2 Learning Objective 1Understand the meaning and application of the ordinary, necessary, and reasonableness requirements for the deductionof business expenses.
3 Ordinary Expenses An expense is ordinary if it is Normal, usual, or customary in the type of business conducted by the taxpayer, andNot capital in natureOrdinary expenses need not be recurring in order to be deductible
4 Necessary Expenses An expense is necessary if A prudent businessperson would incur the same expense, andThe expense is expected to be appropriate and helpful in the taxpayer’s businessSome expenses that are necessary are not ordinary, and therefore are not deductible
5 Reasonable ExpensesThe Code applies the reasonableness requirement only to salaries and other compensationThe courts have applied the reasonableness requirement to all ordinary and necessary business expensesExpenses in excess of reasonable amounts are not deductible
6 Learning Objective 2Describe the cash and accrual methods of accounting for business deductions.
7 Cash Method Requirements Cash basis taxpayers can deduct expenses only when they are actually paid with cash or propertyPayments made with borrowed funds can be deducted, but issuing a note does not meet the “actually paid” requirementFor cash and accrual basis taxpayers, Capital expenditures can be deducted only through amortization, depletion, or depreciation
8 Accrual Method Requirements (slide 1 of 2) Deductions are allowed when the all events test and the economic performance test are metAll events test is met when:All the events have occurred to create the taxpayer’s liability, andThe amount of the liability can be determined with reasonable accuracy
9 Accrual Method Requirements (slide 2 of 2) Economic performance testMet when service, property, or use of property giving rise to the liability is actually performed for, provided to, or used by the taxpayerCertain recurring, immaterial items can be deducted in year incurred if economic performance occurs within 8 1/2 months after close of year such expenses were incurred
10 Learning Objective 3Apply a variety of Internal Revenue Code deduction disallowance provisions.
11 Disallowance Possibilities (slide 1 of 9) Deductions are disallowed for specified expenses that are considered contrary to public policy, including:Bribes and illegal kickbacksFines and penalties paid to a government for violation of lawLegal expenses incurred in defense of civil or criminal penalties are deductible only if directly related to a trade or business
12 Disallowance Possibilities (slide 2 of 9) The ordinary and necessary expenses of operating an illegal business are deductibleExpenses incurred in illegal drug trafficking are not deductible (except for cost of goods sold)Political contributions are not deductible
13 Disallowance Possibilities (slide 3 of 9) Lobbying expenses may be deductible to a limited extentDeduction is not allowed for:Influencing legislationParticipating or intervening in any political campaign (for or against a candidate for public office)Attempting to influence votersAttempting to influence the actions of certain high-ranking public officials
14 Disallowance Possibilities (slide 4 of 9) Exceptions to disallowance of lobbying expenditures (i.e., expenditures are deductible):Influencing local legislation (city or county)Activities devoted solely to monitoring legislationDe minimis exception allows deduction of up to $2,000 of in-house expenditures (unless prohibited by rules discussed previously)
15 Disallowance Possibilities (slide 5 of 9) Executive compensation of covered employees in excess of $1 million per executive per year generally is not deductible by publicly held corporationsException: certain types of compensation (e.g., commissions based on individual performance) are not treated as executive compensation for purposes of this limitationCovered employees include CEO and the four other most highly compensated officers
16 Disallowance Possibilities (slide 6 of 9) Expenses of investigating a business may or may not be deductibleIf the taxpayer is in the same or a similar business, expenses are deductible, whether or not the business is acquiredIf the taxpayer is not in the same or a similar business:Expenses are deductible (amortized over 60 months or more) only if the business is acquiredExpenses are not deductible if the business is not acquired
17 Disallowance Possibilities (slide 7 of 9) A loss on a transaction between related parties is disallowedThis prevents close relatives from establishing deductible losses while keeping the property within the family unitA gain realized on a subsequent sale by the related party purchaser is recognized only to the extent it exceeds the previously disallowed loss
18 Disallowance Possibilities (slide 8 of 9) Accrued expenses and interest owed to a related party are deductible by the accrual basis taxpayer only when actually paid to the cash basis taxpayerThe taxpayer has the burden of proof for substantiating expenses and must retain adequate records; otherwise, IRS can disallow the deductions
