1. Introduction to Business Expenses
Chapter 5
Introduction to Business Expenses
Kevin Murphy
Mark Higgins
©2007 South-Western

2. All tax deductions are a matter of Legislative Grace
Concept Review
All tax deductions are a matter of Legislative Grace
Deductions are part of Congress’ approach to implementation of
Ability-to-Pay

3. Review!
From Chapter 1: All deductible amounts fall into one of three categories:
Business Expenses (Chapters 5 & 6)
Losses (Chapter 7)
Deductions (Chapter 8)

4. Review! There are two primary types of deductions allowed individuals:
Deductions for adjusted gross income
generally have a business purpose
Deductions from adjusted gross income
generally have a personal purpose

5. Review!
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

6. 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

7.  Profit-Motivated Expenditures
To be deductible, an expenditure must have a business purpose unrelated to its tax effect.
Show that the expense is related to a profit-motivated transaction
Show that the business purpose is the primary or dominant motive

8. Trade or Business Requirements to qualify as a trade or business:
Primary purpose is to earn income or a profit
Involvement is regular and continuous
Activity is not merely a hobby

9. Rental Activity
Rental activities may be either trade or business or for the production of income
Expenses are always deducted for AGI
Classification matters when property is sold
Classification is determined by the scope of the taxpayer’s involvement

10. Mixed-Use ( & ) Business and 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 deduct as allowed

11. 3 Positive 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

12. 5 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
After 10/23/04 may expense $5,000 in first year; remainder is amortized over 180 months
Expense is phased-out if total costs > $50,000

13. 5 Negative Tests for Deductibility
Against Public Policy
Resulting from violation of a law
Resulting from an illegal business
Cost of goods sold are always deductible under the capital recovery concept
Ordinary, necessary, and reasonable business expenses are deductible for all illegal businesses except sale of drugs
For lobbying and political activities
Costs to influence local legislation are deductible
Costs to monitor any legislation are deductible

14. 5 Negative Tests for Deductibility
Related to Tax-Exempt Income
Incurred to generate tax-exempt income
Another Person’s Obligation
Cannot recover another’s capital

15. Mixed-Use Expenses Hobby Vs. Business
An income-earning activity without a predominant profit motive is a hobby.

16. Mixed-Use Expenses Hobby Vs. Business
Factors considered in determining profit-motive are
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
Success in similar activities

17. Mixed-Use Expenses Hobby
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 personal itemized deductions
Other expenses that qualify as business expenses
Depreciation on assets used
Allowable expenses are deducted from AGI

18. Mixed-Use Expenses 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 less than 15 days 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 15 days, or
less than or equal to 10% of the days rented

19. Vacation Home Tax Treatment
If classification is:
Personal residence
Vacation home
Rental property
Then tax treatment is:
Report no income or expense
Report income and allocate expenses using three tier system (no loss allowed)
Report income and allocate all expenses; Loss allowed

20. Mixed-Use Expenses Home Office
A taxpayer who operates a trade or business from home may be able to deduct a portion of the home’s expenses.
Expenses of the home are allocated between business and personal use

21. Mixed-Use Expenses 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

22. Mixed-Use Expenses Home Office
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

23. Timing of Deductions
The taxpayer’s accounting method is used to determine the timing of deductions.

24. Timing of Deductions Cash Method
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)

25. Timing of Deductions Accrual Method
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

26. 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
© 2004 South-Western College Publishing

27. Financial Accounting Income Vs. 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

28. End of Chapter 5