1. © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Essentials of Taxation 1 Chapter 5 Business Deductions

2. 2 The Big Picture (slide 1 of 4) Michael Forney operates his small engine service and repair business as a C corp. with a December 31 year- end, uses the accrual method of accounting, and has $435,500 of gross income. Forney owns 80% of the corp’s stock, while his wife, Kathleen, and his mother, Terry, each own 10% of the stock. Michael is a full-time employee at his business. –His mother helps out with the books for about two hours a week. –At this time, Kathleen does not work at the business.

3. 3 The Big Picture (slide 2 of 4) Michael Forney reports the following expense information from his small engine service and repair business. Salaries and wages (including Michael’s salary of $55,000 and Terry’s salary of $3,000) $150,000 Building rent 24,000 Depreciation of machinery, equipment, and office furnishings* 13,000 Insurance (coverage for all assets) 6,000 Consulting Fees6,000 Utilities 12,000 Taxes and licenses 6,000 Advertising 3,000 Interest expense 3,000 Charitable contributions 3,000 Dues –Small Engine Repair Institute10,000 Political contributions 2,000 *$130,000 of new machinery and equipment were purchased this year. The financial reporting system depreciation is based on straight-line depreciation over 10 years. The MACRS cost recovery period for tax purposes is 7 years. Prior year assets have been fully depreciated.

4. 4 The Big Picture (slide 3 of 4) Michael would like to know the amount of his deductible expenses for tax purposes and would like your advice on another matter. Because his business has been very profitable over the years, it has built up large cash reserves, and its cash flow continues to be strong. –His business has never paid any dividends to the shareholders. For next year, he is considering paying himself a salary of $140,000 and his mother a salary of $30,000. –This would give them more cash to spend for planned vacations and home improvements.

5. 5 The Big Picture (slide 4 of 4) Finally, during the current year, Michael purchased another personal residence for $300,000 and converted his original residence to rental property. –The original residence cost $250,000 five years ago and has a current market value of $180,000. He also purchased a condo for $170,000 near his business, which he will rent out to tenants..

6. 6 Trade or Business Deductions (slide 1 of 2) Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including: –Reasonable salaries paid for services –Expenses for the use of business property

7. 7 Trade or Business Deductions (slide 2 of 2) In order for expenses to be deductible, they must be: –Ordinary: normal, usual, or customary for others in similar business, and not capital in nature –Necessary: prudent businessperson would incur same expense –Reasonable: question of fact –Incurred in conduct of business

8. 8 Methods of Accounting The method of accounting affects when deductions are taken –Cash: expenses are deductible only when paid –Accrual: expenses are deductible when incurred Apply the all events test and the economic performance test –Exception to the economic performance test for recurring items

9. 9 Expenditures Contrary To Public Policy Deductions are disallowed for certain specific types of expenditures that are considered contrary to public policy –Examples: penalties, fines, illegal bribes or kickbacks, two-thirds of treble damage payments for violation of anti-trust law

10. 10 Legal Expenses Incurred In Defense Of Civil Or Criminal Penalties To deduct legal expenses –Must be directly related to a trade or business, an income producing activity, or the determination, collection, or refund of a tax

11. 11 Expenses Relating To An Illegal Business Usual expenses of operating an illegal business are deductible –However, deduction for fines, bribes to public officials, illegal kickbacks, and other illegal payments are disallowed Trafficking in controlled substances: only cost of goods sold can reduce gross income

12. 12 Political Contributions And Lobbying Activities Generally, no business deduction is allowed for payments made for political purposes or for lobbying –Exceptions are allowed for lobbying: To influence local legislation, To monitor legislation, and De minimis in-house expenses (limited to $2,000) –If greater than $2,000, none can be deducted

13. 13 The Big Picture - Example 12 Political Contributions Refer to the facts of The Big Picture on p. 5-1. Michael Forney made political contributions to the U.S. Senate campaigns of Tim Kaine & George Allen –Mr. Forney made these contributions to encourage these candidates to support a new bill that is beneficial to small businesses. –Therefore, he assumed that these would be deductible business expenses. However, political contributions are not deductible, so he will receive no tax benefit from them.

