Chapter 5
Introduction to Business Expenses
Murphy & Higgins, Concepts in Federal Taxation, 2010 edition
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Concept Review
All tax deductions are a matter of
Legislative Grace
 Deductions are part of Congress’
approach to implementation of Abilityto-Pay

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Review!

From Chapter 1: All deductible amounts
fall into one of three categories:
Business Expenses (Chapters 5 & 6)
 Losses (Chapter 7)
 Other Itemized Deductions (Chapter 8)

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Review!
There are two primary types of
deductions allowed:
 Deductions for adjusted gross income


generally have a business purpose
Deductions from adjusted gross income

generally have a personal purpose
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Conduit Entity Reporting
Conduit entities are not subject to
tax, but results of operations flowthrough to owners’ returns.
Items subject to special tax treatment
are kept separate
 Items not subject to special tax
treatment are netted to arrive at ordinary
net income or net loss

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Classification of Deductions
All expenditures fall into two categories:
 Profit-motivated
Trade or business expenses
 Expenses for the production of income
(Investment)


Personal
Specifically allowed itemized deductions
 Nondeductible personal expenses

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Profit-Motivated Expenditures
To be deductible, an expenditure must
have a bona fide business purpose
unrelated to its tax effect.
Show that the expense is related to a
profit-motivated transaction
 Show that the business purpose is the
primary or dominant motive

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Trade or Business

Requirements to qualify as a trade or
business:
Primary purpose is to earn income or
a profit
 Involvement is regular and continuous
 Activity is not merely a hobby

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Rental Activity

Rental activities may be either trade
or business or an investment activity
Expenses are always deducted for
AGI
 Classification matters when property
is sold


Classification is determined by the
scope of the taxpayer’s involvement
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Mixed-Use
Business and Personal Use

Mixed-Use Assets
Used both to earn income and for
personal purposes
 Treat as two separate assets by allocating
amount of use


Mixed-Use Expenditures
Incurred both for profit and personal
reasons
 Allocate between business and personal
use and deducted as allowed

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Tests for Deductibility
To be deductible, expenses must be
profit-motivated or specifically allowed,
and also
 Ordinary


Necessary


Normal, common, generally accepted
Appropriate, helpful, prudent
Reasonable in amount

Arm’s length
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5 Negative Tests for
Deductibility
To be deductible, expenses must not be
 Personal



Business purpose is not primary motive
Not specifically allowed
Capital Expenditures


Should be capitalized as assets if useful life
extends beyond a year
Start-up costs
• May expense $5,000 in first year; remainder is
amortized over 180 months
• Expense is phased-out if total costs > $50,000
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1-12
5 Negative Tests for
Deductibility

Against Public Policy


Resulting from violation of a law
Resulting from an illegal business
• Cost of goods sold are always deductible under the
capital recovery concept
• Ordinary, necessary, and reasonable business
expenses are deductible for all illegal businesses
except sale of drugs

For lobbying and political activities
• Costs to influence local legislation are deductible
• Costs to monitor any legislation are deductible
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5 Negative Tests for
Deductibility

Related to Tax-Exempt Income


Incurred to generate tax-exempt income
Another Person’s Obligation

Cannot recover another’s capital
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Mixed-Use Expenses
Hobby Vs. Business
An income-earning activity without a
predominant profit motive is a hobby.
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Mixed-Use Expenses
Hobby Vs. Business

Factors considered in determining
profit-motive are








Manner of conducting activity
Expertise or reliance on expert advice
Time and effort spent on activity
History of income and loss
Amount of occasional profit
Elements of personal pleasure
Financial status
Success in similar activities
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Mixed-Use Expenses
Hobby

Losses from a hobby are not deductible
Expenses allowed up to amount of income
generated
 Deductions taken using three tier system:

• Expenses also allowed as either business or
itemized deductions
• Other expenses that qualify as business
expenses
• Depreciation on assets used

Allowable expenses are deducted from
AGI
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Mixed-Use Expenses
Vacation Home
A residence used for personal vacations and also
rented to unrelated people is a mixed-use asset
and first must be classified as either:
Personal residence if rented 14 days or
fewer in a year
 Vacation home if used personally

• more than 14 days, or
• more than 10% of the number of days rented

Rental property if used personally
• less than or equal to 14 days, or
• less than or equal to 10% of the days rented
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Vacation Home
Tax Treatment
Then tax treatment is:
If classification is:
 Personal residence • Report no income or

Vacation home

Rental property
expense
• Report income and
allocate expenses
using three tier system
(no loss allowed)
• Report income and
allocate all expenses;
Loss allowed
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Mixed-Use Expense
Home Office
A taxpayer who operates a trade or
business from home may be able to
deduct a portion of the home’s expenses.

Expenses of the home are allocated
between business and personal use
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Mixed-Use Expenses
Home Office

A specific portion of the home must be
used
Exclusively and regularly,
 As the principal place of business or as a
place to meet clients, but

• If taxpayer has no other available location to
do administrative or management activities,
this requirement will not disqualify the
deduction
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Mixed-Use Expenses
Home Office

Employees must also show that the use


Is for the convenience of their employer
Required as a condition of employment
Allowed expenses are deducted using the
three tier system
 Deduction is limited to the amount of net
income from the business



Home-office deduction may not create a loss
Excess may be carried-forward
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Timing of Deductions
The taxpayer’s accounting method is
used to determine the timing of
deductions.
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Timing of Deductions
Cash Method

Cash Method: claim a deduction in the
year an expense is paid
Date of mailing for checks
 Date of charge for credit cards
 Prepaid expenses are deductible if used
within one tax year (prepaid interest does
not qualify)

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Timing of Deductions
Accrual Method

Accrual Method: claim a deduction in the
year two tests are met
All-events test is met when a liability
exists and the amount can be determined
 Economic performance test is met when
services or property are provided

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1-25
Timing of Deductions
Related Party Accrued Expenses
Deductions for accrued expenses
payable to a cash basis related party are
limited.
 Related parties include family members
and businesses owned or controlled by
the taxpayer
 Unless both parties are accrual basis,
both report using the cash method; until
income is reported no expense may be
deducted
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Financial Accounting Income Vs.
Taxable Income
Matching and Conservatism are not tax
concepts
 Estimates of expenses are not permitted
for tax purposes

Use specific write-off for bad debts
 Do not estimate warranty expense

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