1. Chapter 9 Business Income- Deductions-Acct- Methods Howard Godfrey, Ph.D., CPA Professor of Accounting ©Howard Godfrey-2015

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5. Classification of Expenses Profit motivated, Trade or business or Production of income, Rental, Personal, Mixed business and pleasure. Tests for Deductibility –Ordinary and necessary, Reasonable in amount. Limits on Deductions. Not against Public policy, Not political or lobbying. Not capital expenditure. Not an expense related to tax-exempt income, Not a personal expense. For taxpayer’s benefit- not paying an expense for another person. Timing – Cash or Accrual basis, Accrual to related party, Financial accounting & tax differences

6. Code Sections Sec. 161 - deductions permitted only for those expenses and losses for which a deduction is authorized Sec. 162(a) authorizes deductions for ordinary and necessary expenses, that are reasonable in amount, and incurred in actively carrying on a trade or business Sec. 212 authorizes deductions for expenses related to production of income (investment-related expenses)

7. Sec. 212. Expenses for Production of Income. In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year- (1) for the production or collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax.

8. Rules for Deductions for AGI. [1 of 7] A taxpayer reports income and can deduct reasonable expenses (and losses) for a trade or business operation. A taxpayer reports income and can deduct reasonable expenses (and losses) for a transaction entered into for profit, even though it does not meet the definition of a trade or business operation.

9. Rules for Deductions for AGI. [2 of 7] A trade or business operation often means providing goods or services to customers. (By comparison, an employee provides services to his or her employer.) When you buy an asset hoping to sell it later at a profit (such as buying IBM stock) you are not in a trade or business, but this is a transaction entered into for profit.

10. Rules for Deductions for AGI. [3 of 7] There is no good definition of a trade or business. An typical investor is not in a trade or business. However, Wachovia Securities invests in stocks and sells stocks to its customers. It is a business. If you buy land and build an apartment building on it for resale, you may not be in a trade or business. If you repeat this 20 times, you are in the real estate business (possibly as a real estate developer). When does your activity rise to the level that causes you to be in a trade or business? Who knows?

11. Rules for Deductions for AGI. [4 of 7] Expenses (and losses) are deductible “For AGI” if they are for a trade or business operation (generally providing goods or services to customers, clients, etc.). Expenses are deductible “For AGI” if they are for a transaction entered into for profit, and they involve property that generates rental income or royalty income. Expenses for other transactions entered into for profit are deductible as Misc. Item. Deductions.

12. Rules for Deductions for AGI.[5 of 7 ] A taxpayer can deduct reasonable expenses (and losses) for a trade or business operation. (Sec. 162) A taxpayer can deduct reasonable expenses (and losses) for a transaction entered into for profit, even though it does not meet the definition of a trade or business operation. (Sec. 212)

13. Rules for Deductions for AGI. [6 of 7] Renting property to tenants (for example under one-year contract or longer) is generally not a trade or business, unless you provide substantial services. A golf course technically rents you the land for a few hours, but you are mainly paying for service. A Marriott Hotel is a trade or business. They have many customers and they provide substantial services to their customers.

14. Rules for Deductions for AGI. [7 of 7] An employee is in the trade or business of being an employee, but is subject to special limits on deductions. Employee expenses are deductible from AGI (Misc. Deductions) except for reimbursed expenses. (If the reimbursement is included in income, there is an offsetting deduction for AGI. Usually, reimbursed expenses are not included in income, so there is no deduction.)

15. Sec. 62. Adjusted Gross Income Defined. (a) General Rule. For purposes of this subtitle, the term “adjusted gross income” means, in the case of an individual, gross income minus the following deductions: (1) Trade and business deductions. The deductions allowed by this chapter (other than by part VII of this subchapter) which are attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.

16. Sec. 62. Adjusted Gross Income Defined. Cont’d (a) General Rule. For purposes of this subtitle, the term “adjusted gross income” means……. (2) Certain trade and business deductions of employees. (A) Reimbursed expenses of employees. The deductions allowed by part VI ( section 161 and following) which consist of expenses paid or incurred by the taxpayer, in connection with the performance by him of services as an employee, under a reimbursement or other expense allowance arrangement with his employer. The fact that the reimbursement may be provided by a third party shall not be determinative of whether or not the preceding sentence applies. (Accountable Plan)

18. Meals & Entertainment. The deduction for business meals and entertainment expenses is limited to 50% of the qualified expenses The 50% limit is imposed on person (employer or employee) that ultimately pays the expense

19. Transportation Expenses. Certain transportation expenses incurred when the taxpayer is not away from home are deductible and include – the cost of transportation from one work location to another – transportation between home and a temporary work location if the taxpayer has a regular place of business – any meal costs are not deductible, however

