1. © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Individual Income Taxes 1 Chapter 7 Deductions and Losses: Certain Business Expenses and Losses

2. 2 The Big Picture (slide 1 of 3) Martha is nearing the end of a year that she would like to forget. Several years ago she loaned a friend, Jamil, $25,000 to enable him to start a business. –Jamil had made scheduled payments of $7,000 ($1,000 of this was interest) when he unexpectedly died in January. At the time of his death, he was insolvent. –Martha’s attempts to collect on the debt were fruitless. Last October Martha invested $50,000 in the stock of a pharmaceutical company that previously had been profitable. –The company lost a patent infringement suit and declared bankruptcy in May of this year. –Martha is notified by the bankruptcy trustee that she can expect to receive nothing from the company.

3. 3 The Big Picture (slide 2 of 3) Martha has owned and operated a bookstore as a sole proprietorship for the past 10 years. –The bookstore previously has produced annual profits of about $75,000. –Due to the growth of online vendors and e-books, Martha’s bookstore sustained a net loss of $180,000 this year. In September, a hurricane caused a large oak tree to blow over onto Martha’s house. –The cost of removing the tree and making repairs was $32,000. –Martha received a check for $25,000 from her insurance company in final settlement of the claim. –Her adjusted basis for the house was $280,000.

4. 4 The Big Picture (slide 3 of 3) Finally, Martha purchased for $20,000 what she believed to be § 1244 stock. –Unfortunately, the stock’s value began to decline significantly soon after its purchase. –Several months after her purchase, Martha sold the stock for $12,000. Can you help to relieve Martha’s feeling of hopelessness by making her aware of beneficial loss provisions in the tax law? –Read the chapter and formulate your response.

5. 5 Bad Debts If an account receivable arising from credit sale of goods or services becomes worthless –A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income –No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected

6. 6 The Big Picture - Example 2 Bad Debts - Cash Basis Taxpayer Return to the facts of The Big Picture on p. 7-1. Martha is a cash basis taxpayer –She cannot take a bad debt deduction for unpaid accrued interest on the loan to her friend because it was never recognized as income.

7. 7 Business Bad Debts (slide 1 of 4) Specific charge-off method must be used –Exception: Reserve method is allowed for some financial institutions Deduct as ordinary loss in the year when debt is partially or wholly worthless

8. 8 Business Bad Debts (slide 2 of 4) If a business bad debt previously deducted as partially worthless becomes totally worthless in a future year –Only the remainder not previously deducted can be deducted in the future year

9. 9 Business Bad Debts (slide 3 of 4) In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless Deductible amount depends on basis in bad debt –If debt arose from sale of services or products and the face amount was previously included in income That amount is deductible –If the taxpayer purchased the debt Deduction is equal to amount paid for debt instrument

10. 10 Business Bad Debts (slide 4 of 4) If a receivable has been written off –The collection of the receivable in a later tax year may result in income being recognized –Income will result if the deduction yielded a tax benefit in the year it was taken

11. 11 Nonbusiness Bad Debts (slide 1 of 2) Nonbusiness bad debt –Debt unrelated to the taxpayer’s trade or business Deduct as short-term capital loss in year amount of worthlessness is known with certainty –No deduction is allowed for partial worthlessness of a nonbusiness bad debt

12. 12 Nonbusiness Bad Debts (slide 2 of 2) Related party (individuals) bad debts are generally suspect and may be treated as gifts –Regulations state that a bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money –Thus, individual circumstances must be examined to determine whether advances between related parties are gifts or loans

13. 13 Classification of Bad Debts Individuals will generally have nonbusiness bad debts unless: –In the business of loaning money, or –Bad debt is associated with the individual’s trade or business Determination is made either at the time the debt was created or when it became worthless

14. 14 The Big Picture - Example 5 Nonbusiness Bad Debts Return to the facts of The Big Picture on p. 7-1. Martha loaned her friend, Jamil, $25,000. –Jamil used the money to start a business, which subsequently failed. –When Jamil died after having made payments of $7,000 on the loan, he was insolvent. Even though the proceeds of the loan were used in a business, the loan is a nonbusiness bad debt –The business was Jamil’s, not Martha’s, and Martha is not in the business of lending money.

