1. Chapter 7 Deductions and Losses: Certain Business Expenses and Losses Copyright ©2007 South-Western/Thomson Learning Individual Income Taxes

2. C7 - 2 Individual Income Taxes Business Bad Debts (slide 1 of 4) Specific charge-off method must be used –Exception: Reserve method is allowed for some financial institutions Deduct as ordinary loss in the year when debt is partially or wholly worthless –Cash basis taxpayer does not have bad debt deduction for unpaid receivables Specific charge-off method must be used –Exception: Reserve method is allowed for some financial institutions Deduct as ordinary loss in the year when debt is partially or wholly worthless –Cash basis taxpayer does not have bad debt deduction for unpaid receivables

3. C7 - 3 Individual Income Taxes Business Bad Debts (slide 2 of 4) If a business debt previously deducted as partially worthless becomes totally worthless in a future year –Only the remainder not previously deducted can be deducted in the future year If a business debt previously deducted as partially worthless becomes totally worthless in a future year –Only the remainder not previously deducted can be deducted in the future year

4. C7 - 4 Individual Income Taxes Business Bad Debts (slide 3 of 4) In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless Deductible amount depends on basis in bad debt –If debt arose from sale of services or products and the face amount was previously included in income That amount is deductible –If the taxpayer purchased the debt Deduction is equal to amount taxpayer paid for debt instrument In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless Deductible amount depends on basis in bad debt –If debt arose from sale of services or products and the face amount was previously included in income That amount is deductible –If the taxpayer purchased the debt Deduction is equal to amount taxpayer paid for debt instrument

5. C7 - 5 Individual Income Taxes Business Bad Debts (slide 4 of 4) If a receivable has been written off –The collection of the receivable in a later tax year may result in income being recognized –Income will result if the deduction yielded a tax benefit in the year it was taken If a receivable has been written off –The collection of the receivable in a later tax year may result in income being recognized –Income will result if the deduction yielded a tax benefit in the year it was taken

6. C7 - 6 Individual Income Taxes Nonbusiness Bad Debts (slide 1 of 2) Nonbusiness bad debt –Debt unrelated to the taxpayer’s trade or business Deduct as short-term capital loss in the year when amount of worthlessness is known with certainty –No deduction is allowed for partial worthlessness of a nonbusiness bad debt Nonbusiness bad debt –Debt unrelated to the taxpayer’s trade or business Deduct as short-term capital loss in the year when amount of worthlessness is known with certainty –No deduction is allowed for partial worthlessness of a nonbusiness bad debt

7. C7 - 7 Individual Income Taxes Nonbusiness Bad Debts (slide 2 of 2) Related party (individuals) bad debts are generally suspect and may be treated as gifts

8. C7 - 8 Individual Income Taxes Classification of Bad Debts Individuals will generally have nonbusiness bad debts unless: –In the business of loaning money, or –Bad debt is associated with the individual’s trade or business Determination is made either at the time the debt was created or when it became worthless Individuals will generally have nonbusiness bad debts unless: –In the business of loaning money, or –Bad debt is associated with the individual’s trade or business Determination is made either at the time the debt was created or when it became worthless

9. C7 - 9 Individual Income Taxes Worthless Securities (slide 1 of 2) Loss on worthless securities is deductible in the year they become completely worthless –These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless Loss on worthless securities is deductible in the year they become completely worthless –These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless

10. C7 - 10 Individual Income Taxes Worthless Securities (slide 2 of 2) Example of worthless securities –On December 1, 2005, Sally purchased stock for $10,000. The stock became worthless on June 1, 2006. Sally’s loss is treated as having occurred on December 31, 2006. The result is a long-term capital loss. Example of worthless securities –On December 1, 2005, Sally purchased stock for $10,000. The stock became worthless on June 1, 2006. Sally’s loss is treated as having occurred on December 31, 2006. The result is a long-term capital loss.