20. Transportation Expenses The prorated business portion of actual auto expenses or a standard mileage rate (57.5¢ for 2015) plus related parking and tolls can be deducted Commuting expenses (between home and regular place of business) are a personal nondeductible expense

21. Documentation Expenses related to Meals, Entertainment, Automobile Usage, Travel, and Business Gifts are deductible subject to limitations and strict documentation requirements – Amount – Time and place – Date and description – Business purpose – Business relationship of other person(s)

24. Travel Away From Home Travel expenses incurred for temporary travel away from home (over night) on business are deductible. Qualifying expenses include lodging: (1) 50% of meals, (2) transportation to destination and back, and (3) incidental expenses – Away from home refers to person’s tax home; that is, the location of principal place of employment regardless of where the family residence is maintained

25. Temporary Assignments Temporary is defined as one year or less Employment away from home in a single location that is realistically expected to last (and does in fact last) for one year or less, will be treated as temporary Assignment for more than one year shifts tax home to the new location (no deduction for travel and living costs)

26. Combining Business with Pleasure Travel Over 50% of the activity requiring travel must have a business purpose – Personal activity costs on a business trip are not deductible – Incidental business expenses on a personal trip are deductible – Travel for general educational purposes or for investment related meetings is not deductible

27. Combining Business with Pleasure Travel For U.S. travel, if the trip is primarily for business, all transportation costs to and from destination are deductible If primary purpose is pleasure, no deduction for transportation Primary purpose is determined by the number of days on business versus personal days

30. Combining Business with Pleasure Travel Meals & lodging are deductible only for days on which business is conducted If a taxpayer remains in a temporary location to reduce costs as a result of – reduced airfare for Saturday night stays or – for business conducted on both Friday and Monday – the costs for additional days are deductible if they are less than the cost of returning home when business is completed

31. Travel Expenses - Martha Martha lives with her husband in Los Angeles but works in San Diego. During the week she stays in a hotel in San Diego and eats in restaurants. On weekends she flies home to Los Angeles. During the year, Martha spent $5,000 for the hotel, and $2,000 for meals while in San Diego. Her airfare for travel between San Diego and Los Angeles was $2,500. What is Martha’s deduction for travel expenses?

32. Travel Expenses-Martha Martha cannot deduct any travel expenses. Her tax home is in San Diego. Her travel to Los Angeles is purely personal and her expenses are nondeductible.

33. Transportation Expense-John John is a high school teacher. He travels three days per week to a school in the next county to work with gifted children in an after- school program that does not end until 6:30 P.M. He normally eats dinner before driving home. If he drives 75 miles each way on 90 days to the gifted program, his meal expense is $900, and he maintains adequate records, how much may John deduct?

34. Transportation Expense-John John is allowed to deduct his mileage only. He has no deduction for meals as he is not “traveling away from home.”

35. Business Gifts. Randy gave one of his best customers a $150 bottle of wine. How much can he deduct for this business gift?

36. Business Gifts – Slide 2 The deduction for business gifts is limited annually to $25 per donee.

37. Meals & Entertainment Directly-related expenses - costs incurred when a significant business discussion takes place between the taxpayer and a customer in atmosphere conducive to the serious conduct of business. Associated-with expenses - deductible when directly preceded or followed by a substantial business discussion – Deduction for entertainment tickets is limited to 50% of the tickets’ face value

38. Deductions Restriction No deduction allowed for the costs of owning and maintaining entertainment facilities such as hunting lodges and yachts No deduction allowed for membership dues and fees paid to social, athletic, or sporting clubs – Deductions are allowed for dues to professional organizations, public service organizations, and trade associations Deduction for business gifts limited to $25 per donee per year

42. Entertainment Expenses - Jim Jim, a self-employed individual, takes an important customer to the hockey playoffs. Although the face value of a ticket is only $70, he pays a scalper $400 for each ticket. Assuming all other requirements are met, how much can Jim deduct for the two tickets?

43. Entertainment Expenses-Jim $70. Entertainment tickets are not only subject to the 50% limit, but the 50% limit applies to the face value of the tickets. Thus, Jim is allowed a deduction for only one-half of the face value of the tickets or $70 (50% x $140).

47. Investor Losses An investor in the stock market deducts investment related expenses from AGI on Schedule A. An investor in the stock market reports gains (and deducts losses) on the sale of stock on Schedule D, and the net gain or loss (subject to loss limits) flows from Schedule D to the front of Form 1040. Capital losses from stock sales are deductible for AGI.

