P pt ch 06

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Income Taxes

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Chapter 6

Deductions and Losses: In General

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The Big Picture (slide 1 of 3)

• Dr. Cliff Payne extracts the following information from his financial reporting system associated with his dental practice.

Salaries including FICA (unpaid at year-end of $5,000) $120,000Building rent 24,000Depreciation of dental equipment and office furnishings and equipment 52,000Insurance (malpractice and of dental equipment and office furnishings and equipment) 22,000Dental supplies (ending inventory of $7,000) 16,000Office supplies (ending inventory of $1,500) 3,000Contribution to U.S. Senate campaign fund of Tim Kaine 1,000Contribution to U.S. Senate campaign fund of George Allen 1,000Legal expenses associated with patient lawsuit (jury decision fordefendant) 4,000Draw by Dr. Payne for living expenses ($5,000 monthly) 60,000

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• Dr. Payne calculates the deductible expenses that he can report on Schedule C of Form 1040 as follows:

Salaries including FICA $120,000Building rent 24,000Depreciation of dental equipment and office furnishings and equipment 52,000Insurance (malpractice and of dental equipment and office furnishings and equipment) 22,000Dental supplies ($16,000 - $7,000) 9,000Office supplies ($3,000 - $1,500) 1,500Contribution to U.S. Senate campaign of Tim Kaine –0–Contribution to U.S. Senate campaign of George Allen –0–Legal expenses associated with patient lawsuit (jury decision for defendant) 4,000Draw by Dr. Payne for living expenses ($5,000 monthly) 60,000

$292,500

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• Dr. Payne’s close relatives include the following:Terry Mother

Jack Father

Camille Mother-in-law

Walter Father-in-law

Pauline Sister (age 17)

Neal Brother (age 18)

• Has Dr. Payne correctly calculated the business expenses for his dental practice?– Read the chapter and formulate your response.

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Deductions

• Exclusive definition of deductions– Deductions are 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

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Deductions for and from AGI (slide 1 of 3)

• Deductions for AGI– Can be claimed even if taxpayer does not itemize– Important in determining the amount of certain

itemized deductions • Certain itemized deductions are limited to amounts in

excess of specified percentages of AGI– e.g., Medial expenses (7.5% of AGI), misc. itemized

deductions ( 2% of AGI)

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• Deductions from AGI:– In total, must exceed the standard deduction to

provide any tax benefit– Called “below the line” or itemized deductions

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• Comparison of deductions for and from AGI (2012 tax year)– Single taxpayer has gross income of $45,000 and

a $6,000 deduction For AGIFrom AGI

Gross income $45,000 $45,000Less: for AGI ded. 6,000 0 AGI $39,000 $45,000Less: from AGI ded. 5,950 6,000Less: personal exempt. 3,800 3,800Taxable income $29,250 $35,200

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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

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• 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

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• Partial list includes:– Interest on student loans– Qualified tuition and related expenses under § 222– Up to $250 for teacher supplies for elementary and

secondary school teachers

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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)

– Certain personal interest expense (e.g., mortgage interest on a personal residence)

– Miscellaneous itemized deductions (in excess of 2% of AGI)

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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

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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

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The Big Picture - Example 5

Ordinary and Necessary Requirement• Return to the facts of The Big Picture on p. 6-1. • Dr. Payne owns a small portfolio of investments,

including 10 shares of Hawk, Inc. common stock worth $1,000. – He incurred $350 in travel expenses to attend the annual

shareholders’ meeting where he voted his 10 shares against the current management group.

• No deduction is permitted because a 10-share investment is insignificant in value in relation to the travel expenses incurred.

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Section 212 Expenses (slide 1 of 2)

• Section 212 allows deductions for ordinary and necessary expenses paid or incurred for the following:– The production or collection of income– The management, conservation, or maintenance of

property held for the production of income– Expenses paid in connection with the

determination, collection, or refund of any tax

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Section 212 Expenses (slide 2 of 2)

• § 212 expenses that are deductions for AGI include:– Expenses related to rent and royalty income

– Expenses paid in connection with the determination, collection, or refund of taxes related to the income of sole proprietorships, rents and royalties, or farming operations

• All other § 212 expenses are itemized deductions (deductions from AGI)– For example, investment-related expenses (e.g., safe

deposit box rentals) are deductible as itemized deductions attributable to the production of investment income

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Business And Nonbusiness Losses

• 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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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• 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

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• 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

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Investigation Of A Business• Return to the facts of The Big Picture on p. 6-1.