11. C7 - 11 Individual Income Taxes Section 1244 Stock (slide 1 of 3) Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals –Ordinary loss treatment (per year) is limited to $50,000 ($100,000 for MFJ taxpayers) Loss in excess of per year limit is treated as capital loss Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals –Ordinary loss treatment (per year) is limited to $50,000 ($100,000 for MFJ taxpayers) Loss in excess of per year limit is treated as capital loss

12. C7 - 12 Individual Income Taxes Section 1244 Stock (slide 2 of 3) Section 1244 loss treatment is limited to stock owned by original purchaser Corporation must meet certain requirements for stock to qualify –Major requirement is limit of $1 million of capital contributions Section 1244 does not apply to gains Section 1244 loss treatment is limited to stock owned by original purchaser Corporation must meet certain requirements for stock to qualify –Major requirement is limit of $1 million of capital contributions Section 1244 does not apply to gains

13. C7 - 13 Individual Income Taxes Section 1244 Stock (slide 3 of 3) Example of § 1244 loss –In 1994, Sam purchases from XYZ Corp. stock costing $150,000. (Total XYZ stock outstanding is $800,000.) In 2006, Sam sells the stock for $65,000. –Sam, a single taxpayer, has the following tax consequences: $50,000 ordinary loss $35,000 long-term capital loss Example of § 1244 loss –In 1994, Sam purchases from XYZ Corp. stock costing $150,000. (Total XYZ stock outstanding is $800,000.) In 2006, Sam sells the stock for $65,000. –Sam, a single taxpayer, has the following tax consequences: $50,000 ordinary loss $35,000 long-term capital loss

14. C7 - 14 Individual Income Taxes Losses of Individuals Only the following losses are deductible by individuals: –Losses incurred in a trade or business, –Losses incurred in a transaction entered into for profit, –Losses caused by fire, storm, shipwreck, or other casualty or by theft Only the following losses are deductible by individuals: –Losses incurred in a trade or business, –Losses incurred in a transaction entered into for profit, –Losses caused by fire, storm, shipwreck, or other casualty or by theft

15. C7 - 15 Individual Income Taxes Definition of Casualty & Theft (C & T) Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft –Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature –Events not treated as casualties include losses from disease and insect damage Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft –Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature –Events not treated as casualties include losses from disease and insect damage

16. C7 - 16 Individual Income Taxes Definition of Theft Theft includes robbery, burglary, embezzlement, etc. –Does not include misplaced items Theft includes robbery, burglary, embezzlement, etc. –Does not include misplaced items

17. C7 - 17 Individual Income Taxes When Casualty & Theft Is Deductible Casualties: year in which loss is sustained –Exception: If declared “disaster area” by President, can elect to deduct loss in year prior to year of occurrence Thefts: year in which loss is discovered Casualties: year in which loss is sustained –Exception: If declared “disaster area” by President, can elect to deduct loss in year prior to year of occurrence Thefts: year in which loss is discovered

18. C7 - 18 Individual Income Taxes Effect of Claim for Reimbursement If reasonable prospect of full recovery: –No casualty loss is permitted –Deduct in year of settlement any amount not reimbursed If only partial recovery is expected, deduct in year of loss any amount not covered –Remainder is deducted in year claim is settled If reasonable prospect of full recovery: –No casualty loss is permitted –Deduct in year of settlement any amount not reimbursed If only partial recovery is expected, deduct in year of loss any amount not covered –Remainder is deducted in year claim is settled

19. C7 - 19 Individual Income Taxes Amount of C&T Deduction Amount of loss and its deductibility depends on whether: –Loss is from nonpersonal (business or production of income) or personal property –Loss is partial or complete Amount of loss and its deductibility depends on whether: –Loss is from nonpersonal (business or production of income) or personal property –Loss is partial or complete

20. C7 - 20 Individual Income Taxes Amount of Nonpersonal C&T Losses Theft or complete casualty (FMV after = 0) –Adjusted basis in property less insurance proceeds Partial casualty –Lesser of decline in value or adjusted basis in property, less insurance proceeds Theft or complete casualty (FMV after = 0) –Adjusted basis in property less insurance proceeds Partial casualty –Lesser of decline in value or adjusted basis in property, less insurance proceeds

