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

6-2 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

6-3 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

6-4 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

6-5 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

6-6 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

6-7 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

6-8 Business or Investment Requirement (1 of 2)  Activity engaged in for profit  Use facts and circumstances test  Trade or business (ToB) vs. investment classification  ToB losses are ordinary losses  ToB expenses are for AGI  Investment losses are capital  Investment expenses are from AGI  Subject to 2% of AGI floor ©2009 Pearson Education, Inc. Publishing as Prentice Hall

6-9 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 ToB if incurred in ordinary course of business  Fees related to taxes also for AGI for ToB  Nonbusiness fees related to taxes from AGI deduction subject to 2% of AGI floor ©2009 Pearson Education, Inc. Publishing as Prentice Hall

6-10 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

6-11 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

6-12 Reasonable Expense  Problems often occur with salaries for shareholder-employees of closely held businesses ©2009 Pearson Education, Inc. Publishing as Prentice Hall

6-13 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

6-14 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

6-15 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

6-16 Expenses Related to Exempt Income  Deduction disallowed because income is not taxable ©2009 Pearson Education, Inc. Publishing as Prentice Hall

6-17 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

6-18 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

6-19 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

6-20 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

6-21 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

6-22 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

6-23 When an Expense is Deductible Accrual Method (1 of 2)  Allowed to deduct expenses in period in which expenses accrue under all-events 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

6-24 When an Expense is Deductible Accrual Method (2 of 2)  Economic performance test is met  When economic performance is deemed to occur  See Table I6-1 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

6-25 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

6-26 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

6-27 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

6-28 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

6-29 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

6-30 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

6-31 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

6-32 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

6-33 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

6-34 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

6-35 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

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 6-36 ©2009 Pearson Education, Inc. Publishing as Prentice Hall