Chapter 5
Introduction to Business
Expenses
Howard Godfrey, Ph.D., CPA
UNC Charlotte
Copyright © 2013
Dr. Howard Godfrey
Edited August 10, 2013
Part 1. Introduction
Part 2. Reporting Deductions, Conduits
Part 3. Classification of Expenses –
Profit motivated, Trade or business or Production
of income, Rental, Personal, Mixed business and
pleasure.
Part 4. Tests for Deductibility –Ordinary, etc., Not
personal, Not capital exp., Public policy, Not
related to tax-exempt income, For taxpayer’s
benefit
Part 5. Limited Mixed-Use Expenses - Hobby,
Vacation home, Home office
Part 6. Timing – Cash basis, Accrual basis,
Related party accrued expenses, Financial
accounting and tax differences
5. DEDUCTIONS
Intro. to Bus. Expenses
Not a Capital Expenditure
Introduction
Not Frustrate Public Policy
Reporting Deductions
Not for Tax-Exempt Income
Conduit Entity Reporting
For Taxpayer's Benefit
Types of Deductions
Limited Mixed-Use Exp.
Profit-Motivated Expenses
Hobby Expenses
Trade or Business Expenses Vacation Homes
Production-of-Income
Home Office Expenses
Timing - Acct. Methods
Rental Activity
Personal Expense
Cash Method
Mixed Bus. & Personal Exp.
Accrual Method
Tests for Deductibility
Related Party Accruals
Ord., Necessary, Reasonable
Not a Personal Expense
Financial vs.Tax Accounting
Summary
Educational Expenses
Barb is a CPA. She operates a tax practice
During the year, she spent the following:
Annual CPA license renewal fee:
Fees for CPE courses to meet
State CPA Board Requirement:
Tuition for first semester in law
school - attending night school:
How much is deductible
$500
$2,000
$8,000
Educational Expenses
Barb is a CPA. She operates a tax practice
During the year, she spent the following:
Annual CPA license renewal fee:
Fees for CPE courses to meet
State CPA Board Requirement:
Tuition for first semester in law
school - attending night school:
How much is deductible
$500
$2,000
$8,000
$2,500
Reporting
Deductions
Conduit
Entities
Taxable income? (single - 1 exemption) - 2011
Income & Exp.
Facts
Wages earned $60,000
Alimony Paid
(10,000)
NC Income Tax
(4,000)
Charity
(3,000)
Union Dues
(1,200)
AGI
Itemized ded.
Exemption
Tax. Income
AGI
From AGI T-Income
Taxable income? (single - 1 exemption) - 2013
Income & Exp.
Facts
AGI
Wages earned $60,000 $60,000
Alimony Paid
(10,000) (10,000)
NC Income Tax
(4,000)
Charity
(3,000)
Union Dues
(1,200)
AGI
Itemized ded.
Exemption
Tax. Income
50,000
From AGI T-Income
Taxable income? (single - 1 exemption) - 2013
Income & Exp.
Facts
AGI
From AGI T-Income
Wages earned $60,000 $60,000
Alimony Paid
(10,000) (10,000)
NC Income Tax
(4,000)
(4,000)
Charity
(3,000)
(3,000)
Union Dues
(1,200)
(200)
AGI
50,000
Itemized ded.
(7,200)
Exemption
(3,900)
Tax. Income
38,900
Entity Reporting
Al and Beth partnership’s income of $37,000
in 2013 included the following:
Dividend income
$ 1,000
Long-term capital gain
4,000
They share profits and losses equally.
What amount of partnership income
(excluding all separately reported items)
should each partner report on his individual
income tax return for 2013?
a. $16,000 b. $18,500 c. $ 15,000 d. Other
10
Al & Beth partnership (50:50)
had book net income of $37,000
in current year which included:
Ordinary
Book income
$37,000
Adjustments
Dividend income $1,000
LT capital gain
4,000
Ordinary Income
What is Ordinary income?
Al & Beth partnership
had book net income of $37,000
in current year which included:
Ptshp
Book income
Beth-1040
$37,000
Adjustments
Dividend income
Long-term cap. gain
$1,000
($1,000)
$500
4,000
(4,000)
$2,000
Ordinary Income
What is Ordinary income?
$32,000 $16,000
Deduction Classification
Profit-Motivated Expenses
Trade or Business or
Production-of-Income
Rental Activity
Personal Expenditures
Bus. & Personal Expenses
Code Sections
• Sec. 161 - deductions permitted only for
those expenses and losses for which a
deduction is authorized
• Sec. 162(a) authorizes deductions for
ordinary and necessary expenses, that are
reasonable in amount, and incurred in
actively carrying on a trade or business
• Sec. 212 authorizes deductions for
expenses related to production of income
(investment-related expenses)
Rules for Deductions for AGI. [1 of 7]
• A taxpayer reports income and
can deduct reasonable expenses
(and losses) for a
trade or business operation.
• A taxpayer reports income and can
deduct reasonable expenses (and
losses) for a transaction entered into
for profit, even though it does not
meet the definition of a trade or
business operation.
Rules for Deductions for AGI. [2 of 7]
• A trade or business operation often
means providing goods or services to
customers. (By comparison, an employee
provides services to his or her employer.)
• When you buy an asset hoping to sell it
later at a profit (such as buying IBM
stock) you are not in a trade or
business, but this is a
transaction entered into for profit.
Rules for Deductions for AGI. [3 of 7]
• There is no good definition of a trade or business.
• An typical investor is not in a trade or business.
However, Wachovia Securities invests in stocks
and sells stocks to its customers. It is a trade or
business.
• If you buy land and build an apartment building
on it for resale, you may not be in a trade or
business. If you repeat this 20 times, you are in a
trade or business as a real estate developer.
• When does your activity rise to the level that
causes you to be in a trade or business?
Who knows?
Rules for Deductions for AGI. [4 of 7]
• Expenses (and losses) are deductible “For
AGI” if they are for a trade or business
operation (generally providing goods or
services to customers, clients, etc.).
• Expenses are deductible “For AGI” is they
are for a transaction entered into for profit,
and they involve property that generates
rental income or royalty income.
