2. 5 - 1 Business Expenses Chapter 5

3. 5 - 2 Code Sections Deductions are permitted by “legislative grace” so they are allowed only if specifically authorized in the Code  Sec. 162(a) authorizes deductions for ordinary and necessary expenses, that are reasonable in amount, and incurred in actively carrying on a trade or business  Sec. 212 authorizes deductions for expenses related to production of income (investment- related expenses)

4. 5 - 3 Disallowed Deductions Unless provided for otherwise in the Code, a deduction will be disallowed if it is  Contrary to public policy (fines, penalties)  Related to tax-exempt income  Accrued to related party (no deduction until related party recognizes income)  The obligation of another taxpayer

5. 5 - 4 Substantiation All taxpayers must maintain records that substantiate their expense deductions Stringent substantiation requirements for travel, entertainment, and gifts include:  Amount of expenditure  Time and place (or date & description of gift)  Business purpose of expenditure  Business relationship of person entertained or receiving a gift

6. 5 - 5 Timing of Deductions Accrual method – expenses deductible when  “All events” have occurred that fix liability and  “Economic performance” occurs (property or services provided or used) Cash basis - expenses deductible when paid  Date check is mailed  Date charged on credit card

7. 5 - 6 Cash Method When an expense is paid by providing services, the expense is deductible but income must also be recognized for FMV of services provided Assets with useful lives extending substantially beyond the end of the year must be capitalized with their cost recovered through depreciation, amortization, or depletion When considering whether to make an early payment of year-end expenses, the tax rates for both years and the time value of money should be considered

8. 5 - 7 Use of Cash Method Businesses that sell merchandise to their customers must use the accrual method to account for purchases and sales of inventory  Cash method can be used for other than inventory and cost of goods sold Large corporations (average annual gross receipts of more than $5 million) cannot use the cash method for tax reporting All personal service corporations can use the cash method regardless of size

9. 5 - 8 Prepaid Expenses Prepaid expenses must be capitalized as assets if their lives exceed one year and the items will not be consumed by the close of the following year (similar to accrual)  Prepaid rents must be capitalized unless paid for one year or less and prepayment is contractually required Prepaid interest must generally be prorated over the life of the loan  OID is a form of prepaid interest and must be amortized over term of loan

10. 5 - 9 Costs of Starting a Business Sec. 162 allows deductions for “carrying on” a business. Expenses incurred prior to the commencement of operations do not qualify as “carrying on” a business but may be deductible as one of the following:  Business investigation expenses  Start-up expenses  Organization costs

11. 5 - 10 Business Investigation Investigation expenses incurred while preparing to enter business include travel, market surveys, and feasibility studies If the taxpayer is in a similar existing business, deduction allowed as a current expense If taxpayer is not in a similar existing business  If new business not acquired – no deduction  If new business acquired – expenses added to start-up expenses to determine deduction and amortization

12. 5 - 11 Start-up Expenses Start-up expenses are incurred after the decision to proceed with the new business, but before beginning actual operations (employee training and advertising) If the new business is related to the taxpayer’s existing business, start-up costs are considered continuing costs and are deductible currently

13. 5 - 12 Start-up Expenses If the new business is not related to an existing business  Can deduct up to $5,000 (combined business investigation and start-up expenses) in the tax year in which the business begins  $5,000 amount is reduced by amount cumulative investigation and start-up expenses exceeds $50,000  Remainder of investigation and start-up expenses amortized over a 15-year period

14. 5 - 13 Organization Costs Defined as costs related to the formation of a corporation or partnership (fees paid to the state for incorporation, legal fees, and accounting fees) and incurred before end of first year Can deduct up to $5,000 in the year business begins $5,000 deduction is reduced by amount organizational costs exceeds $50,000 Remaining organizational costs amortized over 15 years (180 months)

15. 5 - 14 Operating Expenses Most operating expenses shown on a GAAP income statement are deductible on a business tax return Examples include  Advertising  Bank service charges  Commissions  Office supplies  Taxes  Licenses, accounting fees & legal fees  Salaries and wages  Utilities

