Chapter 5 - 1
CHAPTER 5 -- PART ONE
INTRODUCTION TO BUSINESS EXPENSES
I. WHAT IS DEDUCTIBLE
A. Legislative Grace
1. Only deductions specifically allowed by the tax law. Congress’s
attempt to implement the ability-to-pay concept.
2. All requirements for the deduction must be satisfied.
B. Business Purpose -- In order to be deductible, there must be a business
purpose for an expenditure that is unrelated to its tax effect.
In most cases, a business purpose can be established by showing that an
expense is related to a profit-motivated transaction.
II. Reporting of Deductions by Individuals –
A. Deductions “for” adjusted gross income (AGI) vs. deductions “from” AGI
-- Deductions for AGI receive more favorable treatment.
1. Deductions FOR AGI are always deductible
2. Deductions FROM AGI are subject to various limitations
Chapter 5 - 2
B. Exhibit 5-1
EXHIBIT 5-1
INDIVIDUAL INCOME TAX COMPUTATION FRAMEWORK
All Sources of Income (Broadly Defined)
Minus:
Exclusions From Income
Equals: Gross Income
Minus:
Deductions FOR Adjusted Gross Income
Trade or Business Expenses
Rental and Royalty Expenses
Trade or Business Losses
Capital Loss Deduction ($3,000 maximum)
Other Specifically Allowable Deductions
Equals: ADJUSTED GROSS INCOME
Minus:
Deductions FROM Adjusted Gross Income
The Greater of:
1) Standard Deduction
OR
2) Allowable Itemized Deductions
Deductible personal expenditures
Medical expenses
Home mortgage interest / investment interest
Property taxes / state income taxes
Charitable contributions
Personal casualty losses
Other miscellaneous itemized deductions
Investment expenses for the production of income
Expenses related to tax return preparation and compliance
Unreimbursed employee business expenses
Minus:
Personal and Dependency
Equals: Taxable Income
Exemptions
Chapter 5 - 3
III. Conduit Reporting
A. Conduit entities must report their "ordinary taxable income" separately
from any items of income or expense that receives special treatment at
the owner (partner, shareholder) level. This includes any deduction that is
subject to a limitation or is not deductible on the owner's returns.
Examples include miscellaneous expenses (subject to 2% of AGI limit),
charitable contributions, investment interest, investment expenses, and
nondeductible expenses.
IV. Initial Categorization of Expenditures - Figure 5-1
Expenditure
Profit-motivated
business expense
Trade or
Business
Expense
Expense
For the
Production
Of income
Personal
expense
Specifically
Allowed
Itemized
deduction
Nondeductible
Personal
expense
Chapter 5 - 4
A. Motivation for Expenditure
1. Profit Motivated v. Personal Expenditures
a. Primarily Profit Motivated
2. Profit Motivated Expenditures are further classified as being:
a. Trade or Business Expenses
b. Production of Income Expenses (Investment Related Expenses)
Note: Both types of expenses are related to activities that are profitmotivated. A trade or business activity will be identified by the extent
of the taxpayer’s involvement and whether the intent is to earn a living
from the activity.
3. Personal Expenditures
a. General Disallowance
b. Specifically Allowed Itemized Deductions
B. Importance of correct categorization
1. Trade or Business Expenses - All ordinary and necessary business
expenses that are reasonable in amount are deductible.
2. Production of Income Expenses - All ordinary and necessary
investment expenses that are reasonable in amount are allowable as
deductions. However, the amount of the actual deduction may be
limited due to the nature of the investment activity (eg. passive loss
limitations in Chapter 7) or through limitations put on deductions of
individual investment expenses (miscellaneous itemized deduction
limitation in Chapter 8).
3. Personal Expenditures - In general are disallowed; however, certain
personal expenditures (medical, taxes, home mortgage interest) are
allowed as a deduction. Some of these are also subject to limitations
(medical, casualty and theft losses, miscellaneous itemized). Further,
only individuals who have significant personal deductions can actually
take advantage of the allowable deductions (i.e. individuals who use
the standard deduction do not benefit from specific expenditures).
Chapter 5 - 5
V. TRADE OR BUSINESS v. PRODUCTION OF INCOME ACTIVITY
A. Trade of Business is a commonly used term in tax law - not well defined
B. Provision of Goods & Services Test
C. 1987 Supreme Court Decision - 3 Tests (Is gambling a TorB?)
1. Profit Motive - primary purpose for engaging in the activity must be to
earn income or a profit
2. Continuity & Regularity of Activity – must be continuity and regularity
in the taxpayer’s involvement in the activity
3. Must be a Livelihood/ Not a Hobby - activities that are sporadic,
constitute a hobby or an amusement diversion are not TorB.
