation must meet certain requirements for stock to qualify –Major requirement is limit of $1 million of capital contributions Section 1244 does not apply to gains Section 1244 loss treatment is limited to stock owned by original purchaser who acquired the stock from the corporation Corporation must meet certain requirements for stock to qualify –Major requirement is limit of $1 million of capital contributions Section 1244 does not apply to gains

Individual Income Taxes C7-14 Section 1244 Stock (slide 3 of 3) Example of § 1244 loss –In 2004, Sam purchases from XYZ Corp. stock costing $150,000. (Total XYZ stock outstanding is $800,000.) In 2008, Sam sells the stock for $65,000. –Sam, a single taxpayer, has the following tax consequences: $50,000 ordinary loss $35,000 long-term capital loss Example of § 1244 loss –In 2004, Sam purchases from XYZ Corp. stock costing $150,000. (Total XYZ stock outstanding is $800,000.) In 2008, Sam sells the stock for $65,000. –Sam, a single taxpayer, has the following tax consequences: $50,000 ordinary loss $35,000 long-term capital loss

Individual Income Taxes C7-15 Losses of Individuals Only the following losses are deductible by individuals: –Losses incurred in a trade or business, –Losses incurred in a transaction entered into for profit, –Losses caused by fire, storm, shipwreck, or other casualty or by theft Only the following losses are deductible by individuals: –Losses incurred in a trade or business, –Losses incurred in a transaction entered into for profit, –Losses caused by fire, storm, shipwreck, or other casualty or by theft

Individual Income Taxes C7-16 Definition of Casualty & Theft (C & T) Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft –Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature –Events not treated as casualties include losses from disease and insect damage Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft –Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature –Events not treated as casualties include losses from disease and insect damage

Individual Income Taxes C7-17 Definition of Theft Theft includes robbery, burglary, embezzlement, etc. –Does not include misplaced items Theft includes robbery, burglary, embezzlement, etc. –Does not include misplaced items

Individual Income Taxes C7-18 When Casualty & Theft Is Deductible Casualties: year in which loss is sustained –Exception: If declared “disaster area” by President, can elect to deduct loss in year prior to year of occurrence Thefts: year in which loss is discovered Casualties: year in which loss is sustained –Exception: If declared “disaster area” by President, can elect to deduct loss in year prior to year of occurrence Thefts: year in which loss is discovered

Individual Income Taxes C7-19 Effect of Claim for Reimbursement If reasonable prospect of full recovery: –No casualty loss is permitted –Deduct in year of settlement any amount not reimbursed If only partial recovery is expected, deduct in year of loss any amount not covered –Remainder is deducted in year claim is settled If reasonable prospect of full recovery: –No casualty loss is permitted –Deduct in year of settlement any amount not reimbursed If only partial recovery is expected, deduct in year of loss any amount not covered –Remainder is deducted in year claim is settled

Individual Income Taxes C7-20 Amount of C&T Deduction Amount of loss and its deductibility depends on whether: –Loss is from nonpersonal (business or production of income) or personal property –Loss is partial or complete Amount of loss and its deductibility depends on whether: –Loss is from nonpersonal (business or production of income) or personal property –Loss is partial or complete

Individual Income Taxes C7-21 Amount of Nonpersonal C&T Losses Theft or complete casualty (FMV after = 0) –Adjusted basis in property less insurance proceeds Partial casualty –Lesser of decline in value or adjusted basis in property, less insurance proceeds Theft or complete casualty (FMV after = 0) –Adjusted basis in property less insurance proceeds Partial casualty –Lesser of decline in value or adjusted basis in property, less insurance proceeds

Individual Income Taxes C7-22 C&T Examples Business and production of income losses (no insurance proceeds received) Adjusted FMV FMV Item Basis Before After Loss A 6,000 8,000 5,000 3,000 B 6,000 8,000 1,000 6,000 C 6,000 4, ,000 Business and production of income losses (no insurance proceeds received) Adjusted FMV FMV Item Basis Before After Loss A 6,000 8,000 5,000 3,000 B 6,000 8,000 1,000 6,000 C 6,000 4, ,000

