Chapter 6: Deductions and Losses - Pearson Education

Chapter 6: Deductions and Losses - Pearson Education

Chapter 6 Deductions and Losses 2011 Pearson Education, Inc. Publishing as Prentice 6-1 DEDUCTIONS AND LOSSES (1 of 2) Classifying deductions as for vs. from adjusted gross income Criteria for deducting business and investment expenses General restrictions on the deductibility of expenses

Proper substantiation requirement 6-2 2011 Pearson Education, Inc. Publishing as Prentice DEDUCTIONS AND LOSSES (2 of 2) When an expense is deductible Special disallowance rules Tax planning considerations Compliance and procedural considerations 2011 Pearson Education, Inc. Publishing as Prentice 6-3

Classifying Deductions as for vs. from Adjusted Gross Income (1 of 3) For AGI Taxpayer benefits from deduction even if she claims the standard deduction Reduces AGI: +/- benefits for taxpayer + Many deductions and credits phased out above certain AGI thresholds + Reduces AGI floors for certain 2011 Pearson Education, Inc. Publishing as Prentice

6-4 Classifying Deductions as for vs. from Adjusted Gross Income (2 of 3) Most common deductions for AGI Trade or business expenses IRAs Alimony Losses on sale of bus/invest property Moving expenses

Interest paid on qualified education loans 2011 Pearson Education, Inc. Publishing as Prentice 6-5 Classifying Deductions as for vs. from Adjusted Gross Income (3 of 3) From AGI Itemized deduction only will have tax benefit if total deductions exceed the taxpayers standard

deduction Deduct the higher of the standard deduction or sum of itemized deductions Phaseout of itemized deductions scheduled to resume in 2011 at a 6-6 2011 Pearson Education, Inc. Publishing as Prentice Criteria for Deducting Business and Investment Expenses Business or investment requirement

Ordinary expense Necessary expense Reasonable expense Expenses and losses must be incurred directly by the taxpayer 2011 Pearson Education, Inc. Publishing as Prentice 6-7 Business or Investment Requirement (1 of 2) Activity Use engaged in for profit facts and circumstances test Trade

or business (ToB) vs. investment classification ToB losses are ordinary losses ToB expenses are for AGI Investment Investment Subject losses are capital expenses are from AGI to 2% of AGI floor

2011 Pearson Education, Inc. Publishing as Prentice 6-8 Business or Investment Requirement (2 of 2) Losses and expenses related to rents and royalties are for AGI deductions Legal and accounting fees For AGI deduction for ToB if incurred in ordinary course of business Fees related to taxes also for AGI for ToB

Nonbusiness fees related to taxes 6-9 from AGI deduction subject to 2% of 2011 Pearson Education, Inc. Publishing as Prentice Ordinary Expense To be ordinary, an expense must be Reasonable in amount Bear reasonable proximate relationship to income-producing activity or property Must be customary or usual course

of a particular industry or business community 6-10 2011 Pearson Education, Inc. Publishing as Prentice Necessary Expense An expense is considered necessary if it is appropriate and helpful in the taxpayers business 2011 Pearson Education, Inc. Publishing as Prentice 6-11 Reasonable Expense Problems

often occur with salaries for shareholderemployees of closely held businesses 2011 Pearson Education, Inc. Publishing as Prentice 6-12 Expenses and Losses Must Be Incurred Directly by the Taxpayer Generally, a taxpayer cannot take a deduction for a loss or expense of another person 2011 Pearson Education, Inc. Publishing as Prentice 6-13

General Restrictions on the Deductibility of Expenses Capitalization vs. expense deduction Expenses related to exempt income Expenditures that are contrary to public policy Other expenditures specifically disallowed 6-14 2011 Pearson Education, Inc. Publishing as Prentice Capitalization vs. Expense Deduction

General capitalization requirements Election to deduct currently E.g, certain research and experimental expenditures, cost of qualified tangible personal property Capitalization of deduction 2011 Pearson Education, Inc. Publishing as Prentice 6-15

Expenses Related to Exempt Income Deduction disallowed because related income is not taxable 2011 Pearson Education, Inc. Publishing as Prentice 6-16 Expenditures that Are Contrary to Public Policy Cannot deduct illegal payments or payment resulting from an illegal act Fines

and penalties Bribes and Kickbacks Expenses from an illegal trade or business are deductible If taxpayer reports income from 2011 Pearson Education, Inc. Publishing as Prentice 6-17 Other Expenditures Specifically Disallowed (1 of 2) Political contributions and lobbying expenses Business investigation and

preopening expenses Include investment expenses May immediately expense up to $5,000 Deduction phased out $ for $ if > $50,000 2011 Pearson Education, Inc. Publishing as Prentice 6-18 Other Expenditures Specifically Disallowed (2 of 2) Business

investigation and preopening expenses (continued) Amortize remainder over 180 months beginning when business commences No amortization if business not begun 2011 Pearson Education, Inc. Publishing as Prentice 6-19 Proper Substantiation Requirement (1 of 2) The

taxpayer has the burden of proof The Cohan rule Certain expenses may be estimated More restrictive substantiation requirements for travel, entertainment, business gifts 2011 Pearson Education, Inc. Publishing as Prentice 6-20 Proper Substantiation Requirement (2 of 2) Documentation

requirements for travel, entertainment, gifts, etc. Amount Time and place (T & E) Date and description of gift Business purpose Business relationship 2011 Pearson Education, Inc. Publishing as Prentice 6-21 When an Expense Is Deductible Cash Method (1 of 2) Generally

deductible when actually paid Prepaid expenses No current deduction if expenditure creates an asset with a life substantially beyond end of tax year 2011 Pearson Education, Inc. Publishing as Prentice 6-22 When an Expense Is Deductible Cash Method (2 of 2) Prepaid interest

Amortize over period of loan to which interest charge is allocated Points deductible over life of loan Points paid in connection with purchase of principal residence currently deductible 2011 Pearson Education, Inc. Publishing as Prentice 6-23 When an Expense Is Deductible Accrual Method (1 of 2)

Allowed to deduct expenses in period in which expenses accrue under all-events test & economic performance test All-events test met When amount of liability is established Amount of liability is determined 6-24 with reasonable accuracy 2011 Pearson Education, Inc. Publishing as Prentice When an Expense Is Deductible Accrual Method (2 of 2)

Economic performance test is met When economic performance is deemed to occur See Topic Review 3 2011 Pearson Education, Inc. Publishing as Prentice 6-25 Special Disallowance Rules Wash sales Transactions between related parties Hobby losses Vacation home

Expenses of an office in the home 2011 Pearson Education, Inc. Publishing as Prentice 6-26 Wash Sales Wash sales occurs when substantially identical stock or securities acquired by taxpayer within a 61 day period Extends from 30 days before date of sale to 30 days after date of sale Loss

on wash sale disallowed Disallowed loss added to basis of 2011 Pearson Education, Inc. Publishing as Prentice 6-27 Transactions between Related Parties (1 of 2) 267 defines related parties Loss on transaction between related parties disallowed Disallowed loss may be used to

offset gain from subsequent sale to unrelated party 2011 Pearson Education, Inc. Publishing as Prentice 6-28 Transactions between Related Parties (2 of 2) Unpaid expenses Accrual basis taxpayer cannot deduct expense to cash basis related party until cash basis party recognizes payment as income

2011 Pearson Education, Inc. Publishing as Prentice 6-29 Hobby Losses (1 of 3) Activity has more personal attributes than profit motive IRS factors to determine profit motive Activity conducted in businesslike

manner Time and effort expended Expected asset appreciation Taxpayers success in similar 2011 Pearson Education, Inc. Publishing as Prentice activities 6-30 Hobby Losses (2 of 3) Profit motive assumed if activity profitable in 3 of 5 years Three tiers of expenses 1 Deductible even if no hobby

exists 2 Deductible if activity was for profit But do not reduce basis of any assets 2011 Pearson Education, Inc. Publishing as Prentice 6-31 Hobby Losses (3 of 3) Deductible hobby expenses Hobby-related

expenses deductible up to gross income of hobby activity Deductible as miscellaneous itemized deductions subject to 2% of AGI floor Special order of the deductions 2011 Pearson Education, Inc. Publishing as Prentice 6-32 Vacation Home Deductions on vacation home may be limited or disallowed

Vacation home if personal use greater of 14 days, or 10% of # of days property used as rental Expenses allocated based on days of use Property rented < 15 days 2011 Pearson Education, Inc. Publishing as Prentice 6-33 Expenses of an Office in the Home Office in the home expenses deductible only if office regularly and exclusively used for business AND Principal

place of taxpayers business, Place where taxpayer meets with clients, OR a separate structure from 6-34 2011 Pearson Education, Inc. Publishing as Prentice Tax Planning Considerations Hobby losses Control timing of hobby losses Unreasonable

Compensation If IRS feels that a salary payment to an officer is excessive Often recharacterize excess portion as a dividend Timing of deductions 2011 Pearson Education, Inc. Publishing as Prentice 6-35 Compliance and Procedural

Considerations (1 of 2) Schedule C for sole proprietorship Schedule E for rents and royalties Other investment expenses reported on Schedule A Proper substantiation IRS scrutiny 2011 Pearson Education, Inc. Publishing as Prentice 6-36 Compliance and Procedural

Considerations (2 of 2) Business vs. hobby Form 8829 to claim home office deduction on Schedule C Form 2106 to claim home office deduction by employees Taxpayer may be willing to extend statute of limitations period to prove profit motive by filing Form 5231 6-37 2011 Pearson Education, Inc. Publishing as Prentice End Chapter 6

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorados Kenneth W. Monfort College of Business [email protected] 2011 Pearson Education, Inc. Publishing as Prentice 6-38

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