Business Expenses

1
Business Expenses

• Chapter 5

2
Deductions in General

• Exclusive definition of deductions
• Deductions allowed based on legislative grace and
  defined narrowly
• Substantiation requirements
• Taxpayer has burden of proof for substantiating
  all expenses deducted on return
• Thus, adequate records of expenses must be
  maintained

3
Code Sections

• Sec. 161 - deductions permitted only for 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)

4
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 recognizes income)
• The obligation of another taxpayer

5
Deductions FOR and FROM AGI (slide 1 of 3)

• Deductions FOR AGI
• Those listed in 62
• Can be claimed even if taxpayer does not itemize
• Called above the line deductions

6
Deductions FOR and FROM AGI (slide 2 of 3)

• Deductions FROM AGI
• Those not listed in 62
• In total must exceed standard deduction to
  provide any tax benefit
• Called below the line or itemized deductions

7
Deductions FOR and FROM AGI (slide 3 of 3)

• Comparison of deductions FOR and FROM AGI (2005
  tax year)
• Single taxpayer has gross income of 45,000 and a
  6,000 deduction
• For AGI From AGI
• Gross income 45,000 45,000
• Less for AGI ded. 6,000
  0
• AGI 39,000 45,000
• Less from AGI ded. 5,000
  6,000
• Less personal exempt. 3,200
  3,200
• Taxable income 30,800 35,800

8
Types of Deductions

• Trade or Business
• Usually for AGI, except employee expenses
• Nonbusiness
• Related to the production of nonbusiness income
  (Investments)
• Tax determination
• Usually from AGI, except rent or royalty income
• Personal
• Mostly from AGI

9
Deductions FOR AGI (slide 1 of 3)

• Partial list includes
• Trade or business expenses
• Reimbursed employee business expenses
• Deductions from losses on sale or exchange of
  property
• Deductions from rental and royalty property
• Alimony
• One-half of self-employment tax paid

10
Deductions FOR AGI (slide 2 of 3)

• Partial list includes
• 100 of health insurance premiums paid by a
  self-employed individual
• Contributions to pension, profit sharing, annuity
  plans, IRAs, etc.
• Penalty on premature withdrawals from time
  savings accounts or deposits
• Moving expenses

11
Deductions FOR AGI (slide 3 of 3)

• Partial list includes
• Interest on student loans
• Qualified tuition and related expenses under
  222
• Up to 250 for teachers supplies for elementary
  and secondary school teachers

12
Deductions FROM AGI

• Itemized deductions include
• Medical expenses (in excess of 7.5 of AGI)
• Certain state and local taxes
• Contributions to qualified charitable
  organizations
• Personal casualty losses (in excess of 10 of
  AGI and a 100 floor per casualty for
  individuals)
• Certain personal interest expense (e.g., mortgage
  interest on a personal residence)
• Miscellaneous itemized deductions (in excess of
  2 of AGI)

13
Substantiation

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

14
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 - expenses deductible when paid
• Date check is mailed
• Date charged on credit card

15
Cash Method

• When an expense is paid by providing services,
  the expense is deductible but income must also be
  recognized for FMV of services provided
• 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

16
Use of Cash Method

• Businesses that sell merchandise 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 corporations with average annual gross
  receipts of more than 5 million cannot use the
  cash method for tax reporting
• All personal service corporations can use the
  cash method

17
Prepaid Expenses

• Prepaid expenses must be capitalized as assets if
  their lives exceed one year and the items will
  not be consumed by the close of the following
  year (same as accrual)
• 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

18
Business and Nonbusiness Lossesof Individuals

• Deductible losses of individual taxpayers are
  limited to those
• Incurred in a trade or business,
• Incurred in a transaction entered into for profit
• Individuals may also deduct casualty losses from
  fire, storm, shipwreck, and theft

19
Trade or Business Deductions

• In order for expenses to be deductible, they must
  be
• 1. Ordinary normal, usual, or customary for
  others in similar business, and not capital in
  nature
• 2. Necessary prudent businessperson would incur
  same expense
• 3. Reasonable question of fact
• 4. Activity is deemed to be a trade or business