• Expenses for other transactions entered
into for profit are deductible as Misc. Item.
Deductions.
Rules for Deductions for AGI.[5 of 7]
• A taxpayer can deduct reasonable
expenses (and losses) for a trade or
business operation. (Sec. 162)
• A taxpayer can deduct reasonable
expenses (and losses) for a
transaction entered into for profit,
even though it does not meet the
definition of a trade or business
operation. (Sec. 212)
Rules for Deductions for AGI. [6 of 7]
• Renting property to tenants (for example
under one-year contract or longer) is
generally not a trade or business, unless
you provide substantial services.
• A golf course technically rents you the land
for a few hours, but you are mainly paying
for service.
• A Marriott Hotel is a trade or business.
They have many customers and they provide
substantial services to their customers.
Rules for Deductions for AGI. [7 of 7]
• An employee is in the trade or business of
being an employee, but is subject to special
limits on deductions.
• Employee expenses are deductible from
AGI (Misc. Deductions) except for
reimbursed expenses.
(If the reimbursement is included in income,
there is an offsetting deduction for AGI. Usually,
reimbursed expenses are not included in income,
so there is no deduction.)
Charlotte Corporation
Building bought on 1/1/Yr 1
Cost
1/1/Yr-1 $400,000
Mortgage 10%
$400,000
(Pay interest only)
Annual Deprec. Expense $10,000
Annual insurance & taxes
$15,000
Value
1/1/Yr-1 $400,000
Value
Rental
Office
Building
12/31/Yr-1 $500,000
Rental income
$60,000
Per Year
T/P buys Rental Building on 1-1-Year 1
Cost
1/1/Yr-1 $400,000
Mortgage 10%
$400,000
Value of Building
1/1/Yr-1 $400,000
Value of Building
12/31/Yr-1 $500,000
Rent Revenue
Depreciation
Interest Expense
Taxes,insurance
Taxable Income (loss)
$60,000
T/P buys Rental Building on 1-1-Year 1
Cost
1/1/Yr-1 $400,000
Mortgage 10%
$400,000
Value of Building
1/1/Yr-1 $400,000
Value of Building 12/31/Yr-1 $500,000
Rent Revenue
$60,000
Depreciation
(10,000)
Interest Expense
(40,000)
Taxes,insurance
(15,000)
Taxable Income (loss)
($5,000)
An employee reports the following:
Salary
Dividend income
Income from rents
$90,000
2,000
16,000
Expenses for rental property
9,000
Cost of stock mkt newsletter
3,000
Unreimbursed employee exp.
1,000
Which are deductible from AGI (before limits)?
a. $1,000 b. $3,000 c. $4,000 d. $9,000
An employee reports the following:
Salary
Dividend income
Income from rents
$90,000
2,000
16,000
Expenses for rental property
9,000
Cost of stock mkt newsletter
3,000 $3,000
Unreimbursed employee exp.
1,000
Itemized Deductions
1,000
$4,000
Which are deductible from AGI (before limits)?
a. $1,000 b. $3,000 c. $4,000 d. $9,000
Investor Losses
• An investor in the stock market deducts
investment related expenses from AGI on
Schedule A.
• An investor in the stock market reports
gains (and deducts losses) on the sale of
stock on Schedule D, and the net gain or
loss (subject to loss limits) flows from
Schedule D to the front of Form 1040.
• Capital losses from stock sales are
deductible for AGI.
Tests for Deductibility
Ordinary, Necessary,
Reasonable in amount
Not Personal Expense
Not Capital Expenditure
Public Policy
Not for Exempt Income
For Taxpayer's Benefit
Kelley. Interest Deduction
When Kelley couldn’t make payments on a
business loan, her brother Mike made three
monthly payments of $700 each,
a total of $2,100 ($1,950 for interest expense and
$150 for principal) for Kelley’s loan.
Kelley makes the other nine monthly payments
herself ($5,850 for interest expense and $450 for
principal).
a. What is Mike’s deduction for interest expense?
b. What is Kelley’s deduction for interest expense?
c. What could they have done to preserve
the tax deductions? Explain.
Kelley. Interest Deduction
a. Mike cannot deduct anything because it is
not his loan.
b. Kelly can only deduct the $5,850 interest
expense for the nine monthly payments
that she made.
c. Mike should have given (or loaned) the
money to Kelly and let Kelly make the loan
payments.
hat way, Kelly could take a deduction for
the $7,800 interest paid that year.
Expense Requirements.
Business expense: deductible if it is
• Ordinary and necessary
(considered an appropriate
expense by a prudent business
person)
• Reasonable in amount
(not excessive)
Disallowed Deductions.
Unless provided for otherwise in the Code, a
deduction will be disallowed if it is
1. A personal Expense
2. A capital expenditure
But see-Start-up costs.
3. Contrary to public policy (fines, penalties)
4. Lobbying or political expenditure
5. Related to tax-exempt income
6. The obligation of another taxpayer
7. Accrued to related party (no deduction until
related party recognizes income).
Costs of Starting a Business.
• Sec. 162 allows deductions for “carrying
on” a business.
Expenses incurred prior to the
commencement of operations do not
qualify as “carrying on” a business but may
be deductible as one of the following:
– Business investigation expenses
– Start-up expenses
– Organization costs
Business Investigation.
Investigation expenses incurred while preparing to
enter business include travel, market surveys,
and feasibility studies
• If the taxpayer is in a similar existing business deduction allowed as a current expense
• If taxpayer is not in a similar existing business
– If new business acquired - expenses are part of
start-up expenses. See next slide
– If new business not acquired - no deduction
Start-up Expenses.
• Start-up expenses are incurred after
the decision to proceed with the new
business, but before beginning actual
operations
(employee training and advertising)
–If the business is related to the
taxpayer’s existing business, start-up
costs are considered continuing costs
and are deductible currently
Start-up Expenses. Textbook page 5-19.
If the new business is not related to an
existing business
–Can deduct up to $5,000 (combined
business investigation and start-up
expenses) in the tax year in which the
business begins
–$5,000 amount is reduced by amount
cumulative investigation and start-up
expenses exceeds $50,000
–Remainder of investigation and start-up
expenses amortized over a 15-year period
Organization Costs.
