1. Chapter 7 Deductions and Losses: Certain Business Expenses and Losses Copyright ©2006 South-Western/Thomson Learning Individual Income Taxes

2. C7 - 2 Individual Income Taxes Business Bad Debts (slide 1 of 3) 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 3) Example: –Ted uses the accrual method of accounting Ted sells inventory on account for $1,150 –Buyer pays $150 down and makes no other payments Ted has $1,000 bad debt deduction Example: –Ted uses the accrual method of accounting Ted sells inventory on account for $1,150 –Buyer pays $150 down and makes no other payments Ted has $1,000 bad debt deduction

4. C7 - 4 Individual Income Taxes Business Bad Debts (slide 3 of 3) Example: –Tara uses the cash method of accounting Tara performs accounting services for $1,150 –Client pays $150 down and makes no other payments Tara has no bad debt deduction Example: –Tara uses the cash method of accounting Tara performs accounting services for $1,150 –Client pays $150 down and makes no other payments Tara has no bad debt deduction

5. C7 - 5 Individual Income Taxes Nonbusiness Bad Debts (slide 1 of 2) Specific charge-off method must be used 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 Specific charge-off method must be used 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

6. C7 - 6 Individual Income Taxes Nonbusiness Bad Debts (slide 2 of 2) Related party (individuals) bad debts are generally suspect and may be treated as gifts

7. C7 - 7 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

8. C7 - 8 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

9. C7 - 9 Individual Income Taxes Worthless Securities (slide 2 of 2) Example of worthless securities –On December 1, 2004, Sally purchased stock for $10,000. The stock became worthless on June 1, 2005. Sally’s loss is treated as having occurred on December 31, 2005. The result is a long-term capital loss. Example of worthless securities –On December 1, 2004, Sally purchased stock for $10,000. The stock became worthless on June 1, 2005. Sally’s loss is treated as having occurred on December 31, 2005. The result is a long-term capital loss.

10. C7 - 10 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

11. C7 - 11 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 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 to qualify –Major requirement is limit of $1 million of capital contributions Section 1244 does not apply to gains

12. C7 - 12 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 2005, 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 2005, 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

13. C7 - 13 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

14. C7 - 14 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

15. C7 - 15 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

16. C7 - 16 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

17. C7 - 17 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

18. C7 - 18 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

19. C7 - 19 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

20. C7 - 20 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

21. C7 - 21 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

22. C7 - 22 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

23. C7 - 23 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

24. C7 - 24 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

25. C7 - 25 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)

26. C7 - 26 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)]

27. C7 - 27 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

28. C7 - 28 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

29. C7 - 29 Individual Income Taxes Manufacturers’ Deduction (slide 1 of 5) The American Jobs Creation Act of 2004 created a new deduction based on the income from manufacturing activities –The manufacturers’ deduction is based on the following formula: 3% × Lesser of –Qualified production income –Taxable (or adjusted gross) income 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 manufacturers’ deduction is based on the following formula: 3% × Lesser of –Qualified production income –Taxable (or adjusted gross) income The deduction cannot exceed 50% of an employer’s W–2 wages

30. C7 - 30 Individual Income Taxes Manufacturers’ Deduction (slide 2 of 5) Qualified production income is the total of qualified production receipts reduced by: –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 The term also includes receipts for certain services rendered in connection with construction projects in the United States Qualified production receipts do not include proceeds from the sale of food and beverages prepared at a retail establishment Qualified production income is the total of qualified production receipts reduced by: –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 The term also includes receipts for certain services rendered in connection with construction projects in the United States Qualified production receipts do not include proceeds from the sale of food and beverages prepared at a retail establishment

31. C7 - 31 Individual Income Taxes Manufacturers’ Deduction (slide 3 of 5) A phase-in provision increases the applicable rate for the manufacturer’s 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 manufacturer’s deduction as follows: Rate Years 3%2005-2006 6%2007-2009 9%2010 and thereafter

32. C7 - 32 Individual Income Taxes Manufacturers’ Deduction (slide 4 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 probably will be reflected as a Schedule C item 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 probably will be reflected as a Schedule C item

33. C7 - 33 Individual Income Taxes Manufacturers’ Deduction (slide 5 of 5) Observations and operational problems –Concepts introduced by the manufacturers’ deduction are unique Current tax law offers little assistance in resolving the problems that are bound to arise –The IRS can be expected to issue guidelines that will aid taxpayers in utilizing the manufacturers’ deduction correctly Observations and operational problems –Concepts introduced by the manufacturers’ deduction are unique Current tax law offers little assistance in resolving the problems that are bound to arise –The IRS can be expected to issue guidelines that will aid taxpayers in utilizing the manufacturers’ deduction correctly

34. C7 - 34 Individual Income Taxes Net Operating Losses (slide 1 of 7) Definition of net operating loss (NOL) –Business losses from any one year can be taken as a FOR AGI deduction and offset past or future income –Losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL Definition of net operating loss (NOL) –Business losses from any one year can be taken as a FOR AGI deduction and offset past or future income –Losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL

35. C7 - 35 Individual Income Taxes Net Operating Losses (slide 2 of 7) Definition of NOL (continued) –No nonbusiness (personal) losses or deductions may be used in computing NOL Exception: personal casualty and theft losses Definition of NOL (continued) –No nonbusiness (personal) losses or deductions may be used in computing NOL Exception: personal casualty and theft losses

36. C7 - 36 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

37. C7 - 37 Individual Income Taxes Net Operating Losses (slide 4 of 7) Example of NOL carryovers –Ken has a NOL for 2005 –Ken must carryover his NOL in the following order: Carryback to 2003 and 2004, then carryforward to 2006, 2007,..., 2025 –Ken can elect to just carryforward his NOL Carryover would be to 2006, 2007,..., 2025 Example of NOL carryovers –Ken has a NOL for 2005 –Ken must carryover his NOL in the following order: Carryback to 2003 and 2004, then carryforward to 2006, 2007,..., 2025 –Ken can elect to just carryforward his NOL Carryover would be to 2006, 2007,..., 2025

38. C7 - 38 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

39. C7 - 39 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

40. C7 - 40 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

41. C7 - 41 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