1. Chapter 5 Introduction to Business Expenses ©2006 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

2. Transparency 5-2 © 2006 South-Western All tax deductions are a matter of Legislative Grace Deductions are part of Congress’ approach to implementation of Ability-to-Pay Concept Review

3. Transparency 5-3 © 2006 South-Western Review! vFrom Chapter 1: All deductible amounts fall into one of three categories: FBusiness Expenses (Chapters 5 & 6) FLosses (Chapter 7) FDeductions (Chapter 8)

4. Transparency 5-4 © 2006 South-Western Review! There are two primary types of deductions allowed individuals: vDeductions for adjusted gross income Fgenerally have a business purpose vDeductions from adjusted gross income Fgenerally have a personal purpose

5. Transparency 5-5 © 2006 South-Western Review! vItems subject to special tax treatment are kept separate vItems not subject to special tax treatment are netted to arrive at ordinary net income or net loss Conduit entities are not subject to tax, but results of operations flow-through to owners’ returns.

6. Transparency 5-6 © 2006 South-Western Classification of Deductions All expenditures fall into two categories: ¶Profit-motivated FTrade or business expenses FExpenses for the production of income (Investment) ·Personal FSpecifically allowed itemized deductions FNondeductible personal expenses

7. Transparency 5-7 © 2006 South-Western  Profit-Motivated Expenditures vShow that the expense is related to a profit-motivated transaction vShow that the business purpose is the primary or dominant motive To be deductible, an expenditure must have a business purpose unrelated to its tax effect.

8. Transparency 5-8 © 2006 South-Western Trade or Business vRequirements to qualify as a trade or business: FPrimary purpose is to earn income or a profit FInvolvement is regular and continuous FActivity is not merely a hobby

9. Transparency 5-9 © 2006 South-Western Rental Activity vRental activities may be either trade or business or for the production of income FExpenses are always deducted for AGI FClassification matters when property is sold vClassification is determined by the scope of the taxpayer’s involvement

10. Transparency 5-10 © 2006 South-Western Mixed-Use (  &  ) Business and Personal Use vMixed-Use Assets FUsed both to earn income and for personal purposes FTreat as two separate assets by allocating amount of use vMixed-Use Expenditures FIncurred both for profit and personal reasons FAllocate between business and personal use and deduct as allowed

11. Transparency 5-11 © 2006 South-Western 3 Positive Tests for Deductibility and also To be deductible, expenses must be profit-motivated or specifically allowed, and also ¶Ordinary FNormal, common, generally accepted ·Necessary FAppropriate, helpful, prudent ¸Reasonable in amount FArm’s length

12. Transparency 5-12 © 2006 South-Western 5 Negative Tests for Deductibility To be deductible, expenses must not be ¶Personal FBusiness purpose is not primary motive FNot specifically allowed ·Capital Expenditures FShould be capitalized as assets if useful life extends beyond a year FStart-up costs VAfter 10/23/04 may expense $5,000 in first year; remainder is amortized over 180 months VExpense is phased-out if total costs > $50,000

13. Transparency 5-13 © 2006 South-Western 5 Negative Tests for Deductibility ¸Against Public Policy FResulting from violation of a law FResulting from an illegal business VCost of goods sold are always deductible under the capital recovery concept VOrdinary, necessary, and reasonable business expenses are deductible for all illegal businesses except sale of drugs FFor lobbying and political activities VCosts to influence local legislation are deductible VCosts to monitor any legislation are deductible

14. Transparency 5-14 © 2006 South-Western 5 Negative Tests for Deductibility ¹Related to Tax-Exempt Income FIncurred to generate tax-exempt income ºAnother Person’s Obligation FCannot recover another’s capital

15. Transparency 5-15 © 2006 South-Western Mixed-Use Expenses Hobby Vs. Business An income-earning activity without a predominant profit motive is a hobby.

16. Transparency 5-16 © 2006 South-Western Mixed-Use Expenses Hobby Vs. Business vFactors considered in determining profit-motive are FManner of conducting activity FExpertise or reliance on expert advice FTime and effort spent on activity FHistory of income and loss FAmount of occasional profit FElements of personal pleasure FSuccess in similar activities

17. Transparency 5-17 © 2006 South-Western Mixed-Use Expenses Hobby vLosses from a hobby are not deductible FExpenses allowed up to amount of income generated FDeductions taken using three tier system: ¶Expenses also allowed as personal itemized deductions ·Other expenses that qualify as business expenses ¸Depreciation on assets used FAllowable expenses are deducted from AGI

18. Transparency 5-18 © 2006 South-Western Mixed-Use Expenses Vacation Home A residence used for personal vacations and also rented to unrelated people is a mixed-use asset and first must be classified as either: FPersonal residence if rented less than 15 days in a year FVacation home if used personally èmore than 14 days, or èmore than 10% of the number of days rented FRental property if used personally èless than 15 days, or èless than or equal to 10% of the days rented

19. Transparency 5-19 © 2006 South-Western Vacation Home Tax Treatment If classification is: vPersonal residence vVacation home vRental property Then tax treatment is: Report no income or expense Report income and allocate expenses using three tier system (no loss allowed) Report income and allocate all expenses; Loss allowed

20. Transparency 5-20 © 2006 South-Western Mixed-Use Expenses Home Office A taxpayer who operates a trade or business from home may be able to deduct a portion of the home’s expenses. vExpenses of the home are allocated between business and personal use

21. Transparency 5-21 © 2006 South-Western Mixed-Use Expenses Home Office vA specific portion of the home must be used FExclusively and regularly, FAs the principal place of business or as a place to meet clients, but VIf taxpayer has no other available location to do administrative or management activities, this requirement will not disqualify the deduction

22. Transparency 5-22 © 2006 South-Western Mixed-Use Expenses Home Office vEmployees must also show that the use FIs for the convenience of their employer FRequired as a condition of employment vAllowed expenses are deducted using the three tier system vDeduction is limited to the amount of net income from the business FHome-office deduction may not create a loss FExcess may be carried-forward

23. Transparency 5-23 © 2006 South-Western Timing of Deductions The taxpayer’s accounting method is used to determine the timing of deductions.

24. Transparency 5-24 © 2006 South-Western Timing of Deductions Cash Method vCash Method: claim a deduction in the year an expense is paid FDate of mailing for checks FDate of charge for credit cards FPrepaid expenses are deductible if used within one tax year (prepaid interest does not qualify)

25. Transparency 5-25 © 2006 South-Western Timing of Deductions Accrual Method vAccrual Method: claim a deduction in the year two tests are met FAll-events test is met when a liability exists and the amount can be determined FEconomic performance test is met when services or property are provided

26. © 2004 South-Western College Publishing Timing of Deductions Related Party Accrued Expenses Deductions for accrued expenses payable to a cash basis related party are limited. vRelated parties include family members and businesses owned or controlled by the taxpayer vUnless both parties are accrual basis, both report using the cash method; until income is reported no expense may be deducted

27. Transparency 5-27 © 2006 South-Western Financial Accounting Income Vs. Taxable Income vMatching and Conservatism are not tax concepts vEstimates of expenses are not permitted for tax purposes FUse specific write-off for bad debts FDo not estimate warranty expense

28. Transparency 5-28 © 2006 South-Western End of Chapter 5