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Chapter 12

Chapter 12. Expenses Incurred in Business and Profit-Oriented Activities. Net Profits v. Gross Receipts. Tax on Net Profits Gross Receipts Less: Cost of Goods Sold Equals: Gross income Less: Business Expenses Equals: Net Profits For wage earners and salaried employees

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Chapter 12

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  1. Chapter 12 Expenses Incurred in Business and Profit-Oriented Activities

  2. Net Profits v. Gross Receipts • Tax on Net Profits Gross Receipts Less: Cost of Goods Sold Equals: Gross income Less: Business Expenses Equals: Net Profits • For wage earners and salaried employees • Deductions allowed from Gross Receipts is limited • The cost of earning a living is deductible, BUT the cost of living is not deductible.

  3. Statutory Provisions Business Expenses § 162 Expenses of Producing Income § 212 Cost of Goods Sold § 471 Depreciation §§§ 167, 168 and 197 Losses § 165 Hobbies § 183

  4. Business Expenses § 162 “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” • Cost must be an expense • Expense must be ordinary • Expense must be necessary • Expense must be paid or incurred during the taxable yr • Expense must be paid or incurred while carrying on a trade or business

  5. For / From AGI • Business Expenses § 162 • For AGI – nonemployee expenses and reimbursed employee expenses • From AGI – Itemized Deduction subject to 2% floor – employee expenses • Expenses for Producing Income § 212 • For AGI – rents and royalties • From AGI – Itemized Deduction subject to 2% floor - investment expenses

  6. Business-Personal Borderline Inherently Personal – no deduction for expenses incurred whether a taxpayer works or not (even though also serves business purpose) Excess Cost – deduction only for additional expenses incurred for business Allocation – deduction only for business portion Primary Purpose – full deduction for expense incurred if primarily for business purpose (personal benefit – by-product)

  7. Borderline Expenses Food and Shelter Clothing and Personal Grooming Medical Expenses Care of Dependents Commuting Expenses Entertainment Expenses § 274 Business Use of Personal Residences § 280A Education Litigation Expenses Expenses to Protect taxpayer’s Reputation Expenses of Public Officials

  8. Qualified Deductions “Ordinary” – normal, usual, and customary for the particular business (not necessarily often) “Necessary” – appropriate and helpful in developing taxpayer’s business “Reasonable” – paid by the taxpayer to an independent party

  9. Welch v. Helvering Facts: Issue: Decision: Reasons:

  10. Qualified Deductions (continued) • Current expense or capital expenditure • § 263A – denies deduction for amounts paid for acquisition, improvement, or betterment of property • Personal expense or business expense • Ordinary expense or extraordinary expense • Unusual, idiosyncratic, or unique expenditures; could have been avoided or reflect unusual business judgments

  11. Compensation for Personal Services • Disallows unreasonable amounts of compensation • Applied to closely held corporations – inflated salaries to controlling shareholders and related persons • Deductible salaries vs. nondeductible dividends • Disallows payments inflated to disguise a nondeductible transfer

  12. Criteria of Reasonableness • Position held by employee • Hours worked and duties performed • General importance to success of company • Comparison of past duties and salary with current responsibilities and compensation • Comparison with other companies • Size of company, complexity, economic conditions • Existence of exploitable relationship • Bonus system/dividend policy of the company “Independent investor” test – Exacto Springs Corp. v. CIR

  13. Limitations on Compensation Deductions by Corporations • Golden Parachute Payments § 280G • Compensation Exceeding $1 Million § 162(m) – paid to employees of publicly held corporations

  14. Illegal Payments, Bribes, Fines, etc. • Frustration of public policy doctrine – allowance of unlawful payments and bribes would encourage unlawful conduct • In 1969, § 162 amended to disallow deductions for: • Illegal bribes, kickbacks, etc. § 162(c) • Fines and penalties § 162 (f) • Treble damages (excess damages assessed due to a violation harmful to society in general) § 162(g) • In 1982, § 280E added to disallow deductions for illegal trafficking in controlled substances

  15. Lobbying and Other Legislative Activities § 162(e) • Prohibits any deduction for most lobbying expenses • Influencing legislation at highest levels • Local level legislation excluded with respect to matters of direct interest to the taxpayer’s business (i.e., deductible) • § 276 prohibits the deduction of amounts spent for political advertising or for admission to political dinners and similar events

  16. Lobbying and Other Legislative Activities § 162(e) (continued) • Disallows deduction for expenditures for participation or intervention in a political campaign • Disallows deduction for portion of dues paid to a tax-exempt organization allocable to organization’s lobbying expenses

  17. Trade or Business • Trade or business (Higgins v. CIR, CIR v. Groetzinger) • Manner in which business is carried on • Expertise of taxpayer or advisers • Time and effort expended by taxpayer • Expectation that assets may appreciate in value • Success of taxpayer in other similar or dissimilar activities • Taxpayer’s history of income or losses • Amount of occasional profits, if any • Financial status of the taxpayer • Elements of personal pleasure or recreation

