© 2012 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. Chapter 6 Business Expenses Murphy & Higgins Concepts in Federal Taxation, 2012 edition

© 2012 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 deductions are a matter of legislative grace Just because GAAP allows a deduction, don’t assume tax law will too!

© 2012 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. Business Expenses  All expenses must first meet the basic tests for deductibility: Have a business purpose Be ordinary, necessary, and reasonable Be allowed under the legislative grace concept  Requirements Expenses related to Meals, Entertainment, Automobile Usage, Travel, and Business Gifts are deductible subject to limitations and strict documentation requirements  Amount  Time and place  Date and description  Business purpose  Business relationship of other person(s)

© 2011 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. Meals and Entertainment  Meals and entertainment expenses must be directly related to or associated with the active conduct of a business activity The “directly related to” test is met if:  There is more than a general expectation of business benefit  A bona fide business activity takes place during the meal or entertainment  The principal reason for the meal or entertainment is business  The expenses are related to the taxpayer and people involved in the business activity The “associated with” test is met if:  There is a clear business purpose for the meal or entertainment  Meal or entertainment directly precedes or directly follows a substantial business discussion

© 2012 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. Meals and Entertainment: Costs  Meal costs Food, beverage, tax, and tips  Entertainment costs Expenses for clubs, theaters, and sporting events Only the face amount of a ticket is allowed Club dues do not qualify  Limitations Only 50% of the allowable costs may be deducted Exceptions to the 50% limitation  Reimbursed expenses  Expenses that are taxable income to a non-employee recipient (awards, prizes)  Expenses for recreational or social activities which benefit employees

© 2012 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. Auto Expenses  The cost of using an automobile for business is deductible  Requirements Use of the automobile must be for travel  Out of town  From home to a temporary workplace  From the regular to a temporary workplace  From the workplace to a second job The cost of commuting is never deductible  Methods Auto expenses may be computed under one of two methods:  Actual Cost  Standard Mileage Rate

© 2012 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. Auto Expense Methods  Actual cost method Actual cost of using the automobile may be deducted  Business percentage of depreciation, gas and oil, repairs, insurance, interest, license fees, etc. is deductible  Deduction amount is often larger than the standard rate  Standard mileage rate method Administrative convenience concept allows a deduction based on the number of business miles driven during the year  Rate is $0.51 per mile (2011)  Tolls, parking, interest and property taxes may be added Standard rate method is not allowed if multiple cars are used

© 2012 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. Travel Expenses  Travel expenses incurred while on business away from the tax home overnight are deductible Tax home is the principal area in which business is conducted Overnight means longer than a regular workday  Limitations Over 50% of the activity requiring travel must have a business purpose  Personal activity costs on a business trip are not deductible  Incidental business expenses on a personal trip are deductible  Travel for general educational purposes or for investment related meetings is not deductible

© 2012 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. Business Gifts  Cost of a gift given to a business customer may not be fully deductible There is an overall limitation of $25 per person, per year Gifts are not subject to the 50% entertainment limits Delivery, gift wrap, engraving, etc., do not count toward the $25 limitation

© 2012 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. Education Expenses  Costs of education are deductible if Required by law (or employer) to maintain employment, or Maintains or improves current job skills  Costs of education are not deductible if Necessary to meet minimum job requirements, or Qualifies taxpayer for new trade or business  Unreimbursed allowable costs are deductible as miscellaneous itemized deduction  Employee may exclude up to $5,250 of reimbursed expenses from a qualified plan

© 2011 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. Compensation of Employees (slide 1 of 2)  Wages, salaries, bonuses and other compensation paid to employees is deductible if two basic tests are met: Employees must perform actual service Payment must be reasonable in amount  To determine if compensation is reasonable, consider: Duties, responsibilities and pay history of the employee Volume and complexity of the business Time required to do the work Ability and accomplishments of the employee Company pay policy  Payments to a related party may be examined closely for Lack of a business purpose An arms-length transaction Reality of compensation in a closely-held business

