Revised 1-9-2012
Individual Income Tax
ACC 221
Chapter 6
Deductions & Losses
Deductions and Losses that reduce gross income to adjusted gross income are referred to in this
text as adjustments for adjusted gross income. Many practitioners refer to these deductions as
adjustments to gross income. These deductions and losses are allowed in addition to the standard
deduction.
The More Common Deductions from Gross Income:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
All allowable trade and business expenses incurred in a taxpayer’s trade or business
except un-reimbursed employee business expenses
Expenses related to investment activities involving rents and royalties
Reimbursed employee business expenses
Losses from sale or exchange of business or investment property
Expenses attributable to the production of rent or royalty income
Moving expenses
Certain retirement payments (IRA, Keogh, 403(b), etc)
Penalties on early redemption of CD’s or other savings account arrangements
Alimony Paid
Interest on some Educational loans
Contributions to qualified medical savings accounts.
½ of the Self employment tax paid by self employed individuals
100% of Self employed individuals health insurance costs (limited to business profit).
Tuition and fees deduction (must have modified AGI of less than $80,000, 160,000 joint.with AGI of more than $65,000, $130,00 Joint, the deduction is smaller)
Itemized Deductions (and Losses) (Other than the exemption amounts) that reduce adjusted
gross income to taxable income are referred to as itemized deductions. These deductions and
losses are allowed in place of the standard deduction
The More Common Itemized Deductions (most of these are covered in Chapter 7)
Deductions and Losses that reduce adjusted gross income to taxable income are referred to as
itemized deductions. These deductions and losses are allowed in place of the standard deduction
1.
Medical Deductions
2.
Tax Deductions
3.
Donations
4.
Miscellaneous Itemized Deductions
-2Criteria for Business and Investment Expenses
1.
2.
3.
4.
5.
The expense must be related to a business or investment activity that has a profit motive.
The expense must be ordinary and necessary
The expense must be reasonable in amount
There must be proper documentation
The expense must be the expense of the taxpayer - not of someone else
Restrictions on Deductibility - the expenditure can not be:
1.
2.
3.
4.
A Capital Expenditure
Expenditures related to tax exempt income
Expenditures that are illegal or in violation of public policy
Specifically disallowed by the tax law
Profit Motive The activity must be engaged in for profit. No standard test applies. A case-bycase fact and circumstances approach is used by the IRS. Factors include good
record keeping, time and capital devoted to activity.
Trade or
Business
No precise IRS definition is available. One court defined a trade or business as:
AHolding one’s self out to others as engaged in the selling of goods or services.@
A trade or business activity is different than an investment activity. But the text
indicates that one taxpayer was treated as being engaged in a trade or business
when the taxpayer was engaged in short term trades in the market place. Trade or
Business income is subject to self employment tax.
Investment
Activity
An activity where the taxpayer attempts to make a profit on invested capital
(Instructor’s Definition). Rental Activity (but there are exceptions) , investments
in stocks, bonds, other securities, land, mineral rights, etc. represent investment
activities. Only deductions related to rental and royalty activities represent
deductions from gross income. Deductions for other investment activities are
only deductible (within limits) as itemized deductions. Investment income is not
subject to self employment tax.
Ordinary
Expense
Sec 212 indicates that for an expense to be ordinary it must be reasonable in
amount and it must bear a reasonable and proximate relationship to the income
producing activity or property. This means that there must be more than a remote
connection between the expenditure and the anticipated income. However, the
Supreme Court ruled that an expense is ordinary if it is customary or usual in the
context of a particular business or business community. It would appear that
the Supreme Court ruling is broader in scope than a literal reading of Sec
212.
-3Necessary
Expense
Not only must an expense be ordinary but it must also be necessary. The Supreme
Court has ruled that an expense is necessary if it is appropriate and helpful in the
taxpayer’s business. The expense does not have to be indispensable - it only
needs to be an expense that a reasonable or prudent person would incur
under similar circumstances.
Reasonable
Expense
An expense must be reasonable in amount to be deductible. This standard is
already implied by the ordinary and necessary rules. The IRS and Congress do not
want taxpayers deducting items as expense that may in fact represent something
else like a dividend. There is a one million dollar cap (only 1 million is
deductible) on executive compensation for the CEO and four highest paid officers
of a publicly held corporation (performance based exceptions apply and are
widespread).