  18. “Carrying On” Requirement • Two stages in development of a business • Investigatory stage – • used to review different businesses to make decision • Investigatory and start-up costs • Organizational and Start-up Costs • Still not engaged in business, but preparing for it • Organizational expenditures include expenditures to form and organize a business in the form of a corporation or a partnership and are incurred prior to the starting business • Start-up costs are costs businesses incur to start up a business

  19. Chapter 1 Personal Exemptions and Itemized Deductions

  20. Tax Formula Income (broadly conceived) $x,xxx Less:Exclusions(x,xxx) Gross Income $x,xxx Less:Deductionsfor AGI (x,xxx) Adjusted Gross Income (AGI) $x,xxx Less:The greater of- Total itemized deductions or the standard deduction (x,xxx) Personal & dependency exemptions(x,xxx) Taxable Income $x,xxx

  21. Personal and Dependency Exemptions • § 151(b) – allows each individual taxpayer to deduct a personal exemption of $3,650 for 2010/2011. • § 151(c) – allows an individual taxpayer to deduct a dependency exemption for each dependent individual who meets all five dependency tests

  22. WFTRA • One objective of the Working Families Tax Relief Act of 2004 (WFTRA of 2004) • Establish a uniform definition of qualifying child for purposes of the: • Dependency exemption • Head-of-household filing status • Earned income tax credit • Child tax credit • Credit for child and dependent care expenses • Beginning in 2009, a child is a qualifying child for purposes of the child tax credit only if taxpayer can and does claim an exemption for the child.

  23. Dependency Exemptions • A dependency exemption is available for one who is either a qualifying childor a qualifying relative • A qualifying child must meet the following tests: (§ 152(c)) • Relationship • Abode • Age • Support • Joint Return § 152(b)(2) • Citizenship or Residency § 152(b)(3)

  24. Relationship Test § 152(c)(2) • The child must be the taxpayer’s: • Son or daughter • Stepson or stepdaughter • Brother or sister • Stepbrother or stepsister • Half brother or half sister, or • A descendant of such individual (e.g., grandchildren, nephews, nieces) • A child who has been adopted, or whose adoption is pending, qualifies • A foster child may also qualify

  25. Age Test § 152(c)(3) • The child must be under age 19 or under age 24 in the case of a student • A student is a child who, during any part of five months of the year, is enrolled full time at a school or government-sponsored on-farm training course • Individuals who are disabled are not subject to the age test • If they fail the age test, they may qualify under QR. • Just added for 2009 – child must be younger than the person claiming him/her unless the child is permanently and totally disabled.

  26. Abode Test § 152(c)(1)(B) • A qualifying child must live with the taxpayer for more than half of the year • Temporary absences from the household due to special circumstances (e.g., illness, education) are not considered

  27. Support Test § 152(c)(1)(D) • To be a qualifying child, the individual must not be self-supporting • Cannot provide more than one-half of his or her own support • “food, shelter, clothing, medical and dental care, education, and the like,” recreation, and transportation • welfare and social security benefits, although excluded from gross income • rental value of housing • does not include value of uncompensated personal services provided (i.e., cooking, cleaning, nursing) • does not include scholarships received by dependent

  28. Tiebreaker Rules § 152(c)(4)(B) • In situations where a child may be a qualifying child for more than one person • Tiebreaker rules specify which person has priority in claiming the dependency exemption • Beginning in 2009, no person can claim the child unless their AGI is higher than the highest AGI of any parent who could claim the child

  29. Qualifying Relative § 152(d) • In order to claim a dependency exemption for a qualifying relative, the following tests must be met: • Relationship • Gross income • Support • Joint Return • Citizenship or Residency

  30. Relationship Test § 152(d)(2) • The relationship test for a qualifying relative is more expansive than for a qualifying child. Also included are the following relatives: • Lineal ascendants (e.g., parents, grandparents) • Collateral ascendants (e.g., uncles, aunts) • Certain in-laws (e.g., son-, daughter-, father-, mother-, brother-, and sister-in-law) • The relationship test also includes unrelated parties who live with the taxpayer

  31. Gross Income Test § 152(d)(1)(B) • Dependent must have gross income of less than the exemption amount (<$3,650 for 2010/2011) • Tax-exempt income is excluded from gross income

  32. Support Test § 152(d)(1)(C) • Taxpayer must provide more than 50% of the qualifying relative’s support • Only amounts expended are considered in the support test • Scholarships are not considered in the support test • Two exceptions to the support test: • Multiple support agreements • Children of divorced parents

  33. Divorced or Separated Parents § 152 (e) • Special rules apply if the parents meet the following conditions: • They would have been entitled to the dependency exemption had they been married and filed a joint return • They have custody (either jointly or singly) of the child for more than half of the year • Under the general rule, the parent having custody of the child for the greater part of the year (i.e., the custodial parent) is entitled to the dependency exemption • General rule does not apply if • A multiple support agreement is in effect • Custodial parent issues a waiver in favor of the noncustodial parent (Form 8332)