• Defined as costs related to the formation
of a corporation or partnership (fees
paid to the state for incorporation, legal
fees, and accounting fees) and incurred
before end of first year
• Can deduct up to $5,000 in the year
business begins
• $5,000 deduction is reduced by amount
organizational costs exceeds $50,000
• Remaining organizational costs
amortized over 15 years (180 months)
Organization Expenses-1
Costs of issuing or selling
stock and transferring assets
to the corporation reduce the
amount of capital raised and
are not deductible
38
Organization Expenses-2
Which of the following costs are
amortizable organizational expenditures?
a. Professional fees to issue the corporate
stock.
b. Printing costs to issue the corporate stock.
c. Legal fees for drafting the corporate
charter.
d. Commissions paid by the corporation to an
underwriter.
CPA Nov. 1994
39
On 1-1-13, ABC Corp.
was organized. On that
date, Bell paid $23,000 to
its attorney for organizing
the corporation. What
is deducted for 2013?
a $6,000 b. $5,120
c. $6,200 d. $23,000
40
ABC Corporation - Continued
Facts
Organization costs
Threshold
Excess
First-Year write-off amount $5,000
Less: excess above
0
Write-off
Amount to be amortized
Amortization period- Months
Amortization per month
Number of months
Amortization for year
Deduction & amortization
$23,000
50,000
0
Deduct
ABC Corporation - Continued
Facts
Organization costs
Threshold
Excess
First-Year write-off amount $5,000
Less: excess above
0
Write-off
Amount to be amortized
Amortization period- Months
Amortization per month
Number of months
Amortization for year
Deduction & amortization
Deduct
$23,000
50,000
0
5,000
18,000
180
100
12
$1,200
5,000
$1,200
$6,200
On Jan. 1, 2013, Bell Corp.
was organized. On that
date, Bell paid $90,000 to
its attorney for organizing
the corporation. What
is deducted for 2013?
a $6,000
b. $5,120
c. $5,000
d. $6,800
43
Costs of Investigating Potential Business
Already in New Business New Business
that type of is started or
is NOTstarted
Business
acquired
or acquired
Yes
No
Deduct
this year
Up to $5,000
write-off this yr.
Amortize over
180 Months.
Deduct
this year
Never
Deductible
Diane. Business Investigation Expenses
Diane owns and manages a
successful clothing store in Dallas.
Before graduation of her brother,
Cameron, they investigated the
possibility of opening another store
in Atlanta for Cameron to manage.
Diane. Business Investigation Expenses
Diane and Cameron each paid $1,600 in
travel costs while looking for sites for the
store.
Each paid $300 in legal fees for a lawyer to
compile a list of zoning regulations and
other relevant city ordinances.
They decide that it is not feasible to open a
new store at the present time.
Can Diane and Cameron deduct their
business investigation expenses? Explain.
Diane. Business Investigation Expenses
Diane can deduct $1,900 ($1,600 +
$300) in the current year as business
investigation expenses.
Diane can deduct this amount because
she is already in the clothing business
and expenses for potential expansion
are ordinary business expenses
whether or not a new store is opened.
Diane. Business Investigation Expenses
Her brother, however, is not
permitted any deduction for the
$1,900 that he expended.
Cameron could only capitalize
and amortize the expenses if the
new store was opened.
Expenses of Illegal Business
Taxpayer sells drugs at local junior high school.
• We know revenue from an illegal business is
taxable.
• May he deduct expenses such as “pay-offs” to
police and school officials, etc.?
• He cannot deduct certain expenses – when it
would be against public policy to allow the
deduction.
• In many cases normal expenses such as auto
expenses would be deductible.
• But Congress added a code section prohibiting
deduction of expenses by a dealer in illegal
drugs.
• Deductions are allowed for normal expenses of
other types of illegal businesses.
Mixed-Use Expenses
Hobby Expenses
Vacation Homes
Home Office Expense
ACTIVITIES NOT … FOR PROFIT
183(a) GENERAL RULE. --In the case of
an activity engaged in by an individual
or an S corporation, if such activity is
not engaged in for profit, no deduction
attributable to such activity shall be
allowed under this chapter except as
provided in this section.
Hobby Expenses.
• Activities that earn income and incur expenses
but do not meet the requirements to be a
business or investment are hobbies
• Regulations list factors to consider in
determining if activity is a hobby including:
– Manner in which activity carried on
– Expertise of taxpayer and/or consultants
– Time and effort spend in activity
– Actual profits earned in one or more years
– Elements of pleasure or recreation
Hobby Expenses
• If a profit is realized in 3 out of 5 years
(2 out of 7 years for horses) then burden
of proof shifts to IRS to prove activity is a
hobby
– Taxpayer can deduct expenses, even if a net
loss results, by showing activity is run in a
businesslike manner
• If activity is a hobby, the deduction for
expenses is limited to hobby income
Hobby Expenses
Expenses deducted in this order:
1. Otherwise allowable expenses
(mortgage interest, taxes, and casualty
losses)
2. Expenses that do not reduce the tax
basis of the assets used in the hobby
(advertising, insurance, utilities and
maintenance)
3. Depreciation and amortization
Excess expenses are lost - no carryover
Sec. 183 Activities Not.. For Profit -1
(b) Deductions Allowable.-In the case of an activity not engaged in
for profit to which subsection (a)
applies, there shall be allowed-(1) the deductions which would be
allowable … without regard to
whether or not such activity is
engaged in for profit, and
Sec. 183 Activities Not … For Profit -2
(b) Deductions Allowable.-(2) a deduction equal to the amount of the
deductions which would be allowable …
… only if such activity were engaged in
for profit, but only to the extent that the
gross income derived from such activity
for the taxable year exceeds the
deductions allowable by reason of
paragraph (1).
Hobby, Vac. Home, Home Office
Revenue
Interest & Prop. Tax
$100
(60)
40
Insurance, etc. ($30)
(30)
Limit on Depreciation
10
Depreciation ($25)
(10)
Income (Loss)
$0
Teresa. Business vs. Hobby. 1 of 4.
