Chapter 6
Business Expenses
Kevin Murphy
Mark Higgins
©2006 South-Western
All deductions are a matter of
Legislative Grace
Just because GAAP allows a deduction,
don’t assume tax law will too!
© 2006 South-Western
Transparency 6-2
Business Expenses
All expenses must first meet the basic
tests for deductibility Have a business purpose
Be ordinary, necessary, and reasonable
Be allowed under the Legislative Grace
Concept
© 2006 South-Western
Transparency 6-3
Business Expenses
Substantiation Requirements
 Expenses related to Meals, Entertainment,
Automobile Usage, Travel, and Business Gifts
are deductible subject to limitations and strict
documentation requirements
 Amount
 Time and place
 Date and description
 Business purpose
 Business relationship of other person(s)
© 2006 South-Western
Transparency 6-4
Meals and Entertainment
Meals and entertainment expenses
must be directly related to or associated
with the active conduct of a business
activity.
© 2006 South-Western
Transparency 6-5
Meals and Entertainment
Directly Related Test
The “directly related to” test is met if
There is more than a general expectation
of business benefit
A bona fide business activity takes place
during the meal or entertainment
The principal reason for the meal or
entertainment is business
The expenses are related to the taxpayer
and people involved in the business activity
© 2006 South-Western
Transparency 6-6
Meals and Entertainment
Associated With Test
The “associated with” test is met if
There is a clear business purpose for the
meal or entertainment
The meal or entertainment directly
precedes or directly follows a substantial
business discussion
© 2006 South-Western
Transparency 6-7
Meals and Entertainment
Costs
Meal costs include food, beverage, tax,
and tips
Entertainment costs include expenses
for clubs, theaters, and sporting events
Only the face amount of a ticket is allowed
Club dues do not qualify
© 2006 South-Western
Transparency 6-8
Meals and Entertainment
Cost Limitations
Only 50% of the allowable costs may be
deducted
Exceptions to the 50% limitation
Reimbursed expenses
Expenses that are taxable income to a
non-employee recipient (awards, prizes)
Expenses for recreational or social
activities which benefit employees
© 2006 South-Western
Transparency 6-9
Auto Expenses
General Requirements
The cost of using an automobile for
business is deductible
Use of the automobile must be for travel
Out of town
From home to a temporary workplace
From the regular to a temporary workplace
From the workplace to a second job
The cost of commuting is never deductible.
© 2006 South-Western
Transparency 6-10
Auto Expenses
Auto expenses may be computed under
one of two methods:
Actual Cost
Standard Mileage Rate
© 2006 South-Western
Transparency 6-11
Auto Expenses
Actual Cost Method
The actual cost of using the automobile
may be deducted
The business percentage of depreciation,
gas and oil, repairs, insurance, interest,
license fees, etc. is deductible
Deduction amount is often larger than the
standard rate
© 2006 South-Western
Transparency 6-12
Auto Expenses
Standard Mileage Rate Method
 The administrative convenience concept
allows a deduction based on the number of
business miles driven during the year
 Rate is $0.405 per mile
 Tolls, parking, interest and property taxes may be
added
 Standard rate method is not allowed if
multiple cars are used
© 2006 South-Western
Transparency 6-13
Travel Expenses
Travel expenses incurred while on
business away from the tax home
overnight are deductible
Tax home is the principal area in which
business is conducted
Overnight means longer than a regular
workday
© 2006 South-Western
Transparency 6-14
Travel Expenses
Limitations
Over 50% of the activity requiring travel
must have a business purpose
Personal activity costs on a business trip
are not deductible
Incidental business expenses on a
personal trip are deductible
Travel for general educational purposes or
for investment related meetings is not
deductible
© 2006 South-Western
Transparency 6-15
Business Gifts
The cost of a gift given to a business
customer may not be fully deductible
There is an overall limitation of $25 per
person, per year
Gifts are not subject to the 50%
entertainment limits
Delivery, gift wrap, engraving, etc., do not
count toward the $25
© 2006 South-Western
Transparency 6-16
Education Expenses
 Costs of education are deductible if
 Required by law (or employer) to maintain
employment, or
 Maintains or improves current job skills
