Business Expenses

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Business Expenses

• Chapter 5

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Code Sections

• Sec. 161 - deductions are only those expenses and
  losses for which a deduction is authorized
• Sec. 162(a) authorizes deductions for ordinary
  and necessary expenses, that are reasonable in
  amount, and incurred in actively carrying on a
  trade or business
• Sec. 212 authorizes deductions for expenses
  related to production of income
  (investment-related expenses)

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Disallowed Deductions

• Unless provided for otherwise in the Code, a
  deduction will be disallowed if it is
• Contrary to public policy (fines, penalties)
• Related to tax-exempt income
• Accrued to related party (no deduction until
  related party includes in income)
• The obligation of another taxpayer

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Substantiation

• All taxpayers must maintain records that
  substantiate their expense deductions
• Stringent substantiation requirements for travel,
  entertainment, and gifts
• Amount of expenditure
• Time and place (or date description of gift)
• Business purpose of expenditure
• Business relationship of person entertained or
  receiving a gift

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Timing of Deductions

• Accrual method expenses deductible when
• All events have occurred that fix liability and
• Economic performance occurs (property or
  services provided or used)
• Cash basis taxpayer - expenses deductible when
  paid
• Date check is mail
• Date charged on credit card

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Cash Method

• When an expense is paid by providing services,
  the expense can be deducted but the value of the
  services is income
• Assets with useful lives extending substantially
  beyond the end of the year must be capitalized
  with their cost recovered through depreciation,
  amortization, or depletion
• When considering whether to make an early payment
  of year-end expenses, the tax rates for both
  years and the time value of money should be
  considered

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Use of Cash Method

• Businesses that sell merchandize to their
  customers must use the accrual method to account
  for purchases and sales of inventory
• Cash method can be used for other than inventory
  and cost of goods sold
• Large corporation with average annual gross
  receipts of more than 5 million cannot use the
  cash method for tax
• Personal service corporations can use the cash
  method

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Prepaid Expenses

• Prepaid assets must be prorated if their lives
  exceed one year and the items will not be
  consumed by the close of the following year
• Prepaid interest must generally be prorated over
  the life of the loan
• OID is a form of prepaid interest and must be
  amortized over term of loan

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Costs of Starting a Business

• Sec. 162 allows deductions for carrying on a
  business but expenses incurred prior to the
  commencement of operations do not qualify as
  carrying on a business
• Business investigation expenses
• Start-up expenses
• Organization costs

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Business Investigation

• Investigation expenses incurred while preparing
  to enter business include travel, market surveys,
  and feasibility studies
• If the taxpayer in a similar business - deduction
  allowed as current expenses
• If taxpayer not in a similar existing business
• If new business acquired - expenses amortized
  over 60 months
• If new business not acquired - no deduction

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Start-up Expenses

• Start-up expenses are incurred after the decision
  to proceed with the new business, but before
  beginning actual operations (employee training
  and advertising)
• Expenses amortized over 60 months for taxpayers
  who are entering a business not related to an
  existing business
• For taxpayer entering a new business related to
  an existing business, start-up costs are
  considered continuing costs and are currently
  deductible

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Organization Costs

• Costs relating to formation of a corporation or
  partnership (fees paid to the state for
  incorporation, legal fees, and accounting fees)
  and incurred before end of first year
• Organizational costs must be capitalized and can
  be amortized over 60 months

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Operating Expenses

• Most operating expenses shown on a GAAP income
  statement are deductible on a business tax return
• Examples include advertising, bank service
  charges, commissions, office supplies, repairs,
  taxes, licenses, accounting fees, legal fees,
  salaries and wages, travel, and utilities

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Meals Entertainment

• The deduction for business meals and
  entertainment expenses is limited to 50 of the
  amount of qualified expenses
• The 50 limit is imposed on whoever (employer or
  employee) ultimately pays for the expense

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Meals Entertainment

• Directly-related expenses - costs incurred when a
  discussion takes place between the taxpayer and a
  customer about specific business activities in an
  atmosphere conducive to a serious business
  discussion.
• Associated-with expenses - deductible only if
  directly preceded or followed by a substantial
  business discussion
• Deduction for entertainment tickets is based on
  the tickets face value, then the 50 limit
  applies