D. Active Investor v. Active Trader
1. Investor who trades on own account for long-term appreciation and
current dividends, interest, etc. is not engaged in a TorB. Therefore,
the investor’s activities are related to production of income, and
investment expenses are deductible only as miscellaneous itemized
deductions.
2. Trader who trades for short-term profits and not long-term
appreciation and current dividends, interest, etc. may be engaged in a
TorB if the trader’s activities are frequent and substantial. Therefore,
the expenses will be deductible FOR AGI.
3. Dealers in Securities who trade for other taxpayer's accounts and rely
on the commissions from such trading for their livelihood are engaged
in a TorB.
Chapter 5 - 6
E. Rental Activities
1. May be either TorB or Production of Income activity depending on the
scope of ownership and management activities.
a. Classification does not affect deductibility of expenses. The main
effect is the treatment of gains and losses on disposition. Losses
on dispositions of TorB assets are ordinary losses. Losses on
Production of Income assets are capital losses - subject to limits
on deductibility.
F. Mixed Use Assets/Expenditures
1. MUA - An asset that is used in one or more of the above uses.
2. MUE - An expenditure that has one or more of the above uses.
a. Example - Automobile that is used 60% business/ 40% personal
use.
1) Problem - Allocation between use is necessary due to different
rules for deductibility of business use and personal use.
2) The automobile is considered to be two assets - one asset used
for business/one asset used for personal purposes.
Depreciation is allowed on the business use portion of the
auto; not allowed on the personal use portion.
3) The expenditures made for gasoline, oil, repairs, maintenance,
insurance, licensing fees, etc. are mixed use expenditures.
They must be allocated between business and personal use on
some reasonable basis.
3. Because of the potential for conversion of nondeductible personal
expenditures into deductible business expenses on mixed use assets,
the tax law contains very strict recordkeeping and substantiation
requirements to verify the BUSINESS PURPOSE of expenditures where
there is a personal use element.
Chapter 5 - 7
CHAPTER 5 – PART TWO
INTRODUCTION TO BUSINESS EXPENSES
VI. REQUIREMENTS FOR DEDUCTIBILITY
A. Ordinary & Necessary Requirement
1. Ordinary - An expense commonly incurred in the particular income
producing activity. It is normal, common, and accepted as an expense
in the business being conducted. The expense should be assignable
to the current accounting period. Capital expenditures are not
ordinary expenses - they must be capitalized and deducted through
amortization, depreciation, or at disposition.
2. Necessary - The expense is "appropriate and helpful" to the taxpayer's
business. A reasonable and prudent businessman would incur the
same expense in the same situation.
B. Reasonable in Amount
1. Related Party Problems
C. Not a Personal Expenditure
D. Not a Capital Expenditure
1. Repairs & Maintenance v. Improvements, Replacements, Betterments
2. Start-up Costs
a. Up to $5,000 of start-up costs can be expensed in the year in which
the TorB begins. The $5,000 is phased-out $ for $ when expenditures
exceed $50,000 (i.e., no expensing available if expenditures >
$55,000). Any amounts not expensed must be amortized over 180
months.
b. Investigating a business
1) Same Line of Business
2) Different Line of Business
Chapter 5 - 8
E. Not a Payment that Frustrates Public Policy
1. Fines, penalties, illegal bribes or kickbacks are specifically disallowed
2. Expenses of an illegal business - the ordinary and necessary expenses
of an illegal business are deductible (drugs exception)
3. Political Expenses - not deductible
4. Lobbying Expenses - No deduction is allowed for lobbying activities.
a. De minimis exception - taxpayers who incur less than $2,000 of inhouse lobbying expenses can deduct the expenses.
F. Not for Production of Tax-Exempt Income -- Expenses incurred to earn
tax-exempt income are not allowed as deductions. Violation of the abilityto-pay concept.
1. Allocation required if expenses are attributable to more than one class
of income.
G. Expenditure Must be for the Taxpayer's Benefit - Not Another's Expense
VIII. Limited Mixed Use Expenses
A. Hobbies, Vacation Homes, Home Offices all face special limitations due to
their unique mixture of business and personal use.
B. Commonalities
1. All three activities have deduction amounts limited to the income
produced in the activity. The effect of this limitation is to not allow
taxpayers to deduct losses on these activities.
2. All three activities require the allocation of the expenses of the activity
between business and personal use.
Chapter 5 - 9
a. The portion of the expenses that are allocated to the activity are
subject to the income limits. The personal portion of the expenses are
subject to the rules for deduction of personal expenses. i.e. certain
expenses such as interest and property taxes may be deductible as an
itemized deduction, while other personal expenditures (supplies,
depreciation, maintenance) are not deductible.
