Chapter 5 Introduction to Business Expenses ©2008 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

Transparency 5-2 © 2008 South-Western All tax deductions are a matter of Legislative Grace Deductions are part of Congress’ approach to implementation of Ability-to-Pay Concept Review

Transparency 5-3 © 2008 South-Western Review! vFrom Chapter 1: All deductible amounts fall into one of three categories: FBusiness Expenses (Chapters 5 & 6) FLosses (Chapter 7) FDeductions (Chapter 8)

Transparency 5-4 © 2008 South-Western Business Expense vThe expenditure much have a business purpose that is unrelated to its tax effect. vFailure to establish a business purpose can result in the loss of the deduction.

Transparency 5-5 © 2008 South-Western Deductions vTrade or business expenses, expenses related to the production of rent and royalty income, losses on sales of property used in a trade or business and capital losses are deducted to arrive at gross income. These items are netted with the income to arrive at total income.

Transparency 5-6 © 2008 South-Western Deductions vDeductions for AGI vThere are specific items that are deductions for AGI.

Transparency 5-7 © 2008 South-Western Deductions vDeductions from AGI vGreater of standard deduction or itemized deduction. vItemized deductions are allowable personal expenditures and miscellaneous itemized deductions.

Transparency 5-8 © 2008 South-Western Classification of Deductions All expenditures fall into two categories: ¶Profit-motivated FTrade or business expenses FExpenses for the production of income (Investment) ·Personal FSpecifically allowed itemized deductions FNondeductible personal expenses

Transparency 5-9 © 2008 South-Western  Profit-Motivated Expenditures vShow that the expense is related to a profit-motivated transaction vShow that the business purpose is the primary or dominant motive To be deductible, an expenditure must have a business purpose unrelated to its tax effect.

Transparency 5-10 © 2008 South-Western Trade or Business vRequirements to qualify as a trade or business: FPrimary purpose is to earn income or a profit FInvolvement is regular and continuous FActivity is not merely a hobby

Transparency 5-11 © 2008 South-Western Production of Income Expenses vRoyalty vInterest & Dividends

Transparency 5-12 © 2008 South-Western Investment Activities vHave to determine whether individual is in the “business” of trading. vIf so, expenses are deducted to arrive at total income. vIf not, expenses are deducted as itemized deductions on Sch. A.

Transparency 5-13 © 2008 South-Western Rental Activity vRental activities may be either trade or business or for the production of income FExpenses are always netted with gross rental income FClassification matters when property is sold vClassification is determined by the scope of the taxpayer’s involvement

Transparency 5-14 © 2008 South-Western Personal Expenditures v2 Groups FAllowable personal itemized deductions FNondeductible personal expenses

Transparency 5-15 © 2008 South-Western Mixed-Use (  &  ) Business and Personal Use vMixed-Use Assets FUsed both to earn income and for personal purposes FTreat as two separate assets by allocating amount of use vMixed-Use Expenditures FIncurred both for profit and personal reasons FAllocate between business and personal use and deduct as allowed

Transparency 5-16 © 2008 South-Western 3 Positive Tests for Deductibility and also To be deductible, expenses must be profit-motivated or specifically allowed, and also ¶Ordinary FNormal, common, generally accepted ·Necessary FAppropriate, helpful, prudent ¸Reasonable in amount FArm’s length

Transparency 5-17 © 2008 South-Western 5 Negative Tests for Deductibility To be deductible, expenses must not be ¶Personal FBusiness purpose is not primary motive FNot specifically allowed ·Capital Expenditures FShould be capitalized as assets if useful life extends beyond a year FStart-up costs VAfter 10/23/04 may expense $5,000 in first year; remainder is amortized over 180 months VExpense is phased-out if total costs > $50,000

Transparency 5-18 © 2008 South-Western 5 Negative Tests for Deductibility ¸Against Public Policy FResulting from violation of a law FResulting from an illegal business VCost of goods sold are always deductible under the capital recovery concept VOrdinary, necessary, and reasonable business expenses are deductible for all illegal businesses except sale of drugs FFor lobbying and political activities VCosts to influence local legislation are deductible VCosts to monitor any legislation are deductible

Transparency 5-19 © 2008 South-Western 5 Negative Tests for Deductibility ¹Related to Tax-Exempt Income FIncurred to generate tax-exempt income ºAnother Person’s Obligation FCannot recover another’s capital

Transparency 5-20 © 2008 South-Western Mixed-Use Expenses Hobby Vs. Business An income-earning activity without a predominant profit motive is a hobby.