14. 14 The Big Picture - Example 13 Lobbying Expenditures Refer to the facts of The Big Picture on p. 5-1. Mr. Forney’s business made contributions to the Small Engine Repair Institute, a trade association for owners of similar-type businesses. –The trade association estimates that 70% of its dues are allocated to lobbying activities. –Thus, the deduction on the corporate tax return is limited to $3,000 ($10,000 30%).

15. 15 Excessive Executive Compensation (slide 1 of 2) For publicly held corporations: –Deduction for compensation of CEO and four other highest compensated officers is limited to $1 million each –Does not include: Certain performance-based compensation Payments to qualified retirement plans Payments excludible from gross income

16. 16 Investigation Of A Business (slide 1 of 3) Investigation expenses - incurred to determine the feasibility of entering a new business or expanding an existing business –Include costs such as travel, engineering, architectural surveys, marketing reports, various legal and accounting services Tax treatment of these expenses depends on: –The current business, if any, of the taxpayer –The nature of the business being investigated –The extent to which the investigation has proceeded –Whether or not the acquisition actually takes place

17. 17 Investigation Of A Business (slide 2 of 3) If the taxpayer is in a business the same as or similar to that being investigated –Investigation expenses are deductible in the year paid or incurred The tax result is the same whether or not the taxpayer acquires the business being investigated

18. 18 Investigation Of A Business (slide 3 of 3) When the taxpayer is not in a business the same as or similar to that being investigated –Tax result depends on whether new business is acquired If not acquired –All investigation expenses generally are nondeductible If acquired –Investigation expenses must be capitalized –May elect to deduct the first $5,000 of expenses currently –Any excess expenses can be amortized over a period of not less than 180 months (15 years) –In arriving at the $5,000 immediate deduction allowed, a dollar-for- dollar reduction must be made for those expenses in excess of $50,000

19. 19 The Big Picture - Example 15 Investigation Of A Business Return to the facts of The Big Picture on p. 5-1. Michael Forney investigates the purchase of Southside Small Engine Services, LLC, a nearby competitor that is for sale. –Expenses paid to consultants and accountants as part of this investigation totaled $6,000. He determined that Southside Small Engine Services would not be a good investment, so he did not buy it. –The $6,000 spent to investigate this business is deductible as a business expense. –Mr. Forney is already in the small engine service and repair business.

20. 20 Capital Expenditures Amounts are capitalized Asset may be subject to depreciation (or cost recovery), amortization, or depletion

21. 21 Transactions Between Related Parties (slide 1 of 2) Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties –Family and entity relationships apply –Constructive ownership rules apply –Loss disallowed may reduce gain on subsequent disposition to unrelated third party

22. 22 Transactions Between Related Parties (slide 2 of 2) Section 267 also requires the matching principle be applied for unpaid expenses and interest when different accounting methods used –Example: An accrual basis, closely held corporation, cannot deduct accrued, but unpaid, salary to cash basis related party employee/shareholder until it is actually paid

23. 23 Expenses and Interest Relating to Tax-Exempt Income Expenses relating to production of tax-exempt income are nondeductible –Example: interest expense on loan where funds used to acquire municipal bonds

24. 24 Charitable Contributions (slide 1 of 2) Individuals and corporations may deduct contributions made to qualified domestic organizations Contributor must have donative intent and expect nothing in return –If contributor receives tangible benefit, the FMV of such benefit must be deducted from the amount of the contribution

25. 25 Timing of Charitable Contribution Deduction Generally, deductible in year in which the payment is made –Exception: An accrual basis corporation may take deduction in year preceding payment if: The contribution is authorized by the board of directors by the end of that year, and The contribution is paid on or before the fifteenth day of the third month of the following year