Teresa is an accomplished actress.
During the summer, she rented a vacant store to
stage productions of four plays, using the local
townspeople as actors and stagehands.
She sold $24,000 of tickets to the various plays.
Her expenses included
$10,000 for copyright fees,
$3,000 store rental,
$8,000 for costume purchases and rentals, $2,000
for props and other supplies, and
$4,000 for all other miscellaneous expenses related
to producing the series of plays.
Teresa. Business vs. Hobby. 2 of 4.
a. How does Teresa treat the revenue and
expenses if the activity is deemed a
business?
b. How does Teresa treat the revenue and
expenses if the activity is considered a
hobby?
c. What are some of the factors that should
be considered in deciding if this
constitutes a business or a hobby?
Teresa. Business vs. Hobby. 3 of 4.
a. If the activity is a business, Teresa
may deduct all of the expenses from
the revenue; she will report a loss of
$3,000 ($24,000 - $10,000 - $3,000 $8,000 - $2,000 - $4,000).
b. If the activity is a hobby, Teresa will
be able to deduct expenses only to
the extent of her income from the
activity. So she can deduct only
$24,000 of the expenses.
Teresa. Business vs. Hobby. 4 of 4.
c. Some factors that should be considered are:
Manner in which the taxpayer carries on the
activity;
Expertise of the taxpayer and/of the taxpayer’s
consultants;
Time & effort spent by taxpayer in the activity;
Taxpayer’s history of profits or losses for this
activity;
Success of the taxpayer in similar activities;
Overall financial status of the taxpayer; and
Elements of pleasure or recreation that are part
of the activity.
Vacation
Homes
Duplex
Family Residence
Rental Property
Rent Rev. $12,000
Mort. Interest & Property Taxes: $10,000
Sched. A: $5,000
Sched. E: $5,000
Property Ins., Repairs, Maint. : $6,000
Sched. E: $3,000
Depreciation Expense: $8,000
Sched. E: $4,000
Residential Rental Property
• If rental of real estate is a business,
all income is included and all expenses are
deductible, even if it creates a loss
(subject to passive loss rules)
• Expenses include: advertising, cleaning,
maintenance, utilities, insurance, taxes,
interest, commissions for collection of
rent, travel to collect rental income or to
manage the property or maintain the
property
Residential Rental Property
• When property is converted from personal
to rental property, expenses must be
divided between rental and personal use
• No depreciation or insurance deduction
allowed for personal-use part of year
• Mortgage interest and real estate taxes for
personal-use can be deducted as itemized
deductions
Rental of a Vacation Home
• If the residence is rented for
less than 15 days during the year a
de minimis exception applies
–No rental income is reported and
–No deductions are allowed for
expenses other than mortgage
interest and property taxes as
itemized deductions
Rental of a Vacation Home
• If rental period is greater than 14 days and
• If personal use does not exceed the
greater of 14 days or 10% of the rental
days
–All rent is included in income
–Expenses are allocated between rental
and personal use
–All expenses related to the rental use are
deductible (even if this creates a loss)
Rental of a Vacation Home
• If rental period is greater than 14 days but
• Personal use exceeds the greater of 14
days or 10% of the rental days
– Rental expenses limited to rental income (no
loss)
– Nondeductible rental expenses can be
carried forward to the future years
– Real estate taxes and mortgage interest for
personal-use portion allowed as itemized
deductions
Vacation Home Rules
Period Rented To Others
Time
of
Not more than greater of 14 days
or 10% of total days rented
Personal More than greater of 14 days
Use
or 10% of total days rented
14 days or less
15 days or more
1
2
Sec. 183(Hobby Rules)
Sec. 183(Hobby Rules)
3
4
Sec. 280A(g)
Sec. 280A-Gen. Rule
Sec. 280A Disallowance of Certain
Expenses … Business Use of Home,
Rental of Vacation Homes, etc.
(a) General Rule.-- Except as otherwise
provided in this section, in the case of a
taxpayer who is an individual or a S
corporation, no deduction otherwise
allowable … shall be allowed with respect
to the use of a dwelling unit which is used
by the taxpayer during the taxable year as
a residence.
Sec. 280A Disallowance of Certain
Expenses … Business Use of Home,
Rental of Vacation Homes, etc.
(b) Exceptions for Interest, Taxes, Casualty
Losses, Etc.-Subsection (a) shall not apply to any
deduction allowable to the taxpayer
without regard to its connection with his
trade or business (or with his incomeproducing activity).
Sec. 280A Disallowance…
(d) Use as Residence.-(1) In General.--For purposes of this
section, a taxpayer uses a dwelling
unit during the taxable year as a
residence if he uses such unit (or
portion thereof) for personal
purposes for a number of days which
exceeds the greater of--
Sec. 280A Disallowance…
(d) Use as Residence.-(A) 14 days, or 10 percent of the number of
days during such year for which such
unit is rented at a fair rental.
For purposes of subparagraph (B), a unit
shall not be treated as rented at a fair
rental for any day for which it is used for
personal purposes.
Sec. 280A Disallowance…
(g) Special Rule for Certain Rental Use.-Notwithstanding any other provision of
this section or section 183, if a
dwelling unit is used … by the
taxpayer as a residence and
… rented for less than 15 days during
the taxable year, then--
Sec. 280A Disallowance…
(g) Special Rule...-…
(1) no deduction otherwise allowable …
because of the rental use of such dwelling
unit shall be allowed, and (2) the income
derived from such use for the taxable year
shall not be included in the gross income
of such taxpayer under section 61.
(e) Expenses Attributable To Rental.-(1) In General.--…where .. an individual or an S
corp. uses a dwelling unit for personal purposes on
any day .. (whether or not he is treated under this
section as using such unit as a residence), the
amount deductible.. with respect to expenses
attributable to the rental of the unit (or portion
thereof) .. shall not exceed an amount which bears
the same relationship to such expenses as
the number of days during each year that the unit
(or portion thereof) is rented at a fair rental bears
to the total number of days .. that the unit (or
portion thereof) is used.
