Essentials of taxation 2016 cengage chapter 05

Trade or Business Deductions slide 1 of 2 • Section 162a permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including: •..

Essentials of Taxation

Chapter 5

Business Deductions

The Big Picture (slide 1 of 4)

repair business as a C corp with a December 31

year-end, uses the accrual method of accounting, and has

$435,500 of gross income

Kathleen, and his mother, Terry, each own 10% of the

stock

– His mother helps out with the books for about two hours a

week

The Big Picture (slide 2 of 4)

• Michael Forney reports the following expense information from

his small engine service and repair business.

Salaries and wages (including Michael’s salary

of $55,000 and Terry’s salary of $3,000) $150,000

The Big Picture (slide 3 of 4)

deductible expenses for tax purposes and would like

your advice on another matter

the years, it has built up large cash reserves, and its

cash flow continues to be strong

– His business has never paid any dividends to the

shareholders

salary of $140,000 and his mother a salary of

$30,000

The Big Picture (slide 4 of 4)

• Finally, during the current year, Michael

purchased another personal residence for

$300,000 and converted his original residence

to rental property

– The original residence cost $250,000 five years ago and has a current market value of $180,000

• He also purchased a condo for $170,000 near

his business, which he will rent out to tenants

• Read the chapter and formulate your response.

Trade or Business Deductions

(slide 1 of 2)

• Section 162(a) permits a deduction for all

ordinary and necessary expenses paid or

incurred in carrying on a trade or business

including:

•

Trade or Business Deductions

(slide 2 of 2)

• In order for expenses to be deductible, they

must be:

similar business, and not capital in nature

same expense

Trade or Business Deductions

(slide 2 of 2)

• In order for expenses to be deductible, they

must be:

similar business, and not capital in nature

same expense

Trade or Business Deductions

(slide 2 of 2)

• In order for expenses to be deductible, they

must be:

similar business, and not capital in nature

same expense

The Big Picture - Example 3

Ordinary and Necessary Requirement

• Return to the facts of The Big Picture on p 5-1.

Michael Forney, his wife, Kathleen, and his mother,

Terry

– It has never paid dividends

are comparable to what they could earn at similar

The Big Picture - Example 3

Ordinary and Necessary Requirement

his mother’s salary by tenfold is implemented, the

amounts in excess of their current salaries may be

deemed unreasonable.

– If so, the excess would be disallowed as deductible salary

• Salaries are deductible by the corporation, but dividends

are not.

• Salaries would be taxed at ordinary income rates and

are subject to payroll taxes.

Methods of Accounting

• The method of accounting affects when

deductions are taken

• Apply the all events test and the economic performance

test

– Exception to the economic performance test for recurring

items

Methods of Accounting

• The method of accounting affects when

deductions are taken

• Apply the all events test and the economic performance

test

– Exception to the economic performance test for recurring

items

Methods of Accounting

• The method of accounting affects when

deductions are taken

• Apply the all events test and the economic performance

test

– Exception to the economic performance test for recurring

items

Methods of Accounting

• The method of accounting affects when

deductions are taken

• Apply the all events test and the economic performance

test

– Exception to the economic performance test for recurring

items

Methods of Accounting

• The method of accounting affects when

deductions are taken

• Apply the all events test and the economic performance

test

– Exception to the economic performance test for recurring

items

Disallowance Possibilities

of expenses for a variety of reasons

– e.g., May restrict taxpayer attempts to deduct certain items

that, in reality, are personal expenditures

extension of prior court decisions

– e.g., After courts denied deductions for payments in

violation of public policy, tax law was changed to provide

specific authority for the disallowance

Expenditures Contrary

To Public Policy

• Deductions are disallowed for certain specific

types of expenditures that are considered

contrary to public policy

kickbacks, two-thirds of treble damage payments

for violation of anti-trust law

The Big Picture - Example 9

Violations of Public Policy

• Refer to the facts of The Big Picture on p 5-1

for disposing of used motor oil and other engine

fluids from his business

– During the current tax year, he was fined $3,000 by the

city

ordinary business expense

– However, because the fine was due to a violation of public

policy, the $3,000 is not deductible.

Legal Expenses Incurred In Defense

Of Civil Or Criminal Penalties

• To deduct legal expenses

income producing activity, or the determination,

collection, or refund of a tax

• e.g., Corporate officer’s legal fees in defending against

price-fixing charges

• e.g., Landlord’s legal fees associated with eviction of

tenant

Expenses Relating To

An Illegal Business

• Usual expenses of operating an illegal business

are deductible

officials, illegal kickbacks, and other illegal

payments are disallowed

• Trafficking in controlled substances: only cost

of goods sold can reduce gross income

Political Contributions And

Lobbying Activities

• Generally, no business deduction is allowed

for payments made for political purposes or for lobbying

• To influence local legislation,

• To monitor legislation, and

– If greater than $2,000, none can be deducted

The Big Picture - Example 12

Political Contributions

• Refer to the facts of The Big Picture on p 5-1

• Michael Forney made political contributions to the

U.S Senate campaigns of Tim Kaine & George Allen

– Mr Forney made these contributions to encourage these

candidates to support a new bill that is beneficial to small

businesses

– Therefore, he assumed that these would be deductible

business expenses

• However, political contributions are not

deductible, so he will receive no tax benefit

The Big Picture - Example 13

Lobbying Expenditures

• Refer to the facts of The Big Picture on p 5-1

Small Engine Repair Institute, a trade association for

owners of similar-type businesses

are allocated to lobbying activities

limited to $3,000 ($10,000 30%)

Excessive Executive Compensation

(slide 1 of 2)

• For publicly held corporations:

other highest compensated officers is limited to $1

million each

• Payments to qualified retirement plans

Excessive Executive Compensation

(slide 2 of 2)

• An additional limitation applies only to

covered executives of companies receiving

Troubled Asset Relief Program (TARP)

assistance

executive is limited to $500,000

and the three other most highly compensated

officers

Investigation Of A Business

(slide 1 of 3)

feasibility of entering a new business or expanding an

existing business

– Include costs such as travel, engineering, architectural

surveys, marketing reports, various legal and accounting

services

– The current business, if any, of the taxpayer

– The nature of the business being investigated

– The extent to which the investigation has proceeded

– Whether or not the acquisition actually takes place

Investigation Of A Business

(slide 2 of 3)

• If the taxpayer is in a business the same as or

similar to that being investigated

paid or incurred

• The tax result is the same whether or not the taxpayer

acquires the business being investigated

Investigation Of A Business

(slide 3 of 3)

similar to that being investigated

180 months (15 years)

– In arriving at the $5,000 immediate deduction allowed, a

dollar-for-dollar reduction must be made for those expenses in excess of

$50,000

The Big Picture - Example 15

Investigation Of A Business

• Return to the facts of The Big Picture on p 5-1

• Michael Forney investigates the purchase of Southside

Small Engine Services, LLC, a nearby competitor that

is for sale

– Expenses paid to consultants and accountants as part of this

investigation totaled $6,000

• He determined that Southside Small Engine Services

would not be a good investment, so he did not buy it

– The $6,000 spent to investigate this business is deductible as

Capital Expenditures

• Amounts are capitalized

• Asset may be subject to depreciation (or cost

recovery), amortization, or depletion

Capital Expenditures

• Amounts are capitalized

• Asset may be subject to depreciation (or cost

recovery), amortization, or depletion

Transactions Between Related Parties

(slide 1 of 2)

• Section 267 disallows losses from direct or

indirect sales or exchanges of property

between related parties

disposition to unrelated third party

Transactions Between Related Parties

(slide 1 of 2)

• Section 267 disallows losses from direct or

indirect sales or exchanges of property

between related parties

disposition to unrelated third party

Transactions Between Related Parties

(slide 1 of 2)

• Section 267 disallows losses from direct or

indirect sales or exchanges of property

between related parties

disposition to unrelated third party

Transactions Between Related Parties

(slide 2 of 2)

• Section 267 also requires the matching

principle be applied for unpaid expenses and

interest when different accounting methods

used

corporation, cannot deduct accrued, but unpaid,

salary to cash basis related party

employee/shareholder until it is actually paid

The Big Picture - Example 19

Related Parties – Disallowed Losses

• Return to the facts of The Big Picture on p 5-1

investment in his personal portfolio with a basis of

$10,000 to his corporation for its fair market value of

$8,000

– Michael’s $2,000 loss from the sale of the stock is

disallowed because the sale is to a related party

The Big Picture - Example 20

Related Parties – Disallowed Losses

• Assume the same facts as Example 19, except

that the corporation sells the stock for $9,000

to an unrelated party

– The corporation’s gain of $1,000 ($9,000 selling price -

$8,000 basis) is not recognized because of the right of

offset from Michael’s sale of $2,000.