15. 15 Worthless Securities Loss on worthless securities is deductible in the year they become completely worthless –These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless –Capital losses may be of limited benefit due to the $3,000 capital loss limitation

16. 16 The Big Picture - Example 8 Worthless Securities Return to the facts of The Big Picture on p. 7-1. Martha, a calendar year taxpayer, owned stock in Owl Corporation (a publicly held company). –She acquired the stock on October 1, 2014 Cost was $50,000. –On May 31, 2015, the stock became worthless as the company declared bankruptcy. The stock is deemed to have become worthless as of December 31, 2015 –Martha has a long-term capital loss

17. 17 Bad Debt Deductions Summary Concept Summary 7.2

18. 18 Section 1244 Stock (slide 1 of 3) Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals –Ordinary loss treatment (per year) is limited to $50,000 ($100,000 for MFJ taxpayers) Loss in excess of per year limit is treated as capital loss

19. 19 Section 1244 Stock (slide 2 of 3) Section 1244 loss treatment is limited to stock owned by original purchaser who acquired the stock from the corporation Corporation must meet certain requirements for stock to qualify –Major requirement is limit of $1 million of capital contributions Section 1244 does not apply to gains

20. 20 Section 1244 Stock (slide 3 of 3) Example of § 1244 loss –In 2009, Sam purchases from XYZ Corp. stock costing $150,000. (Total XYZ stock outstanding is $800,000.) In 2015, Sam sells the stock for $65,000. –Sam, a single taxpayer, has the following tax consequences: $50,000 ordinary loss $35,000 long-term capital loss

21. 21 The Big Picture - Example 10 Section 1244 Stock Return to the facts of The Big Picture on p. 7-1. On March 8, 2015, Martha purchases what she believes is § 1244 stock from her friend Janice for $20,000. –On November 2, 2015, she sells the stock in the marketplace for $12,000. Because Martha purchases the stock from Janice and not the corporation, the stock is not § 1244 stock to Martha. –Hence, Martha has an $8,000 short-term capital loss.

22. 22 Losses of Individuals Only the following losses are deductible by individuals: –Losses incurred in a trade or business, –Losses incurred in a transaction entered into for profit, –Losses caused by fire, storm, shipwreck, or other casualty or by theft

23. 23 Definition of Casualty & Theft (C & T) Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft –Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature –Events not treated as casualties include losses from disease and insect damage

24. 24 Definition of Theft Theft includes robbery, burglary, embezzlement, etc. –Does not include misplaced items

25. 25 When Casualty & Theft Is Deductible Casualties: year in which loss is sustained –Exception: If declared “disaster area” by President, can elect to deduct loss in year prior to year of occurrence Thefts: year in which loss is discovered

26. 26 Effect of Claim for Reimbursement If reasonable prospect of full recovery: –No casualty loss is permitted –Deduct in year of settlement any amount not reimbursed If only partial recovery is expected, deduct in year of loss any amount not covered –Remainder is deducted in year claim is settled

27. 27 The Big Picture - Example 15 Disaster Area Losses Return to the facts of The Big Picture on p. 7-1. On September 28, 2015, Martha’s personal residence was damaged when a hurricane caused an oak tree to fall onto the house. –The amount of her uninsured loss was $7,000. –Because of the extent of the damage in the area, the President of the United States designated the area a disaster area. Because Martha’s loss is a disaster area loss, Martha has 2 options. –She may elect to file an amended return for 2014 and take the loss in that year. The amount of the loss will be reduced first by $100 and then by 10% of her 2014 AGI. –Alternatively, she may take the loss on her 2015 income tax return. The amount of the loss will be reduced first by $100 and then by 10% of her 2015 AGI.

28. 28 Amount of C&T Deduction Amount of loss and its deductibility depends on whether: –Loss is from nonpersonal (business or production of income) or personal property –Loss is partial or complete

29. 29 Amount of Nonpersonal C&T Losses Theft or complete casualty (FMV after = 0) –Adjusted basis in property less insurance proceeds Partial casualty –Lesser of decline in value or adjusted basis in property, less insurance proceeds

30. 30 C&T Examples Business and production of income losses (no insurance proceeds received) Adjusted FMV FMV Item Basis Before After Loss A 6,000 8,000 5,000 3,000 B 6,000 8,000 1,000 6,000 C 6,000 4,000 0 6,000

