Deductions and Losses: In General

Deductions and Losses: In General
© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture (slide 1 of 2)
Dr. Cliff Payne determines that his deductible expenses associated with his dental practice are as follows: Salaries including FICA ($5,000 are unpaid at year-end) $120,000 Building rent 24,000 Depreciation of dental and office furnishings and equipment 52,000 Insurance (malpractice and of dental equipment and office furnishings and equipment) 22,000 Dental supplies ,000 Office supplies 3,000 Investigation expenses 6,000 Contribution to State Senate campaign fund of Tom Smith 1,000 Contribution to State Senate campaign fund of Virginia White 1,000 Legal expenses associated with patient lawsuit 4,000 Fine imposed by city for improper disposal of medical waste 3,000 Dues paid to The Dental Society 10,000 Draw by Dr. Payne for living expenses ($5,000 monthly) 60,000 2 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture (slide 2 of 2)
Has Dr. Payne correctly calculated the business expenses for his dental practice? Read the chapter and formulate your response 3 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deductions Exclusive definition of deductions
Deductions are allowed based on legislative grace and defined narrowly Substantiation requirements Taxpayer has burden of proof for substantiating all expenses deducted on return Thus, adequate records of expenses must be maintained 4 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deductions for and from AGI (slide 1 of 3)
Deductions for AGI Can be claimed even if taxpayer does not itemize Important in determining the amount of certain itemized deductions Certain itemized deductions are limited to amounts in excess of specified percentages of AGI e.g., Medial expenses (10% of AGI), misc. itemized deductions (2% of AGI) © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deductions from AGI: In total, must exceed the standard deduction to provide any tax benefit Called “below the line” or itemized deductions © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Comparison of deductions for and from AGI (2017 tax year) Single taxpayer has gross income of $45,000 and a $6,500 deduction For AGI From AGI Gross income $45,000 $45,000 Less: for AGI ded , AGI $38,500 $45,000 Less: from AGI ded , ,500 Less: personal exempt , ,050 Taxable income $28,100 $34,450 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deductions for AGI (slide 1 of 3)
Partial list includes: Trade or business expenses Reimbursed employee business expenses Deductions from losses on sale or exchange of property Deductions from rental and royalty property Alimony One-half of self-employment tax paid © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Partial list includes: 100% of health insurance premiums paid by a self-employed individual Contributions to pension, profit sharing, annuity plans, IRAs, etc Penalty on premature withdrawals from time savings accounts or deposits Moving expenses © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Partial list includes: Interest on student loans Qualified tuition and related expenses under § 222 Up to $250 for teacher supplies for elementary and secondary school teachers © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deductions from AGI Itemized deductions include:
Medical expenses (in excess of 10% of AGI) Certain state and local taxes Contributions to qualified charitable organizations Personal casualty losses (in excess of 10% of AGI and a $100 floor per casualty) Certain personal interest expense (e.g., mortgage interest on a personal residence) Miscellaneous itemized deductions (in excess of 2% of AGI) © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Trade or Business Deductions (slide 1 of 2)
Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including: Reasonable salaries paid for services Expenses for the use of business property One-half of self-employment taxes paid Such expenses are deducted for AGI © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Trade or Business Deductions (slide 2 of 2)
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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Section 212 Expenses (slide 1 of 2)
Section 212 allows deductions for ordinary and necessary expenses paid or incurred for the following: The production or collection of income The management, conservation, or maintenance of property held for the production of income Expenses paid in connection with the determination, collection, or refund of any tax © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Section 212 Expenses (slide 2 of 2)
§ 212 expenses that are deductions for AGI include: Expenses related to rent and royalty income Expenses paid in connection with the determination, collection, or refund of taxes related to the income of sole proprietorships, rents and royalties, or farming operations All other § 212 expenses are itemized deductions (deductions from AGI) For example, investment-related expenses (e.g., safe deposit box rentals) are deductible as itemized deductions attributable to the production of investment income © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Business And Nonbusiness Losses
Deductible losses of individual taxpayers are limited to those: Incurred in a trade or business, Incurred in a transaction entered into for profit Individuals may also deduct casualty losses from fire, storm, shipwreck, and theft © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Reporting Procedures Format of Form 1040 (slide 1 of 2)

