1. Chapter 6 Business Expenses ©2006 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

2. Transparency 6-2 © 2006 South-Western All deductions are a matter of Legislative Grace Just because GAAP allows a deduction, don’t assume tax law will too!

3. Transparency 6-3 © 2006 South-Western Business Expenses qAll expenses must first meet the basic tests for deductibility - FHave a business purpose FBe ordinary, necessary, and reasonable FBe allowed under the Legislative Grace Concept

4. Transparency 6-4 © 2006 South-Western Business Expenses Substantiation Requirements qExpenses related to Meals, Entertainment, Automobile Usage, Travel, and Business Gifts are deductible subject to limitations and strict documentation requirements FAmount FTime and place FDate and description FBusiness purpose FBusiness relationship of other person(s)

5. Transparency 6-5 © 2006 South-Western Meals and Entertainment Meals and entertainment expenses must be directly related to or associated with the active conduct of a business activity.

6. Transparency 6-6 © 2006 South-Western Meals and Entertainment Directly Related Test qThe “directly related to” test is met if FThere is more than a general expectation of business benefit FA bona fide business activity takes place during the meal or entertainment FThe principal reason for the meal or entertainment is business FThe expenses are related to the taxpayer and people involved in the business activity

7. Transparency 6-7 © 2006 South-Western Meals and Entertainment Associated With Test qThe “associated with” test is met if FThere is a clear business purpose for the meal or entertainment FThe meal or entertainment directly precedes or directly follows a substantial business discussion

8. Transparency 6-8 © 2006 South-Western Meals and Entertainment Costs qMeal costs include food, beverage, tax, and tips qEntertainment costs include expenses for clubs, theaters, and sporting events FOnly the face amount of a ticket is allowed FClub dues do not qualify

9. Transparency 6-9 © 2006 South-Western Meals and Entertainment Cost Limitations qOnly 50% of the allowable costs may be deducted qExceptions to the 50% limitation FReimbursed expenses FExpenses that are taxable income to a non-employee recipient (awards, prizes) FExpenses for recreational or social activities which benefit employees

10. Transparency 6-10 © 2006 South-Western Auto Expenses General Requirements qThe cost of using an automobile for business is deductible FUse of the automobile must be for travel VOut of town VFrom home to a temporary workplace VFrom the regular to a temporary workplace VFrom the workplace to a second job FThe cost of commuting is never deductible.

11. Transparency 6-11 © 2006 South-Western Auto Expenses qAuto expenses may be computed under one of two methods: FActual Cost FStandard Mileage Rate

12. Transparency 6-12 © 2006 South-Western Auto Expenses Actual Cost Method qThe actual cost of using the automobile may be deducted FThe business percentage of depreciation, gas and oil, repairs, insurance, interest, license fees, etc. is deductible FDeduction amount is often larger than the standard rate

13. Transparency 6-13 © 2006 South-Western Auto Expenses Standard Mileage Rate Method qThe administrative convenience concept allows a deduction based on the number of business miles driven during the year FRate is $0.405 per mile FTolls, parking, interest and property taxes may be added qStandard rate method is not allowed if multiple cars are used

14. Transparency 6-14 © 2006 South-Western Travel Expenses qTravel expenses incurred while on business away from the tax home overnight are deductible FTax home is the principal area in which business is conducted FOvernight means longer than a regular workday

15. Transparency 6-15 © 2006 South-Western Travel Expenses Limitations qOver 50% of the activity requiring travel must have a business purpose FPersonal activity costs on a business trip are not deductible FIncidental business expenses on a personal trip are deductible FTravel for general educational purposes or for investment related meetings is not deductible

16. Transparency 6-16 © 2006 South-Western Business Gifts qThe cost of a gift given to a business customer may not be fully deductible FThere is an overall limitation of $25 per person, per year FGifts are not subject to the 50% entertainment limits FDelivery, gift wrap, engraving, etc., do not count toward the $25