© 2012 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. Compensation of Employees (slide 2 of 2)  Size of deduction for salary paid to a covered employee is limited Covered employees = CEO and the four highest paid officers $1,000,000 limit on compensation deduction per employee Some amounts are exempt from the limit  Commissions and performance based payments  Pension plan contributions  Fringe benefits

© 2012 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. Bad Debts  Bad debts are generally deductible under the capital recovery concept  Business bad debts are deductible only under the accrual method  Nonbusiness (investment) bad debts are deductible if the debt is bona fide Report as a short-term capital loss No deduction is allowed if the debt is voluntarily forgiven

© 2012 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. Qualified Production Activities Deduction (Slide 1 of 2)  Amount of Deduction 9% of the lesser of:  Qualified Production Activities Income OR  Taxable Income before Qualified Production Activities Deduction Cannot Exceed 50% of W-2 wages allocable to domestic production gross receipts of the Taxpayer  Qualified Production Activities Income Domestic Gross Production Receipts  Less the allocable:  Cost of Goods Sold  Direct Expenses and Losses  Indirect Expenses and Losses

© 2012 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. Qualified Production Activities Deduction (Slide 2 of 2)  Domestic Gross Production Receipts arise from Sale, exchange, lease, rental or other disposition of:  Qualifying property manufactured, produced, grown, or extracted in the U.S.  Qualified films produced  Electricity, natural gas, or potable water produced in the U.S. Construction activities performed in the U.S. Engineering or architectural services performed in the U.S.  Qualified Production Property Tangible Personal Property Computer Software Sound Recordings  Retailers who buy from taxpayers with qualified production activities may not claim sales of those products as gross production receipts

© 2012 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. Carlton, Inc. has gross receipts from qualified production activities of $7,500,000. The COGS related to these activities is $3,000,000. The related direct costs are $250,000. Carlton estimates that 40% of the $500,000 indirect costs is attributable to the activities. Taxable income before the QPAD is $4,600,000. What is Carlton’s QPA income? ($7,500,000 - $3,000,000 - $250,000 – (.40 x $500,000) = $4,050,000 What is Carlton’s QPAD? Lesser of: (9% x $4,050,000) or (9% x $4,600,000) = 9% x $4,050,000 = $364,500 © 2011Cengage 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. QPAD Example

© 2012 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. Insurance, Legal Fees, and Taxes  Insurance Insurance premiums paid to protect a business from the following losses are deductible.  Fire, theft, casualty or liability  Group medical, term-life and worker’s compensation  Performance and fidelity bonds  Business interruption  Legal fees Legal fees are deductible if they were paid to defend business income, reputation, or goodwill  If fees are related to property ownership, they are capitalized with the cost of the property  Taxes Most business-related taxes are deductible unless paid to the federal government Exceptions:  Sales taxes related to long-lived assets must be capitalized  Property taxes related to real estate bought or sold during the year must be allocated between buyer and seller  Assessments are not taxes but are for local benefits are added to the property’s basis

© 2012 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. Individual Deductions For Adjusted Gross Income  Expenses paid by individuals For a business purpose, or Specifically allowed by Congress to create equity in tax treatment are allowed as deductions for AGI  Alimony  Reimbursed Employee Business Expenses Accountable Reimbursement Plan Non-accountable Reimbursement Plan

© 2012 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. Reimbursed Employee Business Expenses - Accountable Plan  Employees are required to make an adequate accounting of their expenses  Reimbursements = expenses Nothing is reported  Reimbursements < expenses Reimbursement is reported as income Expenses = reimbursement income are deducted for AGI Excess expenses are deducted from AGI  Reimbursements > expenses and excess is not returned Excess reimbursement is reported as income

© 2012 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. Reimbursed Employee Business Expenses - Nonaccountable Plan  Employees are not required to make an adequate accounting of their expenses All reimbursements are included in income All expenses are deducted from AGI

