Maximizing Business Deductions for Small Engine Service and Repair Business

1. Chapter 5 Business Deductions

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. 2

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 Fees 6,000 Utilities 12,000 Taxes and licenses 6,000 Advertising 3,000 Interest expense 3,000 Charitable contributions 3,000 Dues –Small Engine Repair Institute 10,000 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. 3

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. 4

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. Read the chapter and formulate your response. 5

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 • One-half of self-employment taxes paid • Such expenses are deducted for AGI

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. 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

9. 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

10. The Big Picture - Example 3Ordinary and Necessary Requirement Return to the facts of The Big Picture on p. 5-1. The business, a closely held C corp, is owned by Michael Forney, his wife, Kathleen, and his mother, Terry. The company has been highly profitable. It has never paid dividends. Michael is the key employee of the business. His mother plays a very minor role. Assume their current salaries of $55,000 and $3,000 are comparable to what they could earn at similar companies for the work they do. 10

11. The Big Picture - Example 3Ordinary and Necessary Requirement If Mr. Forney’s plan to double his salary and increase his mother’s salary by tenfold is implemented, the amounts in excess of their current salaries may be deemed unreasonable. If so, the excess would be disallowed as deductible salary and treated as dividends to Michael and Terry. Salaries are deductible by the corporation, but dividends are not. Salaries would be taxed at ordinary income rates and are subject to payroll taxes. However, dividend income would be taxed at long-term capital rates if qualified. 11

12. 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

13. 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

14. 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

15. 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

16. 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

17. Disallowance Possibilities • The tax law disallows the deduction of certain types of expenses for a variety of reasons • e.g., May restrict taxpayer attempts to deduct certain items that, in reality, are personal expenditures • Certain disallowance provisions are a codification or extension of prior court decisions • e.g., After courts denied deductions for payments in violation of public policy, tax law was changed to provide specific authority for the disallowance

18. 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

19. The Big Picture - Example 9Violations of Public Policy Refer to the facts of The Big Picture on p. 5-1. Michael Forney had not instituted proper procedures for disposing of used motor oil and other engine fluids from his business. During the current tax year, he was fined $3,000 by the city. Mr. Forney believes the fine should be deducted as an ordinary business expense. However, because the fine was due to a violation of public policy, the $3,000 is not deductible. 19

20. 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 • e.g., Corporate officer’s legal fees in defending against price-fixing charges • e.g., Landlord’s legal fees associated with eviction of tenant

21. 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

22. 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

23. The Big Picture - Example 12Political 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. 23

24. The Big Picture - Example 13Lobbying 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%). 24

25. 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

26. Excessive Executive Compensation (slide 2 of 2) An additional limitation applies only to covered executives of companies receiving Troubled Asset Relief Program (TARP) assistance The deduction for compensation paid to a covered executive is limited to $500,000 Covered employees include the CEO, the CFO, and the three other most highly compensated officers 26

27. 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

28. 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

29. 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

30. The Big Picture - Example 15Investigation 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. 30

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

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

33. 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

34. 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

35. 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

36. 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

37. The Big Picture - Example 19Related Parties – Disallowed Losses Return to the facts of The Big Picture on p. 5-1. Michael Forney, an 80% shareholder, sells a stock investment in his personal portfolio with a basis of $10,000 to his corporation for its fair market value of $8,000. Michael’s $2,000 loss from the sale of the stock is disallowed because the sale is to a related party. Michael’s business sells the stock several years later for $11,000. Only $1,000 of gain is taxable to the business upon the subsequent sale. $11,000 selling price - $8,000 basis - $2,000 previously disallowed loss. 37

38. The Big Picture - Example 20Related Parties – Disallowed Losses Assume the same facts as Example 19, except that the corporation sells the stock for $9,000 to an unrelated party. The corporation’s gain of $1,000 ($9,000 selling price - $8,000 basis) is not recognized because of the right of offset from Michael’s sale of $2,000. The offset may result in only a partial tax benefit upon the subsequent sale (as in this case). If Michael had sold the stock to an unrelated party rather than to his corporation, he could have recognized a $2,000 loss. However, aggregating the effect to Michael and his corporation, they can benefit from only $1,000 of loss. 38

39. 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

40. 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 40

41. Charitable Contributions(slide 2 of 2) Contribution must be to qualified domestic nonprofit organization or state or possession of U.S. or any subdivisions thereof Many (but not all) qualified domestic charities are listed in IRS Publication #78 41

42. 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 42

43. Ordinary Income Property Defined: assets that would produce ordinary income or short-term capital gain if sold Contribution amount FMV of asset less ordinary income (or STCG) potential; generally the lower of adjusted basis or FMV 43

44. Capital Gain Property Defined: assets that would produce long-term capital gain or Section 1231 gain if sold Contribution amount Generally FMV of asset 44

45. Exceptions to FMV Deduction of Capital Gain Property (slide 1 of 2) Private nonoperating foundations Deduction for contributions to certain private nonoperating foundations must be reduced by the amount of capital gain potential Thus, the amount is limited to the adjusted basis 45

46. Exceptions to FMV Deduction of Capital Gain Property (slide 2 of 2) If a corporation contributes tangible personal property and the charitable organization puts the property to an unrelated use The appreciation on the property is not deductible Unrelated use is defined as use that is not related to the purpose or function that qualifies the organization for exempt status 46

47. Example of Contributions of Tangible Personalty Taxpayer contributes painting to local charity: FMV $100,000 and adjusted basis $10,000 If charitable organization is a local museum that hangs the painting for patrons to view, taxpayer has $100,000 contribution deduction If charitable organization is a local church that sells the painting immediately to obtain funds for its operation, taxpayer has $10,000 contribution 47

48. Exceptions Related to Contributions of Ordinary Income Property (slide 1 of 2) In general, the deduction for a contribution of ordinary income property is limited to the basis of the property On certain contributions of inventory by corps, the amount of the deduction is equal to the lesser of The property’s basis plus 50% of the appreciation on the property, or Twice the property’s basis 48

49. Exceptions Related to Contributions of Ordinary Income Property (slide 2 of 2) This increased deduction amount is available for inventory contributions of Property to a charitable organization for use in its exempt function Such use is solely for the care of the ill, needy, or infants Tangible personal research property constructed by the corp. to a qualified educational or scientific organization Must use the property for research, experimentation, or for research training Property must be contributed within 2 years from date of construction by donor, and Its original use must begin with the donee 49

50. Charitable ContributionLimitation 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 50