Chapter 5
Business Expenses
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Code Sections
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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 (investmentrelated expenses)
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Disallowed Deductions
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Unless provided for otherwise in the Code, a
deduction will be disallowed if it is
Contrary to public policy (fines, penalties)
Related to tax-exempt income
Accrued to related party (no deduction until
related party recognizes income)
The obligation of another taxpayer
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Substantiation
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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
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Timing of Deductions
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Accrual method – expenses deductible when
“All events” have occurred that fix liability and
“Economic performance” occurs (property or
services provided or used)
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Cash basis taxpayer - expenses deductible
when paid
Date check is mailed
Date charged on credit card
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Cash Method
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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
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Use of Cash Method
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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
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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
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Prepaid Expenses
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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
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
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Costs of Starting a Business
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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
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Business Investigation
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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 amortized
over 60 months
 If new business not acquired - no deduction
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Start-up Expenses
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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
If the business is not related to an existing
business, expenses are amortized by the
taxpayer over 60 months
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Organization Costs
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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
Organization costs are capitalized and
amortized over 60 months
Excludes partnership syndications costs and
stock issuance costs
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Operating Expenses
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Most operating expenses shown on a GAAP
income statement are deductible on a
business tax return
Examples include: advertising, bank service
charges, commissions, office supplies,
repairs, taxes, licenses, accounting fees,
legal fees, salaries and wages, travel, and
utilities
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Meals & Entertainment
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The deduction for business meals and
entertainment expenses is limited to 50% of
the qualified expenses
The 50% limit is imposed on whoever
(employer or employee) ultimately pays the
expense
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Meals & Entertainment
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Directly-related expenses - costs incurred
when a significant business discussion takes
place between the taxpayer and a customer in
atmosphere conducive to the serious conduct
of business.
Associated-with expenses - deductible when
directly preceded or followed by a substantial
business discussion
Deduction for entertainment tickets is limited to
50% of the tickets’ face value
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Restriction on Deductions
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No deduction allowed for the costs of owning
and maintaining entertainment facilities such
as hunting lodges and yachts
No deduction allowed for membership dues
and fees paid to social, athletic, or sporting
clubs
Deductions are allowed for dues to
professional organizations, public service
organizations, and trade associations
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Deduction for business gifts limited to $25 per
donee per year
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Travel Away From Home
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Travel expenses incurred for temporary
travel away from home on business are
deductible.
Qualifying expenses include lodging, 50%
of meals, transportation to destination and
back, and incidental expenses
Away from home refers to the person’s tax
home; that is, the location of the principal
place of employment regardless of where
the family residence is maintained
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Temporary Assignments
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Temporary is defined as one year or less
Employment away from home in a single
location that is realistically expected to last
(and does in fact last) for one year or less,
will be treated as temporary
Assignment for more than one year shifts
tax home to the new location (no deduction
for travel and living costs)
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Transportation Expenses
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Certain transportation expenses incurred
when the taxpayer is not away from home are
deductible and include
the cost of transportation from one work
location to another
transportation between home and a temporary
work location if the taxpayer has a regular
place of business
any meal costs are excluded, however
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Transportation Expenses
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The prorated business portion of actual
automobile expenses or a standard mileage rate
(37.5¢ for 2004) plus related parking and tolls
can be deducted
Commuting expenses (between home and the
regular place of business) are a personal
nondeductible expense
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Combining Business with
Pleasure Travel
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For U.S. travel, if the trip is primarily for
business, all transportation costs to and
from destination are deductible
If primary purpose is pleasure, no deduction
for transportation
Primary purpose is determined by the
number of days on business versus
personal days
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Combining Business with
Pleasure Travel
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Meals & lodging are deductible only for days
on which business is conducted
If a taxpayer remains in a temporary location
to reduce costs as a result of
reduced airfare for Saturday night stays or
for business conducted on both Friday and
Monday
the costs for additional days are deductible if
they are less than the cost of returning home
when business is completed
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Foreign Travel
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Transportation expenses must be allocated
between business and personal days unless
Trip does not exceed one week or
Less than 25% of total time spent for personal
purposes
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If trip primarily personal, no deduction for
transportation
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Bad Debt Expense
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Specific charge-off method must be used
Investment and personal loans are
considered nonbusiness (capital losses)
Loan must be valid debt
No bad debt deduction for cash basis
taxpayers who have not previously included
amount in income
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Insurance Expense
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Premiums for fire, casualty, and theft
insurance for business property are
deductible
Payments into a self-insurance reserve are
not deductible - only actual losses are
deductible
Premiums for life insurance when business is
beneficiary are not deductible