20
Trade or Business Deductions

• 5. Not a capital expenditure
• 6. Not related to the production of tax-exempt
  income
• 7. Not contrary to public policy
• 8. For a business purpose rather than a personal
  expenditure

21
Reasonable in amountExample Excessive Executive
Compensation

• For publicly held corporations
• Deduction of salaries for chief executive officer
  and four highest compensated executives is
  limited to 1 million each
• Does not include
• Performance-based compensation and commissions
• Payments to qualified retirement plans
• Payments excludible from gross income

22
4. Incurred in conduct of business

• Activities are either
• Business
• Intent to make a profit
• Involves entrepreneurial effort
• Investment
• Intent to make a profit
• No entrepreneurial effort
• Hobby
• No intent to make a profit
• Involves entrepreneurial effort

23
Hobby Losses

• Hobby defined
• Activity not entered into for profit
• Personal pleasure associated with activity
• Examples raising horses, fishing boat charter
• Often it is difficult to determine if an activity
  is profit motivated or a hobby
• Regulations provide nine factors to consider in
  making this determination hobby including
• Manner in which activity carried on
• Expertise of taxpayer and/or consultants
• Time and effort spent in activity
• Actual profits earned in one or more years
• Elements of pleasure or recreation

24
Hobby Losses

• Profit activity
• If activity is entered into for profit, taxpayer
  can deduct expenses FOR AGI even in excess of
  income from the activity
• (At-risk and passive loss rules may apply)

25
Hobby Losses

• Presumptive rule of 183
• If activity shows profit 3 out of 5 years (2 out
  of 7 years for horses), the activity is presumed
  to be a trade or business rather than a personal
  hobby
• Rebuttable presumption, shifts burden of proof to
  IRS
• Otherwise, taxpayer has burden to prove profit
  motive
• (If the activity generates a loss, it is
  generally better for it not to be considered a
  hobby.)

26
Hobby Losses
27
Hobby Losses

• Hobby activity
• Can only deduct expenses to extent of income from
  activity (i.e., cannot deduct hobby losses)

28
Hobby Losses

• If an activity is a hobby
• Expenses are deductible FROM AGI
• Treated as miscellaneous itemized deductions
  subject to the 2 of AGI limitation
• Exception expenses that are deductible without
  regard to profit motive, such as
• Mortgage interest
• Property taxes

29
Hobby Losses

• Order in which hobby expenses are deductible
• First Those otherwise deductible e.g., home
  mortgage interest and property taxes
• Then Expenses that do not affect adjusted basis
  e.g., maintenance, utilities
• Then Expenses that affect adjusted basis e.g.,
  Depreciation (or cost recovery)
• Excess expenses are lost - no carryover

30
Hobby Losses

• Example of hobby expenses Taxpayer sells horses
  raised as a hobby for 15,500

31
5. Not a capital expenditure

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

32
6. Is not related to the production of
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

33
7. 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
• See Tank Truck Rental, Inc. v. CIR

34
Costs of Starting a Business

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

35
Business Investigation

• Investigation expenses incurred while preparing
  to enter business include travel, market surveys,
  and feasibility studies
• If the taxpayer is in a similar existing
  business, deduction allowed as a current expense
• If taxpayer is not in a similar existing business
• If new business not acquired no deduction
• If new business acquired expenses added to
  start-up expenses to determine deduction and
  amortization

36
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)
• If the business is related to the taxpayers
  existing business, start-up costs are considered
  continuing costs and are deductible currently

37
Start-up Expenses

• If the new business is not related to an existing
  business
• Can deduct up to 5,000 (combined business
  investigation and start-up expenses) in the tax
  year in which the business begins
• 5,000 amount is reduced by amount cumulative
  investigation and start-up expenses exceeds
  50,000
• Remainder of investigation and start-up expenses
  amortized over a 15-year period

38
Organization Costs

• Defined as costs related to the 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
• Can deduct up to 5,000 in the year business
  begins
• 5,000 deduction is reduced by amount
  organizational costs exceeds 50,000
• Remaining organizational costs amortized over 15
  years (180 months)