 Costs of education are not deductible if
 Necessary to meet minimum job requirements, or
 Qualifies taxpayer for new trade or business
© 2006 South-Western
Transparency 6-17
Education Expenses
 Unreimbursed allowable costs are deductible
as miscellaneous itemized deduction
 Employee may exclude up to $5,250 of
reimbursed expenses from a qualified plan
© 2006 South-Western
Transparency 6-18
Compensation of Employees
Wages, salaries, bonuses and other
compensation paid to employees is
deductible if two basic tests are met:
Employees must perform actual service
Payment must be reasonable in amount
© 2006 South-Western
Transparency 6-19
Compensation of Employees
Reasonable Compensation
 Some factors considered when determining if
compensation is reasonable are
 Duties, responsibilities and pay history of the
employee
 Volume and complexity of the business
 Time required to do the work
 Ability and accomplishments of the employee
 Company pay policy
© 2006 South-Western
Transparency 6-20
Compensation of Employees
Reasonable Compensation
Payments to a related party may be
examined closely for
Lack of a business purpose
An arms-length transaction
Reality of compensation in a closely-held
business
© 2006 South-Western
Transparency 6-21
Compensation of Employees
Reasonable Compensation
 Size of deduction for salary paid to a covered
employee is limited
 CEO and the four highest paid officers are covered
employees
 $1,000,000 limit on compensation deduction per
employee
 Some amounts are exempt from the limit
 commissions and performance based payments
 pension plan contributions
 fringe benefits
© 2006 South-Western
Transparency 6-22
Bad Debts
Bad debts are generally deductible
under the capital recovery concept.
Business bad debts are deductible only
under the accrual method
Nonbusiness (investment) bad debts
are deductible if the debt is bona fide
 Report as a short-term capital loss
 No deduction is allowed if the debt is voluntarily
forgiven
© 2006 South-Western
Transparency 6-23
Insurance
Insurance premiums paid to protect a
business from the following losses are
deductible.
Fire, theft, casualty or liability
Group medical, term-life and worker’s
compensation
Performance and fidelity bonds
Business interruption
© 2006 South-Western
Transparency 6-24
Taxes
Most business related taxes are deductible
unless paid to the federal government.
 Exceptions:
 Sales taxes related to long-lived assets must be
capitalized
 Property taxes related to real estate bought or
sold during the year must be allocated between
buyer and seller
 Assessments for local benefits are added to the
property’s basis
© 2006 South-Western
Transparency 6-25
Legal Fees
Legal fees are deductible if they were
paid to defend business income,
reputation, or goodwill
If fees are related to property ownership,
they are capitalized with the cost of the
property
© 2006 South-Western
Transparency 6-26
Individual Deductions
For Adjusted Gross Income
Expenses paid by individuals
for a business purpose, or
specifically allowed by Congress to create
equity in tax treatment
are allowed as deductions for AGI.
© 2006 South-Western
Transparency 6-27
Accountable Plan
Employees are required to make an
adequate accounting of their expenses.
 Reimbursements = expenses
 nothing is reported
 Reimbursements < expenses
 reimbursement is reported as income
 expenses = reimbursement income are deducted for AGI
 excess expenses are deducted from AGI
 Reimbursements > expenses and excess is
not returned
 excess reimbursement is reported as income
© 2006 South-Western
Transparency 6-28
Nonaccountable Plan
Employees are not required to make an
adequate accounting of their expenses.
 All reimbursements are included in income
 All expenses are deducted from AGI
© 2006 South-Western
Transparency 6-29
Deductions for Self-Employed
Taxpayers
To provide self-employed taxpayers
equity with the tax treatment of
employees, they are allowed to deduct:
The cost of health insurance premiums
paid for themselves
50% of the amount of self-employment
tax paid
© 2006 South-Western
Transparency 6-30
Retirement Plan Contribution
Deductions
Taxpayers who do not have access to
an employer sponsored pension plan
are allowed several options:
Keogh or H.R.10 plans (for self-employed
taxpayers only)
Individual Retirement Accounts (for all
taxpayers)
© 2006 South-Western
Transparency 6-31
Individual Retirement Accounts
Contributions
All taxpayers may contribute a
maximum of $4,000 of their earned
income to a Deductible or a Roth IRA.
