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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
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3. DEDUCTIONS AND LOSSES (2 of 2)
When an expense is deductible
Special disallowance rules
Tax planning considerations
Compliance and procedural considerations
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4. Classifying Deductions as for vs. from Adjusted Gross Income (1 of 3)
For AGI
Taxpayer benefits from deduction even if she claims the standard deduction
Reduces AGI which benefits taxpayer
Many deductions and credits are phased out above certain AGI thresholds
Reduces AGI floors for certain categories of itemized deductions
Negative effect of reducing certain deduction ceilings
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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 investment
Interest paid on qualified education loans
1/2 of self-employment tax
Health insurance costs paid by self-employed individuals
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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
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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
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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
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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
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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
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11. Necessary Expense
An expense is considered necessary if it is “appropriate and helpful” in the taxpayer’s business
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12. Reasonable Expense
Problems often occur with salaries for shareholder-employees of closely held businesses
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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
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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
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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
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16. Expenses Related to Exempt Income
Deduction disallowed because income is not taxable
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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
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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
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19. Proper Substantiation Requirement
The taxpayer has the burden of proof
The Cohan rule
Certain expenses may be estimated
More restrictive substantiation requirements for travel, entertainment, business gifts
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20. 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
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21. 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
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22. When an Expense Is Deductible Accrual Method (1 of 2)
Allowed to deduct expenses in period in which the expenses accrue under all-events test and economic performance test
All-events test met
When amount of liability is established
Amount of liability is determined with reasonable accuracy
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23. 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
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24. Special Disallowance Rules
Wash sales
Transactions between related parties
Hobby losses
Vacation home
Expenses of an office in the home
©2007 Prentice Hall, Inc.

25. 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
©2007 Prentice Hall, Inc.

26. 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
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27. 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
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28. Hobby Losses (1 of 2)
Activity that has more personal attributes than profit motive
IRS uses several factors to determine whether activity is profit-motivated
Does taxpayer conduct activity in businesslike manner
The time and effort expended
Whether assets are expected to appreciate
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29. 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
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30. 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
©2007 Prentice Hall, Inc.

31. 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
©2007 Prentice Hall, Inc.

32. 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
©2007 Prentice Hall, Inc.

33. 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
©2007 Prentice Hall, Inc.

34. Compliance and Procedural Considerations (2 of 2)
Hobby Losses
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
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35. ©2007 Prentice Hall, Inc.