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Chapter 7 Overview of Deductions and Losses

Chapter 7 Overview of Deductions and Losses Deductions Authorized by General Sections of the IRC Positive Criteria (general allowance of ded.): Sec. 162: Expenses of carrying on a T/B Sec. 212: Expenses for production of income Sec. 165: Losses Sec. 172: NOL

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Chapter 7 Overview of Deductions and Losses

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  1. Chapter 7Overview of Deductions and Losses

  2. Deductions Authorized by General Sections of the IRC • Positive Criteria (general allowance of ded.): • Sec. 162: Expenses of carrying on a T/B • Sec. 212: Expenses for production of income • Sec. 165: Losses • Sec. 172: NOL • Negative Criteria (general disallowance of ded.): • Sec. 262: Personal, living and family expenses, page 25 • Sec. 263: Capital expenditures • Sec. 265: Expenses & interest relating to tax exempt income - Example 40 • Sec. 162: expenses contrary to public policy Examples 35, 36, 37, 38, 39

  3. Trade or Business Expenses vs. Expenses for the Production of Income • Sec. 162 Requirements: • T/B Related: • Intention to make a profit • Entrepreneurial/personal effort required • No hobbies • Ordinary and Necessary • Reasonable in amount • Paid/incurred during the year

  4. Trade or Business Expenses vs. Expenses for the Production of Income • Sec. 212 Requirements: • For production of income or • for management of property held for production of income or • in connection with the determination, collection or refund of any tax • Ordinary and necessary • “reasonable” is implied • Entrepreneurial/personal effort not required • Paid/incurred during the year • Why bother with the distinction? • Deductibility for/from AGI • Limitations

  5. Deductible FOR or FROM AGI • History of IR Code Sec. 62 • Significance of classification FOR or FROM AGI • Deductions FOR AGI are deductible even if TP doesn’t itemize • Itemized deductions are deducted FROM AGI only if they exceed the standard deduction • If itemized deductions < standard deduction, does the TP “lose” the deduction? • Pages 17 - 20

  6. Deductible FOR or FROM AGI • AGI is used as a base to limit several FROM AGI deductions EXAMPLES Casualties Medical Expenses • Many states use AGI as a starting point to determine state income taxes

  7. Deductible FOR AGI • Business Expenses (Sec. 162) • Rental Expenses (Sec. 212) • Alimony Paid • Gains and losses on property dispositions • Deductible contributions to tax deferred plans - IRAs, Keogh Plans, etc. • Reimbursed employee business expenses (if included in income) • Expenses incurred by a qualified performing artist • Moving expenses • Interest paid on student loans beginning in 1998 • Others

  8. Deductible FROM AGI • Personal Itemized Deductions • Medical and dental • Some taxes • Some interest • Charitable contributions • Casualties and thefts • Miscellaneous deductions not subject to 2% floor • Gambling losses to extent of gambling winnings (Sec. 165(d)) • Job expenses of handicapped • Amortizable bond premiums • Miscellaneous deductions subject to 2% floor

  9. Miscellaneous Itemized Deductions Subject to 2% of AGI Limitation • Employee Business Expenses • Dues to professional societies • Employment-related educational expenses • Job hunting expenses, including agency fees, resumes, etc. • Home office expenses • Outside salesperson expenses • Travel expenses • Transportation expenses • Subscriptions to professional journals and magazines • Work clothes and uniforms • Union dues and fees • 50% of unreimbursed business entertainment expenses

  10. Miscellaneous Itemized Deductions Subject to 2% of AGI Limitation • Expenses for the Production of Income • Legal and accounting fees • Custodial fees related to income-producing property • IRA fees • Fees paid to collect interest or dividends • Hobby expenses (limited to hobby income) • Investment counsel fees • Rental cost of safe deposit boxes used to store non-tax-exempt securities

  11. Miscellaneous Itemized Deductions Subject to 2% of AGI Limitation • Other Miscellaneous Itemized Deductions • Fees paid for investment counsel • Tax counsel and assistance • Cost of tax services, periodicals, return preparation manuals • Appraisal fees establishing a casualty loss or charitable contribution

  12. Example of the 2% Limitation • AGI = $25,000 • Potential Miscellaneous Itemized Deduction = $800 • 25,000 X 2% = 500 (“2% floor”) • 800 - 500 limit = 300 misc. itemized deduction

  13. Deductions for Losses • Losses on personal use assets are deductible only if attributable to a casualty or theft • Individuals may deduct losses incurred in a • trade or business or • transaction entered into for profit • Events which trigger realization of gain or loss: • sale • abandonment • exchange • casualty or theft • involuntary conversion