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Restriction on Deductions

• No deduction for the costs of owning and
  maintaining entertainment facilities such as
  hunting lodges and yachts
• No deduction for membership dues and fees paid to
  social, athletic, or sporting clubs
• Deductions are allowed for dues to professional
  organizations, public service organizations, and
  trade associations
• Deduction for business gifts limited to 25 per
  donee per year

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Travel Away From Home

• Travel expenses include lodging and meals while
  temporarily away from home on business,
  transportation to destination and back, and
  incidental expenses
• A tax home is the location of the principal place
  of employment regardless of where the family
  residence is maintained

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Temporary Assignments

• Temporary is one year or less
• Employment away from home in a single location
  that is realistically expected to last (and does
  in fact last) for one year or less, will be
  treated as temporary
• Assignment of more than one year shifts tax home
  to the new location (no deduction for travel and
  living costs)

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Transportation Expenses

• Transportation expenses are incurred when the
  taxpayer is not away from home (includes cost of
  transportation from one work location to another,
  but excluding any meal costs)
• The business portion of actual automobile
  expenses can be deducted or a standard mileage
  rate (36 for 2003) plus parking and tolls can be
  deducted

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Transportation Expenses

• Commuting expenses are personal nondeductible
  expenses except
• Transportation between home and temporary work
  location if taxpayer has a regular place of
  business
• Travel from one job to another on the same day

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Combining Business with Pleasure Travel

• For U.S. travel, if the trip is primarily for
  business, all transportation costs to and from
  destination are deductible
• If primary purpose is pleasure, no deduction for
  transportation
• Meals lodging deductible only for days on which
  business is conducted

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Travel

• If the primary reason the taxpayer remains in a
  temporary location is because it is less
  expensive then returning home as soon as business
  is completed, these costs are deductible
• Saturday meals lodging
• Business meetings on Friday and Monday

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Foreign Travel

• Transportation expenses must be allocated between
  business and personal days unless
• Trip does not exceed one week or
• Less than 25 of total time spent for personal
  purposes
• If trip primarily personal, no deduction for
  transportation

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Bad Debt Expense

• Specific charge-off method must be used
• Investment and personal loans are considered
  nonbusiness (capital losses)
• Loan must be valid debt
• No bad debt deduction for cash basis taxpayers
  who have not previously included amount in income

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Insurance Expense

• Premiums for fire, casualty, and theft insurance
  for business property are deductible
• Payments into a self-insurance reserve are not
  deductible - only actual losses are deductible
• Premiums for life insurance when business is
  beneficiary are not deductible

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Legal Expenses

• Legal Fees deductible only if related to a trade
  or business
• Legal fees incurred to defend title to property
  are added to the assets basis
• Criminal defense fees are deductible only if the
  legal action has a direct relationship to a
  profit-seeking activity
• Personal legal expenses are not deductible

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Taxes

• Deductible taxes include
• State, local, and foreign real property taxes
• State and local personal property taxes
• State, local, and foreign income taxes
• Employers payroll taxes
• Other federal, state, local, and foreign taxes
  incurred in a business or other income-producing
  activity
• Federal income taxes are not deductible

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Taxes

• When real estate is sold, the sellers portion of
  taxes ends on the day before the sale date
• Assessments for improvements must be added to
  basis of property
• Sales taxes are added to cost of business
  property or service

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UNICAP Rules

• Uniform capitalization rules apply to businesses
  whose average annual gross receipts for the
  preceding three years exceeds 10 million
• UNICAP rules require inventory to include all
  direct costs of manufacturing, purchasing, or
  storing inventory, along with many indirect costs
  typically not included in full absorption costing
• Nonmanufacturing costs (research, selling,
  advertising and distribution expenses) are not
  required to be included in inventory

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Inventory

• Acceptable methods for tax include specific
  identification, FIFO, LIFO, and average cost
• A low inventory valuation results in tax savings
  through a higher cost of goods sold deduction
• The LIFO conformity rule requires use of LIFO for
  financial statements if LIFO is used for tax

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Home Office Expenses

• Home office must be used exclusively on a regular
  basis and meet one of the following three tests
  to be deductible
• 1. the principal place of business for any
  business of taxpayer or
• 2. a place for meeting with clients or customers
  in the normal course of business or
• 3. located in a separate structure