  34. Multiple Support Agreements§ 152 (d)(3) No one person contributed more than 50% More than 50% is contributed by a group of persons who would have been entitled to claim the dependency exemption (except for the support test) A member who contributed more than 10% can claim the dependency exemption File Form 2120 - designates the person who is to claim the dependency exemption

  35. Joint Return Test § 152(b)(2) • Dependent cannot file a joint return with spouse unless: • Filing solely for refund of tax withheld • No tax liability exists for either spouse • Neither spouse required to file return

  36. Citizenship or Residency Test §152(b)(3) • Dependent must be a U.S. citizen or a resident of U.S., Canada, or Mexico for some part of the calendar year in which the taxpayer’s tax year begins • An exception provides that an adopted child need not be a citizen or resident of the U.S. (or a contiguous country) as long as his or her principal abode is with a U.S. citizen

  37. Itemized Deductions §63(d) • A partial list of itemized deductions includes: • Medical expenses (in excess of 7.5% of AGI) • Certain taxes and interest • Charitable contributions • Casualty Losses (in excess of 10% of AGI) • Deductions for expenses related to • The production or collection of income, and • The management of property held for the production of income • Certain miscellaneous itemized deductions (in excess of 2% of AGI)

  38. Miscellaneous Itemized Deductions • Allowed only to the extent that their aggregate amount exceeds 2% of AGI • Defined as: § 67(b) • All deductions other than those in §62, interest, taxes, casualty and wagering losses, charitable contributions, medical expenses • Generally INCLUDES – unreimbursed employee business expenses (§162) and investment expense (§212)

  39. Filing Status 2010 Basic/ Additional Single $5,700 / $1,400 MFS 5,700 / 1,100 Head of Household 8,400 / 1,400 MFJ 11,400 / 1,100 Standard Deduction § 63(e) allows a standard deduction to taxpayers who do not elect to itemize Standard Deduction = Basic + Additional Additional for blind or age > 65 (per each occurrence)

  40. Qualifications • Standard deduction is denied to: • MFS couples if either spouse itemizes • nonresident aliens • individual filing a short year tax return, because of a change in tax year • Standard deduction is limited for individuals claimed as a dependent to greater of: • $800, or • Earned income + $250

  41. Housing Assistance Tax Act of 2008 • For 2008, a property tax deduction is available for non-itemizers • The deduction is added to the standard deduction and is limited to the lesser of: • The amt of real property taxes paid during the year • $500 ($1,000 for MFJ) • Extended through 2009 and 2010

  42. First-time Homebuyer Credit • Began in 2008 • $7,500 – required to be repaid over 15 years • Extended/expanded for 2009-2010 • Through 6/30/2010 for contract signing, closing by 9/1/2010 • Increased to $8,000 • No requirement to repay • In addition, payments that reduce the balance of a home mortgage under the Home Affordable Modification Program are not taxable.

  43. Other Incentives • Making Work Pay Credit (expiring in 2010) • 6.2% of earned income, limited to $400 per person, phased out at $95,000 single and 150,000 MFJ • Administered through an adjustment to wage withholding • Car Purchases (expiring in 2010) • Above-the-line deduction for state sales and excise tax incurred in vehicle purchases • Unemployment Compensation (expiring in 2010) • Exclusion from gross income for up to $2,400 of unemployment compensation benefits • Net Disaster Loss (expiring in 2010) • Increased standard deduction for net disaster loss

  44. Chapter 13 Capital Expenditures

  45. §263 • § 263 - disallows deductions for: • cost of acquisition or construction of buildings, furniture and fixtures, and similar property having a useful life > 1 year • amounts paid to add value or prolong useful life of property • amounts paid to adapt property to a new or different use

  46. Benefit Extending Substantially Beyond the Taxable Year Separate and Distinct Asset - permits deduction of items of short life and small cost (tools and supplies)(CIR v. Lincoln Savings & Loan Ass’n) Current v. Future Benefits - rejected Lincoln Savings & Loan Ass’n and concluded that a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is undeniably important(INDOPCO, Inc. v. CIR) Matching still counts (US Freightways v. CIR)

  47. Capital Expenditures • Cost of Acquisition (Woodward v. CIR; US v. Hilton Hotels) • Assets which produce a continuing, long-term benefit • Basis is equal to cost • Cost of defending or perfecting title (Georater v. US; Medco Products v. CIR) • Includes fees for a new title as well as defending a pre-existing one • Cost of disposal (Stegar v. CIR) • Deductible in the year of disposal

  48. Commissioner v. Idaho Power Facts: Issue: Decision: Reasons:

  49. §263A • § 263A - (Uniform Capitalization Rules) Requires capitalization of both direct and indirect costs to: • produce real or tangible personal property used by taxpayer in trade or business (PPE) • produce or hold property for sale to customers (inventory)

  50. Repairs vs. Improvements and Replacements • Repairs – deductible (Midland Empire Packing v. CIR) • Neither materially increase the value nor appreciably prolong life, but keep in an ordinarily efficient operating condition • Generally must remedy a defect • Improvements and Replacements – capitalized (Mt. Morris Drive-In Theatre v. CIR) • To the extent that they arrest deterioration and appreciably prolong life, or adapt to a new or different use

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