19 Disallowance Possibilities (slide 9 of 9) Expenses and interest related to tax exempt income are disallowed
20 Learning Objective 4Understand the limitations applicable to the charitable contribution deduction for corporations.
21 Charitable Contributions (slide 1 of 6) Contributions are not deductible unless made to qualified domestic charitable organizationsSee list on p of text
22 Charitable Contributions (slide 2 of 6) Contributions are generally deductible when the payment is made, both for cash and accrual basis taxpayersException: Accrual basis corporations may deduct contribution in year of accrual if:Authorized by the board of directors, andActually paid within 2 1/2 months of end of year
23 Charitable Contributions (slide 3 of 6) The deduction for a charitable contribution of property depends on the type of property contributedOrdinary income propertyDeduction generally is adjusted basisLong-term capital gain propertyDeduction generally is fair market value (FMV)
24 Charitable Contributions (slide 4 of 6) Exceptions for certain contributions of long-term capital gain property:Basis (rather than FMV) is used if the property is tangible personal property and is put to an unrelated use by the doneeBasis (rather than FMV) is used for contributions to certain private nonoperating foundations
25 Charitable Contributions (slide 5 of 6) Deduction is equal to basis plus half of appreciation for contributions of certain types of property:Inventory used solely for care of the ill, the needy, or infantsScientific property donated to colleges and certain scientific research organizations for use in research
26 Charitable Contributions (slide 6 of 6) Corporate contribution deductions are limited to 10% of taxable income computed without regard to:The charitable contribution deductionAny NOL or capital loss carrybackThe dividends received deductionIndividuals may be subject to limits of 20%, 30%, or 50% (see Chapter 15)
27 Learning Objective 5Recognize and apply the alternative tax treatments for research and experimental expenditures.
28 Research & Experimental Expenditures (slide 1 of 2) R & E expenditures are defined in the Regulations (see p in text)Includes costs of developing a model, a plant process, a product, a formula, or an inventionIncludes costs of improving an existing property of type mentioned aboveExcludes costs for ordinary testing, quality control, efficiency surveys, etc
29 Research & Experimental Expenditures (slide 2 of 2) Alternative treatments for R & E expenditures:Expense in the year paid or incurredDefer and amortize over a period of not less than 60 monthsCapitalize
30 Other Expense Rules - Interest Corporations may generally deduct all business interest incurred (unless associated with a passive activity)Individuals may deduct some type of interest but not othersDeductible: business interest, home mortgage interest (to a limited extent), and investment interest (to a limited extent)Not deductible: personal interest (unless the loan is secured by the taxpayer’s home)
31 Other Expense Rules - Taxes (slide 1 of 2) Taxes of all types incurred by business entities are generally deductible (unless incurred in a passive activity)Most Federal taxes are not deductible
32 Other Expense Rules - Taxes (slide 2 of 2) Taxes incurred by individuals are generally deductible if related to business or investmentsTaxes on realty and personalty generally are deductible, even if the property is for personal useWhen real property is sold during the year, real estate taxes must be apportioned between the buyer and seller on the basis of days owned during the tax year
33 Learning Objective 6Determine the amount of cost recovery under MACRS, and apply the § 179 expensing election and the deduction limitations on listed property and automobiles when making the MACRS calculation.
34 Depreciation vs. Cost Recovery Allowances Depreciation rules applied to assets before 1980 and continue to apply to pre-1981 assets and certain assets placed in service after 1980The accelerated cost recovery system (ACRS) generally applied to assets acquired after 1980 and before 1987ACRS cost recovery lives were shorter than depreciation lives and used more accelerated methods
35 MACRS (slide 1 of 2) MACRS applies to post-1986 property Depreciation and ACRS rules, which are applicable to pre-1987 property, are not covered in the textDifferent cost recovery tables apply to personalty and realtyRealty includes land, buildings, etc. (real estate)Personalty includes assets that are not realty (machines, equipment, furniture, etc.)
36 MACRS (slide 2 of 2)Trade or business or production of income assets are eligible for cost recoveryAssets that do not decline in value or have a determinable useful life are not eligible (e.g., land, antiques, stock)Basis of property must be reduced by cost recovery allowed and by not less than the allowable amountBasis for cost recovery of personal-use assets converted to business or income-producing use is the lower of adjusted basis or FMV at time property is converted
37 MACRS - Personalty (slide 1 of 3) Determine cost recovery period of asset (Exhibit 4-2, p in text)Look up rate in appropriate tableTable 4-1 (Half-year convention)Table 4-2 (Mid-quarter convention)Table 4-4 (Straight-line election, half-year convention)Multiply rate times basisGenerally, allowed 1/2 year of cost recovery in year of acquisition and disposition
38 MACRS Personalty (slide 2 of 3) Example 1 - AcquisitionAcme acquires a computer on 1/1/01 for $10,0005-year property (see Exhibit 4-2)Rate from Table 4-1 = 20%Cost recovery allowance for 2001:$10,000 x 20% = $2,000Cost recovery allowance for 2002:$10,000 x 32% = $3,200