• Dr. Payne’s mother, Terry, an accrual basis sole proprietor, owns and operates three motels in Georgia.

• In the current year, Terry incurs expenses of $8,500 in investigating the possibility of acquiring several additional motels located in South Carolina. – The $8,500 is deductible in the current year whether Terry

acquires the motels in South Carolina.

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Hobby Losses (slide 1 of 8)

• Hobby defined– Activity not entered into for profit

• Personal pleasure associated with activity

• Examples: raising horses, fishing boat charter

• If an activity is not engaged in for profit, the hobby loss rules apply– Hobby expenses are deductible only to the extent

of hobby income

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• 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

• 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

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• 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

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Year Income (loss) Hobby?

2006 $500 Yes

2007 (1,500) Yes

2008 700 Yes

2009 (1,000) Yes

2010 900 No, profit 3 of 5 years

2011 (500) Yes, profit only 2 of 5 years

2012 1,200 No, profit 3 of 5 years

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• If an activity is deemed to be a hobby– Can only deduct expenses to extent of income

from activity (i.e., cannot deduct hobby losses)

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• 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 are deductible in full, such as

– Home mortgage interest

– Property taxes

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• 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)

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

Amount Order Amount

Income $15,500

Interest 6,000 1 $ 6,000

Taxes 3,000 1 3,000

Vet Bills 2,000 2 2,000

Feed 4,000 2 4,000

Depreciation 1,000 3 Ltd. to 500

Total 15,500

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• Return to the facts of The Big Picture on p. 6-1. • Camille and Walter are Dr. Payne’s mother- and

father-in-law.• Camille is an executive for a large corporation

– She earns a salary of $800,000. • Walter is a collector of antiques.

– Several years ago, Walter opened an antique shop in a local shopping center and spends most of his time buying and selling antiques.

– He occasionally earns a small profit from the shop but usually incurs substantial losses.

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• Return to the facts of The Big Picture on p. 6-1. • If Walter’s losses are business related, they are fully

deductible against Camille’s salary. • In resolving this issue, consider the following:

– Initially determine if Walter’s antique shop meets the three - of - five years profit test.

– If not, the activity may nevertheless qualify as a business • Walter should show that his intent is to engage in a profit-seeking

activity. • It is not necessary to show actual profits.

– Try to fit the operation within the 9 criteria prescribed in the Regs.

• These criteria are the factors considered in trying to rebut the § 183 presumption

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Rental Vacation Homes(slide 1 of 9)

• May have both personal and rental use of a vacation home

• Deduction of 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

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• 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)

– More than 14 days: Treatment depends on amount of personal use

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• Primarily rental 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

• Rental loss subject to at-risk and passive loss rules

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• 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

– Treated similar to hobby• Rental expenses deducted in three step process

• No rental loss allowed

• Carryforward of disallowed rental expenses

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• Example of personal use

Rental days: 200 (10% = 20)

Personal use Not Significant Significant 7 days X 18 days X 25 days X

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• Example of personal use

Rental days: 100 (10% = 10)

Personal Use Not Significant Significant 7 days X14 days X18 days X

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• 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

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• 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

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• 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

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The Big Picture - Example 24Vacation Home - Primarily Personal Use

• Return to the facts of The Big Picture on p. 6-1. • Camille, Dr. Payne’s mother-in-law, owns a vacation home she

used as follows last year:– Rented it for $1,600 for 2 weeks, – Lived in it 2 months, and – Left it vacant the rest of the year.

• The year’s expenses amounted to $6,000 mortgage interest expense, $500 property taxes, $1,500 utilities & maintenance, and $2,400 depreciation.

• Since the property was not rented for at least 15 days, the income is excluded from gross income– The mortgage interest and property tax expenses are itemized

deductions– The remaining expenses are nondeductible personal expenses.

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The Big Picture - Example 25Vacation Home - Primarily Rental Use

• Assume instead that Camille in Example 24 used the cottage for 12 days and rented it for 48 days for $4,800.