16. 5 - 15 Meals & Entertainment The deduction for business meals and entertainment expenses is limited to 50% of the qualified expenses The 50% limit is imposed on whoever (employer or employee) ultimately pays the expense

17. 5 - 16 Meals & Entertainment Directly-related expenses - costs incurred when a significant business discussion takes place between the taxpayer and a customer in atmosphere conducive to the serious conduct of business Associated-with expenses - deductible when directly preceded or followed by a substantial business discussion  Deduction for entertainment tickets is limited to 50% of the tickets’ face value

18. 5 - 17 Restriction on Deductions No deduction allowed for the costs of owning and maintaining entertainment facilities such as hunting lodges and yachts No deduction allowed for membership dues and fees paid to social, athletic, or sporting clubs  Deductions are allowed for dues to professional organizations, public service organizations, and trade associations Deduction for business gifts limited to $25 per donee per year

19. 5 - 18 Travel Away From Home Travel expenses incurred for temporary travel away from home on business are deductible  Away from home refers to the person’s tax home; that is, the location of the principal place of employment regardless of where the family residence is maintained Qualifying expenses include lodging, 50% of meals, transportation to destination and back, and incidental expenses

20. 5 - 19 Temporary Assignments Temporary is defined as one year or less Employment away from home in a single location that is realistically expected to last (and does in fact last) for one year or less, will be treated as temporary Assignment for more than one year shifts tax home to the new location (no deduction for travel and living costs)

21. 5 - 20 Transportation Expenses Certain transportation expenses incurred when the taxpayer is not away from home are deductible and include  Cost of transportation from one work location to another  Transportation between home and a temporary work location if the taxpayer has a regular place of business  Meal costs are generally not deductible

22. 5 - 21 Transportation Expenses The prorated business portion of actual automobile expenses or a standard mileage rate (55¢ for 2009) plus related parking and tolls can be deducted Commuting expenses (between home and the regular place of business) are personal nondeductible expenses

23. 5 - 22 Combining Business with Pleasure Travel For U.S. travel, if the trip is primarily for business, all transportation costs to and from destination are deductible If primary purpose is pleasure, no deduction for transportation Primary purpose is determined by the number of days on business versus personal days

24. 5 - 23 Combining Business with Pleasure Travel Meals & lodging are deductible only for days on which business is conducted If a taxpayer remains in a temporary location to reduce costs as a result of  Reduced airfare for Saturday night stays or for business conducted on both Friday and Monday  Costs for additional days are deductible if they are less than the cost of returning home when business is completed

25. 5 - 24 Foreign Travel Transportation expenses must be allocated between business and personal days unless  Trip does not exceed one week or  Less than 25% of total time spent for personal purposes If trip primarily personal, no deduction for transportation

26. 5 - 25 Bad Debt Expense Specific charge-off method must be used  Deduct accounts receivable or other business debts only when actually written off as uncollectible Investment and personal loans are considered nonbusiness (capital losses)  Loan must be valid debt No bad debt deduction for cash basis taxpayers who have not previously included amount in income

27. 5 - 26 Insurance Expense Premiums for fire, casualty, and theft insurance for business property are deductible Payments into a self-insurance reserve are not deductible - only actual losses are deductible Premiums for life insurance when business is beneficiary are not deductible

28. 5 - 27 Legal Expenses Legal Fees deductible only if related to a trade or business  Legal fees incurred to defend title to property are added to the asset’s basis  Criminal defense fees are deductible only if the legal action has a direct relationship to a profit-seeking activity  Personal legal expenses are not deductible

29. 5 - 28 Taxes Deductible taxes include  State, local, and foreign real property taxes  State and local personal property taxes  State, local, and foreign income taxes  Employer’s payroll taxes  Other federal, state, local, and foreign taxes incurred in a business or other income- producing activity  Federal income taxes are not deductible

30. 5 - 29 Taxes When real estate is sold, the seller is responsible for taxes through the day before the sale date Assessments for improvements must be added to basis of property Sales taxes are added to cost of business property or service