39
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
• Taxes
• Licenses, accounting fees legal fees
• Salaries and wages
• Utilities

40
Meals Entertainment

• Deductions are very restricted due to abuse
  possibilities
• Amount allowed
• 50 of meals and entertainment
• 100 of transportation costs
• Amounts cannot be lavish or extravagant
• The 50 limit is imposed on whoever (employer or
  employee) ultimately pays the expense

41
Meals Entertainment

• Directly-related expenses - costs incurred when a
  significant business discussion takes place
  between the taxpayer and a customer in atmosphere
  conducive to the serious conduct of business
• Actual business meeting or discussion occurs
  during meal or entertainment
• Associated-with expenses - deductible when
  directly preceded or followed by a substantial
  business discussion
• Deduction for entertainment tickets is limited to
  50 of the tickets face value

42
Restrictions on Entertainment Expenses

• Club dues
• Generally not deductible
• Exception Clubs formed for public service and
  community volunteerism (e.g., Kiwanis, Rotary)
• Business entertainment expenses incurred at club
  are still deductible (50)

43
Restrictions on Entertainment Expenses

• Business gifts
• Business gifts of tangible personalty with a
  value of 25 or less per person per year are
  deductible
• Incidental costs (e.g., gift-wrapping) are not
  included in the cost of the gift in applying the
  limit
• If the value is 4 or less (e.g., pen with
  company name) then not subject to 25 limit
• Gifts to employers or superiors are not deductible

44
Restriction on Deductions

• No deduction allowed for the costs of owning and
  maintaining entertainment facilities such as
  hunting lodges and yachts
• No deduction allowed 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

45
Travel Away From Home

• Travel expenses incurred for temporary travel
  away from home on business are deductible
• Away from home refers to the persons tax home
  that is, the location of the principal place of
  employment regardless of where the family
  residence is maintained
• Qualifying expenses include lodging, 50 of
  meals, transportation to destination and back,
  and incidental expenses

46
Temporary Assignments

• Temporary is defined as 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 for more than one year shifts tax home
  to the new location (no deduction for travel and
  living costs)

47
Transportation Expenses

• Certain transportation expenses incurred when the
  taxpayer is not away from home are deductible and
  include
• Cost of transportation from one work location to
  another
• Transportation between home and a temporary work
  location if the taxpayer has a regular place of
  business
• Meal costs are generally not deductible

48
Transportation Expenses

• The prorated business portion of actual
  automobile expenses or a standard mileage rate
  (40.5 for 2005) plus related parking and tolls
  can be deducted
• Commuting expenses (between home and the regular
  place of business) are a personal nondeductible
  expense

49
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
• Primary purpose is determined by the number of
  days on business versus personal days

50
Combining Business with Pleasure Travel

• Meals lodging are deductible only for days on
  which business is conducted
• If a taxpayer remains in a temporary location to
  reduce costs as a result of
• Reduced airfare for Saturday night stays or for
  business conducted on both Friday and Monday
• Costs for additional days are deductible if they
  are less than the cost of returning home when
  business is completed

51
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

52
Business Bad Debts

• Specific charge-off method must be used
• Exception Reserve method is allowed for some
  financial institutions
• Deduct as ordinary loss in the year when debt is
  partially or wholly worthless
• Cash basis taxpayer does not have bad debt
  deduction for unpaid receivables

53
Nonbusiness Bad Debts

• Specific charge-off method must be used
• Deduct as short-term capital loss in the year
  when amount of worthlessness is known with
  certainty
• No deduction is allowed for partial worthlessness
  of a nonbusiness bad debt

54
Nonbusiness Bad Debts

• Related party (individuals) bad debts are
  generally suspect and may be treated as gifts
• Was a note properly executed?
• Did it include a reasonable rate of interest?
• Was the debt secured by collateral?
• Were collection efforts made?
• What was the intent of the parties?