Reporting Procedures Format of Form 1040 (slide 2 of 2)

Methods of Accounting (slide 1 of 2)
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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Methods of Accounting (slide 2 of 2)
Exception to the economic performance test for recurring items allows immediate deduction if The item is recurring in nature and is treated consistently Either the accrued item is not material or accruing it in the current period results in better matching of income and expenses All of the events have occurred that determine the existence of the liability, and the amount of the liability can be determined with reasonable accuracy. Economic performance occurs within a reasonable period (but not later than 8 1/2 months after the close of the taxable year) © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture - Example 17 Nondeductible Fines
Return to the facts of The Big Picture on p. 6-1 Dr. Payne had not instituted proper procedures for disposing of medical waste from his laboratory During the current tax year, he was fined $3,000 by the city Dr. Payne believes the fine should be deducted as an ordinary business expense However, because the fine was due to a violation of public policy, the $3,000 is not deductible 23 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 Ordinary and necessary expenses incurred in connection with a trade or business or with rental or royalty property held for the production of income are deductible for AGI All other deductible legal expenses are deductible from AGI © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture - Example 23 Political Contributions
Return to the facts of The Big Picture on p. 6-1 Dr. Payne made political contributions to the State Senate campaigns of Tom Smith and Virginia White Dr. Payne made these contributions to encourage these senators to support a new bill that is beneficial to the state’s dental profession Therefore, he assumed that these would be deductible business expenses However, political contributions are not deductible, so he will receive no tax benefit from them 27 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture - Example 24 Political Contributions
Return to the facts of The Big Picture on p. 6-1 Dr. Payne had made contributions to The Dental Society, a trade association for dentists. The trade association estimates that 70% of its dues are allocated to lobbying activities. As a result, his deduction on Schedule C is limited to $3,000 ($10, %). 28 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Excessive Executive Compensation
For publicly held corporations: Deduction for compensation of CEO and four other highest compensated officers is limited to $1 million each Does not include: Certain performance-based compensation Payments to qualified retirement plans Payments excludible from gross income © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture - Example 27 Investigation Of A Business (slide 1 of 2)
Return to the facts of The Big Picture on p. 6-1 Dr. Payne believes that his administrative and business skills can be used to turn around dental practices whose revenues have been declining He investigates Teeth Restoration, LLC, a local dental practice that is for sale Expenses paid to consultants and accountants as part of this investigation totaled $6,000 He determined that Teeth Restoration would not be a good investment, so he did not buy it 33 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture - Example 27 Investigation Of A Business (slide 2 of 2)
Return to the facts of The Big Picture on p. 6-1 The $6,000 spent to investigate this business is deductible as a business expense because Dr. Payne is already in the dental business Investigating new business opportunities in one’s current trade or business are deductible as ordinary and necessary business expense 34 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Hobby Losses (slide 1 of 8)
Hobby defined Activity not entered into for profit Personal pleasure associated with activity Examples: raising horses, fishing boat charter If an activity is not engaged in for profit, the hobby loss rules apply Hobby expenses are deductible only to the extent of hobby income © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Profit activity If activity is entered into for profit, taxpayer can deduct expenses for AGI even in excess of income from the activity At-risk and passive loss rules may apply Often it is difficult to determine if an activity is profit motivated or a hobby Regulations provide nine factors to consider in making this determination © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Presumptive rule of § 183 If activity shows profit 3 out of 5 years (2 out of 7 years for horses), the activity is presumed to be a trade or business rather than a personal hobby Rebuttable presumption, shifts burden of proof to IRS Otherwise, taxpayer has burden to prove profit motive © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Year Income (loss) Hobby? 2010 $500 Yes 2011 (1,500) 2012 700 2013 (1,000) 2014 900 No, profit 3 of 5 years 2015 (500) Yes, profit only 2 of 5 years 2016 1,200 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

If an activity is deemed to be a hobby Can only deduct expenses to extent of income from activity (i.e., cannot deduct hobby losses) © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

