1. Chapter 5 Introduction to Business Expenses Murphy & Higgins
Concepts in Federal Taxation, 2014 edition
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2. Concept Review All tax deductions are a matter of Legislative Grace
Deductions are part of Congress’ approach to implementation of Ability-to-Pay
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3. 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
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4. 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
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5. 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
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6. 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
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7. 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
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8. 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
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9. 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
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10. 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
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11. 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
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12. 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
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13. 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
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14. 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
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15. 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
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16. 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
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