55
Classification of Bad Debts

• Individuals will generally have nonbusiness bad
  debts unless
• In the business of loaning money, or
• Bad debt is associated with the individuals
  trade or business
• Determination is made either at the time the debt
  was created or when it became worthless

56
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

57
Legal Expenses

• Legal Fees deductible only if related to a trade
  or business
• 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 officers legal fees in defending
  against price-fixing charges
• e.g., Landlords legal fees associated with
  eviction of tenant
• 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

58
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

59
Taxes

• When real estate is sold, the seller is
  responsible for taxes through 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

60
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 (Schedule
  E)
• Expenses include advertising, cleaning,
  maintenance, utilities, insurance, taxes,
  interest, commissions for collection of rent,
  travel to collect rental income or to manage the
  property or maintain the property

61
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 may be deductible as itemized
  deductions

62
Vacation Homes
63
Rental Vacation Homes

• May have both personal and rental use of a
  vacation home
• Rental expenses may be limited to rental income
  if primarily used for personal purposes
• Determination of vacation home treatment is
  dependent on personal use vs. rental use

64
Rental Vacation Homes

• I. Personal Property (insufficient rental usage)
• Rental days
• Less than 15 days No gross income recognized
  from rentals and no deductible rental expenses
• Mortgage interest and property taxes treated as
  if on personal residence (generally deductible in
  full)

65
Rental Vacation Homes

• Rental days
• More than 14 days Treatment depends on amount of
  personal use

66
Rental Vacation Homes

• II. Primarily rental use (Insufficient personal
  use)
• If rented for 15 days or more and personal use
  days NOT more than the greater of 14 days or 10
  percent of fair rental days
• Can deduct all expenses allocated to rental use
  even if loss results (Schedule E)
• Rental loss subject to passive loss rules and
  possibly, hobby loss rules.
• If there is personal use, what amount is reported
  on Schedule A?

67
Rental Vacation Homes

• III. Personal/rental use
• If rented for 15 days or more and personal use
  days exceed the greater of 14 days or 10 percent
  of fair rental days
• Expenses are allocated between personal and
  rental days.
• Treated similar to hobby
• Rental expenses deducted in three step process
• No rental loss allowed
• Carryforward of disallowed rental expenses
• Rental income expenses are reported on
  Schedule E.
• What is reported on Schedule A?

68
Rental Vacation Homes

• Example of personal use
• Rental days 200 (10 20)
• Personal use Not Significant Significant
• 7 days X
• 18 days X
• 25 days X

69
Rental Vacation Homes

• Example of personal use
• Rental days 100 (10 10)
• Personal Use Not Significant Significant
• 7 days X
• 14 days X
• 18 days X

70
Rental Vacation Homes

• Allocation of expenses between personal and
  rental
• Mortgage interest and real estate taxes
• IRS requires allocation based on total days used
• Courts have allowed allocation based on days in
  year
• Other expenses are allocated based on total days
  used

71
Example Assume Taxpayer used vacation home
for 30 days and rental use was 250 days. Mortgage
interest is 1000.

• IRS Method
• Rental 250/280 .89 x 1000890
• Personal 1000-890110 (Deductible?)
• Tax Court Method
• Rental 250/265684.93
• Personal 1000-684.93315.07
• Which is better to use?

72
Rental Vacation Homes

• Tax treatment of income and expenses of a
  primarily rental vacation home
• Rental income included in gross income
• Rental expenses deductible FOR AGI
• Rental income and expenses reported on Sch. E

73
Rental Vacation Homes

• Treatment of allocated personal portion of
  vacation home expenses
• Primarily rental use taxes deductible FROM AGI,
  mortgage interest nondeductible (personal
  interest)
• Personal/rental use mortgage interest and taxes
  deductible FROM AGI
• Personal portion of other expenses (e.g.,
  insurance, maintenance) nondeductible

74
Office in the Home(slide 1 of 3)

• Deductibility is very restricted due to abuse
  possibilities
• Office must be used exclusively and on a regular
  basis as
• The principal place of business, or
• A place of business used by clients, patients, or
  customers
• For employees, office must also be for the
  convenience of the employer

75
Office in the Home(slide 2 of 3)

• What constitutes principal place of business?
• Home office qualifies as a principal place of
  business if
• Taxpayer conducts admin. and mgmt. activities in
  the home office, and
• There is no other fixed location where taxpayer
  conducts these activities