31. 5 - 30 Residential Rental Property If rental of real estate is a business, all income is included and all expenses are deductible, even if it creates a loss  Expenses include: advertising, cleaning, maintenance, utilities, insurance, taxes, interest, commissions for collection of rent, travel to collect rental income or to manage the property or maintain the property

32. 5 - 31 Residential Rental Property When property is converted from personal to rental property, expenses must be divided between rental and personal use No depreciation or insurance deduction allowed for personal-use part of year Mortgage interest and real estate taxes for personal-use may be deductible as itemized deductions

33. 5 - 32 Rental of a Vacation Home If the residence is rented for less than 15 days during the year, a de minimis exception applies  No rental income is reported but  No deductions are allowed for expenses other than mortgage interest and property taxes as itemized deductions

34. 5 - 33 Rental of a Vacation Home If rental period is greater than 14 days and If personal use does not exceed the greater of 14 days or 10% of the rental days  All rent is included in income  Expenses are allocated between rental & personal use  All expenses related to the rental use are deductible (even if this creates a loss)  Personal portion of interest is not deductible as itemized deduction (but taxes are deductible) (# Rental Days / Total # Days Used) x Total Expense = Rental-use Expense

35. 5 - 34 Rental of a Vacation Home If rental period is greater than 14 days but Personal use exceeds the greater of 14 days or 10% of the rental days  Rental expenses limited to rental income (no loss)  Nondeductible rental expenses can be carried forward to future years  Real estate taxes and mortgage interest for personal-use portion allowed as itemized deductions

36. 5 - 35 Home Office Expenses To be deductible, home office must be used exclusively on a regular basis and meet one of the following three tests: 1)The principal place of business for any business of taxpayer, or 2)A place for meeting with clients or customers in the normal course of business, or 3)Located in a separate structure

37. 5 - 36 Home Office Expenses Principal place of business - place used for the administrative or management activities of the business if there is no other fixed location available Employee must also show that the office is maintained for the convenience of the employer Deductible expenses are limited to gross income from the business and include  Portion of rent or mortgage interest, property taxes, insurance, utilities, repairs, & depreciation

38. 5 - 37 Home Office Expenses Expenses are deducted in this order: 1)Expenses directly related to the business other than home office expenses (supplies) 2)The allocated portion of otherwise deductible itemized deductions (mortgage interest and property taxes) 3)Other home expenses including utilities, insurance, and maintenance 4)Depreciation Excess expenses are carried forward

39. 5 - 38 Hobby Expenses Hobbies - activities that earn income and incur expenses but do not meet the requirements to be a business or investment Regulations list factors to consider in determining if activity is a hobby including:  Manner in which activity carried on  Expertise of taxpayer and/or consultants  Time and effort spent in activity  Actual profits earned in one or more years  Elements of pleasure or recreation

40. 5 - 39 Hobby Expenses If a profit is realized in 3 out of 5 years (2 out of 7 years for horses) then burden of proof shifts to IRS to prove activity is a hobby  Taxpayer may deduct expenses, even if a net loss results, by showing activity is run in a businesslike manner If activity is a hobby, the deduction for expenses is limited to hobby income

41. 5 - 40 Hobby Expenses Expenses must be deducted in this order: 1)Otherwise allowable expenses (mortgage interest, taxes, and casualty losses) 2)Expenses that do not reduce the tax basis of the assets used in the hobby (advertising, insurance, utilities and maintenance) 3)Depreciation and amortization Excess expenses are lost - no carryover

42. 5 - 41 Accounting for Income Taxes FAS 109 states that income tax expense reported on financial statements must be based on financial statement income rather than taxable income  Actual taxes paid may differ significantly from expense recognized Differences fall into two categories  Permanent differences  Temporary differences

43. 5 - 42 Permanent Differences Income that is not taxed but is reported for financial accounting purposes  Interest income from municipal bonds Expenses that can never be deducted on the tax return  Fines and penalties Expenses that have limited deductibility  50% of meals and entertainment

44. 5 - 43 Temporary Differences Income or expense items that are reported in one year for accounting income and in a different year for taxable income  Examples: depreciation expense, bad debt expense, warranty expenses, and prepaid income

45. 5 - 44 Reconciling Book/Tax Income Schedule M-1 of Form 1120 reconciles accounting (book) income to taxable income  More detailed Schedule M-3 required if corporation has assets of $10 million or more

46. 5 - 45 Calculating Tax Expense If only permanent differences, adjust book income by  Adding expenses that are not tax deductible  Subtracting tax-exempt income Then multiply adjusted book income by the tax rate to get the book tax expense If there are both permanent and temporary differences, book income is first adjusted by permanent differences and then adjusted for temporary differences.