Taxpayer
Entity
Concept
Only expenses and losses that belong to the taxpayer can be deducted by the
taxpayer. The taxpayer can not deducted expenses and losses that belong to
another taxpayer. You can not deduct losses or expenses, even if you paid them
yourself, if they are properly allocable to another person.
Capital
Sec 263 indicates that current deductions may not be taken for Capital
Expenditures Expenditures. Capital expenditures add to the value, increase the usefulness, or
prolong the life of an asset. (Except for land, Capital expenditures are deducted
through the depreciation, amortization, or depletion process)
Election to
Capitalize
Expenses
Sec 266 is elective not mandatory. It allows a taxpayer to capitalize otherwise
allowable current deductions for taxes, interest, and carrying charges on
unimproved and unproductive real estate and on real estate under development.
Expenses
Related to
Expenses related to tax exempt income are not deductible. Interest on money
Tax Exempt borrowed to carry tax exempt income is not deductible (Even home equity debt).
Income
Expenses
Contrary
to Public
Policy
Illegal payments, bribes, kickbacks to government officials. Even Lawful fines
and penalties paid by taxpayers in the ordinary course of business if related to an
unlawful act. These payments are not deductible. Bribes to officials of Foreign
governments are not always disallowed - if the payment is customary within the
country where it is made and if it is not unlawful under the Foreign Corrupt
Practices Act, it may be deducted.
-4-
Expenses Specifically Disallowed
1.
2.
Political contributions and expenses related to influencing political issues or legislation.
These expenses are not necessarily illegal – they are just not deductible.
Business Start up expenditures including business investigation expenses and pre-opening
start up costs (usually these amounts can be capitalized and expensed later through
amortization). These expenditures are for taxpayers who are not already engaged in the
trade or business.
Substantiation for Deductions The burden of proof is on the taxpayer to substantiate with
appropriate checks, invoices, receipts, and other records, the amount and nature of each
deductible expenses
1.
2.
3.
In general appropriate records are required.
Cohen rule. (We’ll I’ll be a Yankee Doodle Dandy) Where appropriate records are not
kept, a deduction for a reasonable amount may nevertheless be allowed if it is evident that
expenditure has been made.
Special rules for travel, entertainment, business use of personal auto, business gifts,
computers, autos, and other business vehicles. For these items, records must include:
(1)
Amount of expense
(2)
Time and place of travel or entertainment
(3)
Date and description of gift
(4)
Business Purpose
(5)
Business Relationship to the taxpayer
(6)
For lodging, a receipt is mandatory
(7)
The Cohen rule does not apply to the above 6 items.
When an Expense is Deductible (Cash Basis Taxpayers)
1.
2.
3.
4.
When it is paid in cash
When it is paid by check. You go to New Years Eve Church Services. During the
service an offering is collected 10 seconds before midnight - your contribution is
deductible. But if the offering is collected 10 seconds after midnight - your offering is
not deductible until the next year.
When you charge the item on a credit card (Bank Credit Card: Visa, MasterCard,
Discover Card, American Express, etc.) but a charge on an open account (Sears, JC
Penny’s, Dillards, Texaco, etc.) is not a payment.
Prepaid expenses are not usually deductible but there are exceptions (especially for
farmers. Exceptions also apply when you purchase a primary residence)
-5-
5.
Points (Prepaid Interest) paid in connection with the purchase or improvement of a
principal residence may be deductible in the year paid if:
(1)
the closing agreement clearly identifies the points
(2)
the points are computed as a percent of the amount borrowed
(3)
the charging of the points is a common business practice in that area
(4)
the points must be paid from funds other than those borrowed
(5)
points paid by the seller are Adeemed@ paid by the buyer and the amount is
subtracted from the purchase price of the property
Accrual Method Taxpayers - this method is so rare in individual income taxation that it will not
be covered in this course.
Wash Sales No deduction for a loss is allowed on a Wash Sale. A Wash Sale occurs when:
1.
A taxpayer realizes a loss on the sale of stock and securities.
2.
Substantially identical securities are acquired by the taxpayer within a 61 day period that
extends from 30 days before the date of sale until 30 days after the date of sale.
3.
Related Parties rules apply
4.
Dealers in securities are exempt from the Wash Sale rules.
5.
Limited other exceptions apply.
Transactions Between Related Parties - Recognition of gains between related parties is ok but
some losses and expenses between related parties are not allowed.
1.
Losses on the Sale of property
2.
Expenses that remain unpaid at the end of the tax year.