• The offset may result in only a partial tax benefit upon the

subsequent sale (as in this case)

• If Michael had sold the stock to an unrelated

party rather than to his corporation, he could

have recognized a $2,000 loss

Expenses and Interest Relating to

Tax-Exempt Income

• Expenses relating to production of tax-exempt

income are nondeductible

used to acquire municipal bonds

Charitable Contributions

(slide 1 of 2)

• Individuals and corporations may deduct

contributions made to qualified domestic

organizations

• Contributor must have donative intent and

expect nothing in return

of such benefit must be deducted from the amount

of the contribution

Charitable Contributions

(slide 2 of 2)

• Contribution must be to qualified domestic

nonprofit organization or state or possession of

U.S or any subdivisions thereof

listed in IRS Publication #78

Timing of Charitable Contribution

Deduction

• Generally, deductible in year in which the

payment is made

deduction in year preceding payment if:

• The contribution is authorized by the board of directors

by the end of that year, and

• The contribution is paid on or before the fifteenth day

of the third month of the following year

Ordinary Income Property

• Defined: assets that would produce ordinary

income or short-term capital gain if sold

• Contribution amount

potential; generally the lower of adjusted basis or

FMV

Capital Gain Property

• Defined: assets that would produce long-term

capital gain or Section 1231 gain if sold

• Contribution amount

Exceptions to FMV Deduction of Capital

Gain Property (slide 1 of 2)

• Private nonoperating foundations

nonoperating foundations must be reduced by the

amount of capital gain potential

Exceptions to FMV Deduction of Capital

Gain Property (slide 2 of 2)

• If a corporation contributes tangible personal

property and the charitable organization puts

the property to an unrelated use

• Unrelated use is defined as use that is not

related to the purpose or function that qualifies

the organization for exempt status

Example of Contributions of

Tangible Personalty

• Taxpayer contributes painting to local charity:

FMV $100,000 and adjusted basis $10,000

hangs the painting for patrons to view, taxpayer

has $100,000 contribution deduction

sells the painting immediately to obtain funds for

its operation, taxpayer has $10,000 contribution

Exceptions Related to Contributions of Ordinary

Income Property (slide 1 of 2)

• In general, the deduction for a contribution of

ordinary income property is limited to the

basis of the property

• On certain contributions of inventory by corps,

the amount of the deduction is equal to the

lesser of

on the property, or

Exceptions Related to Contributions of Ordinary

Income Property (slide 2 of 2)

inventory contributions of

– Property to a charitable organization for use in its exempt

function

• Such use is solely for the care of the ill, needy, or infants

– Tangible personal research property constructed by the

corp to a qualified educational or scientific organization

• Must use the property for research, experimentation, or for research

training

• Property must be contributed within 2 years from date of

construction by donor, and

Charitable Contribution

Limitation

• A corporate taxpayer’s contribution deduction

is limited to 10% of taxable income before

Charitable Contributions Carryover

• Contributions in excess of the 10% limit may

be carried forward for 5 years

contributions subject to the 10% limit

must be deducted first, with excess deductions

from previous years deducted in order of time

Research and Experimental Expenditures

(slide 1 of 2)

• Definition of research and experimental (R&E)

expenditures

model, plant process, product, formula, invention,

or similar property and improvement of such

existing property

Research and Experimental Expenditures

(slide 2 of 2)

• Three alternatives are available for R&E

expenditures

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

based on the following formula:

Domestic Production Activities Deduction

(slide 2 of 4)

• Qualified production activities income is the

excess of domestic production gross receipts

over the sum of:

receipts

directly allocable to such receipts

that are not directly allocable to such receipts or

another class of income

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

–