47. 5 - 46 Deferred Taxes Temporary differences create  A deferred tax liability that is a current tax savings that will have to be paid in a future year when the temporary difference reverses  A deferred tax asset that is a prepayment of tax that will be refunded in a future year when the temporary difference reverses

48. 5 - 47 Deferred Tax Liabilities Deferred tax liabilities result when  Expense deductible for tax purposes before book  Income recognized for book purposes before tax Effectively an interest-free loan from government  Tax savings can be invested until taxes are due Adjusting the book tax expense prevents overstatement of financial statement income

49. 5 - 48 Deferred Tax Assets Deferred tax assets result when  Expense deductible for book purposes before tax  Income recognized for tax purposes before book To realize the benefit of a deferred tax asset (tax prepayment), the business must have future income and a related tax liability  A more-likely-than-not test is used to determine if a valuation account (contra asset) is needed

50. 5 - 49 FIN 48 FIN 48 provides guidance on accounting for deferred taxes when a business takes an uncertain tax position  Tax position refers to the manner of recognition of a transaction in a tax return that will result in a current or deferred tax asset or liability  The uncertainly refers to the question as to whether the position will be challenged by IRS  Example: a deduction taken on a tax return for a current expenditure that IRS may claim should be capitalized

51. 5 - 50 FIN 48 A tax benefit from any uncertain tax position that reduces a business’s current or future tax liability can only be reported in the financial statements to the extent each benefit is recognized and measured under a two-step approach  Step 1: the business must evaluate each tax position to assess whether it is more likely than not (greater than 50%) that the position would be sustained upon examination by IRS

52. 5 - 51 FIN 48 Step 2: if a tax position satisfies the 1 st step, the business can then measure the tax benefit  If no single amount is more likely than not (MLTN) to be realized, then a cumulative probability analysis of the possible outcomes is required  The business records the largest tax benefit that meets a greater than 50% cumulative probability The business must review & modify its reporting of uncertain tax positions if new information becomes available

53. 5 - 52 FIN 48 If a business determines that a tax position no longer meets the MLTN threshold, then the business must derecognize the benefit (it cannot use a valuation allowance as a substitute for derecognition) Expanded disclosure requirements include tables identifying unrecognized tax benefits and details on the tax uncertainties for which it is possible that the amount of unrecognized tax benefit will change within the next year

54. 5 - 53 Consolidated Financial Statements Under FAS 109, income tax expense reported on consolidated financial statements should include the total of all federal, state, local, and foreign income taxes including both current and deferred income taxes

55. 5 - 54 Consolidated Financial Statements APB 23 exception allows parent to exclude future U.S. income tax on foreign subsidiary income earnings if permanently reinvested outside the U.S.  Allows U.S. corporation to report higher financial statement income because its income statement includes the foreign income but excludes the deferred U.S. tax that could eventually be due on this income  Earnings repatriated later can cause a spike in the corporation's effective tax rate in that year

56. 5 - 55 UNICAP Rules Uniform capitalization rules apply to businesses whose average annual gross receipts for the preceding three years exceed $10 million  UNICAP rules require inventory costs to include all direct costs of manufacturing, purchasing, or storing inventory, along with many indirect costs typically not included in full absorption costing  Nonmanufacturing costs (research, selling, advertising and distribution expenses) are not required to be included in inventory

57. 5 - 56 Inventory Acceptable methods for tax accounting include specific identification, FIFO, LIFO, and average cost When prices are rising, the LIFO method results in a lower inventory valuation and tax savings through a higher deduction for cost of goods sold The LIFO conformity rule requires use of LIFO for financial statements if LIFO is used for tax

58. 5 - 57 The End