39 MACRS Personalty (slide 3 of 3) Example 2 - DispositionAcme sells the computer on 1/1/03 for $6,000Half-year convention applies (half-year of cost recovery is allowed in year of disposition)Cost Recovery Allowance for 2003:$10,000 x 19.20% from Table 4-1 x 1/2 = $960Accumulated Cost Recovery Allowance:[20% + 32% + (1/2 x 19.20%)] = ($2,000 + $3,200 + $960) = $6,160Basis is $10,000 - $6,160 = $3,840
40 MACRS - Realty (slide 1 of 3) MACRS for Post-1987 RealtyBased on SL method, mid-month convention27.5 year life for residential property39 year life for nonresidential property (31.5 year life from 1/1/87 through 5/12/93)Multiply base x rate from Table 4-3
41 MACRS - Realty (slide 2 of 3) Example – AcquisitionTaxpayer acquires a warehouse for $100,000 on April 1, 20012001 Cost Recovery Allowance (CRA)$100,000 X 1.819% from Table 4-3 = $1,819
42 MACRS - Realty (slide 3 of 3) CRA in year of disposition is based on the mid-month conventionExample – DispositionTaxpayer disposes of above warehouse on October 1, 20022002 Cost Recovery Allowance($100,000 x 2.564%) [from Table 4-3] x (9.5/12) = $2,030
43 Mid-Quarter Convention Applies if > 40% of personalty is placed in service during last quarter of the yearMust group property by quarter acquiredProperty acquired in1st quarter is allowed 10.5 months of cost recovery; 2nd quarter, 7.5 months; 3rd quarter 4.5 months; 4th quarter, 1.5 monthsUse Table 4-2 (Mid-quarter convention)
44 The MACRS Straight-Line Election (Personalty) MACRS allows accelerated depreciation for personalty placed in service after 1986 (Table 4-1)The taxpayer may elect straight-line depreciation for personalty placed in service after 1986 (Table 4-4)Taxpayer may wish to take slower write-offs for various reasons (e.g., tax bracket is expected to be higher in later years)
45 Election to Expense Assets Under § 179 (slide 1 of 3) Maximum amount allowed:2000 $20,0002001 or 2002 $24,0002003 and thereafter $25,000
46 Election to Expense Assets Under § 179 (slide 2 of 3) Example: Corporation buys a $100,000 truck (5-year property) on February 15, 2001 and elects immediate expensing of the maximum amountCost of machine $100,000§ 179 deduction 24,000Amount subject to ACRS $ 76,000MACRS rate .20Cost recovery allowance $ 15,200Total cost recovery allowed in 2001 is $39, ($24,000 + $15,200)
47 Election to Expense Assets Under § 179 (slide 3 of 3) Annual limitations on § 179 expenseThe § 179 deduction is reduced dollar-for-dollar to the extent eligible property placed in service during the year exceeds $200,000The amount expensed under § 179 cannot exceed the aggregate amount of taxable income derived from the conduct of any trade or business by the taxpayer
48 Limits on Autos and Other Listed Property (slide 1 of 6) Limits on MACRS deductions apply toAutomobilesListed property (see next slide) used for both business and personal purposesTypes of limitsRestrictions on allowable cost recovery method (depends on predominant use); applies to autos and listed propertyDollar limits apply to autos
49 Limits on Autos and Other Listed Property (slide 2 of 6) Listed property includes:Passenger automobilesCertain other property used for transportationProperty used for entertainment, recreation, or amusementCertain computer equipment and peripheralsCellular phones and similar telecommunications equipmentOther property specified in the regulations
50 Limits on Autos and Other Listed Property (slide 3 of 6) Methods for determining cost recovery allowanceStatutory percentage method–may be used if property is predominantly (>50%) used for business; results in faster write-off than straight-line methodStraight-line method–required if property is not used predominantly for business
51 Limits on Autos and Other Listed Property (slide 4 of 6) Dollar limits applicable to automobiles (for 2001)Recovery Year Recovery Limitation1 $3,060,000,950Remaining years* 1,775* $1,775 is recovered each year until cost is recovered completely
52 Limits on Autos and Other Listed Property (slide 5 of 6) Example: Taxpayer acquired an auto in 2001 for $20,000 and used it 80% for business.2001 cost recovery allowance:($20,000 x 20%) $4,000Deduction is limited to $3,060 $3,060x Business use .80Cost recovery allowance $2,448
53 Limits on Autos and Other Listed Property (slide 6 of 6) Autos and listed property not used predominantly in businessStraight-line cost recovery tables applyChange from predominantly business useCost recovery allowances computed under statutory percentage method are subject to recapture
54 Leased AutomobilesA taxpayer who leases an automobile must report an inclusion amount in gross incomePrevents taxpayers from circumventing dollar limitations by leasing instead of purchasingInclusion amount is computed from a table provided by the IRS
55 Alternative Depreciation System (ADS) ADS must be used in certain cases:To calculate the AMT adjustment(Chapter 13)To compute depreciation on propertyUsed predominantly outside the U.S.Leased or otherwise used by a tax-exempt entityFinanced with the proceeds of tax-exempt bondsImported from foreign countries that maintain discriminatory trade practices or otherwise engage in discriminatory actsTo compute depreciation for earnings and profits purposes ( Chapter 10)
56 Learning Objective 7Identify intangible assets that are eligible for amortization and calculate the amount of the deduction.
57 Amortization (slide 1 of 2) Amortization refers to the systematic write-off of intangible assetsAmortizable § 197 intangibles may be written off over a 15-year period
58 Amortization (slide 2 of 2) § 197 intangibles include:Goodwill and going concern valueFranchises (except sports franchises)Trademarks and trade namesCertain other intangibles obtained in acquisition of a business (e.g., covenant not to compete, patents)