Essentials of taxation 2016 cengage chapter 06

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 wh

Essentials of Taxation

Chapter 6

Losses and Loss Limitations

The Big Picture (slide 1 of 3)

• Robyn 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

– Robyn’s attempts to collect on the debt were fruitless.

• Last year Robyn invested $60,000 in the stock of Owl Corp, a

company started by her brother

– The company declared bankruptcy in May of this year

– Robyn is notified by the bankruptcy trustee that she can expect to

receive nothing from the company

The Big Picture (slide 2 of 3)

• Robyn 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 a downturn in the economy, Robyn’s bookstore

sustained a net loss of $180,000 this year

• In September, a tornado caused a large oak tree to

blow over onto Robyn’s house

– The cost of removing the tree and making repairs was

$32,000

– Robyn 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.

The Big Picture (slide 3 of 3)

• Robyn invested $20,000 for a 10% interest in a limited

partnership that owns and operates orange groves in Florida

– Due to a hard freeze that damaged much of the

fruit, the partnership lost $200,000 and allocated

$20,000 of ordinary loss to Robyn.

• Robyn comes to you for tax advice and would like to know the

tax ramifications of each of the transactions listed above

• Read the chapter and formulate your response.

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

The Big Picture - Example 2 Bad Debts - Cash Basis Taxpayer

• Return to the facts of The Big Picture on p 6-1

• Robyn is a cash basis taxpayer

– She cannot take a bad debt deduction for unpaid

accrued interest on the loan to her friend, Jamil,

because it was never recognized as income.

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

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

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

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

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

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

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

The Big Picture - Example 5

Nonbusiness Bad Debts

• Return to the facts of The Big Picture on p 6-1

• Robyn loaned her friend, Jamil, $25,000

– Jamil used the money to start a business, which

subsequently failed

– When Jamil died after having made principal

payments of $6,000 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 Robyn’s.

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

The Big Picture - Example 8

• Return to the facts of The Big Picture on p 6-1

• Robyn, a calendar year taxpayer, owned stock in Owl

Corporation

– She acquired the stock on October 1, 2014

• Cost was $60,000

– 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

– Robyn has a long-term capital loss

The Big Picture - Example 8

Worthless Securities (slide 2 of 2)

• Alternatively, if the stock is § 1244 small business stock (see

below),

– She has a $50,000 ordinary loss and a $10,000

long-term capital loss.

Bad Debt Deductions Summary

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

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

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 2014, Sam sells the stock for

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

Definition of Theft

• Theft includes robbery, burglary, embezzlement, etc.

– Does not include misplaced items

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

The Big Picture - Example 13

Disaster Area Losses

• On September 28, 2015, Robyn’s personal residence was

damaged when a tornado 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 Robyn’s loss is a disaster area loss, Robyn has 2

– Alternatively, she may take the loss on her 2015 income tax return

her 2015 AGI.

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

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

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

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

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

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

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

• 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

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

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)

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)]

– 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

Net Operating Losses

• 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

Net Operating Losses

(slide 4 of 4)

• Example of NOL carryovers

– Ken has a NOL for 2015

– Ken must carryover his NOL in the following

• Generally, disallow the deduction of passive losses against

active or portfolio income

Passive Loss Rules

(slide 2 of 2)

• In general, passive losses can only offset passive income

• Passive losses are also subject to the at-risk rules

– Designed to prevent taxpayers from deducting

losses in excess of their economic investment in an activity

• Amount of cash and adjusted basis of property

contributed to the activity plus amounts borrowed for which taxpayer is personally liable (recourse debt)

At-Risk Limits

(slide 2 of 4)

• At-risk defined

– At-risk amount does not include nonrecourse debt

unless the activity involves real estate

• For real estate activities, qualified nonrecourse

financing is included in determining at-risk limitation

– Any losses disallowed due to at-risk limitation are

carried forward until at-risk amount is increased

– Previously allowed losses must be recaptured to

the extent the at-risk amount is reduced below zero

– At-risk limitations must be computed for each

activity of the taxpayer separately

At-Risk Limits

(slide 4 of 4)

• Interaction of at-risk rules with passive loss rules

– At-risk limitation is applied FIRST to each activity

to determine maximum amount of loss allowed for

year

– THEN, passive loss limitation applied to ALL

losses from ALL passive activities to determine

actual amount of loss deductible for year

Calculation of At-Risk Amount

• Increases to a taxpayer’s at-risk

amount:

property contributed to the

activity

activity for which the taxpayer is

personally liable or has pledged

as security property not used in

the activity

borrowed for use in the activity

that are qualified nonrecourse

loss

reductions of debt for which recourse against the taxpayer exists or reductions of qualified nonrecourse debt

Passive Loss Limits – Classification and Impact

(slide 1 of 4)

• The passive loss rules require taxpayers to classify their

income and losses into one of the following 3 categories

– Active,

– Passive, or

– Portfolio

• Then the rules limit the extent to which losses in the passive

category can be used to offset income in the other categories

– Profit from trade or business activity in which

taxpayer materially participates

– Gain from sale or disposition of assets used in an

active trade or business

– Income from intangible property created by

taxpayer

Passive Loss Limits – Classification and Impact

(slide 3 of 4)

• Portfolio income

– Interest, dividends, annuities, and certain royalties

not derived in the ordinary course of business

– Gains/losses from disposition of assets that

produce portfolio income or held for investment

Passive Loss Limits – Classification and Impact

(slide 4 of 4)

• Passive activity defined

– Any trade or business or income-producing

activity in which the taxpayer does not materially

participate

– Subject to certain exceptions, all rental activities,

whether the taxpayer materially participates or not