26. 26 Charitable Contribution Limitation A corporate taxpayer’s contribution deduction is limited to 10% of taxable income before –The charitable contribution deduction –Any NOL or capital loss carryback –The dividends received deduction, and –The domestic production activities deduction

27. 27 Charitable Contributions Carryover Contributions in excess of the 10% limit may be carried forward for 5 years –Any carryforward is added to subsequent contributions subject to the 10% limit –In carryforward year, current year contributions must be deducted first, with excess deductions from previous years deducted in order of time

28. 28 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

29. 29 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 “increasing” R&E expenditures is also available

30. 30 Domestic Production Activities Deduction (slide 1 of 4) 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: 9% × 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 paid to employees engaged in qualified production activities

31. 31 Domestic Production Activities Deduction (slide 2 of 4) 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. 32 Domestic Production Activities Deduction (slide 3 of 4) 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. 33 Domestic Production Activities Deduction (slide 4 of 4) 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

34. 34 Cost Recovery Recovery of the cost of business or income- producing assets is through: –Cost recovery or depreciation: tangible assets –Amortization: intangible assets –Depletion: natural resources

35. 35 Nature of Property Property includes both realty (real property) and personalty (personal property) –Realty generally includes land and buildings permanently affixed to the land –Personalty is defined as any asset that is not realty Personalty includes furniture, machinery, equipment, and many other types of assets Personalty (or personal property) should not be confused with personal use property –Personal use property is any property (realty or personalty) that is held for personal use rather than for use in a trade or business or an income-producing activity Write-offs are not allowed for personal use assets

36. 36 General Considerations (slide 1 of 3) Basis in an asset is reduced by the amount of cost recovery that is allowed and by not less than the allowable amount –Allowed cost recovery is cost recovery actually taken –Allowable cost recovery is amount that could have been taken under the applicable cost recovery method If no cost recovery is claimed on property –The basis of the property must still be reduced by the amount that should have been deducted i.e., The allowable cost recovery

37. 37 General Considerations (slide 2 of 3) If personal use assets are converted to business or income-producing use –Basis for cost recovery and for loss is lower of Adjusted basis or Fair market value at time property was converted –Losses that occurred prior to conversion can not be recognized for tax purposes through cost recovery

38. 38 General Considerations (slide 3 of 3) MACRS applies to: –Assets used in a trade or business or for the production of income –Assets subject to wear and tear, obsolescence, etc. –Assets that have a determinable useful life or decline in value on a predictable basis –Assets that are tangible personalty or realty

39. 39 The Big Picture - Example 40 Cost Recovery Basis for Personal Use Assets Converted to Business Use Return to the facts of The Big Picture p. 5-1. Five years ago Michael Forney purchased his personal residence for $250,000. –This year Michael found a larger home that he acquired for his personal residence. –Unfortunately he cannot sell his original residence and recover his purchase price of $250,000. The residence was appraised at $180,000. Instead of continuing to try to sell the original residence, Michael converted it to rental property. –The basis for cost recovery of the rental property is $180,000 because the fair market value is less than the adjusted basis. –The $70,000 decline in value is deemed to be personal (since it occurred while the property was held for personal use by Michael) and therefore nondeductible.

40. 40 MACRS-Personalty MACRS characteristics: MACRS Personalty. Statutory lives: 3, 5, 7, 10 yrs 15, 20 yrs Method: 200% DB 150% DB Convention: Half Yr or Mid-Quarter DB = declining balance with switch to straight-line Straight-line depreciation may be elected

41. 41 Half-Year Convention General rule for personalty Assets treated as if placed in service (or disposed of) in the middle of taxable year regardless of when actually placed in service (or disposed of)

42. 42 Example: Half-Year Convention Purchased and placed an asset in service on March 15 (Tax year end is December 31) –Treated as placed in service June 30 –Six months cost recovery in year 1 (and year disposed of, if within recovery period)

43. 43 Mid-Quarter Convention Applies when more than 40% of personalty is placed in service during last quarter of year Assets treated as if placed into service (or disposed of) in the middle of the quarter in which they were actually placed in service (or disposed of)

