Post on 23-Jun-2018
6-1©2011 Pearson Education, Inc. Publishing as Prentice Hall
6-2
DEDUCTIONS AND LOSSES
(1 of 2)
Classifying deductions as for vs. from adjusted gross income
Criteria for deducting business and investment expenses
General restrictions on the deductibility of expenses
Proper substantiation requirement
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6-3
DEDUCTIONS AND LOSSES
(2 of 2)
When an expense is deductibleSpecial disallowance rulesTax planning considerationsCompliance and procedural
considerations
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Classifying Deductions as for vs. from Adjusted
Gross Income (1 of 3)
For AGITaxpayer benefits from deduction
even if she claims the standard deduction
Reduces AGI: +/- benefits for taxpayer+ Many deductions and credits
phased out above certain AGI thresholds
+ Reduces AGI floors for certain categories of itemized deductions
- Reduces certain deduction ceilings©2011 Pearson Education, Inc. Publishing as Prentice
Hall
6-5
Classifying Deductions as for vs. from Adjusted
Gross Income (2 of 3)
Most common deductions for AGITrade or business expensesIRAsAlimonyLosses on sale of bus/invest
propertyMoving expensesInterest paid on qualified education
loans1/2 of self-employment tax Health insurance paid by self-
employeds
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6-6
Classifying Deductions as for vs. from Adjusted
Gross Income (3 of 3)
From AGIItemized deduction only will have
tax benefit if total deductions exceed the taxpayer’s standard deductionDeduct the higher of the standard
deduction or sum of itemized deductions
Phaseout of itemized deductions scheduled to resume in 2011 at a 3% rateFate of phaseout for 2010 still
uncertain.
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6-7
Criteria for Deducting Business and Investment
ExpensesBusiness or investment
requirementOrdinary expenseNecessary expenseReasonable expenseExpenses and losses must be
incurred directly by the taxpayer©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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Business or Investment Requirement (1 of 2)
Activity engaged in for profitUse facts and circumstances test
Trade or business (ToB) vs. investment classificationToB losses are ordinary losses
ToB expenses are for AGIInvestment losses are capital
Investment expenses are from AGISubject to 2% of AGI floor
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6-9
Business or Investment Requirement (2 of 2)
Losses and expenses related to rents and royalties are for AGI deductions
Legal and accounting feesFor AGI deduction for ToB if incurred
in ordinary course of businessFees related to taxes also for AGI for ToB
Nonbusiness fees related to taxes from AGI deduction subject to 2% of AGI floor
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Ordinary ExpenseTo be ordinary, an expense must
beReasonable in amountBear reasonable proximate
relationship to income-producing activity or property
Must be customary or usual course of a particular industry or business community©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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Necessary ExpenseAn expense is considered
necessary if it is “appropriate and helpful” in the taxpayer’s business
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Reasonable ExpenseProblems often occur with
salaries for shareholder-employees of closely held businesses
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Expenses and Losses Must Be Incurred Directly by the
TaxpayerGenerally, a taxpayer cannot
take a deduction for a loss or expense of another person
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General Restrictions on the Deductibility of
ExpensesCapitalization vs. expense
deductionExpenses related to exempt
incomeExpenditures that are contrary
to public policyOther expenditures specifically
disallowed©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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Capitalization vs. Expense Deduction
General capitalization requirements
Election to deduct currentlyE.g, certain research and
experimental expenditures, cost of qualified tangible personal property
Capitalization of deduction itemsE.g., carrying charges on
unproductive unimproved real estate
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Expenses Related to Exempt Income
Deduction disallowed because related income is not taxable
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Expenditures that Are Contrary to Public Policy
Cannot deduct illegal payments or payment resulting from an illegal actFines and penaltiesBribes and Kickbacks
Expenses from an illegal trade or business are deductibleIf taxpayer reports income from
activity©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Other Expenditures Specifically Disallowed (1 of 2)
Political contributions and lobbying expenses
Business investigation and preopening expensesInclude investment expenses May immediately expense up to
$5,000 Deduction phased out $ for $ if >
$50,000©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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Other Expenditures Specifically Disallowed (2 of 2)
Business investigation and preopening expenses (continued)Amortize remainder over 180
months beginning when business commencesNo amortization if business not
begun