Individual Income Taxes C7-23 Nonpersonal C&T Losses Losses on business, rental, and royalty properties –Deduction will be FOR AGI –Not subject to the $100 per event and the 10% of AGI limitation Losses not connected with business, rental, and royalty properties –Deduction will be From AGI –Example - theft of a security Theft losses of investment property are not subject to the 2% of AGI floor on certain miscellaneous itemized deductions Losses on business, rental, and royalty properties –Deduction will be FOR AGI –Not subject to the $100 per event and the 10% of AGI limitation Losses not connected with business, rental, and royalty properties –Deduction will be From AGI –Example - theft of a security Theft losses of investment property are not subject to the 2% of AGI floor on certain miscellaneous itemized deductions

Individual Income Taxes C7-24 Nonpersonal C&T Gains Depending on the property, gain can be ordinary or capital Amount of nonpersonal gains –Insurance proceeds less adjusted basis in property Depending on the property, gain can be ordinary or capital Amount of nonpersonal gains –Insurance proceeds less adjusted basis in property

Individual Income Taxes C7-25 Personal C&T Gains and Losses (slide 1 of 4) Casualty and theft losses attributable to personal use property are subject to the $100 per event and the 10% of AGI limitations –These losses are itemized deductions, but they are not subject to the 2% of AGI floor Amount of personal C&T losses –Lesser of decline in value or adjusted basis in property, less insurance proceeds Insurance proceeds may result in gain recognition on certain casualty and thefts Casualty and theft losses attributable to personal use property are subject to the $100 per event and the 10% of AGI limitations –These losses are itemized deductions, but they are not subject to the 2% of AGI floor Amount of personal C&T losses –Lesser of decline in value or adjusted basis in property, less insurance proceeds Insurance proceeds may result in gain recognition on certain casualty and thefts

Individual Income Taxes C7-26 Personal C&T Gains and Losses (slide 2 of 4) If a taxpayer has both personal casualty and theft gains as well as losses, a special set of rules applies –A personal casualty gain is the recognized gain from a casualty or theft of personal use property –A personal casualty loss for this purpose is a casualty or theft loss of personal use property after the application of the $100 floor Taxpayer must first net (offset) the personal casualty gains and personal casualty losses –Tax treatment depends on the results of this netting process If a taxpayer has both personal casualty and theft gains as well as losses, a special set of rules applies –A personal casualty gain is the recognized gain from a casualty or theft of personal use property –A personal casualty loss for this purpose is a casualty or theft loss of personal use property after the application of the $100 floor Taxpayer must first net (offset) the personal casualty gains and personal casualty losses –Tax treatment depends on the results of this netting process

Individual Income Taxes C7-27 Personal C&T Gains and Losses (slide 3 of 4) If netting personal casualty gains and losses results in a net gain –Treat as gains and losses from the sale of capital assets Short term or long term, depending on holding period Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property If netting personal casualty gains and losses results in a net gain –Treat as gains and losses from the sale of capital assets Short term or long term, depending on holding period Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property

Individual Income Taxes C7-28 Personal C&T Gains and Losses (slide 4 of 4) If netting personal casualty gains and losses results in a net loss –All gains and losses are treated as ordinary items The gains—and the losses to the extent of gains— are treated as ordinary income and ordinary loss in computing AGI Losses in excess of gains are deducted as itemized deductions to the extent the losses exceed 10% of AGI If netting personal casualty gains and losses results in a net loss –All gains and losses are treated as ordinary items The gains—and the losses to the extent of gains— are treated as ordinary income and ordinary loss in computing AGI Losses in excess of gains are deducted as itemized deductions to the extent the losses exceed 10% of AGI

Individual Income Taxes C7-29 Example of C&T Limitation (slide 1 of 2) Karen (AGI = $40,000) has the following C&T (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6,000) with camera inside ($500) 2.Earthquake damage: house ($2,000), furniture ($1,000) Karen (AGI = $40,000) has the following C&T (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6,000) with camera inside ($500) 2.Earthquake damage: house ($2,000), furniture ($1,000)