(e) Expenses Attributable To Rental.--
(2) Exception for Deductions Otherwise
Allowable.--This subsection shall not
apply with respect to deductions
which would be allowable under this
chapter for the taxable year whether
or not such unit (or portion thereof)
was rented.
Sue rents her vacation home for 60 days and
lives in the home for 30 days. Sue's gross Rental
income is
$5,000
Expenses for the entire year:
Real estate taxes
$2,300
Mortgage interest expense
$7,000
Utilities and maintenance
$2,400
Depreciation
$9,000
How much depreciation will Sue
deduct on her tax return?
a. $1,871 b. $6,000 c. $3,000 d. $1,400
Vacation Home Rules
Period Rented To Others
Time
of
Not more than greater of 14 days
or 10% of total days rented
Personal More than greater of 14 days
Use
or 10% of total days rented
14 days or less
15 days or more
1
2
Sec. 183(Hobby Rules)
Sec. 183(Hobby Rules)
3
4
Sec. 280A(g)
Sec. 280A-Gen. Rule
VACATION HOME
Home Use:
Problem
Data The tax rules covering this
Days of Personal Use
30
Days Rented
60
Total Days Used
90
Rev. & Exp. shown below
problem are in IRC Section
280A. Note that there are
two ways to allocate
interest and taxes between
rental and personal use.
See Textbook. Repeat this
with IRS Approach.
Vacation Home for Sue
Revenue
Schedule E
Schedule A
and Expenses
Total
Revenue
$5,000
1. Interest
7,000
/
/
2. Taxes
2,300
/
/
Fraction
$5,000
Total Interest & Taxes 9,300
Subtotal
3. Other Exp. except Deprec. 2,400
/
Net Income Before Dep.
4. Depreciation Expense
Limit on Depreciation
Net Income or Loss
9,000
Rental Fraction
/
Personal
Vacation Home for Sue
Revenue
Schedule E
Schedule A
and Expenses
Total
Revenue
$5,000
1. Interest
7,000
60 /
365
1,151
305 /
365
$5,849
2. Taxes
2,300
60 /
365
378
305 /
365
1,922
90
1,529
3,471
1,600
Fraction
Subtotal
60 /
Net Income Before Dep.
4. Depreciation Expense
Limit on Depreciation
Net Income or Loss
1,871
9,000
Personal
$5,000
Total Interest & Taxes 9,300
3. Other Exp. except Deprec. 2,400
Rental Fraction
60 /
90
6,000
1,871
$
-
7,771
Home
Office
Expenses
Home Office Expenses
Home office must be used exclusively on a
regular basis and meet one of the following
three tests to be deductible
1. the principal place of business for any
business of taxpayer, or
2. a place for meeting with clients or
customers in the normal course of
business, or
3. located in a separate structure
Home Office Expenses
• Principal place of business includes a place used
for the administrative or management activities
of the business if there is no other fixed location
available
• Employee must also show that the office is
maintained for the convenience of the employer
• Deductible expenses include portion of rent or
mortgage interest, property taxes, insurance,
utilities, repairs, depreciation but are limited to
gross income from the business
Home Office Expenses
Expenses are deducted in this order:
Expenses directly related to the business other
than home office expenses (supplies)
The allocated portion of otherwise deductible
itemized deductions (mortgage interest and
property taxes)
3. Other home expenses including utilities,
insurance, and maintenance
4. Depreciation
Excess expenses are carried forward
Maureen. Home Office Expenses
Maureen operates a cosmetic sales business from her
home. She uses 400 of 1,600 square feet of the home
as an office.
Her income before her home office deduction is
$2,300.
How much of the following unapportioned expenses
for the home are deductible?
If any of the expenses are not deductible currently,
how are they treated for tax purposes?
Mortgage interest
Property taxes
Utilities
Repairs and maintenance
Depreciation for the entire house
$5,000
1,400
1,200
600
6,000
Maureen. Home Office Expenses
Deductible expenses for home office are limited to the
business income ($2,300) and she must account for
expenses in the following order:
Mortgage interest & property taxes
[($5,000 + $1,400) x (400/1600)]
$1,600
Utilities & repairs
[($1,200 + $600) x 400/1600]
450
Depreciation ($6,000 x 400/1600 = $1,500)
limited to $250 ($2,300 - $1,600 - $450 = $250).
250
The nondeductible portion of the depreciation ($1,250)
will be carried forward to future years and subject to
similar limitations.
Section 280A
(c) Exceptions for Certain Business or Rental Use;
Limitation on Deductions for Such Use.-(1) Certain Business Use.--Subsection (a) shall not apply to
any item to the extent such item is allocable to a
portion of the dwelling unit which is exclusively used
on a regular basis-(A) the principal place of business for any trade or
business of the taxpayer,
(B) as a place of business which is used by patients,
clients, or customers in meeting or dealing with the
taxpayer in the normal course of his trade or
business, or
(C) in the case of a separate structure which is not
attached to the dwelling unit, in connection with the
taxpayer's trade or business. In the case of an
employee, the preceding sentence shall apply only if
the exclusive use referred to in the preceding sentence
is for the convenience of his employer.
Section 280A
(c) Exceptions for Certain Business or Rental Use;
Limitation on Deductions for Such Use.--
For purposes of subparagraph (A), the term
"principal place of business" includes a
place of business which is used by the
taxpayer for the administrative or
management activities of any trade or
business of the taxpayer if there is no
other fixed location of such trade or
business where the taxpayer conducts
substantial administrative or
management activities of such trade or
business.
Timing—Acct. Method
Cash Method
Accrual Method
Related Parties
Fin-Tax Differences
Cash Method
• When an expense is paid by providing services,
the expense can be deducted but the value of
the services provided is also income
• Assets with useful lives extending substantially
beyond the end of the year must be capitalized
with their cost recovered through depreciation,
amortization, or depletion
• When considering whether to make an early
payment of year-end expenses, the tax rates for
both years and the time value of money should
be considered
Use of Cash Method
• Businesses that sell merchandise to their
customers must use the accrual method to
account for purchases and sales of
inventory
– Cash method can be used for other than
inventory and cost of goods sold
• Large corporations with average annual
gross receipts of more than $5 million
cannot use the cash method for tax
reporting
• All personal service corporations can use
the cash method
Prepaid Expenses
• Prepaid expenses must be capitalized as assets
and their costs prorated if their lives exceed
one year and the items will not be consumed
by the close of the following year
• But see one-year rule.
