Module 9 Business Deductions

Module Topics n Statutory Scheme for Deductions n §162 Business Deductions: The Basic Requirements n Prohibited Deductions n Deductions Common to Most Businesses n Special Deductions for Corporations n Capitalization Issues

Statutory Scheme for Deductions Key Learning Objective n Apply the three-tier expense deduction classification scheme

Tax Concept n No expenditure is deductible unless allowed by a provision in the tax law u Specifically authorized by the Code, or u Satisfies general criteria

General Criteria for Deductibility n Expense must be: u Ordinary, necessary, and reasonable in amount u Incurred in connection with a trade or business or in the production of income n Expense is not: u A capital expenditure u A personal expenditure u Related to tax-exempt income u Contrary to public policy

Deduction Classification Scheme n Trade or business deductions--§162 n Production of income deductions--§212 n Statutory personal deductions

Trade or Business Deductions (§162) n Must be ordinary and necessary and reasonable in amount n Profit must be primary motive of the activity u Net loss from “hobby” not deductible n Activity must be ongoing and entrepreneurial in nature

Production of Income Deductions (§212) n Must be ordinary and necessary and reasonable in amount n Must be for the: u Production or collection of income u Management, conservation, or maintenance of property held for the production of income u Determination, collection, or refund of any tax

Statutory Personal Deductions n §262 disallows the deduction of personal, living, or family expenses n Other Code sections allow deductions for specific items u e.g., medical expenses, charitable contributions, mortgage interest, state and local income taxes, property taxes (Module 27)

§162 Business Deductions: The Basic Requirements Key Learning Objective n Apply the ordinary, necessary, and reasonableness requirements for business deductions

Basic Requirements n Ordinary u Acceptable, given the circumstances n Necessary u Appropriate when incurred n Reasonable u Not lavish

Research Query: Political Office- A Trade or Business? n A senator's administrative assistant incurred expenses of more than $100,000 over a four- year period despite the fact his salary had been only $1,200 a year n Should he be allowed to deduct these as ordinary and necessary business expenses?

Solution--Research Query: Political Office-ATrade/Business Frank, Gerald v. U.S., (1978, CA9) 42 AFTR 2d n Performing functions of public office is a trade or business n No requirement that a public employee intends to earn a livelihood from his government job in order to deduct his expenses n Deductions were allowed

Paid or Incurred Requirement n Cash-basis taxpayers u Expenses deductible when paid u Prepayments extending beyond one year generally must be accrued n Accrual-basis taxpayers u Expenses deductible when incurred u All-events test u Economic performance test

Prohibited Deductions Key Learning Objective n Distinguish between allowable deductions and those which are prohibited

Prohibited Deductions n Expenditures in violation of public policy u Are fines, penalties, illegal bribes, etc. n Lobbying expenses u Influence legislation, public opinion, or political elections at the state or national level n Expenditures associated with tax-exempt income u Prevents arbitrage

Compliance Query: Which Illegal Business is Best? n n T operates an illegal smuggling operation n n T incurred the following expenses: Salaries $ 50,000 Illegal kickbacks 20,000 Bribes to U. S. border guards 25,000 Cost of goods sold 150,000 n n How much is deductible if T smuggles u u Guns u u Drugs

Solution--Compliance Query: Which Illegal Business is Best? n Gun smuggler--treated like any other business. Cost of goods sold $150,000 Salaries 50,000 $200,000 n Other items against public policy n Drug smuggler-- limited to cost of goods sold. Cost of goods sold $150,000 $150,000

Deductions Common to Most Businesses Key Learning Objective n Identify and compute common business deductions

Deferred Compensation-- Potential Benefits n Immediate deduction for employer n Nontaxable to employee until payments are received n Deferral of tax on earnings until funds are distributed n Reduced or deferred tax on lump-sum distributions

Deferred Compensation--Types (covered in later modules) n Qualified pension plans n Nonqualified plans u Fewer potential benefits n Keogh plans n SEPs n IRAs

Interest n Generally deductible if business related n Must capitalize construction period interest and taxes n Prepaid interest must be accrued n Related party borrowings u Accrual-basis payer and cash-basis payee n Imputed interest

Taxes n Generally deductible if business related n Sales taxes capitalized as part of cost n Employer portion of payroll taxes deductible n Federal income taxes not deductible

Charitable Contributions n Deductible by corporations subject to 10% limit u 5-year carryover for unused deductions n Amount deductible (basis or FMV) depends on type of property donated u “Ordinary income” or “capital gain” property u Special rules for certain inventory, scientific equipment, and tangible personal property

Business Gifts n Limited to $25 per donee per year n Special rules for safety or length of service awards to employees

Travel n Generally deductible if business related n Includes incidental expenses n “Away from home” requirement for meals and lodging u 50% limit for meals n Strict substantiation requirements

Research Query: Where is a Traveling Man’s Home? n An unmarried salesman who spends almost all of his time on the road keeps some stuff at his sister’s home. n Will be be treated as “away from home” and entitled to deduct travel expenses if u He pays his sister a fair rent for the room? u He has free use of the room?

Solution--Research Query: A Traveling Man’s Tax Home n He is “away from home” and entitled to deduct travel expenses if he rents a room in his sister's home to use whenever he wants to and he pays his sister. n Sapson, Irving, (1968) 49 TC 636, acq(1973) CB 3 39 n IRS doesn't allow “away from home” treatment if the salesman pays no rent u Rev Rul , CB 37

Entertainment n Deductible if “directly related to” or “associated with” active conduct of business n 50% limit n Cost of entertainment facilities generally not deductible n No deduction for club membership dues n Strict substantiation requirements

Special Deductions for Corporations Key Learning Objective n Calculate deductions for corporate organizational costs and dividends received

Organization Costs n Includes first year attorney, accountant, and filing fees, etc., related to corporate formation n Does not include costs of issuing stock n Not currently deductible n Can capitalize and amortize over 60 months u Must make election

Dividend Received Deduction n Mitigates triple taxation n Applies generally to dividends from domestic corporations n Percent deductible (70%; 80%; 100%) depends on ownership percentage n Taxable income limitation may apply

Capitalization Issues Key Learning Objective n Classify expenditures that contain both repair and capitalization attributes

Issues n Deductible repair or capital expenditure? u Not always clear-cut n The Indopco decision u Creation of a separate asset is not a necessary condition for capitalization u Future benefit key factor for capitalization n Environmental cleanup costs u Present or future benefit? u Generally must capitalize

Research Query: Capital Expenditure or Repair? n The taxpayer’s road has several potholes. What are the tax consequences of each of the following alternatives? n Replacing gravel driveway with a cement driveway n Recrowning and resurfacing with the same materials

Solution--Research Query: Capital Expenditure or Repair? n Replacing gravel driveway with a cement driveway will be treated as a capital expenditure. u Jones, A. Raymond, (1956) 25 TC 1100 n Recrowning and resurfacing with the same materials should be a deductible repair. u Pennock Plantation Inc, (1951) PH TCM ¶51341