  14. Tax Accounting Methods for Expenditures • Cash Basis: • Generally, recognize income when payments are received, recognize expenses when paid. • Modification to Cash Basis Reporting for Expenditures: • Generally, cash basis TPs may deduct currently prepayments made for assets if: • Business purpose for prepayment • Asset will be consumed before end of next year • Income will not be materially distorted • Accrual method must be used for sales and COGS when inventories are income producing

  15. More Modifications to Cash Basis Reporting for Expenditures • Prepayments for Rent & Services: deduct only when: • Prepayments are for 1 year or less and • TP is obligated legally to prepay • Prepaid Insurance: always accrue • Prepaid Interest: accrue only Except for “points” paid for loan on personal residence.

  16. More Modifications to Cash Basis Reporting for Expenditures • Points paid on personal residence mortgages • Definition of “Points” • Prepaid points incurred to secure a loan on a principle residence are deductible currently if: • Paid by the buyer or seller • They are not withheld from loan proceeds, i.e. they are paid from a separate fund. • If points paid for refinancing, accrue the deductions

  17. Tax Accounting Methods for Expenditures • Accrual Basis Reporting: • Generally recognize income when earned and expenses when incurred • Modifications to Accrual Basis: • To deduct an expense, 2 things must be satisfied • All events test must be satisfied • All events which legally fix liability have occurred and • liability can be estimated with reasonable accuracy • And “Economic performance” must have occurred Example: Warranties, contingent liabilities may not be accrued unless there is reasonable basis to estimate the amount

  18. Tax Accounting Methods for Expenditures • “Economic Performance” • When TP provides goods or services • Economic performance occurs when the TP provides the goods or services • When TP receives goods or services • Economic performance occurs when TP receives goods or services, or uses the property in the case of rentals • Exhibit 7-1

  19. Exception to Economic Performance Requirement • If “economic performance” has not occurred but will occur within 8 1/2 months of end of period and • Expense is of reoccurring nature and • TP consistently accrues the item and • Accruing results in a better match against revenue, then ok to accrue • Example 17 Example: One-time payment in November for snow removal for season, may be accrued.

  20. Self-employed v. Employee Instructions Integration* Training Services rendered personally Hiring, supervising, and paying assistants Continuing relationship Employer-defined hours of work Full-time required Doing work on the employer’s premises Setting the order or sequence of work Self-employed v. Employee Oral or written reports required Payment by the hour, week, month* Payment of business or travel expense Furnishing of tools, materials Significant investment* Realization of profits or loss Working for more than one firm at a time Making services available to the general public Right to discharge* Right to terminate* Common Law Factors That Indicate “Control” (IRS)

  21. Disallowance of Losses on Transactions Between Related Parties -- Sec. 267(b) • “Related parties under Sec. 267(b) • lineal antecedents and descendants • brothers and sisters • spouses • TP and his/her corporation or P/S if the TP owns > 50% directly or indirectly • Estates and their beneficiaries - Examples 44, 45, 46 RULE Losses are disallowed between related parties. But, disallowed losses may be used to offset gains on a subsequent sale to an unrelated party.

  22. FMV = 20 Basis = 30 (10) FMV = 35 Basis = 20 asset Disallowance of Losses on Transactions Between Related Parties -- Sec. 267(b) Example: Father (F) sells Daughter (D) an antique asset realized loss, not recognized Later, D sells the asset to an unrelated party 15 realized gain (10) F’s previously disallowed loss 5 gain recognized by D

  23. Limitation on Deduction for Executive Compensation • Publicly held corporations may deduct maximum of $1,000,000 of “compensation” to certain employees. • “Publicly Held Corporations” • Listed on a national securities exchange and • At least $5,000,000 in assets and • At least 500 shareholders • Covered Employees • CEO plus • Any of four most highly paid officers • “Applicable Employee Remuneration” • Includes: Cash and benefits • Excludes: Commissions; performance related pay if approved by shareholders; payment to a qualified retirement plan

  24. Repairs vs. Improvements • Tax Treatment: • Deduct repair expenses currently • Capitalize improvements (a.k.a. betterments) • Distinguishing between repairs and improvements • Improvements: Any expenditure for a property that • Materially increases its value, or • Materially prolongs its life, or • Changes its use for the taxpayer • Repairs: expenditures that are not improvements • Examples • Pages 26, 27, 28

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