• Since she rented the cottage for 15 days or more but did not use it for more than 14 days, the cottage is treated as rental property. – The expenses must be allocated between personal

and rental days.

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The Big Picture - Example 25 Vacation Home - Primarily Rental Use

• The expenses must be allocated between personal and rental days.

Percentage of Use Rental Personal

80% 20%Income $ 4,800 $ –0–ExpensesMortgage interest ($6,000) ($ 4,800) ($1,200)Property taxes ($500) (400) (100)Utilities and maintenance ($1,500) (1,200) (300)Depreciation ($2,400) (1,920) (480)Total expenses ($ 8,320) ($2,080)Rental loss ($ 3,520) $ –0–

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• Example 25 (Cont’d)• The tax treatment is as follows:

– Camille deducts the $3,520 rental loss for AGI

– She also has an itemized deduction for property taxes of $100 associated with the personal use.

– The mortgage interest of $1,200 associated with the personal use is not deductible as an itemized deduction

• The cottage is not a qualified residence (qualified residence interest) for this purpose

– The utilities, maintenance, & depreciation attributable to personal use are not deductible

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• Assume instead that Camille in Example 24 rented the cottage for 200 days and lived in it for 19 days. – The cottage is still primarily rental use

• She rented it for 15 days or more and did not use it for personal purposes > 20 days (10% of rental days).

– The expenses must be allocated between personal and rental days as illustrated in Example 25.

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The Big Picture - Example 27 Vacation Home - Personal/Rental Use

• Assume instead that Camille in Example 24 rented the property for 30 days and lived in it for 30 days.– The residence is now classified as personal/rental

use property since she used it > 14 days and rented it for 15 days or more.

• The expenses must be allocated between rental use and personal use

• The rental expenses are allowed only to the extent of rental income.

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Expenditures Incurred for Taxpayer’s Benefit or Obligation

• No deduction is allowed for payment of another taxpayer’s expenses– Must be incurred for taxpayer’s benefit or arise

from taxpayer’s obligation– Exception: Payment of medical expenses for a

dependent

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Personal Expenditures

• Unless otherwise provided in the Code, personal expenses are not deductible

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The Big Picture - Example 33 Disallowance Of Personal Expenditures

• Return to the facts of The Big Picture on p. 6-1. • Terry and Jack, Dr. Payne’s parents, are divorced near

the end of the current tax year. • They had been married for 28 years and have two

dependent children, Pauline (age 17), and Neal (age 18). (Dr. Payne is no longer his parents’ dependent.)

• As part of the divorce agreement, Jack paid all of the legal fees, which amounted to $24,300.

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The Big Picture - Example 33 Disallowance Of Personal Expenditures

• Return to the facts of The Big Picture on p. 6-1. • The invoice from the divorce lawyer listed the

following charges:Child custody agreement and determination ofamount of monthly child support $ 3,000Divorce decree proceedings 10,000County court filing costs 1,800Property settlement determination 6,000Tax consequences of property settlement 2,000Tax consequences of child custody and childsupport payments and tax filing status 1,500

$24,300

• Only the $3,500 ($2,000 + $1,500) paid by Jack for the charges relating to tax advice is deductible.

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Capital Expenditures

• Amounts are capitalized

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

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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

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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

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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

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Refocus On The Big Picture (slide 1 of 2)

• Using the accrual method, Dr. Payne has correctly calculated the deductible business expenses of his dental practice except for his monthly $5,000 draw– Since the dental practice is a sole proprietorship, Dr. Payne

will report net income of the practice on his Form 1040.

– So a deduction for his monthly draw is not permitted.

• The $232,500($292,500- $60,000) amount will be reported by Dr. Payne on Schedule C of Form 1040.

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Refocus On The Big Picture (slide 2 of 2)

• Several of the items included in Dr. Payne’s calculation of deductible business expenses require clarification. – Political contributions ($1,000 + $1,000) cannot be

deducted. – The dental supplies expense and the office supplies

expense must be reduced by the amount of the ending inventory (i.e., $7,000 and $1,500, respectively) since Dr. Payne is using the accrual method of accounting.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 66

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

P pt ch 06

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