Related Parties Include:
1.
Individuals and their families (spouse, brothers and sisters including half brothers and
sisters, ancestors, and lineal descendants)
2.
An individual and a corporation in which the individual owns more than 50% of the value
of the outstanding stock.
3.
Various relationships between grantors and beneficiaries of trusts.
4.
Various relationships between partnerships and related corporations.
-6Hobby Losses When an activity is deemed to be a Hobby, only expenses up to the amount of
gross income derived from the Hobby are deductible and then in a specific order. The IRS uses
the following factors on a case by case approach to determine if an activity is a Business or a
Hobby.
1.
2.
3.
4.
5.
6.
7.
8.
Does the taxpayer conduct the activity in a Business like manner
The expertise of the Taxpayer or the Taxpayer’s advisors
Time and effort expended by the Taxpayer
Whether the assets used in the activity are expected to appreciate in value
Whether the assets used in the activity are expected to appreciate in value
The taxpayer’s history of income or loss with the activity
The amount of profits earned
The taxpayer’s financial status
Presumptive Test under the Code:
1.
Where an activity generates a profit in three out of the last five years, the presumption
under the code is that the activity is an activity engaged in for profit and the burden of
proof shifts to the IRS to prove otherwise.
2.
Where an activity does not generate a profit in three out of the last five years, the
presumption is that the activity is a Hobby and the burden of proof shift to the taxpayer to
prove the activity is engaged in for profit.
Hobby Expenses are deductible to the extent of Hobby Income in the following order:
1.
Expenses that may be deducted even though not incurred in a trade or business (some
taxes and interest)
2.
Other expenses related to the activity except depreciation and amortization
3.
Depreciation and amortization
Vacation Home Rules These rules apply to a residence that is used by the taxpayer as a
residence and also rented out to others during the year. Where a property is used for both
personal residence and rental activities, an allocation of the expenses must be made. A dwelling
unit is considered to be a residence if the taxpayer uses it for more than the greater of
1.
14 days or
2.
10% of the number of days the property is rented at a fair rental.
3.
Taxpayer includes family members, brothers & sisters, defendants & ancestors, and any
individual who does not pay a fair rental (rental to a family member at a fair rental
removes that person from the family)
Nominal Rental Days Exception The vacation home rules do not apply, all rent received is tax
free income, and no rental expense deductions are allowed where the rental use portion of the
total use is less than 15 days during the tax year.
-7Limitation on Expenses for Business Use of Home To deduct expenses related to the business
use of a personal residence, the taxpayer must meet the following tests:
1.
The home must be the principal place of business for a trade or business of the taxpayer
or a place where the taxpayer meets with clients in the normal course of business.
2.
The business use must be regular and exclusive of any personal use.
3.
If the taxpayer is an employee, the use must be for the convenience of the employer.
(The author will add more to these rules in Chapter 19)
Self Employed Health Insurance Deduction
Self employed individuals can deduct 100% of their Health Insurance Premiums as an adjustment
to gross income subject to the following limitations (chapter 7-6)
1.
The deductible amount cannot exceed the net income from self employment.
(Exception – if one of the optional methods is used to computer self employment tax, use
the amount subject to self employment tax rather than the net income)
2.
If either the employee or the employee’s spouse is eligible to receive subsidized health
insurance coverage from employment, the deduction is not allowed.
(Note the key words eligible to receive and subsidized. If your employer or your
spouse’s employer has a non subsidized optional health plan, you could deduct those
premiums.)
Health Savings Account Deduction (HSA) (Chapter 9-43)
Individuals can deduct as an adjustment to gross income amounts contributed to a Health Savings
account or Archer medical savings account.
An employee purchases a high deductible health insurance policy. Then the employee
contributes monies to the HSA account. The money in the account can be used to pay medical
costs not covered by the high deductible health insurance.
Requirements
1.
High deductible means a minimum deductible equal to or greater than $1,150 single or
$2,300 family.
2.
The minimum deductible is $1,200 ($2,400 family)
3.
The maximum deductible amount is $5,950 single ($11,90 family).
4.
Taxpayer can not also be covered under non high deductible plans.
5.
Taxpayer is not eligible for Medicare
6.
Taxpayer may not be claimed as dependent.
7.
Deductible contributions are determined monthly
8.
Distributions for anything other than medical costs are includible in income and subject
to a 10% penalty unless the taxpayer has attained the age of 65.