3. Because of the commingling and allocation in (2), the tax law requires
a strict order in which deductions are taken under the income limitation:
a. Amounts that are otherwise deductible (interest, taxes, casualty
losses) must be deducted first.
b. Amounts that are deductible only as trade or business expenses
(repairs, maintenance, insurance, supplies, etc) are deducted second.
c. Amounts that affect the basis of a property (depreciation) are taken
last. This category of expenses is usually not fully deductible under
the income limitation.
4. The ordering above has two effects:
a. Taking the otherwise allowable deductions first provides the least
tax benefit from the activity.
b. Taking depreciation last minimizes future gains
C. Hobbies
1. An activity that produces income which does not meet the criteria for a
trade or business or an income producing activity. That is, the activity
is pursued mainly for recreation and personal enjoyment, with
profitability of secondary (at best) concern. That is, the predominant
motive for the activity is not a profit motive, it is personal.
a. Factors considered - see page 195
2. The income received from a hobby must be included in gross income
under the All-Inclusive Income Concept.
Chapter 5 - 10
3. The deductions allowed for hobby expenses is limited to the gross
income from the hobby.
a. Hobby expense deductions are taken as miscellaneous itemized
deductions. They are subject to the 2% of adjusted gross income
limitation on miscellaneous itemized deductions.
1) If the taxpayer uses the standard deduction, there is no
deduction benefit. Because of 2% limit most hobbies produce
some taxable income.
D. Vacation Homes
1. A property that is both rented out during the year and used for
personal purposes by the taxpayer.
2. Objective Test - based on days of personal use
a. If personal use is greater than the greater of 1) 14 days, or 2) 10%
of rental days, the property is a vacation home and subject to the
vacation home limitations.
b. If the test above is not met, the property is considered a rental
property and treated like any other rental property. i.e. it is not
subject to the vacation home limitations. Note: you can use a
property up to 14 days and not have it classified as a vacation
home.
1) In this case, expenses must still be allocated between business
and personal use.
c. De Minimis Rule - If the property is rented less than 15 days, no
income is reported and no deductions for the rental are allowed
(other than the otherwise allowable expenses - interest, taxes,
casualties).
3. Limitation - Deductions on vacation homes cannot exceed the gross
rental income from the property.
a. Deductions are taken in the same order as in hobbies.
Chapter 5 - 11
4. Allocation basis - Interest Expense/Property Taxes - 2 views
a. IRS - all costs including interest & property taxes should be
allocated based on the number of days of actual use.
NOTE: This is the approach assumed in the text.
b. Courts - have held that the proper allocation of interest and
property taxes is based on the total number of days in the year
rather than number of days used.
1) The courts allocation method is more favorable as it allocates
less to the rental and more to the personal use, resulting in a larger
overall deduction (due to increased itemized deduction for
mortgage interest and property taxes).
E. Home Offices
1. A deduction is allowed for the use of an office in the home that is
exclusively used continuously and regularly as
a. A Principal Place of Business
or
b. A place for meeting and dealing with customers, clients, etc.
2. For an employee to deduct home office costs, the office must also be
for the convenience of the employer.
3. Home office deductions are limited to the income after subtracting the
other direct costs of the business (cost of goods sold, auto expenses,
supplies, etc.)
a. Any home office costs not deductible under the limitation may be
carried forward and deducted in future years, subject to the income
limitation.
b. To deduct basic telephone costs, you must have a separate line
(number). Business related long-distance is always deductible.
Chapter 5 - 12
IX. WHEN TO DEDUCT
A. Effect of Accounting Method
B. Cash Method
1. In General
a. When payment is made
2. Prepaid Expenses
a. One year rule for prepayments
C. Accrual Method
1. Requirements for Deductibility -- Only when all-events test and
economic performance test have been met can an expense be accrued
and deducted for tax purposes.
a. All Events Test -- Met when all the events have occurred that
determine that a liability exists and the amount of the liability can be
determined with reasonable accuracy.
b. Economic Performance Test -- Economic performance occurs
when services or property are provided to the taxpayer or when the
taxpayer uses property.
1)
Exceptions for recurring payments
a) Economic performance occurs shortly after the end of the year
(but < 8 1/2 months)
b) Item is recurring in nature and taxpayer consistently treats
similar items as incurred in the year the all-events test is met
c) Better matching occurs
c. Effect on use of estimated expenses (bad debts, warranties)
D. Related Party Accrued Expenses
1. The cash method must be used by an accrual basis taxpayer for
recognition of expenses paid to a cash basis Related Party.