Individual Income Taxes C7-30 Example of C&T Limitation (slide 2 of 2) Example of C&T limitation (cont’d) Karen has no insurance coverage for either loss: 1. $6,000 + $500 = $6,500 – $100 = $6, $2,000 + $1,000 = $3,000 – $100 = $2,900 Karen’s deductible C&T loss is $5,300 [$6,400 + $2,900 – (10% $40,000)] Example of C&T limitation (cont’d) Karen has no insurance coverage for either loss: 1. $6,000 + $500 = $6,500 – $100 = $6, $2,000 + $1,000 = $3,000 – $100 = $2,900 Karen’s deductible C&T loss is $5,300 [$6,400 + $2,900 – (10% $40,000)]

Individual Income Taxes C7-31 Research and Experimental Expenditures (slide 1 of 2) Definition of research and experimental (R&E) expenditures –Costs for the development of an experimental model, plant process, product, formula, invention, or similar property and improvement of such existing property Definition of research and experimental (R&E) expenditures –Costs for the development of an experimental model, plant process, product, formula, invention, or similar property and improvement of such existing property

Individual Income Taxes C7-32 Research and Experimental Expenditures (slide 2 of 2) Three alternatives are available for R&E expenditures –Expense in year paid or incurred, –Defer and amortize over period of 60 months or more, or –Capitalize (deductible when project abandoned or worthless) Tax credit of 20% of certain R&E expenditures is available Three alternatives are available for R&E expenditures –Expense in year paid or incurred, –Defer and amortize over period of 60 months or more, or –Capitalize (deductible when project abandoned or worthless) Tax credit of 20% of certain R&E expenditures is available

Individual Income Taxes C7-33 Domestic Production Activities Deduction (slide 1 of 5) The American Jobs Creation Act of 2004 created a new deduction based on the income from manufacturing activities –The Domestic Production Activities deduction is based on the following formula: 6% × Lesser of –Qualified production activities income –Taxable (or modified adjusted gross) income or AMTI The deduction cannot exceed 50% of an employer’s W–2 wages paid to employees engaged in qualified production activities The American Jobs Creation Act of 2004 created a new deduction based on the income from manufacturing activities –The Domestic Production Activities deduction is based on the following formula: 6% × Lesser of –Qualified production activities income –Taxable (or modified adjusted gross) income or AMTI The deduction cannot exceed 50% of an employer’s W–2 wages paid to employees engaged in qualified production activities

Individual Income Taxes C7-34 Domestic Production Activities Deduction (slide 2 of 5) Qualified production activities income is the excess of domestic production gross receipts over the sum of: –Cost of goods sold that are attributable to such receipts –Other deductions, expenses, or losses that are directly allocable to such receipts –A share of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income Qualified production activities income is the excess of domestic production gross receipts over the sum of: –Cost of goods sold that are attributable to such receipts –Other deductions, expenses, or losses that are directly allocable to such receipts –A share of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income

Individual Income Taxes C7-35 Domestic Production Activities Deduction (slide 3 of 5) Domestic production gross receipts include the following five specific categories: –The lease, license, sale, exchange, or other disposition of qualified production property manufactured, produced, grown, or extracted in the U.S. –Qualified films largely created in the U.S. –The production of electricity, natural gas, or potable water –Construction (but not self-construction) performed in the U.S. –Engineering and architectural services for domestic construction Items specifically excluded from this definition include: –The sale of food and beverages prepared by a taxpayer at a retail establishment and –The transmission or distribution of electricity, natural gas, or potable water Domestic production gross receipts include the following five specific categories: –The lease, license, sale, exchange, or other disposition of qualified production property manufactured, produced, grown, or extracted in the U.S. –Qualified films largely created in the U.S. –The production of electricity, natural gas, or potable water –Construction (but not self-construction) performed in the U.S. –Engineering and architectural services for domestic construction Items specifically excluded from this definition include: –The sale of food and beverages prepared by a taxpayer at a retail establishment and –The transmission or distribution of electricity, natural gas, or potable water

Individual Income Taxes C7-36 Domestic Production Activities Deduction (slide 4 of 5) A phase-in provision increases the applicable rate for the Domestic Production Activities deduction as follows: Rate Years 6% %2010 and thereafter A phase-in provision increases the applicable rate for the Domestic Production Activities deduction as follows: Rate Years 6% %2010 and thereafter