17. Transparency 6-17 © 2006 South-Western Education Expenses qCosts of education are deductible if FRequired by law (or employer) to maintain employment, or FMaintains or improves current job skills qCosts of education are not deductible if FNecessary to meet minimum job requirements, or FQualifies taxpayer for new trade or business

18. Transparency 6-18 © 2006 South-Western qUnreimbursed allowable costs are deductible as miscellaneous itemized deduction qEmployee may exclude up to $5,250 of reimbursed expenses from a qualified plan Education Expenses

19. Transparency 6-19 © 2006 South-Western Compensation of Employees qWages, salaries, bonuses and other compensation paid to employees is deductible if two basic tests are met: FEmployees must perform actual service FPayment must be reasonable in amount

20. Transparency 6-20 © 2006 South-Western Compensation of Employees Reasonable Compensation qSome factors considered when determining if compensation is reasonable are FDuties, responsibilities and pay history of the employee FVolume and complexity of the business FTime required to do the work FAbility and accomplishments of the employee FCompany pay policy

21. Transparency 6-21 © 2006 South-Western Compensation of Employees Reasonable Compensation qPayments to a related party may be examined closely for FLack of a business purpose FAn arms-length transaction FReality of compensation in a closely-held business

22. Transparency 6-22 © 2006 South-Western Compensation of Employees Reasonable Compensation qSize of deduction for salary paid to a covered employee is limited F CEO and the four highest paid officers are covered employees F$1,000,000 limit on compensation deduction per employee FSome amounts are exempt from the limit Vcommissions and performance based payments Vpension plan contributions Vfringe benefits

23. Transparency 6-23 © 2006 South-Western Bad Debts qBusiness bad debts are deductible only under the accrual method qNonbusiness (investment) bad debts are deductible if the debt is bona fide FReport as a short-term capital loss FNo deduction is allowed if the debt is voluntarily forgiven Bad debts are generally deductible under the capital recovery concept.

24. Transparency 6-24 © 2006 South-Western Insurance FFire, theft, casualty or liability FGroup medical, term-life and worker’s compensation FPerformance and fidelity bonds FBusiness interruption Insurance premiums paid to protect a business from the following losses are deductible.

25. Transparency 6-25 © 2006 South-Western Taxes qExceptions: FSales taxes related to long-lived assets must be capitalized FProperty taxes related to real estate bought or sold during the year must be allocated between buyer and seller FAssessments for local benefits are added to the property’s basis Most business related taxes are deductible unless paid to the federal government.

26. Transparency 6-26 © 2006 South-Western Legal Fees Legal fees are deductible if they were paid to defend business income, reputation, or goodwill FIf fees are related to property ownership, they are capitalized with the cost of the property

27. Transparency 6-27 © 2006 South-Western Individual Deductions For Adjusted Gross Income Expenses paid by individuals Ffor a business purpose, or Fspecifically allowed by Congress to create equity in tax treatment are allowed as deductions for AGI.

28. Transparency 6-28 © 2006 South-Western Accountable Plan qReimbursements = expenses Fnothing is reported qReimbursements < expenses Freimbursement is reported as income Fexpenses = reimbursement income are deducted for AGI Fexcess expenses are deducted from AGI qReimbursements > expenses and excess is not returned Fexcess reimbursement is reported as income Employees are required to make an adequate accounting of their expenses.

29. Transparency 6-29 © 2006 South-Western Nonaccountable Plan Employees are not required to make an adequate accounting of their expenses. qAll reimbursements are included in income qAll expenses are deducted from AGI

30. Transparency 6-30 © 2006 South-Western Deductions for Self-Employed Taxpayers To provide self-employed taxpayers equity with the tax treatment of employees, they are allowed to deduct: qThe cost of health insurance premiums paid for themselves q50% of the amount of self-employment tax paid

31. Transparency 6-31 © 2006 South-Western Retirement Plan Contribution Deductions Taxpayers who do not have access to an employer sponsored pension plan are allowed several options: FKeogh or H.R.10 plans (for self-employed taxpayers only) FIndividual Retirement Accounts (for all taxpayers)

32. Transparency 6-32 © 2006 South-Western Individual Retirement Accounts Contributions qAll taxpayers may contribute a maximum of $4,000 of their earned income to a Deductible or a Roth IRA. FSpecial “Catch-up” rule allows up to $4,500 if 50 or older qA married couple may contribute $8,000 in total ($9,000 if over 50), but not more than $4,000 ($4,500) to any one account.

