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Chapter 5

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Chapter 5

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  1. Chapter 5 Introduction to Business Expenses Kevin Murphy Mark Higgins ©2007 South-Western

  2. Concept Review All tax deductions are a matter of Legislative Grace Deductions are part of Congress’ approach to implementation of Ability-to-Pay

  3. Review! • From Chapter 1: All deductible amounts fall into one of three categories: • Business Expenses (Chapters 5 & 6) • Losses (Chapter 7) • Deductions (Chapter 8)

  4. Review! There are two primary types of deductions allowed individuals: • Deductions for adjusted gross income • generally have a business purpose • Deductions from adjusted gross income • generally have a personal purpose

  5. Review! • Items subject to special tax treatment are kept separate • Items not subject to special tax treatment are netted to arrive at ordinary net income or net loss Conduit entities are not subject to tax, but results of operations flow-through to owners’ returns.

  6. Classification of Deductions All expenditures fall into two categories: • Profit-motivated • Trade or business expenses • Expenses for the production of income (Investment) • Personal • Specifically allowed itemized deductions • Nondeductible personal expenses

  7.  Profit-Motivated Expenditures To be deductible, an expenditure must have a business purpose unrelated to its tax effect. • Show that the expense is related to a profit-motivated transaction • Show that the business purpose is the primary or dominant motive

  8. Trade or Business • Requirements to qualify as a trade or business: • Primary purpose is to earn income or a profit • Involvement is regular and continuous • Activity is not merely a hobby

  9. Rental Activity • Rental activities may be either trade or business or for the production of income • Expenses are always deducted for AGI • Classification matters when property is sold • Classification is determined by the scope of the taxpayer’s involvement

  10. Mixed-Use ( & ) Business and Personal Use • Mixed-Use Assets • Used both to earn income and for personal purposes • Treat as two separate assets by allocating amount of use • Mixed-Use Expenditures • Incurred both for profit and personal reasons • Allocate between business and personal use and deduct as allowed

  11. 3 Positive Tests for Deductibility To be deductible, expenses must be profit-motivated or specifically allowed, and also • Ordinary • Normal, common, generally accepted • Necessary • Appropriate, helpful, prudent • Reasonable in amount • Arm’s length

  12. 5 Negative Tests for Deductibility To be deductible, expenses must not be • Personal • Business purpose is not primary motive • Not specifically allowed • Capital Expenditures • Should be capitalized as assets if useful life extends beyond a year • Start-up costs • After 10/23/04 may expense $5,000 in first year; remainder is amortized over 180 months • Expense is phased-out if total costs > $50,000

  13. 5 Negative Tests for Deductibility • Against Public Policy • Resulting from violation of a law • Resulting from an illegal business • Cost of goods sold are always deductible under the capital recovery concept • Ordinary, necessary, and reasonable business expenses are deductible for all illegal businesses except sale of drugs • For lobbying and political activities • Costs to influence local legislation are deductible • Costs to monitor any legislation are deductible

  14. 5 Negative Tests for Deductibility • Related to Tax-Exempt Income • Incurred to generate tax-exempt income • Another Person’s Obligation • Cannot recover another’s capital

  15. Timing of Deductions The taxpayer’s accounting method is used to determine the timing of deductions.

  16. Timing of DeductionsCash Method • Cash Method: claim a deduction in the year an expense is paid • Date of mailing for checks • Date of charge for credit cards • Prepaid expenses are deductible if used within one tax year (prepaid interest does not qualify)

  17. Timing of DeductionsAccrual Method • Accrual Method: claim a deduction in the year two tests are met • All-events test is met when a liability exists and the amount can be determined • Economic performance test is met when services or property are provided

  18. Timing of DeductionsRelated Party Accrued Expenses Deductions for accrued expenses payable to a cash basis related party are limited. • Related parties include family members and businesses owned or controlled by the taxpayer • Unless both parties are accrual basis, both report using the cash method; until income is reported no expense may be deducted © 2004 South-Western College Publishing

  19. Financial Accounting Income Vs. Taxable Income • Matching and Conservatism are not tax concepts • Estimates of expenses are not permitted for tax purposes • Use specific write-off for bad debts • Do not estimate warranty expense

  20. Mixed-Use ExpensesHobby Vs. Business An income-earning activity without a predominant profit motive is a hobby.

  21. Mixed-Use ExpensesHobby Vs. Business • Factors considered in determining profit-motive are • Manner of conducting activity • Expertise or reliance on expert advice • Time and effort spent on activity • History of income and loss • Amount of occasional profit • Elements of personal pleasure • Success in similar activities

  22. Mixed-Use ExpensesHobby • Losses from a hobby are not deductible • Expenses allowed up to amount of income generated • Deductions taken using three tier system: • Expenses also allowed as personal itemized deductions • Other expenses that qualify as business expenses • Depreciation on assets used • Allowable expenses are deducted from AGI

  23. Mixed-Use ExpensesVacation Home A residence used for personal vacations and also rented to unrelated people is a mixed-use asset and first must be classified as either: • Personal residence if rented less than 15 days in a year • Vacation home if used personally • more than 14 days, or • more than 10% of the number of days rented • Rental property if used personally • less than 15 days, or • less than or equal to 10% of the days rented

  24. If classification is: Personal residence Vacation home Rental property Vacation HomeTax Treatment • Then tax treatment is: • Report no income or expense • Report income and allocate expenses using three tier system (no loss allowed) • Report income and allocate all expenses; Loss allowed

  25. Mixed-Use ExpensesHome Office A taxpayer who operates a trade or business from home may be able to deduct a portion of the home’s expenses. • Expenses of the home are allocated between business and personal use

  26. Mixed-Use ExpensesHome Office • A specific portion of the home must be used • Exclusively and regularly, • As the principal place of business or as a place to meet clients, but • If taxpayer has no other available location to do administrative or management activities, this requirement will not disqualify the deduction

  27. Mixed-Use ExpensesHome Office • Employees must also show that the use • Is for the convenience of their employer • Required as a condition of employment • Allowed expenses are deducted using the three tier system • Deduction is limited to the amount of net income from the business • Home-office deduction may not create a loss • Excess may be carried-forward

  28. End of Chapter 5