If an activity is a hobby: Expenses are deductible from AGI Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation Exception: expenses that are deductible without regard to profit motive are deductible in full, such as Home mortgage interest Property taxes © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Order in which hobby expenses are deductible: First: Those otherwise deductible: e.g., home mortgage interest and property taxes Then: Expenses that do not affect adjusted basis: e.g., maintenance, utilities Then: Expenses that affect adjusted basis: e.g., depreciation (or cost recovery) © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example of hobby expenses: Taxpayer sells horses raised as a hobby for $15,500 Amount Order Income $15,500 Interest 6,000 1 $ 6,000 Taxes 3,000 Vet Bills 2,000 2 Feed 4,000 Depreciation 1,000 3 Ltd. to 500 Total 15,500 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Rental Vacation Homes (slide 1 of 9)
May have both personal and rental use of a vacation home Deduction of rental expenses may be limited to rental income if primarily used for personal purposes Determination of vacation home treatment is dependent on personal use vs. rental use © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Rental days Less than 15 days: No gross income recognized from rentals and no deductible rental expenses Mortgage interest and property taxes treated as if on personal residence (generally deductible in full) More than 14 days: Treatment depends on amount of personal use © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Primarily rental use If rented for 15 days or more and personal use days NOT more than the greater of 14 days or 10 percent of fair rental days Can deduct all expenses allocated to rental use even if loss results Rental loss subject to at-risk and passive loss rules © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Personal/rental use If rented for 15 days or more and personal use days exceed the greater of 14 days or 10% of fair rental days Treated similar to hobby Rental expenses deducted in three step process No rental loss allowed Carryforward of disallowed rental expenses © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example of personal use Rental days: 200 (10% = 20) Personal use Not Significant Significant 7 days X 18 days X 25 days X © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example of personal use Rental days: 100 (10% = 10) Personal use Not Significant Significant 7 days X 14 days X 18 days X © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Allocation of expenses between personal and rental Mortgage interest and real estate taxes IRS requires allocation based on total days used Courts have allowed allocation based on days in year Other expenses are allocated based on total days used © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Tax treatment of income and expenses of a primarily rental vacation home Rental income included in gross income Rental expenses deductible for AGI Rental income and expenses reported on Sch. E © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Treatment of allocated personal portion of vacation home expenses Primarily rental use: taxes deductible from AGI, mortgage interest nondeductible (personal interest) Personal/rental use: mortgage interest and taxes deductible from AGI Personal portion of other expenses (e.g., insurance, maintenance) nondeductible © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Expenditures Incurred for Taxpayer’s Benefit or Obligation
No deduction is allowed for payment of another taxpayer’s expenses Must be incurred for taxpayer’s benefit or arise from taxpayer’s obligation Exception: Payment of medical expenses for a dependent © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Personal Expenditures
Unless otherwise provided in the Code, personal expenses are not deductible © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Capital Expenditures Amounts are capitalized
Asset may be subject to depreciation (or cost recovery), amortization, or depletion © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Refocus On The Big Picture (slide 1 of 2)
Of the expenses incurred by Dr. Payne, several comments need to be made Being personal in nature, none of the $5,000 monthly draw is deductible and the amount involved is not subject to the reasonableness test (see Example 7) Dr. Payne is a sole proprietor and not in an employment relationship The fine paid for violating waste control rules comes under the public policy limitations (see Example 17) and is specifically made nondeductible by Code § 162(f) Along the same line are the political contributions (Example 23) made nondeductible by § 162(e) 58 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Refocus On The Big Picture (slide 2 of 2)
However, Dr. Payne’s investigation of the practice of another dental firm (Example 27) appears reasonable and the expense incurred deductible The dues paid to The Dental Society are not 100% deductible because 70% of the Society’s efforts relate to lobbying activities Although not specifically discussed in the text, Dr. Payne’s legal fees incurred in connection with a lawsuit filed by a patient appear related to his practice (Example 19) As such, they are ordinary and necessary to his trade or business 59 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Dr. Donald R. Trippeer, CPA
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 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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