21. C7 - 21 Individual Income Taxes C&T Examples Business and production of income losses (no insurance proceeds received) Adjusted FMV FMV Item Basis Before After Loss A 6,000 8,000 5,000 3,000 B 6,000 8,000 1,000 6,000 C 6,000 4,000 0 6,000 Business and production of income losses (no insurance proceeds received) Adjusted FMV FMV Item Basis Before After Loss A 6,000 8,000 5,000 3,000 B 6,000 8,000 1,000 6,000 C 6,000 4,000 0 6,000

22. C7 - 22 Individual Income Taxes Nonpersonal C&T Losses Business, rental, and royalty properties –Deduction will be FOR AGI Investment properties –Deduction will be FROM AGI Misc. itemized deduction not subject to 2% of AGI limitation Business, rental, and royalty properties –Deduction will be FOR AGI Investment properties –Deduction will be FROM AGI Misc. itemized deduction not subject to 2% of AGI limitation

23. C7 - 23 Individual Income Taxes Nonpersonal C&T Gains Depending on the property, gain can be ordinary or capital Amount of nonpersonal gains –Insurance proceeds less adjusted basis in property Depending on the property, gain can be ordinary or capital Amount of nonpersonal gains –Insurance proceeds less adjusted basis in property

24. C7 - 24 Individual Income Taxes Personal C&T Gains Net personal casualty gains and losses –If gains exceed losses, treat as gains and losses from the sale of capital assets Short term or long term, depending on holding period –Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property Net personal casualty gains and losses –If gains exceed losses, treat as gains and losses from the sale of capital assets Short term or long term, depending on holding period –Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property

25. C7 - 25 Individual Income Taxes Personal C&T Losses Net personal casualty gains and losses –If losses exceed gains, C&T deduction will be FROM AGI (an itemized deduction) Amount of personal C&T losses –Lesser of decline in value or adjusted basis in property, less insurance proceeds –C&T Limitation Each C&T occurrence is deductible to extent > $100, and aggregate of C&T losses for year must be > 10% AGI Net personal casualty gains and losses –If losses exceed gains, C&T deduction will be FROM AGI (an itemized deduction) Amount of personal C&T losses –Lesser of decline in value or adjusted basis in property, less insurance proceeds –C&T Limitation Each C&T occurrence is deductible to extent > $100, and aggregate of C&T losses for year must be > 10% AGI

26. C7 - 26 Individual Income Taxes Example of C&T Limitation (slide 1 of 2) Karen (AGI = $40,000) has the following C&T (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6,000) with camera inside ($500) 2.Earthquake damage: house ($2,000), furniture ($1,000) Karen (AGI = $40,000) has the following C&T (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6,000) with camera inside ($500) 2.Earthquake damage: house ($2,000), furniture ($1,000)

27. C7 - 27 Individual Income Taxes Example of C&T Limitation (slide 2 of 2) Example of C&T limitation (cont’d) Karen has no insurance coverage for either loss: 1. $6,000 + $500 = $6,500 – $100 = $6,400 2. $2,000 + $1,000 = $3,000 – $100 = $2,900 Karen’s deductible C&T loss is $5,300 [$6,400 + $2,900 – (10% $40,000)] Example of C&T limitation (cont’d) Karen has no insurance coverage for either loss: 1. $6,000 + $500 = $6,500 – $100 = $6,400 2. $2,000 + $1,000 = $3,000 – $100 = $2,900 Karen’s deductible C&T loss is $5,300 [$6,400 + $2,900 – (10% $40,000)]

28. C7 - 28 Individual Income Taxes 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 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

29. C7 - 29 Individual Income Taxes 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 available 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 available

30. C7 - 30 Individual Income Taxes 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: 3% × 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 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: 3% × 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