44. 44 Example: Mid-Quarter Convention Business with 12/31 year end purchased and placed in service the following used 5-year class assets: Asset 1: on 3/28 for $50,000, and Asset 2: on 12/28 for $100,000 More than 40% placed in service in last quarter; therefore, mid-quarter convention used: Asset 1: $50,000 × 35% (Table 5.2) = $17,500 Asset 2: $100,000 ×.05 (Table 5.2) = $5,000

45. 45 MACRS-Realty (slide 1 of 2) MACRS characteristics: MACRS Realty Residential Rental Nonresid. Realty Statutory lives: 27.5 yrs 31.5 yrs or 39 yrs Method: Straight-line Convention: Mid-month Residential rental real estate –Includes property where 80% or more of gross rental revenues are from nontransient dwelling units e.g., Apartment building –Hotels, motels, and similar establishments are not residential rental property

46. 46 MACRS-Realty (slide 2 of 2) Mid-month Convention –Property placed in service at any time during a month is treated as if it was placed in service in the middle of the month –Example: Business building placed in service April 25 is treated as placed in service April 15

47. 47 Optional Straight-line Election May elect straight-line rather than accelerated depreciation on personalty placed in service during year –Use the class life of the asset for the recovery period –Use half-year or mid-quarter convention as applicable –Election is made annually by class of property

48. 48 Additional First-Year Depreciation (slide 1 of 2) Additional first-year depreciation has been allowed for several years –In 2012 and 2013, 50% additional first-year depreciation was allowed Although the provision was written to expire at the end of 2013, Congress may extend this provision during 2015

49. 49 Additional First-Year Depreciation (slide 2 of 2) Additional first-year depreciation allows an additional 50% of cost recovery in year asset is placed in service Qualified property includes most types of new property other than buildings –Property that is used but new to the taxpayer does not qualify

50. 50 Example: Additional First-Year Depreciation Maple Company acquires a 5-year class asset on April 25, 2015, for $20,000. Maple’s cost recovery deduction for 2015 is computed as follows: 50% additional first-year depreciation ($20,000 X.50) $10,000 MACRS cost recovery [($20,000 - $10,000) X.20 (Exhibit 5.5)] 2,000 Total cost recovery $12,000

51. 51 Election to Expense Assets -Section 179 (slide 1 of 5) General rules –Can elect to immediately expense up to $500,000 of business tangible personalty placed in service in 2015 (maybe) –Cannot use § 179 for most realty or production of income property

52. 52 Election to Expense Assets -Section 179 (slide 2 of 5) Section 179 general rules –Amount expensed reduces depreciable basis –Any elected § 179 expense is taken before additional first-year depreciation is computed The base for calculating the standard MACRS deduction is net of the § 179 expense and the additional first-year depreciation (50% in 2015)

53. 53 Election to Expense Assets -Section 179 (slide 3 of 5) Annual limitations: –Expense limitation ($500,000 for 2015) is reduced by amount of § 179 property placed in service during year that exceeds $2,000,000 in 2015 Example: In 2015, taxpayer placed in service $2,015,000 of § 179 property. –The § 179 expense limit is reduced to $485,000 [$500,000 – ($2,015,000 – $2,000,000)]

54. 54 Election to Expense Assets -Section 179 (slide 4 of 5) Annual limitations: –Election to expense cannot exceed taxable income (before § 179) of taxpayer’s trades or businesses Any amount expensed under § 179 over taxable income limitation may be carried over to subsequent year(s) Amount carried over still reduces basis currently –The § 179 amount eligible for expensing in a carryforward year is limited to the lesser of The statutory dollar amount ($500,000 in 2015) reduced by the cost of § 179 property placed in service in excess of $2,000,000 (in 2015) in the carryforward year, or The business income limitation in the carryforward year.

