Chapter 5
Introduction to Business Expenses
Murphy & Higgins
Concepts in Federal Taxation, 2014 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 Ability-to-Pay
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Review

All deductible amounts fall into one of
three categories:
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


Business Expenses (Chapters 5 & 6)
Losses (Chapter 7)
Other Itemized Deductions (Chapter 8)
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 flow-through 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



Must show that the expense is
related to a profit-motivated
transaction
Must show that the business
purpose is the primary or
dominant motive

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
Trade or business

Requirements to qualify:



Primary purpose is to earn
income or a profit
Involvement is regular and
continuous
Activity is not merely a hobby
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Mixed Use: Business & Personal Use

Mixed-Use Assets


Used both to earn income
and for personal purposes
Mixed-Use
Expenditures

Incurred both for profit and
personal reasons

Allocate between business
and personal use and
deducted as allowed
Treat as two separate



assets by allocating
amount of use
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Tests for Deductibility

To be deductible, expenses must be profitmotivated or specifically allowed, and also

Ordinary

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Necessary

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Normal, common, generally accepted
Appropriate, helpful, prudent
Reasonable in amount

Arm’s length
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Five Negative Tests for Deductibility

To be deductible, expenses
must not be

Against Public Policy
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
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


Resulting from violation of a law
Resulting from an illegal business
May expense $5,000 in first year;
remainder is amortized over 180
months
First year expense is phased-out
if total costs > $50,000
For lobbying and political activities



Costs to influence local
legislation are deductible
Costs to monitor any legislation
are deductible
Related to Tax-Exempt Income


Cost of goods sold is always
deductible under the capital
recovery concept
Ordinary, necessary, and
reasonable business expenses
are deductible for all illegal
businesses except sale of illegal
drugs
Incurred to generate tax-exempt
income
Another Person’s Obligation

Cannot recover another’s capital
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Mixed Use: Hobby versus Business


An income-earning activity
without a predominant profit
motive is a hobby

Losses from a hobby are not
deductible

Expenses allowed up to amount of
income generated

Deductions taken using three tier
system:
Factors considered in
determining profit-motive:
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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




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: Vacation Home

A residence used for personal vacations and
also rented to unrelated people is a mixeduse 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
If classification is:
Then tax treatment is:
Personal residence
Report no income or
expense
Vacation home
Report income and
allocate expenses using
three tier system (no
loss allowed)
Rental property
Report income and
allocate all expenses;
Loss allowed
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Mixed Use: 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

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Employees must also show that the use




If taxpayer has no other available location to do administrative or
management activities, this requirement will not disqualify the deduction
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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Timing of Deductions

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The taxpayer’s accounting method is used to
determine the timing of deductions
Cash Method: Claim a deduction in the year an
expense is paid

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

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)
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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Financial Accounting Income
versus 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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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