© 2010 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, 2010 edition

6-2 © 2010 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. All deductions are a matter of Legislative Grace Just because GAAP allows a deduction, don’t assume tax law will too!

6-3 © 2010 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

6-4 © 2010 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 Substantiation 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)

6-5 © 2010 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

6-6 © 2010 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 Directly Related Test 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

6-7 © 2010 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 Associated With Test 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

6-8 © 2010 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 include food, beverage, tax, and tips Entertainment costs include expenses for clubs, theaters, and sporting events Only the face amount of a ticket is allowed Club dues do not qualify

6-9 © 2010 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 Cost 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

6-10 © 2010 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 General Requirements The cost of using an automobile for business is deductible 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.

6-11 © 2010 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 Auto expenses may be computed under one of two methods: Actual Cost Standard Mileage Rate

6-12 © 2010 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 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

6-13 © 2010 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 Standard Mileage Rate Method Administrative convenience concept allows a deduction based on the number of business miles driven during the year Rate is $0.505 per mile (2008) Tolls, parking, interest and property taxes may be added Standard rate method is not allowed if multiple cars are used

6-14 © 2010 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

6-15 © 2010 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 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

6-16 © 2010 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

6-17 © 2010 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

6-18 © 2010 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. Unreimbursed allowable costs are deductible as miscellaneous itemized deduction Employee may exclude up to $5,250 of reimbursed expenses from a qualified plan Education Expenses

6-19 © 2010 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 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

6-20 © 2010 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 Reasonable Compensation Some factors considered when determining if compensation is reasonable are 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

6-21 © 2010 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. 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 Compensation of Employees Reasonable Compensation

6-22 © 2010 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. 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 Compensation of Employees Reasonable Compensation

6-23 © 2010 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

6-24 © 2010 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 Amount Of Deduction 6% of the lesser of: Qualified Production Activities Income OR Taxable Income before Qualified Production Activities Deduction Cannot Exceed 50% of W-2 wages paid by Taxpayer

6-25 © 2010 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 Income equals: Domestic Gross Production Receipts Less the allocable: Cost of Goods Sold Direct Expenses and Losses Indirect Expenses and Losses Qualified Production Activities Deduction

6-26 © 2010 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. 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. Qualified Production Activities Deduction

6-27 © 2010 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. 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 Qualified Production Activities Deduction

6-28 © 2010 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. Retailers who buy from taxpayers with qualified production activities may not claim sales of those products as gross production receipts Qualified Production Activities Deduction

6-29 © 2010 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. QPAD example 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? 6% x ($4,050,000 or $4,600,000) = 6% x $4,050,000 = $243,00

6-30 © 2010 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 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

6-31 © 2010 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. 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 for local benefits are added to the property’s basis

6-32 © 2010 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. 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

6-33 © 2010 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

6-34 © 2010 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. 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

6-35 © 2010 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. 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

6-36 © 2010 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

6-37 © 2010 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)

6-38 © 2010 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 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

6-39 © 2010 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. Three Major IRA Types Conventional Roth Coverdell Educational Savings Account

6-40 © 2010 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. 1. 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)

6-41 © 2010 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 Phase-out Amounts Tax YearMarriedSingle 2009$89,000$55, $85,000$53,000

6-42 © 2010 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 - $55,000)/10,000] = $5,000 X [ ] = $5,000 X 0.70 = $3,500 maximum deduction

6-43 © 2010 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. 2. 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 $166,000 Others beginning at $105,000

6-44 © 2010 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. 3. 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}]

6-45 © 2010 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. 3. CESA Continued Tax-free growth in the IRA No tax at time of withdrawal if used for qualified expenses Tuition and fees of student

6-46 © 2010 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 HOPE or Lifetime Learning Credits (Chapter 8)

6-47 © 2010 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. Educational 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}]

6-48 © 2010 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 Moving expenses are deductible if they meet two tests. Distance test New job x + 51 miles Old house x miles Old job

6-49 © 2010 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 Time 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

6-50 © 2010 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 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

6-51 © 2010 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 Reimbursements Any reimbursement of moving expenses received from an employer is included as income