1. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Taxation of Business Entities 1 Chapter 5 Business Deductions

2. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 Trade or Business Deductions 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

3. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 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

4. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 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

5. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 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

6. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 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

7. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 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

8. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 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

9. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 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

10. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Capital Expenditures Amounts are capitalized Asset may be subject to depreciation (or cost recovery), amortization, or depletion

11. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 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

12. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 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

13. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 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

14. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 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

15. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 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

16. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 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

17. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Charitable Contributions (slide 1 of 2) Individuals and corporations may deduct contributions made to qualified domestic organizations Contributor must have donative intent and expect nothing in return –If contributor receives tangible benefit, the FMV of such benefit must be deducted from the amount of the contribution

18. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Charitable Contributions (slide 2 of 2) Contribution must be to qualified domestic nonprofit organization or state or possession of U.S. or any subdivisions thereof –Many (but not all) qualified domestic charities are listed in IRS Publication #78

19. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 Timing of Charitable Contribution Deduction Generally, deductible in year in which the payment is made –Exception: An accrual basis corporation may take deduction in year preceding payment if: The contribution is authorized by the board of directors by the end of that year, and The contribution is paid on or before the fifteenth day of the third month of the following year

20. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 Ordinary Income Property Defined: assets that would produce ordinary income or short-term capital gain if sold Contribution amount –FMV of asset less ordinary income (or STCG) potential; generally the lower of adjusted basis or FMV

21. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 Capital Gain Property Defined: assets that would produce long-term capital gain or Section 1231 gain if sold Contribution amount –Generally FMV of asset

22. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 Exceptions to FMV Deduction of Capital Gain Property (slide 1 of 2) Private nonoperating foundations –Deduction for contributions to private nonoperating foundations must be reduced by the amount of capital gain potential –Thus, the amount is limited to the adjusted basis

23. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Exceptions to FMV Deduction of Capital Gain Property (slide 2 of 2) Tangible personalty –If asset contributed is not used in charity’s exempt function, the charitable deduction must be reduced by the amount of capital gain potential, thus, limiting the amount to the adjusted basis

24. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 Example of Contributions of Tangible Personalty Taxpayer contributes painting to local charity: FMV $100,000 and adjusted basis $10,000 –If charitable organization is a local museum that hangs the painting for patrons to view, taxpayer has $100,000 contribution deduction –If charitable organization is a local church that sells the painting immediately to obtain funds for its operation, taxpayer has $10,000 contribution

25. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 Exceptions Related to Contributions of Ordinary Income Property (slide 1 of 2) On certain contributions of inventory by corps, the amount of the deduction is equal to the lesser of –The sum of the property’s basis plus 50% of the appreciation on the property, or –Twice the property’s basis

26. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 Exceptions Related to Contributions of Ordinary Income Property (slide 2 of 2) The following inventory contributions qualify for this increased deduction amount –A contribution of property to a charitable organization for use in its exempt function Such use is solely for the care of the ill, needy, or infants –A contribution of books to a public school (K through 12) that uses the books in its educational programs –A contribution of tangible personal research property constructed by the corporation to a qualified educational or scientific organization that uses the property for research or experimentation, or research training –A contribution of computer equipment and software to a qualified educational organization or public library that uses the property for educational purposes

27. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 Charitable Contribution Limitation A corporate taxpayer’s contribution deduction is limited to 10% of taxable income before –The charitable contribution deduction –Any NOL or capital loss carryback –The dividends received deduction, and –The domestic production activities deduction

28. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 Charitable Contributions Carryover Contributions in excess of the 10% limit may be carried forward for 5 years –Any carryforward is added to subsequent contributions subject to the 10% limit –In carryforward year, the current year’s contributions must be deducted first, with excess deductions from previous years deducted in order of time

29. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 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

30. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 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) Credit of 20% of certain R&E expenditures is also available

31. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 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

32. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 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

33. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 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

34. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34 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 3%2005-2006 6%2007-2009 9%2010 and thereafter

35. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 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

36. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36 Cost Recovery Recovery of the cost of business or income- producing assets is through: –Cost recovery or depreciation: tangible assets –Amortization: intangible assets –Depletion: natural resources

37. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37 Nature of Property Property includes both realty (real property) and personalty (personal property) –Realty generally includes land and buildings permanently affixed to the land –Personalty is defined as any asset that is not realty Personalty includes furniture, machinery, equipment, and many other types of assets Personalty (or personal property) should not be confused with personal use property –Personal use property is any property (realty or personalty) that is held for personal use rather than for use in a trade or business or an income-producing activity Write-offs are not allowed for personal use assets

38. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 General Considerations (slide 1 of 3) Basis in an asset is reduced by the amount of cost recovery that is allowed and by not less than the allowable amount –Allowed cost recovery is cost recovery actually taken –Allowable cost recovery is amount that could have been taken under the applicable cost recovery method If no cost recovery is claimed on property –The basis of the property must still be reduced by the amount that should have been deducted i.e., The allowable cost recovery

39. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39 General Considerations (slide 2 of 3) If personal use assets are converted to business or income-producing use –Basis for cost recovery and for loss is lower of Adjusted basis or Fair market value at time property was converted –Losses that occurred prior to conversion can not be recognized for tax purposes through cost recovery

40. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 40 General Considerations (slide 3 of 3) MACRS applies to: –Assets used in a trade or business or for the production of income –Assets subject to wear and tear, obsolescence, etc. –Assets must have a determinable useful life –Assets that are tangible personalty or realty

41. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41 MACRS-Personalty MACRS characteristics: MACRS Personalty. Statutory lives: 3, 5, 7, 10 yrs 15, 20 yrs Method: 200% DB 150% DB Convention: Half Yr or Mid-Quarter DB = declining balance with switch to straight-line Straight-line depreciation may be elected

42. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42 Half-Year Convention General rule for personalty Assets treated as if placed in service (or disposed of) in the middle of taxable year regardless of when actually placed in service (or disposed of)

43. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 43 Example: Half-Year Convention Bought and placed an asset in service on March 15 (Tax year end is December 31) –Treated as placed in service June 30 –Six months cost recovery in year 1 (and year disposed of, if within recovery period)

44. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 44 Additional First-Year Depreciation The Economic Stimulus Act of 2008 provides for additional first-year depreciation on qualified property –Applies to property acquired after 12/31/07 and before 01/01/09 and placed in service before 01/01/09 –ARRTA of 2009 extends additional first-year depreciation for an additional year (qualified property acquired and placed in service before January 1, 2010) Allows an additional 50% cost recovery in year asset is placed in service Qualified property includes most types of new property other than buildings –Property that is used but new to the taxpayer does not qualify

45. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45 Example: Additional First-Year Depreciation Maple Company acquires a 5-year class asset on March 20, 2009, for $20,000. Maple’s cost recovery deduction for 2009 is computed as follows: 50% additional first-year depreciation ($20,000 X.50) $10,000 MACRS cost recovery [($20,000 - $10,000) X.20 (Table 8–1)] 2,000 Total cost recovery $12,000

46. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 46 Mid-Quarter Convention Applies when more than 40% of personalty is placed in service during last quarter of year Assets treated as if placed into service (or disposed of) in the middle of the quarter in which they were actually placed in service (or disposed of)

47. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 47 Example: Mid-Quarter Convention Business with 12/31 year end purchased and placed in service the following 5-year class assets: Asset 1: on 3/28 for $50,000, and Asset 2: on 12/28 for $100,000 More than 40% placed in service in last quarter; therefore, mid-quarter convention used: Asset 1: $50,000 ×.20 × 200% × 10.5/12 = $17,500 Asset 2: $100,000 ×.20 × 200% × 1.5/12 = $5,000 Table 8-2 provides the relevant percentages to be used when applying the mid-quarter convention

48. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 48 MACRS-Realty (slide 1 of 2) MACRS characteristics: MACRS Realty Residential Rental Nonresid. Realty Statutory lives: 27.5 yrs 31.5 yrs or 39 yrs Method: Straight-line Convention: Mid-month Residential rental real estate –Includes property where 80% or more of gross rental revenues are from nontransient dwelling units –e.g., Apartment building

49. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 49 MACRS-Realty (slide 2 of 2) Mid-month Convention –Property placed in service at any time during a month is treated as if it was placed in service in the middle of the month –Example: Business building placed in service April 25 is treated as placed in service April 15

50. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 50 Optional Straight-line Election May elect straight-line rather than accelerated depreciation on personalty placed in service during year –Use the class life of the asset for the recovery period –Use half-year or mid-quarter convention as applicable –Election is made annually by class of property

51. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 51 Farm Property (slide 1 of 2) Generally, for farm assets use: –MACRS 150% declining-balance method for personalty MACRS straight-line method is required for any tree or vine bearing fruits or nuts –Straightline method over the normal periods (27.5 years and 39 years) for real property –If the election is made to not have the uniform capitalization rules apply, alternative depreciation system (ADS) straight-line method must be used

52. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 52 Farm Property (slide 2 of 2) Under the Emergency Economic Stabilization Act of 2008 –New machinery or equipment placed in service in a farming business in 2009 has a recovery period of 5 years under MACRS Does not include a grain bin, cotton ginning asset, fence, or land improvement

53. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 53 Leasehold Improvement Property (slide 1 of 3) If lessor is owner of leasehold improvement property, depreciation is calculated as follows: –Real Property – Use straight-line method over 27.5 or 39 year statutory recovery periods –Tangible personal property – Use the shorter MACRS lives and accelerated methods When these improvements are disposed of or abandoned by the lessor due to lease termination –Property is treated as disposed of by the lessor –A loss can be taken for the unrecovered basis

54. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 54 Leasehold Improvement Property (slide 2 of 3) If lessee is owner of leasehold improvement property –Costs of leasehold improvements are recovered in accordance with the general cost recovery rules Cost recovery period is determined without regard to the lease term –Any unrecovered basis in the leasehold improvement property not retained by the lessee is deducted in the year the lease is terminated

55. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 55 Leasehold Improvement Property (slide 3 of 3) Under the Emergency Economic Stabilization Act of 2008, qualified leasehold improvement property placed in service before 01/01/10 is allowed 15-year recovery period –Includes any improvement to an interior portion of nonresidential real property if: The improvement is § 1250 property The lease is not between related persons Interior portion of building is to be occupied exclusively by the lessee or any sublessee of that interior portion Improvement is placed in service > 3 years after date building was first placed in service by any person

56. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 56 Election to Expense Assets -Section 179 (slide 1 of 5) General rules –Can elect to immediately expense up to $250,000 (for 2009) of business tangible personalty placed in service during the year –Cannot use § 179 for realty or production of income property

57. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 57 Election to Expense Assets -Section 179 (slide 2 of 5) Section 179 general rules –Amount expensed reduces depreciable basis –Any elected § 179 expense is taken before the 50% additional first-year depreciation is computed –The base for calculating the standard MACRS deduction is net of the § 179 expense and the 50% additional first-year depreciation

58. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 58 Election to Expense Assets -Section 179 (slide 3 of 5) Annual limitations: –Expense limitation ($250,000 for 2009) is reduced by amount of § 179 property placed in service during year that exceeds $800,000 Example: In 2009, taxpayer placed in service $815,000 of § 179 property. –The § 179 expense limit is reduced to $235,000 [$250,000 – ($815,000 – $800,000)]

59. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 59 Election to Expense Assets -Section 179 (slide 4 of 5) Annual limitations: –Election to expense cannot exceed taxable income (before § 179) of taxpayer’s trades or businesses Any amount expensed under § 179 over taxable income limitation may be carried over to subsequent year(s) Amount carried over still reduces basis currently

60. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 60 Election to Expense Assets -Section 179 (slide 5 of 5) Example: Taxpayer buys 5-year property for $275,000 on August 15, 2009 and elects immediate expensing of the maximum amount. The total deduction for the year is calculated as follows: § 179 expense $250,000 50% additional first-year depreciation [($275,000 - $250,000) X.50] 12,500 Standard MACRS calculation [($275,000 - $250,000 - $12,500) X.20] 2,500 Total cost recovery allowed in 2009$265,000

61. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 61 Listed Property (slide 1 of 4) There can be substantial limits on cost recovery of assets considered listed property Listed property includes the following: –Passenger automobile –Other property used as a means of transportation –Property used for entertainment, recreation, or amusement –Computer or peripheral equipment –Cellular telephone

62. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 62 Listed Property (slide 2 of 4) To be considered as predominantly used for business, business use must exceed 50% Use of asset for production of income is not considered in this 50% test However, both business and production of income use percentages are used to compute cost recovery

63. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 63 Listed Property (slide 3 of 4) To be considered as predominantly used for business (cont’d) If 50% test is met, then allowed to use statutory percentage method of cost recovery with some limitations

64. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 64 Listed Property (slide 4 of 4) If asset is not used predominantly for business i.e., business use does not exceed 50% –Must use straight-line method –If business use falls to 50% or lower after year property is placed in service, must recapture excess cost recovery

65. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 65 Passenger Auto Cost Recovery Limits (slide 1 of 7) For autos placed in service in 2008, cost recovery limits are: Year Recovery Limitation 1 $2,960 2 4,800 3 2,850 Succeeding years until the cost is recovered 1,775 If passenger automobile qualifies for 50% additional first- year depreciation (i.e., new property), the 2009 recovery limitation is increased by $8,000 –The initial-year cost recovery limitation increases from $2,960 to $10,960 ($2,960 + $8,000)

66. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 66 Passenger Auto Cost Recovery Limits (slide 2 of 7) Limits are for 100% business use –Must reduce limits by percentage of personal use Limit in the first year includes any amount the taxpayer elects to expense under § 179

67. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 67 Passenger Auto Cost Recovery Limits (slide 3 of 7) Example: Taxpayer acquired an auto in 2009 for $30,000 and used it 80% for business 2009 cost recovery allowance: {[($30,000 X 50%) + ($15,000 X 20%)] X 80%}$14,400 But deduction is limited to $10,960 × Business use %.80 Cost recovery allowance$8,768

68. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 68 Passenger Auto Cost Recovery Limits (slide 4 of 7) Limit on § 179 deduction –For certain vehicles not subject to the statutory dollar limits imposed on passenger automobiles the § 179 deduction is limited to $25,000 The limit applies to sport utility vehicles with an unloaded GVW rating of more than 6,000 pounds and not more than 14,000 pounds

69. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 69 Passenger Auto Cost Recovery Limits (slide 5 of 7) Listed property that fails the >50% business usage test in year property is placed in service must be recovered using the straight-line method –Such property does not qualify for the 50% additional first- year depreciation If the >50% business usage test is failed in a year after the property is placed in service, straight-line method must be used for remainder of property’s life –Cost recovery of passenger auto under straight-line listed property rule still subject to annual limits

70. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 70 Passenger Auto Cost Recovery Limits (slide 6 of 7) Change from predominantly business use –If the business use percentage falls to 50% or lower after the year the property is placed in service, the property is subject to cost recovery recapture –The amount recaptured as ordinary income is the excess cost recovery Excess cost recovery is the excess of the cost recovery deductions taken in prior years using the statutory percentage method over the amount that would have been allowed if the straight-line method had been used

71. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 71 Passenger Auto Cost Recovery Limits (slide 7 of 7) Leased autos subject to “inclusion amount” rule –Using IRS tables, taxpayer has gross income equal to each lease year’s inclusion amount –Purpose is to prevent avoidance of cost recovery dollar limits applicable to purchased autos by leasing autos

72. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 72 Alternative Depreciation System (ADS) (slide 1 of 2) ADS is an alternative depreciation system that is used in calculating depreciation for: –Alternative minimum tax (AMT) –Assets used predominantly outside the U.S. –Property owned by the taxpayer and leased to tax exempt entities –Earnings and profits

73. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 73 Alternative Depreciation System (ADS) (slide 2 of 2) Generally, use straight-line recovery without regard to salvage value –For AMT, 150% declining balance is allowed for personalty –Half-year, mid-quarter, and mid-month conventions still apply

74. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 74 Amortization Can claim amortization deduction on § 197 intangibles –Use straight-line recovery over 15 years (180 months) beginning in month intangible is acquired Section 197 intangibles include acquired goodwill, going-concern value, trademarks, trade names, etc.

75. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 75 Depletion (slide 1 of 4) Two methods of natural resource depletion –Cost: determined by using the adjusted basis of the resource and allocating over the recoverable units –Percentage: determined using percentage provided in Code and multiplying by gross income from resource sales

76. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 76 Depletion (slide 2 of 4) Cost depletion –Depletion is computed on a per unit basis –Per unit amount is determined by dividing the basis of the resource by the estimated recoverable units of resource Number of units sold in year × per unit depletion = depletion for year –Total depletion can not exceed total cost of the property

77. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 77 Depletion (slide 3 of 4) Percentage depletion –Depletion is computed by using the statutory percentage rate for the type of resource –Rate is applied to the gross income from the property

78. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 78 Depletion (slide 4 of 4) Percentage depletion –Percentage depletion cannot exceed 50% of the taxable income (before depletion) from the property –Percentage depletion reduces basis in property –However, total percentage depletion may exceed the total cost of the property Example: Property with zero basis but still generating income

79. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 79 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta