5 - 1 ©2004 prentice hall, inc. business expenses chapter 5

5 - 1©2004 Prentice Hall, Inc.

Business Expenses

Chapter 5


Code Sections

Sec. 161 - deductions are only those expenses and losses for which a deduction is authorized

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)


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 includes in income) The obligation of another taxpayer


Substantiation

All taxpayers must maintain records that substantiate their expense deductions

Stringent substantiation requirements for travel, entertainment, and giftsAmount of expenditureTime and place (or date & description of gift)Business purpose of expenditureBusiness relationship of person entertained or

receiving a gift


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 taxpayer - expenses deductible

when paidDate check is mailDate charged on credit card


Cash Method

When an expense is paid by providing services, the expense can be deducted but the value of the services is income

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


Use of Cash Method

Businesses that sell merchandize to their customers must use the accrual method to account for purchases and sales of inventoryCash method can be used for other than

inventory and cost of goods sold Large corporation with average annual gross

receipts of more than $5 million cannot use the cash method for tax

Personal service corporations can use the cash method


Prepaid Expenses

Prepaid assets must be prorated if their lives exceed one year and the items will not be consumed by the close of the following year

Prepaid interest must generally be prorated over the life of the loanOID is a form of prepaid interest and must

be amortized over term of loan


Costs of Starting a Business

Sec. 162 allows deductions for “carrying on” a business but expenses incurred prior to the commencement of operations do not qualify as “carrying on” a businessBusiness investigation expensesStart-up expensesOrganization costs


Business Investigation

Investigation expenses incurred while preparing to enter business include travel, market surveys, and feasibility studies

If the taxpayer in a similar business - deduction allowed as current expenses

If taxpayer not in a similar existing business If new business acquired - expenses amortized

over 60 months If new business not acquired - no deduction


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)Expenses amortized over 60 months for

taxpayers who are entering a business not related to an existing business

For taxpayer entering a new business related to an existing business, start-up costs are considered continuing costs and are currently deductible


Organization Costs

Costs relating to 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

Organizational costs must be capitalized and can be amortized over 60 months


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, repairs, taxes, licenses, accounting fees, legal fees, salaries and wages, travel, and utilities


Meals & Entertainment

The deduction for business meals and entertainment expenses is limited to 50% of the amount of qualified expenses

The 50% limit is imposed on whoever (employer or employee) ultimately pays for the expense


Meals & Entertainment

Directly-related expenses - costs incurred when a discussion takes place between the taxpayer and a customer about specific business activities in an atmosphere conducive to a serious business discussion.

Associated-with expenses - deductible only if directly preceded or followed by a substantial business discussionDeduction for entertainment tickets is based on

the ticket’s face value, then the 50% limit applies


Restriction on Deductions

No deduction for the costs of owning and maintaining entertainment facilities such as hunting lodges and yachts

No deduction for membership dues and fees paid to social, athletic, or sporting clubsDeductions are allowed for dues to

professional organizations, public service organizations, and trade associations

Deduction for business gifts limited to $25 per donee per year


Travel Away From Home

Travel expenses include lodging and meals while temporarily away from home on business, transportation to destination and back, and incidental expensesA tax home is the location of the principal

place of employment regardless of where the family residence is maintained


Temporary Assignments

Temporary is 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 of more than one year shifts tax home to the new location (no deduction for travel and living costs)


Transportation Expenses

Transportation expenses are incurred when the taxpayer is not away from home (includes cost of transportation from one work location to another, but excluding any meal costs)

The business portion of actual automobile expenses can be deducted or a standard mileage rate (36¢ for 2003) plus parking and tolls can be deducted


Transportation Expenses

Commuting expenses are personal nondeductible expenses except: Transportation between home and

temporary work location if taxpayer has a regular place of business

Travel from one job to another on the same day


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

Meals & lodging deductible only for days on which business is conducted


Travel

If the primary reason the taxpayer remains in a temporary location is because it is less expensive then returning home as soon as business is completed, these costs are deductibleSaturday meals & lodgingBusiness meetings on Friday and Monday


Foreign Travel

Transportation expenses must be allocated between business and personal days unlessTrip does not exceed one week orLess than 25% of total time spent for

personal purposes If trip primarily personal, no deduction for

transportation


Bad Debt Expense

Specific charge-off method must be used 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


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


Legal Expenses

Legal Fees deductible only if related to a trade or businessLegal fees incurred to defend title to

property are added to the asset’s basisCriminal defense fees are deductible only if

the legal action has a direct relationship to a profit-seeking activity

Personal legal expenses are not deductible


Taxes

Deductible taxes includeState, local, and foreign real property taxesState and local personal property taxesState, local, and foreign income taxesEmployer’s payroll taxesOther federal, state, local, and foreign

taxes incurred in a business or other income-producing activity

Federal income taxes are not deductible


Taxes

When real estate is sold, the seller’s portion of taxes ends on 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


UNICAP Rules

Uniform capitalization rules apply to businesses whose average annual gross receipts for the preceding three years exceeds $10 million

UNICAP rules require inventory 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


Inventory

Acceptable methods for tax include specific identification, FIFO, LIFO, and average cost

A low inventory valuation results in tax savings through a higher cost of goods sold deduction

The LIFO conformity rule requires use of LIFO for financial statements if LIFO is used for tax


Home Office Expenses

Home office must be used exclusively on a regular basis and meet one of the following three tests to be deductible: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



Principal place of business includes a 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 include portion of rent or mortgage interest, property taxes, insurance, utilities, repairs, depreciation and are limited to gross income from the business



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. Operating expenses including utilities, insurance, and maintenance

4. Depreciation Excess expenses are carried forward


Hobby Expenses

Activities that earn income and incur expenses but do not meet the requirements to be a business or investment are hobbies

Regulations list factors to consider in determining if a hobby including:Manner in which activity carried onExpertise of taxpayer and/or consultantsTime and effort spend in activityActual profits earned in one or more yearsElements of pleasure or recreation


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 it is a hobbyEven with losses, taxpayer can deduct

expenses by showing activity run in a businesslike manner

If a hobby, then expenses limited to hobby income


Hobby Expenses

Expenses must be taken 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


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 may include: advertising, cleaning, maintenance, utilities, insurance, taxes, interest, commissions for collection of rent, travel to collect rental income or to manager the property or maintain the property


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 can be deducted as itemized deductions


Rental of a Vacation Home

A home used for both rental and personal use purposes falls into one of 3 categories:

1. Less than 15 days rental

2. More than 2 week rental and primarily rental property

3. More than 2 week rental but primarily personal use property (mixed rental/personal use)



If the residence is rented out for less than 15 days during the year:No rental income is reported butNo deductions are allowable (except

mortgage interest and property taxes may still be deducted as itemized deductions)



Primarily rental - if rental period is greater than 14 days and personal use is equal to or less than the greater of 14 days or 10% of the rental days)Expenses allocated between rental and

personal-useRental expenses can exceed rental income

and create a lossNo deduction for personal-use expenses



Mixed personal/rental use - if the rental period is greater than 14 days and personal-use more than the greater of 14 days or 10% of the rental daysRental expenses limited to rental income (no

loss)Nondeductible rental expenses can be carried

forward to the future yearsMortgage interest & real estate taxes for

personal-use allowed as itemized deductible


Book/Tax Differences

Permanent differencesInterest income from municipal bondsFines and penaltiesLife insurance proceeds50% of meals and entertainment

Temporary differencesBad debtsDepreciation


Income Tax Expense

If only permanent differences, adjust book income byAdding expenses that are not tax deductibleSubtracting tax-exempt incomeMultiply adjusted book income by the tax rate

Temporary differences createA deferred tax asset that is a prepayment of tax

that will be refunded in a future year orA deferred tax liability this is a current savings

that will have to be paid in a future year


The End

5 - 1 ©2004 prentice hall, inc. business expenses chapter 5

Documents

prentice hall

business expenses chapter

necessary expenses

gift slide

taxpayer slide

use of cash method businesses

disallowed deductions

term of loan slide