1. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 6 Business Expenses Murphy & Higgins Concepts in Federal Taxation, 2014 edition

2. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Concept Review  All deductions are a matter of legislative grace Just because GAAP allows a deduction, don’t assume tax law will too!

3. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Business Expenses - Review  All expenses must first meet the basic tests for deductibility: Have a business purpose Be ordinary, necessary, and reasonable Be allowed under the legislative grace concept

4. Business Expenses Expenses related to Meals, Entertainment, Automobile Usage, Travel, and Business Gifts are deductible subject to limitations and strict documentation requirements Documentation Requirements  Amount  Time and place  Date and description  Business purpose  Business relationship of other person(s) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Meals and Entertainment  To be deductible meals and entertainment expenses must be directly related to or associated with the active conduct of a business activity

6. Meals and Entertainment: Directly Related To The “directly related to” test is met if:  There is more than a general expectation of business benefit  A bona fide business activity takes place during the meal or entertainment  The principal reason for the meal or entertainment is business  The expenses are related to the taxpayer and people involved in the business activity © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Meals and Entertainment – Associated With The “associated with” test is met if:  There is a clear business purpose for the meal or entertainment  Meal or entertainment directly precedes or directly follows a substantial business discussion © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Meals and Entertainment: Deductible Costs and Limitations  Meal costs Food, beverage, tax, and tips  Entertainment costs Expenses for clubs, theaters, and sporting events Only the face amount of a ticket is allowed Club dues do not qualify  Limitations Only 50% of the allowable costs may be deducted Exceptions to the 50% limitation  Reimbursed expenses  Expenses that are taxable income to a non-employee recipient (awards, prizes)  Expenses for recreational or social activities which benefit employees

9. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Auto Expenses  The cost of using an automobile for business is deductible  Deductibility Requirements Use of the automobile must be for travel  Out of town  From home to a temporary workplace  From the regular to a temporary workplace  From the workplace to a second job The cost of commuting is never deductible

10. Auto Expense Methods (2) – Actual Cost Method  Actual cost method Actual cost of using the automobile may be deducted  Business percentage of depreciation, gas and oil, repairs, insurance, interest, license fees, etc. is deductible  Deduction amount is often larger than the standard rate © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Auto Expense Methods – Standard Mileage Method  Standard mileage rate method Administrative convenience concept allows a deduction based on the number of business miles driven during the year  Rate is $0.565 per mile (2013)  Tolls, parking, interest and property taxes may be added Standard rate method is not allowed if multiple cars are used © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Travel Expenses  Travel expenses incurred while on business away from the tax home overnight are deductible Tax home is the principal area in which business is conducted Overnight means longer than a regular workday  Limitations 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

13. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Business Gifts  Cost of a gift given to a business customer may not be fully deductible There is an overall limitation of $25 per person, per year Gifts are not subject to the 50% entertainment limits Delivery, gift wrap, engraving, etc., do not count toward the $25 limitation

14. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Education Expenses  Costs of education are deductible if Required by law (or employer) to maintain employment, or Maintains or improves current job skills  Costs of education are not deductible if Necessary to meet minimum job requirements, or Qualifies taxpayer for new trade or business  Unreimbursed allowable costs are deductible as miscellaneous itemized deduction subject too the 2% floor  Employee may exclude up to $5,250 of reimbursed expenses from a qualified plan

15. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Compensation of Employees (slide 1 of 2)  Wages, salaries, bonuses and other compensation paid to employees is deductible if two basic tests are met: Employees must perform actual service Payment must be reasonable in amount  To determine if compensation is reasonable, consider: Duties, responsibilities and pay history of the employee Volume and complexity of the business Time required to do the work Ability and accomplishments of the employee Company pay policy  Payments to a related party may be examined closely for Lack of a business purpose An arms-length transaction Reality of compensation in a closely-held business

16. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Compensation of Employees (slide 2 of 2)  Size of deduction for salary paid to a covered employee is limited Covered employees = CEO and the four highest paid officers $1,000,000 limit on compensation deduction per employee Some amounts are exempt from the limit  Commissions and performance based payments  Pension plan contributions  Fringe benefits

17. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bad Debts  Bad debts are generally deductible under the capital recovery concept  Business bad debts are deductible only under the accrual method  Nonbusiness (investment) bad debts are deductible if the debt is bona fide Report as a short-term capital loss No deduction is allowed if the debt is voluntarily forgiven

18. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Qualified Production Activities Deduction (Slide 1 of 2)  Amount of Deduction 9% of the lesser of:  Qualified Production Activities Income OR  Taxable Income before Qualified Production Activities Deduction Cannot Exceed 50% of W-2 wages allocable to domestic production gross receipts of the Taxpayer  Qualified Production Activities Income Domestic Gross Production Receipts  Less the allocable:  Cost of Goods Sold  Direct Expenses and Losses  Indirect Expenses and Losses

19. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Qualified Production Activities Deduction (Slide 2 of 2)  Domestic Gross Production Receipts arise from Sale, exchange, lease, rental or other disposition of:  Qualifying property manufactured, produced, grown, or extracted in the U.S.  Qualified films produced  Electricity, natural gas, or potable water produced in the U.S. Construction activities performed in the U.S. Engineering or architectural services performed in the U.S.  Qualified Production Property Tangible Personal Property Computer Software Sound Recordings  Retailers who buy from taxpayers with qualified production activities may not claim sales of those products as gross production receipts

20. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Carlton, Inc. has gross receipts from qualified production activities of $7,500,000. The COGS related to these activities is $3,000,000. The related direct costs are $250,000. Carlton estimates that 40% of the $500,000 indirect costs is attributable to the activities. Taxable income before the QPAD is $4,600,000. What is Carlton’s QPA income? ($7,500,000 - $3,000,000 - $250,000 – (.40 x $500,000) = $4,050,000 What is Carlton’s QPAD? Lesser of: (9% x $4,050,000) or (9% x $4,600,000) = 9% x $4,050,000 = $364,500 QPAD Example

21. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Insurance, Legal Fees, and Taxes  Insurance Insurance premiums paid to protect a business from the following losses are deductible.  Fire, theft, casualty or liability  Group medical, term-life and worker’s compensation  Performance and fidelity bonds  Business interruption  Legal fees Legal fees are deductible if they were paid to defend business income, reputation, or goodwill  If fees are related to property ownership, they are capitalized with the cost of the property  Taxes Most business-related taxes are deductible unless paid to the federal government Exceptions:  Sales taxes related to long-lived assets must be capitalized  Property taxes related to real estate bought or sold during the year must be allocated between buyer and seller  Assessments are not taxes but are for local benefits are added to the property’s basis

22. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Individual Deductions For Adjusted Gross Income  Expenses paid by individuals For a business purpose, or Specifically allowed by Congress to create equity in tax treatment are allowed as deductions for AGI  Alimony  Reimbursed Employee Business Expenses Accountable Reimbursement Plan Non-accountable Reimbursement Plan

23. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reimbursed Employee Business Expenses - Accountable Plan  Employees are required to make an adequate accounting of their expenses  Reimbursements = expenses Nothing is reported  Reimbursements < expenses Reimbursement is reported as income Expenses = reimbursement income are deducted for AGI Excess expenses are deducted from AGI  Reimbursements > expenses and excess is not returned Excess reimbursement is reported as income

24. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reimbursed Employee Business Expenses - Nonaccountable Plan  Employees are not required to make an adequate accounting of their expenses All reimbursements are included in income All expenses are deducted from AGI

25. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Deductions for Self-Employed Taxpayers  To provide self-employed taxpayers equity with the tax treatment of employees, they are allowed to deduct: The cost of health insurance premiums paid for themselves 50% of the amount of self-employment tax paid 50% of the amount of the hospital insurance tax imposed on self-employed income over the threshold amount

26. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Retirement Plan Contribution Deductions  Taxpayers who do not have access to an employer sponsored pension plan are allowed several options: Keogh or H.R.10 plans (for self-employed taxpayers only) Individual Retirement Accounts (for all taxpayers)  Individual retirement accounts contributions: All taxpayers may contribute a maximum of $5,500 of their earned income to a Deductible or a Roth IRA.  Special “Catch-up” rule allows up to $6,500 if 50 or older A married couple may contribute $11,000 in total ($13,000 if over 50), but not more than $5,500 ($6,500) to any one account  Two major Retirement IRA types: Conventional Roth

27. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Conventional IRA  Contributions limited to lesser of $5,500 ($6,500 if > 50) or amount of earned income Fully deductible if not covered by an employer’s plan  Not linked to spouse’s coverage If covered, maximum deduction equals: (Maximum contribution) x [1 – IRA percentage*]* (AGI - phase-out) / $10,000 ($20,000 MFJ)  Phase out amounts Tax YearMarriedSingle 2013$95,000$59,000 2012$92,000$58,000

28. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Conventional IRA Example  Single taxpayer with AGI = $60,000 contributes $5,500 to an IRA. How much is deductible if the t/p is covered by a qualified plan? $5,500 X [ 1 - ($60,000 - $59,000)/10,000] = $5,500 X [ 1 - 0.10] = $5,500 X 0.90 = $4,950 maximum deduction

29. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Roth IRA  Contributions are not deductible  Earnings distributions are tax-free if: IRA has existed for 5 years, and Taxpayer is >59 1/2 years old No age limit to begin distributions  Contributions are phased-out like Conventional IRA Married beginning at $178,000 Others beginning at $112,000

30. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Coverdell Education Savings Account (CESA)  Set up as a trust for the benefit of any person under age 18  $2,000 nondeductible contribution per student per year Phased-out for AGI greater than  Married, from $190,000  Others, from $95,000  Max. contribution x [1 - {(AGI - phase-out) / 15,000}]  Tax-free growth in the IRA  No tax at time of withdrawal if used for qualified expenses Tuition and fees of student

31. Deduction for Higher Education Expenses  For AGI deduction  Maximum deduction of $4,000 for tuition and fees paid  For taxpayers with AGI >$130,000 MFJ, $65,000 all others  Reduced to $2,000 for taxpayers with AGI between $130,000 and $160,000 MFJ, or between $65,000 and $80,000 all others  Cannot take this deduction and claim an American Opportunity Tax credit or a lifetime Learning credit  May receive a distribution from an educational IRA but not for the same expenses © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Education Loan Interest  May deduct up to $2,500 for interest paid on education loans Taken as a “for” deduction Only for payments made during first 60 months of the loan Deduction phased-out when AGI exceeds  Married, $120,000; Others, $60,000  Deduction = Amt. Allowed x [1 - {(AGI - phase-out) / 15,000}]

33. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Moving Expenses (slide 1 of 2)  Moving expenses are deductible if they meet two tests: Distance test Time test  Employee taxpayers must be employed in the new area for 39 weeks of the 12 months after moving  Self-employed taxpayers must be employed in the new area for 78 weeks of the 24 months after moving  Waived for death, disability, or required transfer New job x + 51 miles Old house x miles Old job

34. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Moving Expenses (slide 2 of 2)  Qualifying Expenses Only two types of expenses are deductible:  Costs of moving household goods and personal items to the new location  Transportation and lodging costs of moving the taxpayer and family to the new location  Mileage is allowed at $0.24 per mile  None of the cost of meals is deductible  Reimbursements Any reimbursement of moving expenses received from an employer is included as income