• Prepaid interest must generally be prorated
over the life of the loan
– OID is a form of prepaid interest and must be
amortized over term of loan
Bender. Prepaid Rent
On October 1, Bender (calendar-year, cash-basis taxpayer) signs a
lease with Realco to rent office space for 36 months. Bender
obtains favorable monthly payments of $600 by agreeing to
prepay the rent for the entire 36-month period.
a. If Bender pays the entire $21,600 on October 1, how much can
it deduct in the current year?
b. Assume the same facts above except that the lease requires
Bender to make three annual payments of $7,200 each on
October 1 of each year for the next 12 months rent. On October 1
of the current year, Bender pays $7,200 for the first 12-month
rental period. How much can Bender Company deduct in the
current year?
Bender. Prepaid Rent
a. Bender can only deduct $1,800 (3 x
$600) rent for the three months remaining
in the current year, because the rent
payment is for a period extending beyond
the end of the succeeding year.
b. Bender can deduct the $7,200 in each
year that it is paid. The contract calls for
the advance payments and each payment
does not extend beyond the end of the
year following the year it is paid.
Simon Corp. Prepaid Expenses
On December 15, Simon Corporation
(a cash-basis calendar-year
corporation) paid $5,000 for five
months of supplies and $9,000 for an
insurance policy covering its office
building for the next three calendar
years.
How much can Simon deduct this year
for these expenses?
Simon Corp. Prepaid Expenses
Simon can only deduct the $5,000
paid for supplies.
The insurance payment must be
capitalized and written off onethird in each of the years it covers
as if Simon was an accrual-basis
taxpayer.
Substantiation.
• All taxpayers must maintain records that
substantiate their expense deductions
• Stringent substantiation requirements for
travel, entertainment, and gifts
– Amount of expenditure
– Time and place (or date & description of gift)
– Business purpose of expenditure
– Business relationship of person entertained
or receiving a gift
Timing of Deductions
• Accrual method – expenses deductible when
– “All events” have occurred that fix liability
and
– “Economic performance” occurs (property
or services provided or used)
• Cash basis taxpayer - expenses deductible
when paid
– Date check is mailed
– Date charged on credit card
Accrual Accounting-1
REG §1.446-1. ..methods of accounting
…a liability is incurred, …,
[when] all events have occurred that
establish the liability,
the amount of the liability can be
determined with reasonable accuracy,
and
economic performance has occurred
with respect to the liability.
Aloha. Timing of Expense Deduction
Aloha Airlines is required by law to have its aircraft
engines tested and recertified after 5,000 flight
hours. Molokai Maintenance performs the engine
tests and recertification for $2,200 per aircraft. For
financial accounting purposes, Aloha establishes a
reserve account and accrues a maintenance expense
of 44 cents per flight hour. When the maintenance is
done, the amount paid for the maintenance is
deducted from the reserve account.
For tax purposes, when can the maintenance
expense be deducted?
Aloha. Timing of Expense Deduction
Businesses are not permitted to use
reserves for expenses for tax purposes.
Aloha can only deduct the repair
expenses
1. in the year repairs are performed,
if it is an accrual-basis taxpayer, or
2. when they are paid, if it is a cashbasis taxpayer.
Accrual Accounting-1
REG §1.446-1. ..methods of accounting
…a liability is incurred, …,
[when] all events have occurred that
establish the liability,
the amount of the liability can be
determined with reasonable accuracy,
and
economic performance has occurred
with respect to the liability.
104
Accrual Accounting-1
• Automobile manufacturer sells an auto to
dealer for a wholesale price of $30,000.
• Dealer sells it later that year for $40,000.
• Manufacturer warrants the auto for five
years and estimates that the warranty cost
over five years will be $3,000 per auto.
• Is the manufacturer permitted to recognize
an expense in the year of sale and set up a
“reserve” for future warranty costs (equal
to $3,000 per auto sold this year)? See Reg
earlier.
105
Accrual Accounting-2A
Manufacturer provides a 3-year warranty.
Financial statement for its first year:
Sales
$1,000,000
Cost of sales
600,000
Expenses
300,000
Net income before taxes
$100,000
Expenses include a reserve of
$20,000
[Reserve for future repair costs
on units sold in the current year.]
What is taxable income for current year?
a. $100,000 b. $80,000 c. $120,000
106
Accrual Accounting-2-Ans
Manufacturer provides a 3-year warranty.
Financial statement for its first year:
Sales
$1,000,000
Cost of sales
600,000
Expenses
300,000
Net income before taxes
$100,000
Expenses include a reserve of
$20,000
[Reserve for future repair costs
on units sold in the current year.]
What is taxable income for current year?
a. $100,000 b. $80,000 c. $120,000
107
Accrual Accounting-3A
Manufacturer provides a 3-year warranty.
Financial statement for its first year:
Sales
$1,000,000
Cost of sales
600,000
Expenses
300,000
Net income before taxes
$100,000
Expenses include a reserve of
$20,000
[Reserve for future repair costs on units
sold in the current year.] Tax Rate 40% .
Balance in deferred tax asset or liability
account at end of Year 1?
108
Accrual Accounting-3-Ans
Manufacturer provides a 3-year warranty.
Financial statement for its first year:
Sales
$1,000,000
Cost of sales
600,000
Expenses
300,000
Net income before taxes
$100,000
Expenses include a reserve of
$20,000
[Reserve for future repair costs on units
sold in the current year.] Tax Rate 40% .
Balance in deferred tax asset or liability
account at end of Year 1?
$8,000
109
Compute taxable income for Hurd, Inc.
Hurd, Inc. reported for year ending 12-31-2013:
Info.
Return
Book net income before taxes
$900,000 $900,000
Records show:
Interest on municipal bonds
70,000
Depreciation on tax return in
excess of deprec. per books
130,000
Warranty expense- accrual basis
40,000
Actual warranty expenditures
60,000
Taxable income
Tax Rate
40%
40%
Tax liability
110
Compute taxable income for Hurd, Inc.