31. 31 Nonpersonal C&T Losses Losses on business, rental, and royalty properties –Deduction will be for AGI –Not subject to the $100 per event and the 10% of AGI limitation Losses not connected with business, rental, and royalty properties –Deduction will be from AGI –Example - theft of a security Theft losses of investment property are not subject to the 2% of AGI floor on certain miscellaneous itemized deductions

32. 32 Nonpersonal C&T Gains Depending on the property, gain can be ordinary or capital Amount of nonpersonal gains –Insurance proceeds less adjusted basis in property

33. 33 Personal C&T Gains and Losses (slide 1 of 4) Casualty and theft losses attributable to personal use property are subject to the $100 per event and the 10% of AGI limitations –These losses are itemized deductions, but they are not subject to the 2% of AGI floor Amount of personal C&T losses –Lesser of decline in value or adjusted basis in property, less insurance proceeds Insurance proceeds may result in gain recognition on certain casualty and thefts

34. 34 Personal C&T Gains and Losses (slide 2 of 4) If a taxpayer has both personal casualty and theft gains as well as losses, a special set of rules applies –A personal casualty gain is the recognized gain from a casualty or theft of personal use property –A personal casualty loss for this purpose is a casualty or theft loss of personal use property after the application of the $100 floor Taxpayer must first net (offset) the personal casualty gains and personal casualty losses –Tax treatment depends on the results of this netting process

35. 35 Personal C&T Gains and Losses (slide 3 of 4) If netting personal casualty gains and losses results in a net gain –Treat as gains and losses from the sale of capital assets Short term or long term, depending on holding period Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property

36. 36 Personal C&T Gains and Losses (slide 4 of 4) If netting personal casualty gains and losses results in a net loss –All gains and losses are treated as ordinary items The gains—and the losses to the extent of gains—are treated as ordinary income and ordinary loss in computing AGI Losses in excess of gains are deducted as itemized deductions to the extent the losses exceed 10% of AGI

37. 37 Example of C&T Limitation (slide 1 of 2) Karen (AGI = $40,000) has the following C&T in 2015 (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6,000) with camera inside ($500) 2. Earthquake damage: house ($2,000), furniture ($1,000)

38. 38 Example of C&T Limitation (slide 2 of 2) Example of C&T limitation (cont’d) Karen has no insurance coverage for either loss: 1. $6,000 + $500 = $6,500 – $100 = $6,400 2. $2,000 + $1,000 = $3,000 – $100 = $2,900 Karen’s deductible C&T loss is $5,300 [$6,400 + $2,900 – (10% $40,000)]

39. 39 Research and Experimental Expenditures (slide 1 of 2) Definition of research and experimental (R&E) expenditures –Costs for the development of an experimental model, plant process, product, formula, invention, or similar property and improvement of such existing property

40. 40 Research and Experimental Expenditures (slide 2 of 2) Three alternatives are available for R&E expenditures –Expense in year paid or incurred, –Defer and amortize over period of 60 months or more, or –Capitalize (deductible when project abandoned or worthless) Tax credit of 20% of certain R&E expenditures is available

41. 41 Domestic Production Activities Deduction (slide 1 of 4) The American Jobs Creation Act of 2004 created a new deduction based on the income from manufacturing activities –The Domestic Production Activities deduction is based on the following formula: 9% × Lesser of –Qualified production activities income –Taxable (or modified adjusted gross) income or AMTI The deduction cannot exceed 50% of an employer’s W–2 wages paid to employees engaged in qualified production activities

42. 42 Domestic Production Activities Deduction (slide 2 of 4) Qualified production activities income is the excess of domestic production gross receipts over the sum of: –Cost of goods sold attributable to such receipts –Other deductions, expenses, or losses that are directly allocable to such receipts –A share of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income

43. 43 Domestic Production Activities Deduction (slide 3 of 4) Domestic production gross receipts include the following five specific categories: –The lease, license, sale, exchange, or other disposition of qualified production property manufactured, produced, grown, or extracted in the U.S. –Qualified films largely created in the U.S. –The production of electricity, natural gas, or potable water –Construction (but not self-construction) performed in the U.S. –Engineering and architectural services for domestic construction Items specifically excluded from this definition include: –The sale of food and beverages prepared by a taxpayer at a retail establishment and –The transmission or distribution of electricity, natural gas, or potable water