Special “Catch-up” rule allows up to $4,500
if 50 or older
A married couple may contribute $8,000
in total ($9,000 if over 50), but not more
than $4,000 ($4,500) to any one
account.
© 2006 South-Western
Transparency 6-32
Three Major IRA Types
Conventional
Roth
Educational
© 2006 South-Western
Transparency 6-33
1. Conventional IRA
Contributions limited to lesser of $4,000
($4,500 if > 50) or amount of earned
income
Fully deductible if not covered by an
employer’s plan
Not linked to spouse’s coverage
If covered, maximum deduction equals:
(Maximum contribution) X [1 - {(AGI - phase-out) / $10,000}]
© 2006 South-Western
Transparency 6-34
Conventional IRA:
Phase-out Amounts
Tax Year
2005
2006
2007
© 2006 South-Western
Married
$70,000
$75,000
$80,000
Single
$50,000
$50,000
$50,000
Transparency 6-35
Conventional IRA - Example
 Single taxpayer with AGI = $58,000
contributes $4,000 to an IRA. How much
is deductible if the t/p is covered by a
qualified plan?
=
=
=
$4,000 X [ 1 - ($58,000 - $50,000)/10,000]
$4,000 X [ 1 - 0.80]
$4,000 X 0.20
$600 maximum deduction
© 2006 South-Western
Transparency 6-36
2. Roth IRA
Contributions are not deductible
Earnings distributions are tax-free if
IRA has existed for 5 years, and
Taxpayer is >59 1/2 years old
No age limit to begin distributions
Contributions are phased-out like
Conventional IRA
Married, between $150,000 to $160,000
Others, between $95,000 to $110,000
© 2006 South-Western
Transparency 6-37
3. Educational IRA
Set up as a trust for the benefit of any
person under age 18
$2,000 nondeductible contribution per
student per year
Phased-out for AGI greater than
Married, from $190,000
Others, from $95,000
Max. contribution X [1 - {(AGI - phase-out) / 15,000}]
© 2006 South-Western
Transparency 6-38
3. Educational IRA Continued
Tax-free growth in the IRA
No tax at time of withdrawal if used for
qualified expenses
Tuition and fees of student
© 2006 South-Western
Transparency 6-39
Higher Education Expense
Deduction
May deduct up to $4,000 of qualifying
higher education expense
Qualifying = tuition and fees
Must have AGI < $65,000 if single
($130,000 for MFJ)
Cannot claim in addition to HOPE or
Lifetime Learning Credits
© 2006 South-Western
Transparency 6-40
Educational Loan Interest
May deduct up to $2,500 for interest
paid on education loans
Taken as a “for” deduction
Only for payments made during first 60
months of the loan
Deduction phased-out when AGI exceeds
Married, from $105,000; Others, from $50,000
Deduction = Amt. Paid X [1 - {(AGI - phase-out) / 15,000}]
© 2006 South-Western
Transparency 6-41
Moving Expenses
Moving expenses are deductible if they
meet two tests.
1. Distance test
Old job
New job
Old house
© 2006 South-Western
Transparency 6-42
Moving Expenses
Time Test
2. Time Test
Employee taxpayers must be employed in
the new area for 39 weeks of the 12
months after moving
Self-employed taxpayers must be
employed in the new area for 78 weeks of
the 24 months after moving
Waived for death, disability, or required
transfer
© 2006 South-Western
Transparency 6-43
Moving Expenses
Qualifying Expenses
Only two types of expenses are
deductible:
Costs of moving household goods and
personal items to the new location
Transportation and lodging costs of moving
the taxpayer and family to the new location
Mileage is allowed at $0.15 per mile
None of the cost of meals is deductible
© 2006 South-Western
Transparency 6-44
Moving Expenses
Reimbursements
Any reimbursement of moving expenses
received from an employer is included
as income
© 2006 South-Western
Transparency 6-45
End of Chapter 6
© 2006 South-Western
Transparency 6-46