Hurd, Inc. reported for year ending 12-31-2013:
Info.
Return
Book net income before taxes
$900,000 $900,000
Records show:
Interest on municipal bonds
70,000 ($70,000)
Depreciation on tax return in
excess of deprec. per books
130,000 ($130,000)
Warranty expense- accrual basis
40,000
40,000
Actual warranty expenditures
60,000 ($60,000)
Taxable income
680,000
Tax Rate
40%
40%
Tax liability
$272,000
111
Income Tax Accounting
Sales in Yr. 1 - Accrual method
$400,000
Warranty period
12 Months
Est. warranty cost - % of sales
10%
Est. warranty cost for year 1
$40,000
Part of warranty cost paid in Yr. 1
40%
Part of warranty cost paid in Yr. 2
60%
Income Tax Rate
30%
Amt. of Warranty Liab.- End of Yr. 1
Amt. of deferred tax asset or
liability at end of Year 1?
Is it a Deferred Asset or Liability?
Liability for Warranties [1 of 4]
MufCo sells mufflers with a 1-year guarantee.
MufCo provides a free replacement of a defective
muffler, and installs the muffler for a service
charge of $10. In 2010, MufCo sold 100,000
mufflers at $50 each, and expects that 1% of the
mufflers will be defective. Mufflers cost MufCo
$20 each. The entry to record warranty expense
for 2010 would include:
a. credit product warranty expense for $20,000
b. debit estimated warranty liability for $20,000
c. debit product warranty expense for $30,000
d. credit estimated warranty liability for $20,000
Muffler Company - 2 of 4
Mufflers sold (in dollars)
Mufflers sold (in units)
Expected defect rate
Expected defects
Cost per muffler
Estimated warranty cost
$5,000,000
100,000
1%
1,000
$20
$20,000
Warranties [3 of 4]
Journal Entries
Accts. Receivable
Sales
Warranty Expense
Warranty Liability
Warranty Liability
Inventory
Cash
Revenue
Warranties [4 of 4]
Journal Entries
Accts Receivable
Sales
5,000,000
5,000,000
Warranty Expense
Warranty Liability
20,000
Warranty Liability
Inventory
Cash
Revenue
20,000
20,000
20,000
10,000
10,000
Assumes 1,000 mufflers were replaced during year.
Turtle Co. Slide 1 of 3
Turtle Co. bought equipment on Jan-1
year 1, for $50,000.
Equipment had an estimated 5-year
service life & no expected salvage value.
Turtle uses the 200% double-declining
depreciation method. Assume income
tax rate is 30%. What is accumulated
depreciation at the end of year 2?
a. $30,000 b. $32,000
c. $39,200 d. $42,000
Turtle Co. Tax Accounting. [2 of 3]
Begin.
Book
Year Value
Tax
Deprec.
Exp.
GAAP
Deprec.
Exp.
Income Income
Excess
Tax
Tax
Deprec. Rate Benefit
Yr. 1
50,000
20,000
10,000
10,000
30%
3,000
Yr. 2
30,000
12,000
10,000
2,000
30%
600
Assume 30% income tax rate. Complete for Year 1.
GAAP Expenses including depreciation total $60,000.
GAAP
Revenue
Expenses
Net Income before Tax
Income Tax Expense
Net Income
Tax
$100,000 Revenue
$100,000
60,000 Expenses
$40,000 Taxable Income
Tax Due
What is the deferred tax liability at the end of year 1?
Answer?
Turtle Co. Tax Accounting. [3 of 3]
Begin.
Book
Year Value
Tax
Deprec.
Exp.
GAAP
Deprec.
Exp.
Income Income
Excess
Tax
Tax
Deprec. Rate Benefit
Yr. 1
50,000
20,000
10,000
10,000
30%
3,000
Yr. 2
30,000
12,000
10,000
2,000
30%
600
Assume 30% income tax rate. Complete for Year 1.
GAAP Expenses including depreciation total $60,000.
GAAP
Revenue
Expenses
Net Income before Tax
Income Tax Expense
Net Income
$100,000
60,000
$40,000
$12,000
$28,000
Tax
Revenue
$100,000
Expenses
70,000
Taxable Income $30,000
Tax Due
$9,000
What is the deferred tax liability at the end of year 1?
Answer?
$3,000
Sales Co. (Co. started in 2010) [Slide-1]
Bad Debts. Direct write-off for Tax Purposes
Amounts in
$Thousands
Sales
2010
GAAP
2011
Tax
$800 $800
GAAP
Tax
$800
$800
Cost of Sales
500
500
500
500
Gross Margin
300
300
300
300
80
60
50
60
100
100
120
120
Bad Debts Expense
Total other expenses
Net Income Before Tax $120 $140 $130 $120
Amount of the deferred tax asset at 12-31-11?
Assume income tax rate is 34%
Sales Co. [Slide-2]
Book
Income
$120,000
130,000
250,000
Year
2010
2011
Total
Difference
Marginal rate
Deferred Tax Asset
Taxable
Income
$140,000
120,000
260,000
10,000
34%
$3,400
Sales Company [Slide-3]
In 2010, taxable income exceeded book net
income because write-off of receivables on
tax return was less than bad debts expense
(Uncollectible Accounts Expense) in
financial statements.
In 2011, taxable income was less than book
income.
Cumulative difference at end of 2011 was
$10,000.
Tax Accounting
vs.
Financial Acct
Tax vs. Financial Accounting
The goals of financial accounting
are not the same as those for tax
reporting
–Financial accounting seeks to
provide information that decision
makers find useful.
–Tax reporting seeks to collect
revenue equitably.
Tax vs. Financial Accounting
Differences fall into two
categories
– Temporary or timing
differences
–Permanent differences
Bad Debts Problem ($000) 1 of 5
Sales (All on credit)
Bad debts (provision)
Other Expenses
Total Expenses
Net Income before Taxes
Accounts Receivable
Allowance for Bad Debts
$100
5
70
75
$25
Beg. End.