33. Transparency 6-33 © 2006 South-Western Three Major IRA Types qConventional qRoth qEducational

34. Transparency 6-34 © 2006 South-Western 1. Conventional IRA qContributions limited to lesser of $4,000 ($4,500 if > 50) or amount of earned income FFully deductible if not covered by an employer’s plan VNot linked to spouse’s coverage FIf covered, maximum deduction equals: (Maximum contribution) X [1 - {(AGI - phase-out) / $10,000}]

35. Transparency 6-35 © 2006 South-Western Conventional IRA: Phase-out Amounts

36. Transparency 6-36 © 2006 South-Western Conventional IRA - Example qSingle taxpayer with AGI = $58,000 contributes $4,000 to an IRA. How much is deductible if the t/p is covered by a qualified plan? $4,000 X [ 1 - ($58,000 - $50,000)/10,000] =$4,000 X [ 1 - 0.80] =$4,000 X 0.20 =$600 maximum deduction

37. Transparency 6-37 © 2006 South-Western 2. Roth IRA qContributions are not deductible qEarnings distributions are tax-free if FIRA has existed for 5 years, and FTaxpayer is >59 1/2 years old FNo age limit to begin distributions qContributions are phased-out like Conventional IRA FMarried, between $150,000 to $160,000 FOthers, between $95,000 to $110,000

38. Transparency 6-38 © 2006 South-Western 3. Educational IRA qSet up as a trust for the benefit of any person under age 18 q$2,000 nondeductible contribution per student per year FPhased-out for AGI greater than VMarried, from $190,000 VOthers, from $95,000 Max. contribution X [1 - {(AGI - phase-out) / 15,000}]

39. Transparency 6-39 © 2006 South-Western 3. Educational IRA Continued qTax-free growth in the IRA qNo tax at time of withdrawal if used for qualified expenses FTuition and fees of student

40. Transparency 6-40 © 2006 South-Western Higher Education Expense Deduction qMay deduct up to $4,000 of qualifying higher education expense FQualifying = tuition and fees FMust have AGI < $65,000 if single ($130,000 for MFJ) FCannot claim in addition to HOPE or Lifetime Learning Credits

41. Transparency 6-41 © 2006 South-Western Educational Loan Interest qMay deduct up to $2,500 for interest paid on education loans FTaken as a “for” deduction FOnly for payments made during first 60 months of the loan FDeduction phased-out when AGI exceeds VMarried, from $105,000; Others, from $50,000 Deduction = Amt. Paid X [1 - {(AGI - phase-out) / 15,000}]

42. Transparency 6-42 © 2006 South-Western Moving Expenses Moving expenses are deductible if they meet two tests. 1. Distance test Old house Old job x + 51 miles x miles New job

43. Transparency 6-43 © 2006 South-Western Moving Expenses Time Test 2. Time Test FEmployee taxpayers must be employed in the new area for 39 weeks of the 12 months after moving FSelf-employed taxpayers must be employed in the new area for 78 weeks of the 24 months after moving FWaived for death, disability, or required transfer

44. Transparency 6-44 © 2006 South-Western Moving Expenses Qualifying Expenses qOnly two types of expenses are deductible: FCosts of moving household goods and personal items to the new location FTransportation and lodging costs of moving the taxpayer and family to the new location VMileage is allowed at $0.15 per mile VNone of the cost of meals is deductible

45. Transparency 6-45 © 2006 South-Western Moving Expenses Reimbursements qAny reimbursement of moving expenses received from an employer is included as income

46. Transparency 6-46 © 2006 South-Western End of Chapter 6