© 2012 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. Deductions for Self-Employed Taxpayers  To provide self-employed taxpayers equity with the tax treatment of employees, they are allowed to deduct:  The cost of health insurance premiums paid for themselves  50% of the amount of self-employment tax paid

© 2012 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. Retirement Plan Contribution Deductions  Taxpayers who do not have access to an employer sponsored pension plan are allowed several options: Keogh or H.R.10 plans (for self-employed taxpayers only) Individual Retirement Accounts (for all taxpayers)  Individual retirement accounts contributions: All taxpayers may contribute a maximum of $5,000 of their earned income to a Deductible or a Roth IRA.  Special “Catch-up” rule allows up to $6,000 if 50 or older A married couple may contribute $10,000 in total ($12,000 if over 50), but not more than $5,000 ($6,000) to any one account  Two major Retirement IRA types: Conventional Roth

© 2012 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. Conventional IRA  Contributions limited to lesser of $5,000 ($6,000 if > 50) or amount of earned income Fully deductible if not covered by an employer’s plan  Not linked to spouse’s coverage If covered, maximum deduction equals: (Maximum contribution) x [1 – IRA percentage*]* (AGI - phase-out) / $10,000 ($20,000 MFJ)  Phase out amounts Tax YearMarriedSingle 2011$90,000$56, $89,000$56,000

© 2012 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. Conventional IRA Example  Single taxpayer with AGI = $58,000 contributes $5,000 to an IRA. How much is deductible if the t/p is covered by a qualified plan? $5,000 X [ 1 - ($58,000 - $56,000)/10,000] = $5,000 X [ ] = $5,000 X 0.80 = $4,000 maximum deduction

© 2012 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. Roth IRA  Contributions are not deductible  Earnings distributions are tax-free if: IRA has existed for 5 years, and Taxpayer is >59 1/2 years old No age limit to begin distributions  Contributions are phased-out like Conventional IRA Married beginning at $169,000 Others beginning at $107,000

© 2012 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. Coverdell Education Savings Account (CESA)  Set up as a trust for the benefit of any person under age 18  $2,000 nondeductible contribution per student per year Phased-out for AGI greater than  Married, from $190,000  Others, from $95,000  Max. contribution x [1 - {(AGI - phase-out) / 15,000}]  Tax-free growth in the IRA  No tax at time of withdrawal if used for qualified expenses Tuition and fees of student

© 2012 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. Higher Education Expense Deduction  May deduct up to $4,000 of qualifying higher education expense Qualifying = tuition and fees Must have AGI < $65,000 if single ($130,000 for MFJ) Cannot claim in addition to American Opportunity Tax Credit or Lifetime Learning Credit (Chapter 8 )

© 2012 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. Education Loan Interest  May deduct up to $2,500 for interest paid on education loans Taken as a “for” deduction Only for payments made during first 60 months of the loan Deduction phased-out when AGI exceeds  Married, from $120,000; Others, from $60,000  Deduction = Amt. Allowed x [1 - {(AGI - phase-out) / 15,000}]

© 2012 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. Moving Expenses (slide 1 of 2)  Moving expenses are deductible if they meet two tests: Distance test Time test  Employee taxpayers must be employed in the new area for 39 weeks of the 12 months after moving  Self-employed taxpayers must be employed in the new area for 78 weeks of the 24 months after moving  Waived for death, disability, or required transfer New job x + 51 miles Old house x miles Old job

© 2012 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. Moving Expenses (slide 2 of 2)  Qualifying Expenses Only two types of expenses are deductible:  Costs of moving household goods and personal items to the new location  Transportation and lodging costs of moving the taxpayer and family to the new location  Mileage is allowed at $0.19 per mile  None of the cost of meals is deductible  Reimbursements Any reimbursement of moving expenses received from an employer is included as income