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Legal Expenses
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Legal Fees deductible only if related to a
trade or business
Legal fees incurred to defend title to property
are added to the asset’s basis
Criminal defense fees are deductible only if
the legal action has a direct relationship to a
profit-seeking activity
Personal legal expenses are not deductible
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Taxes
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Deductible taxes include
State, local, and foreign real property taxes
State and local personal property taxes
State, local, and foreign income taxes
Employer’s payroll taxes
Other federal, state, local, and foreign taxes
incurred in a business or other incomeproducing activity
Federal income taxes are not deductible
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Taxes
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When real estate is sold, the seller is
responsible for taxes through the day before
the sale date
Assessments for improvements must be
added to basis of property
Sales taxes are added to cost of business
property or service
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UNICAP Rules
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Uniform capitalization rules apply to businesses
whose average annual gross receipts for the
preceding three years exceeds $10 million
UNICAP rules require inventory costs to include all
direct costs of manufacturing, purchasing, or
storing inventory, along with many indirect costs
typically not included in full absorption costing
Nonmanufacturing costs (research, selling,
advertising and distribution expenses) are not
required to be included in inventory
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Inventory
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Acceptable methods for tax accounting
include specific identification, FIFO, LIFO,
and average cost
When prices are rising, the LIFO method
results in a lower inventory valuation and tax
savings through a higher deduction for cost of
goods sold
The LIFO conformity rule requires use of
LIFO for financial statements if LIFO is used
for tax
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Residential Rental Property
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If rental of real estate is a business, all
income is included and all expenses are
deductible, even if it creates a loss
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
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Residential Rental Property
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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
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Rental of a Vacation Home
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If the residence is rented for less than 15
days during the year a de minimis
exception applies
No rental income is reported but
No deductions are allowed for expenses
other than mortgage interest and property
taxes as itemized deductions
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Rental of a Vacation Home
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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)
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Rental of a Vacation Home
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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
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Home Office Expenses
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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
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Home Office Expenses
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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
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Home Office Expenses
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Expenses are deducted in this order:
1. Expenses directly related to the business other
than home office expenses (supplies)
2. The allocated portion of otherwise deductible
itemized deductions (mortgage interest and
property taxes)
3. Other home expenses including utilities,
insurance, and maintenance
4. Depreciation
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Excess expenses are carried forward
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Hobby Expenses
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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
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Hobby Expenses
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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
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If activity is a hobby, the deduction for
expenses is limited to hobby income
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Hobby Expenses
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Expenses must be 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
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Excess expenses are lost - no carryover
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Accounting for Income Taxes
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FAS 109 states that income tax expense
reported on financial statements must be
based on financial statement income rather
than taxable income
Differences fall into two categories
Permanent differences
Temporary differences
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Permanent Differences
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Income that is not taxed but is reported
for financial accounting purposes
Interest income from municipal bonds
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Expenses that can never be deducted on
the tax return
Fines and penalties
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Expenses that have limited deductibility
50% of meals and entertainment
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Temporary Differences
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Income or expense items that are reported in
one year for accounting income and in a
different year for taxable income
Examples: depreciation expense, bad debt
expense, warranty expenses, and prepaid
income
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Schedule M-1 of Form 1120 reconciles
accounting (book) income to taxable income
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Schedule M-1
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Calculating Tax Expense
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If only permanent differences, adjust book
income by
Adding expenses that are not tax deductible and
Subtracting tax-exempt income, then
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Multiply adjusted book income by the tax rate
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Deferred Taxes
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Temporary differences create
A deferred tax liability that is a current tax
savings that will have to be paid in a future
year
A deferred tax asset that is a prepayment of
tax that will be refunded in a future year
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Deferred Tax Assets
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To realize the benefit of a deferred tax asset
(tax prepayment) the business must have
future income and a related tax liability
A more-likely-than-not test is used to
determine if a valuation account (contra
asset) is needed
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Consolidated
Financial Statements
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Under FAS 109, income tax expense
reported on consolidated financial
statements should include the total of all
federal, state, local, and foreign income
taxes including both current and deferred
income taxes
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Consolidated
Financial Statements
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Exception under APB 23 allows parent to
exclude future U.S. income tax on foreign
subsidiary income if these earnings are
permanently reinvested outside the U.S.
 Allows U.S. corporation to report higher financial
statement income because its income statement
includes the foreign income but excludes the
deferred U.S. tax that could eventually be due on
this income
 Earnings repatriated later can cause a spike in the
corporation's effective tax rate in that year
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The End
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