Transparency 5-21 © 2008 South-Western Mixed-Use Expenses Hobby Vs. Business vFactors considered in determining profit-motive are FManner of conducting activity FExpertise or reliance on expert advice FTime and effort spent on activity FHistory of income and loss FAmount of occasional profit FElements of personal pleasure FSuccess in similar activities

Transparency 5-22 © 2008 South-Western Mixed-Use Expenses Hobby vLosses from a hobby are not deductible FExpenses allowed up to amount of income generated FDeductions taken using three tier system: ¶Expenses also allowed as personal itemized deductions ·Other expenses that qualify as business expenses ¸Depreciation on assets used FAllowable expenses are deducted from AGI

Transparency 5-23 © 2008 South-Western Mixed-Use Expenses Vacation Home A residence used for personal vacations and also rented to unrelated people is a mixed-use asset and first must be classified as either: FPersonal residence if rented less than 15 days in a year FVacation home if used personally èmore than 14 days, or èmore than 10% of the number of days rented FRental property if used personally èless than 15 days, or èless than or equal to 10% of the days rented

Transparency 5-24 © 2008 South-Western Vacation Home Tax Treatment If classification is: vPersonal residence vVacation home vRental property Then tax treatment is: Report no income or expense Report income and allocate expenses using three tier system (no loss allowed) Report income and allocate all expenses; Loss allowed

Transparency 5-25 © 2008 South-Western Mixed-Use Expenses Home Office A taxpayer who operates a trade or business from home may be able to deduct a portion of the home’s expenses. vExpenses of the home are allocated between business and personal use

Transparency 5-26 © 2008 South-Western Mixed-Use Expenses Home Office vA specific portion of the home must be used FExclusively and regularly, FAs the principal place of business or as a place to meet clients, but VIf taxpayer has no other available location to do administrative or management activities, this requirement will not disqualify the deduction

Transparency 5-27 © 2008 South-Western Mixed-Use Expenses Home Office vEmployees must also show that the use FIs for the convenience of their employer FRequired as a condition of employment vAllowed expenses are deducted using the three tier system vDeduction is limited to the amount of net income from the business FHome-office deduction may not create a loss FExcess may be carried-forward

Transparency 5-28 © 2008 South-Western Timing of Deductions The taxpayer’s accounting method is used to determine the timing of deductions.

Transparency 5-29 © 2008 South-Western Timing of Deductions Cash Method vCash Method: claim a deduction in the year an expense is paid FDate of mailing for checks FDate of charge for credit cards FPrepaid expenses are deductible if used within one tax year (prepaid interest does not qualify)

Transparency 5-30 © 2008 South-Western Timing of Deductions Accrual Method vAccrual Method: claim a deduction in the year two tests are met FAll-events test is met when a liability exists and the amount can be determined FEconomic performance test is met when services or property are provided

© 2004 South-Western College Publishing Timing of Deductions Related Party Accrued Expenses Deductions for accrued expenses payable to a cash basis related party are limited. vRelated parties include family members and businesses owned or controlled by the taxpayer vUnless both parties are accrual basis, both report using the cash method; until income is reported no expense may be deducted

Transparency 5-32 © 2008 South-Western Financial Accounting Income Vs. Taxable Income vMatching and Conservatism are not tax concepts vEstimates of expenses are not permitted for tax purposes FUse specific write-off for bad debts FDo not estimate warranty expense