31. C7 - 31 Individual Income Taxes 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 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

32. C7 - 32 Individual Income Taxes 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 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

33. C7 - 33 Individual Income Taxes 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 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

34. C7 - 34 Individual Income Taxes 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 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

35. C7 - 35 Individual Income Taxes Net Operating Losses (slide 1 of 7) NOLs from any one year can be offset against taxable income of other years –The NOL provision is intended as a form of relief for business income and losses –Only losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL NOLs from any one year can be offset against taxable income of other years –The NOL provision is intended as a form of relief for business income and losses –Only losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL

36. C7 - 36 Individual Income Taxes Net Operating Losses (slide 2 of 7) No nonbusiness (personal) losses or deductions may be used in computing NOL Exception: personal casualty and theft losses No nonbusiness (personal) losses or deductions may be used in computing NOL Exception: personal casualty and theft losses

37. C7 - 37 Individual Income Taxes Net Operating Losses (slide 3 of 7) Carryover period –Must carryback to 2 prior years, then carryforward to 20 future years May make an irrevocable election to just carryforward When there are NOLs from two or more years, use on a FIFO basis –3 year carryback is available for: Individuals with NOL from casualty or thefts Farming businesses and small businesses with NOLs from Presidentially declared disasters Carryover period –Must carryback to 2 prior years, then carryforward to 20 future years May make an irrevocable election to just carryforward When there are NOLs from two or more years, use on a FIFO basis –3 year carryback is available for: Individuals with NOL from casualty or thefts Farming businesses and small businesses with NOLs from Presidentially declared disasters

38. C7 - 38 Individual Income Taxes Net Operating Losses (slide 4 of 7) Example of NOL carryovers –Ken has a NOL for 2006 –Ken must carryover his NOL in the following order: Carryback to 2004 and 2005, then carryforward to 2007, 2008,..., 2026 –Ken can elect to just carryforward his NOL Carryover would be to 2007, 2008,..., 2026 Example of NOL carryovers –Ken has a NOL for 2006 –Ken must carryover his NOL in the following order: Carryback to 2004 and 2005, then carryforward to 2007, 2008,..., 2026 –Ken can elect to just carryforward his NOL Carryover would be to 2007, 2008,..., 2026

39. C7 - 39 Individual Income Taxes Net Operating Losses (slide 5 of 7) Computing NOL amount –Individual must start with taxable income and add back: 1. Personal and dependency exemptions 2. NOLs from other years 3. Excess nonbusiness capital losses 4. Excess nonbusiness deductions 5. Excess business capital losses Computing NOL amount –Individual must start with taxable income and add back: 1. Personal and dependency exemptions 2. NOLs from other years 3. Excess nonbusiness capital losses 4. Excess nonbusiness deductions 5. Excess business capital losses

40. C7 - 40 Individual Income Taxes Net Operating Losses (slide 6 of 7) Effect of NOL in carryback year –Taxpayer must recompute taxable income and the income tax –All limitations and deductions based on AGI must be recomputed with the exception of charitable contribution deduction –All credits limited by or based on the tax liability must be recomputed Effect of NOL in carryback year –Taxpayer must recompute taxable income and the income tax –All limitations and deductions based on AGI must be recomputed with the exception of charitable contribution deduction –All credits limited by or based on the tax liability must be recomputed

41. C7 - 41 Individual Income Taxes Net Operating Losses (slide 7 of 7) Calculating remaining NOL after carryovers –After using the NOL in the initial carryover year, the taxpayer must determine how much NOL remains to carry to other years Calculating remaining NOL after carryovers –After using the NOL in the initial carryover year, the taxpayer must determine how much NOL remains to carry to other years

42. C7 - 42 Individual Income Taxes If you have any comments or suggestions concerning this PowerPoint Presentation for West Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA TRIPPEDR@oneonta.edu SUNY Oneonta If you have any comments or suggestions concerning this PowerPoint Presentation for West Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA TRIPPEDR@oneonta.edu SUNY Oneonta