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6-20
Proper Substantiation Requirement (1 of 2)
The taxpayer has the burden of proof
The Cohan ruleCertain expenses may be
estimatedMore restrictive substantiation
requirements for travel, entertainment, business gifts
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Proper Substantiation Requirement (2 of 2)
Documentation requirements for travel, entertainment, gifts, etc.AmountTime and place (T & E)Date and description of giftBusiness purposeBusiness relationship
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When an Expense Is Deductible
Cash Method (1 of 2)
Generally deductible when actually paid
Prepaid expensesNo current deduction if
expenditure creates an asset with a life substantially beyond end of tax year
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6-23
When an Expense Is Deductible
Cash Method (2 of 2)
Prepaid interestAmortize over period of loan to
which interest charge is allocatedPoints deductible over life of loan
Points paid in connection with purchase of principal residence currently deductible
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6-24
When an Expense Is Deductible
Accrual Method (1 of 2)
Allowed to deduct expenses in period in which expenses accrue under all-events test & economic performance testAll-events test met
When amount of liability is established
Amount of liability is determined with reasonable accuracy©2011 Pearson Education, Inc. Publishing as Prentice
Hall
6-25
When an Expense Is Deductible
Accrual Method (2 of 2)
Economic performance test is metWhen economic performance is deemed to occur
See Topic Review 3
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Special Disallowance Rules
Wash salesTransactions between related
partiesHobby lossesVacation homeExpenses of an office in the
home©2011 Pearson Education, Inc. Publishing as Prentice
Hall
6-27
Wash SalesWash sales occurs when
“substantially identical” stock or securities acquired by taxpayer within a 61 day periodExtends from 30 days before date
of sale to 30 days after date of saleLoss on wash sale disallowed
Disallowed loss added to basis of recently purchased stock or securities
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Transactions between Related Parties (1 of 2)
§267 defines related partiesLoss on transaction between
related parties disallowedDisallowed loss may be used to
offset gain from subsequent sale to unrelated party
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Transactions between Related Parties (2 of 2)
Unpaid expensesAccrual basis taxpayer cannot
deduct expense to cash basis related party until cash basis party recognizes payment as income
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6-30
Hobby Losses(1 of 3)
Activity has more personal attributes than profit motiveIRS factors to determine profit
motiveActivity conducted in businesslike
mannerTime and effort expendedExpected asset appreciationTaxpayer’s success in similar
activitiesProfits earned and profit historyTaxpayer’s financial status
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Hobby Losses(2 of 3)
Profit motive assumed if activity profitable in 3 of 5 years
Three tiers of expenses1 – Deductible even if no hobby
exists2 – Deductible if activity was for
profitBut do not reduce basis of any assets
3 – Deductible if activity was for profit
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Hobby Losses(3 of 3)
Deductible hobby expensesHobby-related expenses
deductible up to gross income of hobby activity
Deductible as miscellaneous itemized deductions subject to 2% of AGI floorSpecial order of the deductions
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Vacation HomeDeductions on vacation home may
be limited or disallowedVacation home if personal use
greater of 14 days, or 10% of # of days property used as rental
Expenses allocated based on days of use
Property rented < 15 daysNo taxable income and no deductions©2011 Pearson Education, Inc. Publishing as Prentice
Hall
6-34
Expenses of an Office in the Home
Office in the home expenses deductible only if office regularly and exclusively used for business ANDPrincipal place of taxpayer’s
business,Place where taxpayer meets with
clients,OR a separate structure from
houseEmployees must also use office
for convenience of employer
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Tax Planning Considerations
Hobby lossesControl timing of hobby losses
Unreasonable CompensationIf IRS feels that a salary payment
to an officer is excessiveOften recharacterize excess portion
as a dividend Timing of deductions
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Compliance and Procedural
Considerations (1 of 2)
Schedule C for sole proprietorship
Schedule E for rents and royalties
Other investment expenses reported on Schedule A Proper substantiationIRS scrutinyStatutory requirements
Travel and entertainment are of particular interest to the IRS
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Compliance and Procedural
Considerations (2 of 2)
Business vs. hobby Form 8829 to claim home office
deduction on Schedule CForm 2106 to claim home office
deduction by employeesTaxpayer may be willing to extend
statute of limitation’s period to prove profit motive by filing Form 5231 ©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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