Chapter 5 Introduction to Business Expenses Murphy & Higgins Concepts in Federal Taxation, 2014 edition © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Concept Review All tax deductions are a matter of Legislative Grace Deductions are part of Congress’ approach to implementation of Ability-to-Pay © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Review All deductible amounts fall into one of three categories: Business Expenses (Chapters 5 & 6) Losses (Chapter 7) Other Itemized Deductions (Chapter 8) Two primary types of deductions allowed: Deductions for adjusted gross income Generally have a business purpose Deductions from adjusted gross income Generally have a personal purpose © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Conduit Entity Reporting Conduit entities are not subject to tax, but results of operations flow-through to owners’ returns Items subject to special tax treatment are kept separate Items not subject to special tax treatment are netted to arrive at ordinary net income or net loss © 2014Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Classification of Deductions All expenditures fall into two categories: Profit-motivated Trade or business expenses Expenses for the production of income (Investment) Personal Specifically allowed itemized deductions Nondeductible personal expenses © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profit-Motivated Expenditures To be deductible, an expenditure must have a bona fide business purpose unrelated to its tax effect Must show that the expense is related to a profit-motivated transaction Must show that the business purpose is the primary or dominant motive Trade or business Requirements to qualify: Primary purpose is to earn income or a profit Involvement is regular and continuous Activity is not merely a hobby Rental activities May be either trade or business or an investment activity Expenses are always deducted for AGI Classification matters when property is sold Classification is determined by the scope of the taxpayer’s involvement © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Mixed Use: Business & Personal Use Mixed-Use Assets Used both to earn income and for personal purposes Treat as two separate assets by allocating amount of use Mixed-Use Expenditures Incurred both for profit and personal reasons Allocate between business and personal use and deducted as allowed © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tests for Deductibility To be deductible, expenses must be profit-motivated or specifically allowed, and also Ordinary Normal, common, generally accepted Necessary Appropriate, helpful, prudent Reasonable in amount Arm’s length © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Five Negative Tests for Deductibility To be deductible, expenses must not be Personal Business purpose is not primary motive Not specifically allowed Capital Expenditures Should be capitalized as assets if useful life extends beyond a year Start-up costs May expense $5,000 in first year; remainder is amortized over 180 months First year expense is phased-out if total costs > $50,000 Against Public Policy Resulting from violation of a law Resulting from an illegal business Cost of goods sold is always deductible under the capital recovery concept Ordinary, necessary, and reasonable business expenses are deductible for all illegal businesses except sale of illegal drugs For lobbying and political activities Costs to influence local legislation are deductible Costs to monitor any legislation are deductible Related to Tax-Exempt Income Incurred to generate tax-exempt income Another Person’s Obligation Cannot recover another’s capital © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Mixed Use: Hobby versus Business An income-earning activity without a predominant profit motive is a hobby Factors considered in determining profit-motive: Manner of conducting activity Expertise or reliance on expert advice Time and effort spent on activity History of income and loss Amount of occasional profit Elements of personal pleasure Financial status Success in similar activities Losses from a hobby are not deductible Expenses allowed up to amount of income generated Deductions taken using three tier system: Expenses also allowed as either business or itemized deductions Other expenses that qualify as business expenses Depreciation on assets used Allowable expenses are deducted from AGI © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Mixed Use: Vacation Home A residence used for personal vacations and also rented to unrelated people is a mixed-use asset and first must be classified as either: Personal residence if rented 14 days or fewer in a year Vacation home if used personally more than 14 days, or more than 10% of the number of days rented Rental property if used personally less than or equal to 14 days, or less than or equal to 10% of the days rented © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Vacation Home Tax Treatment If classification is: Then tax treatment is: Personal residence Report no income or expense Vacation home Report income and allocate expenses using three tier system (no loss allowed) Rental property Report income and allocate all expenses; Loss allowed © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Mixed Use: Home Office A specific portion of the home must be used Exclusively and regularly, As the principal place of business or As a place to meet clients, but If taxpayer has no other available location to do administrative or management activities, this requirement will not disqualify the deduction Employees must also show that the use Is for the convenience of their employer Required as a condition of employment Allowed expenses are deducted using the three tier system Deduction is limited to the amount of net income from the business Home-office deduction may not create a loss Excess may be carried-forward © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Timing of Deductions The taxpayer’s accounting method is used to determine the timing of deductions Cash Method: Claim a deduction in the year an expense is paid Date of mailing for checks Date of charge for credit cards Prepaid expenses are deductible if used within one tax year (prepaid interest does not qualify) Accrual Method: Claim a deduction in the year two tests are met All-events test is met when a liability exists and the amount can be determined Economic performance test is met when services or property are provided © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Timing of Deductions Related Party Accrued Expenses Deductions for accrued expenses payable to a cash basis related party are limited Related parties include family members and businesses owned or controlled by the taxpayer Unless both parties are accrual basis, both report using the cash method; until income is reported no expense may be deducted © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial Accounting Income versus Taxable Income Matching and Conservatism are not tax concepts Estimates of expenses are not permitted for tax purposes Use specific write-off for bad debts Do not estimate warranty expense © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.