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Home Office Expenses

• Principal place of business includes a place used
  for the administrative or management activities
  of the business if there is no other fixed
  location available
• Employee must also show that the office is
  maintained for the convenience of the employer
• Deductible expenses include portion of rent or
  mortgage interest, property taxes, insurance,
  utilities, repairs, depreciation and are limited
  to gross income from the business

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Home Office Expenses

• Expenses are deducted in this order
• 1. Expenses directly related to the business
  other than home office expenses (supplies)
• 2. The allocated portion of otherwise deductible
  itemized deductions (mortgage interest and
  property taxes)
• 3. Operating expenses including utilities,
  insurance, and maintenance
• 4. Depreciation
• Excess expenses are carried forward

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Hobby Expenses

• Activities that earn income and incur expenses
  but do not meet the requirements to be a business
  or investment are hobbies
• Regulations list factors to consider in
  determining if a hobby including
• Manner in which activity carried on
• Expertise of taxpayer and/or consultants
• Time and effort spend in activity
• Actual profits earned in one or more years
• Elements of pleasure or recreation

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Hobby Expenses

• If a profit is realized in 3 out of 5 years (2
  out of 7 years for horses) then burden of proof
  shifts to IRS to prove it is a hobby
• Even with losses, taxpayer can deduct expenses by
  showing activity run in a businesslike manner
• If a hobby, then expenses limited to hobby income

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Hobby Expenses

• Expenses must be taken in this order
• Otherwise allowable expenses (mortgage interest,
  taxes, and casualty losses)
• Expenses that do not reduce the tax basis of the
  assets used in the hobby (advertising, insurance,
  utilities and maintenance)
• Depreciation and amortization
• Excess expenses are lost - no carryover

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Residential Rental Property

• If rental of real estate is a business, all
  income is included and all expenses are
  deductible, even if it creates a loss
• Expenses may include advertising, cleaning,
  maintenance, utilities, insurance, taxes,
  interest, commissions for collection of rent,
  travel to collect rental income or to manager the
  property or maintain the property

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Residential Rental Property

• When property is converted from personal to
  rental property, expenses must be divided between
  rental and personal use
• No depreciation or insurance deduction allowed
  for personal-use part of year
• Mortgage interest and real estate taxes for
  personal-use can be deducted as itemized
  deductions

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Rental of a Vacation Home

• A home used for both rental and personal use
  purposes falls into one of 3 categories
• 1. Less than 15 days rental
• 2. More than 2 week rental and primarily rental
  property
• 3. More than 2 week rental but primarily personal
  use property (mixed rental/personal use)

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Rental of a Vacation Home

• If the residence is rented out for less than 15
  days during the year
• No rental income is reported but
• No deductions are allowable (except mortgage
  interest and property taxes may still be deducted
  as itemized deductions)

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Rental of a Vacation Home

• Primarily rental - if rental period is greater
  than 14 days and personal use is equal to or less
  than the greater of 14 days or 10 of the rental
  days)
• Expenses allocated between rental and
  personal-use
• Rental expenses can exceed rental income and
  create a loss
• No deduction for personal-use expenses

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Rental of a Vacation Home

• Mixed personal/rental use - if the rental period
  is greater than 14 days and personal-use more
  than the greater of 14 days or 10 of the rental
  days
• Rental expenses limited to rental income (no
  loss)
• Nondeductible rental expenses can be carried
  forward to the future years
• Mortgage interest real estate taxes for
  personal-use allowed as itemized deductible

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Book/Tax Differences

• Permanent differences
• Interest income from municipal bonds
• Fines and penalties
• Life insurance proceeds
• 50 of meals and entertainment
• Temporary differences
• Bad debts
• Depreciation

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Income Tax Expense

• If only permanent differences, adjust book income
  by
• Adding expenses that are not tax deductible
• Subtracting tax-exempt income
• Multiply adjusted book income by the tax rate
• Temporary differences create
• A deferred tax asset that is a prepayment of tax
  that will be refunded in a future year or
• A deferred tax liability this is a current
  savings that will have to be paid in a future year

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The End