$30 $35
$7
$4
Amount of Accounts Rec. written off?
What is taxable Income?
Bad Debts Problem (2 of 5)
Transaction
Beg. Bal.
Cash
Accts. Rec.
Allowance
XXX
1
Sales
3
Collection
4
Write-off
5
Other Exp.
6
Provision
Balance
Revenue and Expense ($000)
Transaction
1
Sales
5
Other Exp.
5
Provision
Revenue
Other Exp.
Bad Debts Exp.
Bad Debts Problem (3 of 5)
Transaction
Beg. Bal.
Cash
XXX
1
Sales
3
Collection
4
Write-off
5
Other Exp.
6
Provision
Accts. Rec.
Allowance
80
100
87
7
87
8
8
70
5
Balance
Revenue and Expense ($000)
Transaction
1
Sales
5
Other Exp.
5
Provision
Revenue
100
Other Exp.
Bad Debts Exp.
70
5
Bad Debts Problem 4 of 5
Allowance for Bad Debts
Allowance Balance- Jan 1.
Provision for Bad Debts
Subtotal
Accounts Written Off
$7,000
5,000
12,000
?
Allowance Balance- Dec. 31. $4,000
Amount Written Off
$8,000
Bad Debts Problem 5 of 5
Accounts Receivable
Receivables Balance- Jan 1. $30,000
Credits sales for year
100,000
Subtotal
130,000
Accounts Written Off
(8,000)
Rec. Balance after write-off
122,000
Collections of Receivables
?
Receivables Balance- Dec. 31. 35,000
Collections
$87,000
Temporary Differences.
• Arise when income is taxed either before or
after it is accrued for accounting purposes
–Example: prepaid rent generally is
taxable when received from the tenant
but it is included in financial
accounting income only as it is earned
• Are accounted for as either a deferred tax
asset or deferred tax liability on financial
statements
Permanent Differences.
• Income that is not taxed but is
reported for financial accounting
purposes
–Example: municipal bond
interest generally is not taxed
but is recorded as income in
financial accounting records
Planning - GAAP vs. Income Tax
GAAP
Revenue
Tax Return
Recognize Recognize
this year
later
Recognize Recognize
Expenses
later
this year
Next Slide.
A company normally has annual
revenue of $200,000 &
expenses of $130,000. (NI of $70,000)
In 2013, company sold some land for
$100,000. Company had paid $80,000
for the land. Company will collect
$60,000 in 2014 and $40,000 in 2015.
(Ignore accrual of interest on loan.)
Corp. sold land (cost $80,000) for $100,000 in 2013.
Company will collect $60,000 in 2014 & $40,000 in 2015.
GAAP Fin. Reports
2013
2014
2014
Service Revenue
200,000
200,000
200,000
Operating Expenses
(130,000) (130,000) (130,000)
Net Operating Income
Gain-Installment sale
Net Income Before Tax
Tax Expense-40% rate
Tax Return
Net Income Before Tax
Adjust for Gain
Taxable Income
Current Tax Expense
Corp. sold land (cost $80,000) for $100,000 in 2013.
Company will collect $60,000 in 2014 & $40,000 in 2015.
GAAP Fin. Reports
2013
2014
2014
Service Revenue
200,000
200,000
200,000
Operating Expenses
(130,000)
Net Operating Income
70,000
Gain-Installment sale
20,000
Net Income Before Tax 90,000
Tax Expense-40% rate
36,000
Tax Return
Net Income Before Tax
Adjust for Gain
Taxable Income
Current Tax Expense
Corp. sold land (cost $80,000) for $100,000 in 2013.
Company will collect $60,000 in 2014 & $40,000 in 2015.
GAAP Fin. Reports
2013
2014
2014
Service Revenue
200,000
200,000
200,000
Operating Expenses
(130,000)
Net Operating Income
70,000
Gain-Installment sale
20,000
Net Income Before Tax 90,000
Tax Expense-40% rate
36,000
Tax Return
Net Income Before Tax 90,000
Adjust for Gain
(20,000)
Taxable Income
70,000
Current Tax Expense
28,000
Corp. sold land (cost $80,000) for $100,000 in 2013.
Company will collect $60,000 in 2014 & $40,000 in 2015.
GAAP Fin. Reports
2013
2014
2014
Service Revenue
200,000
200,000
200,000
Operating Expenses
(130,000) (130,000) (130,000)
Net Operating Income
70,000
70,000
70,000
Gain-Installment sale
20,000
Net Income Before Tax 90,000
70,000
70,000
Tax Expense-40% rate
36,000
28,000
28,000
Tax Return
Net Income Before Tax 90,000
Adjust for Gain
(20,000)
Taxable Income
70,000
Current Tax Expense
28,000
70,000
12,000
82,000
32,800
70,000
8,000
78,000
31,200
Accounts
Cash
Notes Receivable
Land
Gain-Recognized
Current income tax exp.
Deferred income tax exp.
Current tax liability
Deferred tax liability
2013
2014
Accounts
Cash
Notes Receivable
Land
Gain-Recognized
Current income tax exp.
Deferred income tax exp.
Current tax liability
Deferred tax liability
2013
100,000
80,000
20,000
28,000
8,000
28,000
8,000
2014
Accounts
Cash
Notes Receivable
Land
Gain-Recognized
Current income tax exp.
Deferred income tax exp.
Current tax liability
Deferred tax liability
2013
2014
60,000
100,000
60,000
80,000
20,000
28,000
8,000
28,000
28,000
8,000
32,800
4,800
Tax Allocation Concepts
Deferred tax asset
A deferred tax asset is the increase in
tax refund or savings in future years as
a result of deductible temporary differences
existing at the end of the current year.
Deferred tax liability
Amount that is recognized for deferred tax
consequences of temporary differences that
will result in taxable amounts in future years.
Relationship of Book Income
and Taxable Income
Net income for books (before taxes)
Adjust for permanent differences
Adjust for timing differences
Equals taxable income
Summary
Income tax payable in
current year
XX
Adjust for change in net
deferred taxes during the year
XX
Equals Income tax expense
in financial reports.
XX
End