76
Office in the Home(slide 3 of 3)

• Office in the home expenses cannot cause net loss
  from the business activity
• Office in home deduction limited to business
  gross income in excess of other business expenses
  (ordering rules apply)
• Expenses directly related to the business other
  than home office expenses (supplies)
• The allocated portion of otherwise deductible
  itemized deductions (mortgage interest and
  property taxes)
• Other home expenses including utilities,
  insurance, and maintenance
• Depreciation
• Excess is carried forward (subject to limit)
• Form 8829 is used to report office in home
  expenses

77
Office in the Home Problem

• Peggy is a high school teacher who also engages
  in a retail sales business. She uses part of her
  home as the principal place of business for the
  retail business.
• Can she deduct the expenses for the business use
  of her home?
• What if the area is used for storing inventory?
• What if she uses part of her home exclusively to
  do work for school?

78
Office in the Home Problem

• Assume that Peggy earned 20,000 from the retail
  business after taking all her deductions from
  that business except the business use of home
  deduction. She uses 1/5 of her home for the
  retail business. She has the following home
  expenses
• Total for Home
• Real estate taxes 3600
• Mtg interest 4200
• Maintenance on home 1200
• Depreciation 3000
• What if her income had been only 2,000?

79
Accounting for Income Taxes

• FAS 109 states that income tax expense reported
  on financial statements must be based on
  financial statement income rather than taxable
  income
• Actual taxes paid may differ significantly from
  expense recognized
• Differences fall into two categories
• Permanent differences
• Temporary differences

80
Permanent Differences

• Income that is not taxed but is reported for
  financial accounting purposes
• Interest income from municipal bonds
• Expenses that can never be deducted on the tax
  return
• Fines and penalties
• Expenses that have limited deductibility
• 50 of meals and entertainment

81
Temporary Differences

• Income or expense items that are reported in one
  year for accounting income and in a different
  year for taxable income
• Examples depreciation expense, bad debt expense,
  warranty expenses, and prepaid income

82
Reconciling Book/Tax Income

• Schedule M-1 of Form 1120 reconciles accounting
  (book) income to taxable income
• More detailed Schedule M-3 required if
  corporation has assets of 10 million or more

83
Calculating Tax Expense

• If only permanent differences, adjust book income
  by
• Adding expenses that are not tax deductible and
• Subtracting tax-exempt income, then
• Multiply adjusted book income by the tax rate

84
Deferred Taxes

• Temporary differences create
• A deferred tax liability that is a current tax
  savings that will have to be paid in a future
  year or
• A deferred tax asset that is a prepayment of tax
  that will be refunded in a future year

85
Deferred Tax Assets

• To realize the benefit of a deferred tax asset
  (tax prepayment), the business must have future
  income and a related tax liability
• A more-likely-than-not test is used to determine
  if a valuation account (contra asset) is needed

86
ConsolidatedFinancial Statements

• Under FAS 109, income tax expense reported on
  consolidated financial statements should include
  the total of all federal, state, local, and
  foreign income taxes including both current and
  deferred income taxes

87
ConsolidatedFinancial Statements

• APB23 exception allows parent to exclude future
  U.S. income tax on foreign subsidiary income
  earnings if permanently reinvested outside the
  U.S.
• Allows U.S. corporation to report higher
  financial statement income because its income
  statement includes the foreign income but
  excludes the deferred U.S. tax that could
  eventually be due on this income
• Earnings repatriated later can cause a spike in
  the corporation's effective tax rate in that year

88
UNICAP Rules

• Uniform capitalization rules apply to businesses
  whose average annual gross receipts for the
  preceding three years exceed 10 million
• UNICAP rules require inventory costs 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

89
Inventory

• Acceptable methods for tax accounting include
  specific identification, FIFO, LIFO, and average
  cost
• When prices are rising, the LIFO method results
  in a lower inventory valuation and tax savings
  through a higher deduction for cost of goods sold
  
• The LIFO conformity rule requires use of LIFO for
  financial statements if LIFO is used for tax

90
The End