Individual Income Taxes C7-37 Domestic Production Activities Deduction (slide 5 of 5) Eligible taxpayers include: –Individuals, partnerships, S corporations, C corporations, cooperatives, estates, and trusts For a pass-through entity (e.g., partnerships, S corporations), the deduction flows through to the individual owners For sole proprietors, a deduction for AGI results and is claimed on Form 1040, line 35 on page 1 Eligible taxpayers include: –Individuals, partnerships, S corporations, C corporations, cooperatives, estates, and trusts For a pass-through entity (e.g., partnerships, S corporations), the deduction flows through to the individual owners For sole proprietors, a deduction for AGI results and is claimed on Form 1040, line 35 on page 1

Individual Income Taxes C7-38 Net Operating Losses (slide 1 of 7) NOLs from any one year can be offset against taxable income of other years –The NOL provision is intended as a form of relief for business income and losses –Only losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL NOLs from any one year can be offset against taxable income of other years –The NOL provision is intended as a form of relief for business income and losses –Only losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL

Individual Income Taxes C7-39 Net Operating Losses (slide 2 of 7) No nonbusiness (personal) losses or deductions may be used in computing NOL Exception: personal casualty and theft losses No nonbusiness (personal) losses or deductions may be used in computing NOL Exception: personal casualty and theft losses

Individual Income Taxes C7-40 Net Operating Losses (slide 3 of 7) Carryover period –Must carryback to 2 prior years, then carryforward to 20 future years May make an irrevocable election to just carryforward When there are NOLs from two or more years, use on a FIFO basis –3 year carryback is available for: Individuals with NOL from casualty or thefts Small businesses with NOLs from Presidentially declared disasters –5-year carryback period and a 20-year carryover period are allowed for a farming loss Carryover period –Must carryback to 2 prior years, then carryforward to 20 future years May make an irrevocable election to just carryforward When there are NOLs from two or more years, use on a FIFO basis –3 year carryback is available for: Individuals with NOL from casualty or thefts Small businesses with NOLs from Presidentially declared disasters –5-year carryback period and a 20-year carryover period are allowed for a farming loss

Individual Income Taxes C7-41 Net Operating Losses (slide 4 of 7) Example of NOL carryovers –Ken has a NOL for 2008 –Ken must carryover his NOL in the following order: Carryback to 2006 and 2007, then carryforward to 2009, 2010,..., 2028 –Ken can elect to just carryforward his NOL Carryover would be to 2009, 2010,..., 2028 Example of NOL carryovers –Ken has a NOL for 2008 –Ken must carryover his NOL in the following order: Carryback to 2006 and 2007, then carryforward to 2009, 2010,..., 2028 –Ken can elect to just carryforward his NOL Carryover would be to 2009, 2010,..., 2028

Individual Income Taxes C7-42 Net Operating Losses (slide 5 of 7) Computing NOL amount –Individual must start with taxable income and add back: 1. Personal and dependency exemptions 2. NOLs from other years 3. Excess nonbusiness capital losses 4. Excess nonbusiness deductions 5. Excess business capital losses Computing NOL amount –Individual must start with taxable income and add back: 1. Personal and dependency exemptions 2. NOLs from other years 3. Excess nonbusiness capital losses 4. Excess nonbusiness deductions 5. Excess business capital losses

Individual Income Taxes C7-43 Net Operating Losses (slide 6 of 7) Effect of NOL in carryback year –Taxpayer must recompute taxable income and the income tax –All limitations and deductions based on AGI must be recomputed with the exception of charitable contribution deduction –All credits limited by or based on the tax liability must be recomputed Effect of NOL in carryback year –Taxpayer must recompute taxable income and the income tax –All limitations and deductions based on AGI must be recomputed with the exception of charitable contribution deduction –All credits limited by or based on the tax liability must be recomputed

Individual Income Taxes C7-44 Net Operating Losses (slide 7 of 7) Calculating remaining NOL after carryovers –After using the NOL in the initial carryover year, the taxpayer must determine how much NOL remains to carry to other years Calculating remaining NOL after carryovers –After using the NOL in the initial carryover year, the taxpayer must determine how much NOL remains to carry to other years

Individual Income Taxes C7-45 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