49. Business casualty and theft losses result from damage caused by a sudden, unexpected and/or unusual event – For property fully destroyed, deduct the adjusted basis less insurance recovery – For property partially destroyed, deduct lesser of the property’s adjusted basis, or the decline in the property’s value

50. Involuntary Conversions An involuntary conversion results from – Theft – embezzlement, larceny and robbery (but not simply losing items) – Casualty – requires a sudden, unexpected, and unusual event such as a fire, flood, tornado, hurricane or vandalism – Condemnation – lawful taking of property for its fair market value by a government under the right of eminent domain

51. Casualties and Thefts Gains and losses sustained on casualties and thefts are not under a taxpayer ’ s control so they receive special tax treatment – Allowable losses (including personal losses) are immediately deductible – Gains (due to receipt of insurance proceeds) may be deferred if all insurance proceeds are used to repair the damaged property or to acquire qualifying replacement property

52. Casualty and Theft Losses Partial destruction of Business or Investment Property– Loss limited to the lesser of: Decline in fair market value (or repair costs to restore property to pre-casualty condition), or The adjusted basis of the property Complete Destruction of Business Property For business property that is completely destroyed, the loss is always the property ’ s adjusted basis. The loss computed above is then reduced by any insurance proceeds received

55. Casualty &Theft Loss Deductions Thefts are deductible in year of discovery For casualties in designated disaster areas, taxpayer can elect to deduct loss in preceding year A net business loss is deducted from ordinary income; an investment loss is an itemized deduction Individuals have additional limits on losses from personal-use property: – $100 floor per casualty (per event) – 10% of AGI threshold – Must itemize to deduct loss

56. Jim's business building was totally destroyed by fire. The property had an adjusted basis of $150,000 and a FMV of $130,000 before the fire. Jim received insurance reimbursement of $120,000 for the destruction of the workshop. Jim's AGI was $70,000, before considering this loss. Jim had no casualty gains during the year. What is Jim’s fire loss deduction on his tax return? a. $ 2,900 b. $ 8,500 c. $ 30,000

59. Gains on Involuntary Conversions If the insurance recovery on a casualty or theft is greater than the loss, the taxpayer has a gain Condemnations usually result in gain because proceeds received are usually fair market value

60. Gains on Involuntary Conversions If all proceeds are used to acquire qualified replacement property (or repair the property to its pre-casualty condition) within the required replacement period, the gain is deferred Gain may have to be recognized if all proceeds are not used to acquire replacement property (or make repairs to the damaged property) within the required time period

61. Jane's residence was totally destroyed by fire. The property had an adjusted basis of $150,000 and a FMV of $130,000 before the fire. Jane received insurance reimbursement of $120,000 for the destruction of her home. Jane's adjusted gross income was $70,000. Jane had no casualty gains during the year. What amount of the fire loss was Jane entitled to claim as an itemized deduction on her tax return? a. $ 2,900 b. $ 8,500 c. $ 8,600 d. $10,000

62. Requirements for recognizing taxable income tend to be structured to recognize income earlier than the recognition rules for GAAP accounting. Requirements for accruing tax deductions tend to be structured to recognize less accrued expenses than the recognition rules for GAAP reporting purposes. The government's main objective for writing tax laws is to collect revenues. Tax accounting rules for accrual-method businesses tend to bias against understating income.

70. Income Taxes – Nike. The Company accounts for income taxes using the asset and liability method. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. The allowance for uncollectible accounts receivable was $78 million and $78 million at May 31, 2015 and 2014, respectively, of which $24 million and $37 million, respectively, was classified as long-term and recorded in Deferred income taxes and other assets. Why?

75. Accrual Accounting-Revenues-1 REG §1.451-1.methods of accounting.. income is included in gross income [when] all events have occurred that fix the right to receive the income, and the amount can be determined with reasonable accuracy.

82. Note: We will not cover inventory methods in this course. We assume you have covered several chapters on inventories in prior accounting courses. So you will not have test questions on inventory in this course. None on Uniform Capitalization rules either.

84. Timing of Deductions – Tax Rules Accrual method – expenses deductible when – “All events” have occurred that fix liability and – “Economic performance” occurs (property or services provided or used) Cash basis taxpayer - expenses deductible when paid – Date check is mailed – Date charged on credit card

85. Accrual Accounting-Expenses-1 REG §1.461-1...methods of accounting …a liability is incurred, …, [when] all events have occurred that establish the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

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98. Bad Debt Expense. Specific charge-off method must be used Investment and personal loans are considered nonbusiness (capital losses) Loan must be valid debt No bad debt deduction for cash basis taxpayers who have not previously included amount in income

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107. The End