55. 55 Election to Expense Assets -Section 179 (slide 5 of 5) Example:

56. 56 Listed Property (slide 1 of 4) There can be substantial limits on cost recovery of assets considered listed property Listed property includes the following: –Passenger automobile –Other property used as a means of transportation –Property used for entertainment, recreation, or amusement –Computer or peripheral equipment –Cellular telephone

57. 57 Listed Property (slide 2 of 4) To be considered as predominantly used for business, business use must exceed 50% Use of asset for production of income is not considered in this 50% test However, both business and production of income use percentages are used to compute cost recovery

58. 58 Listed Property (slide 3 of 4) To be considered as predominantly used for business (cont’d) If 50% test is met, then allowed to use statutory percentage method of cost recovery with some limitations

59. 59 Listed Property (slide 4 of 4) If asset is not used predominantly for business i.e., business use does not exceed 50% –Must use straight-line method –If business use falls to 50% or lower after year property is placed in service, must recapture excess cost recovery

60. 60 Passenger Auto Cost Recovery Limits (slide 1 of 7) For autos placed in service in 2014, cost recovery limits are: Year Recovery Limitation 1 $3,160 2 5,100 3 3,050 Succeeding years until the cost is recovered 1,875 If a passenger auto used predominantly for business qualifies for additional first-year depreciation –First-year recovery limitation is increased by $8,000 Limit increases from $3,160 to $11,160 ($3,160 + $8,000).

61. 61 Passenger Auto Cost Recovery Limits (slide 2 of 7) Limits are for 100% business use –Must reduce limits by percentage of personal use Limit in the first year includes any amount the taxpayer elects to expense under § 179

62. 62 Passenger Auto Cost Recovery Limits (slide 3 of 7) Example: Taxpayer acquired an auto in 2014 for $30,000 and used it 80% for business, and elects not to take additional first-year depreciation. 2014 cost recovery allowance: ($30,000 × 20%) × 80%$4,800 But deduction is limited to $3,160 × Business use % × 80% Cost recovery allowance$2,528

63. 63 Passenger Auto Cost Recovery Limits (slide 4 of 7) Limit on § 179 deduction –For certain vehicles not subject to the statutory dollar limits imposed on passenger automobiles the § 179 deduction is limited to $25,000 The limit applies to sport utility vehicles with an unloaded GVW rating of more than 6,000 pounds and not more than 14,000 pounds

64. 64 Passenger Auto Cost Recovery Limits (slide 5 of 7) Listed property that fails the >50% business usage test in year property is placed in service must be recovered using the straight-line method –Such property does not qualify for additional first-year depreciation If the >50% business usage test is failed in a year after the property is placed in service, straight-line method must be used for remainder of property’s life –Cost recovery of passenger auto under straight-line listed property rule still subject to annual limits

65. 65 Passenger Auto Cost Recovery Limits (slide 6 of 7) Change from predominantly business use –If the business use percentage falls to 50% or lower after the year the property is placed in service, the property is subject to cost recovery recapture –The amount recaptured as ordinary income is the excess cost recovery Excess cost recovery is the excess of the cost recovery deductions taken in prior years using the statutory percentage method over the amount that would have been allowed if the straight-line method had been used

66. 66 Passenger Auto Cost Recovery Limits (slide 7 of 7) Leased autos subject to inclusion amount rule –Using IRS tables, taxpayer has gross income equal to each lease year’s inclusion amount –Purpose is to prevent avoidance of cost recovery dollar limits applicable to purchased autos by leasing autos

67. 67 Amortization (slide 1 of 2) Can claim amortization deduction on § 197 intangibles –Use straight-line recovery over 15 years (180 months) beginning in month intangible is acquired Section 197 intangibles include acquired goodwill, going-concern value, trademarks, trade names, etc.

68. 68 Amortization (slide 2 of 2) Startup expenditures are also partially amortizable under § 195 –Treatment is available only by election Allows the taxpayer to deduct the lesser of: –The amount of startup expenditures, or –$5,000, reduced by the amount startup expenditures exceed $50,000 –Any amounts not deducted may be amortized ratably over 180-months beginning in month trade or business begins