44. 44 Domestic Production Activities Deduction (slide 4 of 4) Eligible taxpayers include: –Individuals, partnerships, S corporations, C corporations, cooperatives, estates, and trusts For a pass-through entity (e.g., partnerships, S corporations), the deduction flows through to the individual owners For sole proprietors, a deduction for AGI results and is claimed on Form 1040, line 35 on page 1

45. 45 Net Operating Losses (slide 1 of 7) NOLs from any one year can be offset against taxable income of other years –The NOL provision is intended as a form of relief for business income and losses –Only losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL

46. 46 Net Operating Losses (slide 2 of 7) No nonbusiness (personal) losses or deductions may be used in computing NOL Exception: personal casualty and theft losses

47. 47 Net Operating Losses (slide 3 of 7) Carryover period –Must carryback to 2 prior years, then carryforward to 20 future years May make an irrevocable election to just carryforward When there are NOLs from two or more years, use on a FIFO basis –3 year carryback is available for: Individuals with NOL from casualty or thefts Small businesses with NOLs from Presidentially declared disasters –5-year carryback period and a 20-year carryover period are allowed for a farming loss

48. 48 Net Operating Losses (slide 4 of 7) Example of NOL carryovers –Ken has a NOL for 2015 –Ken must carryover his NOL in the following order: Carryback to 2013 then 2014, then carryforward to 2016, 2017,..., 2035 –Ken can elect to just carryforward his NOL Carryover would be to 2016, 2017,..., 2035

49. 49 Net Operating Losses (slide 5 of 7) Computing NOL amount –Individual must start with taxable income and add back: 1. Personal and dependency exemptions 2. NOLs from other years 3. Excess nonbusiness capital losses 4. Excess nonbusiness deductions 5. Excess business capital losses

50. 50 Net Operating Losses (slide 5 of 7) Computing NOL amount –Individual must start with taxable income and add back: 1. Personal and dependency exemptions 2. NOLs from other years 3. Excess nonbusiness capital losses 4. Excess nonbusiness deductions 5. Excess business capital losses

51. 51 Net Operating Losses (slide 6 of 7) Effect of NOL in carryback year –Taxpayer must recompute taxable income and the income tax –All limitations and deductions based on AGI must be recomputed Exception - charitable contribution deduction –Determined without regard to any NOL carryback but with regard to any other modification affecting AGI –All credits limited by or based on the tax liability must be recomputed

52. 52 Net Operating Losses (slide 7 of 7) Calculating remaining NOL after carryovers –After using the NOL in the initial carryover year, the taxpayer must determine how much NOL remains to carry to other years

53. 53 Refocus On The Big Picture (slide 1 of 2) Martha can receive tax benefits associated with her unfortunate occurrences during the current tax year. Bad Debt –It appears that Martha’s loan to her friend was a bona fide debt. The amount of the deduction is the unpaid principal balance of $19,000 ($25,000 - $6,000). Since the bad debt is a nonbusiness bad debt, it is classified as a short-term capital loss. Loss from Investments –The $50,000 loss is deductible as a long-term capital loss. Although the actual holding period was not greater than one year (October through May), the disposal date for the stock (a worthless security) is deemed to be the last day of the tax year. The loss does not appear to qualify for ordinary loss treatment under § 1244. –The stock she purchased from her friend results in an $8,000 short-term capital loss (and does not qualify under § 1244).

54. 54 Refocus On The Big Picture (slide 2 of 2) Loss from Bookstore –The $180,000 loss from the bookstore is reported on Schedule C of Form 1040. It is an ordinary loss, and it qualifies for NOL treatment. Martha can carry the $180,000 net loss back and offset it against the net income of the bookstore for the past two years. –Any amount not offset (probably about $30,000) can be carried forward for the next 20 years. –The carryback will produce a claim for a tax refund. Casualty Loss –The loss on the damage to Martha’s personal residence is a personal casualty loss. Using the cost of repairs method, the amount of the casualty loss is $7,000 ($32,000 - $25,000). This amount must be reduced by $100 and 10% of AGI. –If Martha’s house is located in an area declared a disaster area by the President, Martha has the option of deducting the casualty loss on the prior year’s tax return.

55. © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 55 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta