6-1 ©2009 pearson education, inc. publishing as prentice hall

6-2

DEDUCTIONS AND DEDUCTIONS AND LOSSESLOSSES

(1 of 2)(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

©2009 Pearson Education, Inc. Publishing as Prentice Hall

6-3

DEDUCTIONS AND DEDUCTIONS AND LOSSESLOSSES

(2 of 2)(2 of 2)

When an expense is deductibleSpecial disallowance rulesTax planning considerationsCompliance and procedural

considerations


6-4

Classifying Deductions as Classifying Deductions as forfor vs. vs. from from Adjusted Gross Adjusted Gross

IncomeIncome (1 of 3)(1 of 3)

For AGITaxpayer benefits from deduction even

if he/she claims the standard deductionReduces AGI: +/- benefits for taxpayer

+ Many deductions and credits phased out above certain AGI thresholds

+ Reduces AGI floors for certain categories of itemized deductions

- Reduces certain deduction ceilings


6-5



Most common deductions for AGITrade or business expensesIRAsAlimonyLosses on sale of bus/invest propertyMoving expensesInterest paid on qualified education loans1/2 of self-employment tax Health insurance paid by self-employeds


6-6



From AGIItemized deduction only will have

tax benefit if total deductions exceed the taxpayer’s standard deductionDeduct higher of standard deduction or

sum of itemized deductions


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Criteria for Deducting Criteria for Deducting Business and Investment Business and Investment

ExpensesExpenses

Business or investment requirement

Ordinary expenseNecessary expenseReasonable expenseExpenses and losses must be

incurred directly by the taxpayer


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Business or Investment Requirement (1 of 2)

Activity engaged in for profitUse facts and circumstances test

Trade or business (ToB) vs. investment classificationToB losses are ordinary losses

ToB expenses are for AGIInvestment losses are capital

Investment expenses are from AGISubject to 2% of AGI floor


6-9

Business or Investment Requirement (2 of 2)

Losses and expenses related to rents and royalties are for AGI deductions

Legal and accounting feesFor AGI deduction for ToB if incurred in

ordinary course of businessFees related to taxes also for AGI for ToB

Nonbusiness fees related to taxes from AGI deduction subject to 2% of AGI floor


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Ordinary Expense

To be ordinary, an expense must beReasonable in amountBear reasonable proximate

relationship to income-producing activity or property

Must be customary or usual course of a particular industry or business community


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Necessary Expense

An expense is considered necessary if it is “appropriate and helpful” in the taxpayer’s business


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Reasonable Expense

Problems often occur with salaries for shareholder-employees of closely held businesses


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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


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General Restrictions on General Restrictions on the Deductibility of the Deductibility of

ExpensesExpenses

Capitalization vs. expense deductionExpenses related to exempt incomeExpenditures that are contrary to

public policyOther expenditures specifically

disallowed


6-15

Capitalization vs. Expense Deduction

General capitalization requirementsElection to deduct currently

E.g., certain research and experimental expenditures, cost of qualified tangible personal property

Capitalization of deduction itemsE.g., carrying charges on unproductive

unimproved real estate


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Expenses Related to Exempt Income

Deduction disallowed because income is not taxable


6-17

Expenditures that Are Contrary to Public Policy

Cannot deduct illegal payments or payment resulting from an illegal actFines and penaltiesBribes and kickbacks

Expenses from an illegal trade or business are deductibleIf taxpayer reports income from activity


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Other Expenditures Specifically Disallowed

Political contributions and lobbying expenses

Business investigation and preopening expensesMay elect to immediately expense up

to $5,000Amortize remainder over 180 months

beginning when business commencesNo amortization if business not begun


6-19

Proper Substantiation Proper Substantiation RequirementRequirement (1 of 2) (1 of 2)

The taxpayer has the burden of proof

The Cohan ruleCertain expenses may be estimated

More restrictive substantiation requirements for travel, entertainment, business gifts


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Proper Substantiation Proper Substantiation RequirementRequirement (2 of 2) (2 of 2)

Documentation requirements for travel, entertainment, gifts, etc.AmountTime and place (T&E)Date and description of giftBusiness purposeBusiness relationship


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When an Expense is When an Expense is DeductibleDeductible

Cash Method (1 of 2)Cash Method (1 of 2)

Generally deductible when actually paid

Prepaid expensesNo current deduction if

expenditure creates an asset with a life substantially beyond end of tax year


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Cash Method (2 of 2)Cash Method (2 of 2)

Prepaid interestAmortize over period of loan to

which interest charge is allocatedPoints deductible over life of loan

Points paid in connection with purchase of principal residence currently deductible


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Accrual Method (1 of 2)Accrual Method (1 of 2)

Allowed to deduct expenses in period in which expenses accrue under all-events test & economic performance testAll-events test met

When amount of liability is establishedAmount of liability is determined with reasonable accuracy


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Accrual Method (2 of 2)Accrual Method (2 of 2)

Economic performance test is metWhen economic performance is deemed to occur

See Table I6-1


6-25

Special Disallowance Special Disallowance RulesRules

Wash salesTransactions between related

partiesHobby lossesVacation homeExpenses of an office in the

home


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Wash Sales

Wash sales occurs when “substantially identical” stock or securities acquired by taxpayer within a 61-day periodExtends 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 recently purchased stock or securities


6-27

Transactions between Related Parties (1 of 2)

§267 defines related partiesLoss on transaction between

related parties disallowedDisallowed loss may be used to

offset gain from subsequent sale to unrelated party


6-28

Transactions between Related Parties (2 of 2)

Unpaid expensesAccrual basis taxpayer cannot

deduct expense to cash basis related party until cash basis party recognizes payment as income


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Hobby Losses(1 of 2)

Activity has more personal attributes than profit motiveIRS factors to determine profit motive

Activity conducted in businesslike mannerTime and effort expendedExpected asset appreciationTaxpayer’s success in similar activitiesProfits earned and profit historyTaxpayer’s financial status


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Hobby Losses(2 of 2)

Profit motive assumed if activity profitable in 3 of 5 years

Deductible hobby expensesHobby-related expenses deductible up

to gross income of hobby activityDeductible as miscellaneous itemized

deductions subject to 2% of AGI floorSpecial order of the deductions


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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

No taxable income and no deductions


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Expenses of an Office in the Home

Office in the home expenses deductible only if office regularly and exclusively used for business ANDPrincipal place of taxpayer’s business,Place where taxpayer meets with clients,OR a separate structure from house

Employees must also use office for convenience of employer


6-33

Tax Planning Tax Planning ConsiderationsConsiderations

Hobby lossesControl timing of hobby losses

Unreasonable CompensationIf IRS feels that a salary payment to

an officer is excessiveOften recharacterize excess portion as a

dividend

Timing of deductions


6-34

Compliance and Compliance and Procedural Procedural

ConsiderationsConsiderations (1 of 2) (1 of 2)

Schedule C for sole proprietorship Schedule E for rents and royalties Other investment expenses reported on

Schedule A Proper substantiationIRS scrutinyStatutory requirements

Travel and entertainment are of particular interest to the IRS


6-35

Compliance and Compliance and Procedural Procedural

ConsiderationsConsiderations (2 of 2) (2 of 2)

Business vs. hobby Form 8829 to claim home office

deduction on Schedule CForm 2106 to claim home office

deduction by employeesTaxpayer may be willing to extend

statute of limitation’s period to prove profit motive by filing Form 5231


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6-36©2009 Pearson Education, Inc. Publishing as Prentice Hall

6-1 ©2009 pearson education, inc. publishing as prentice hall

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