Chapter 7
Deductions and Losses: Certain
Business Expenses and Losses
Individual Income Taxes
Copyright ©2006 South-Western/Thomson Learning
Business Bad Debts
(slide 1 of 3)
• Specific charge-off method must be used
– Exception: Reserve method is allowed for some
financial institutions
• Deduct as ordinary loss in the year when
debt is partially or wholly worthless
– Cash basis taxpayer does not have bad debt
deduction for unpaid receivables
Individual Income Taxes
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Business Bad Debts
(slide 2 of 3)
• Example:
– Ted uses the accrual method of accounting
• Ted sells inventory on account for $1,150
– Buyer pays $150 down and makes no other payments
• Ted has $1,000 bad debt deduction
Individual Income Taxes
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Business Bad Debts
(slide 3 of 3)
• Example:
– Tara uses the cash method of accounting
• Tara performs accounting services for $1,150
– Client pays $150 down and makes no other payments
• Tara has no bad debt deduction
Individual Income Taxes
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Nonbusiness Bad Debts
(slide 1 of 2)
• Specific charge-off method must be used
• Deduct as short-term capital loss in the year when
amount of worthlessness is known with certainty
– No deduction is allowed for partial worthlessness of a
nonbusiness bad debt
Individual Income Taxes
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Nonbusiness Bad Debts
(slide 2 of 2)
• Related party (individuals) bad debts are
generally suspect and may be treated as
gifts
Individual Income Taxes
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Classification of Bad Debts
• Individuals will generally have nonbusiness
bad debts unless:
– In the business of loaning money, or
– Bad debt is associated with the individual’s
trade or business
• Determination is made either at the time the
debt was created or when it became
worthless
Individual Income Taxes
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Worthless Securities
(slide 1 of 2)
• Loss on worthless securities is deductible in
the year they become completely worthless
– These losses are capital losses deemed to have
occurred on the last day of the year in which the
securities became worthless
Individual Income Taxes
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Worthless Securities
(slide 2 of 2)
• Example of worthless securities
– On December 1, 2004, Sally purchased stock
for $10,000. The stock became worthless on
June 1, 2005. Sally’s loss is treated as having
occurred on December 31, 2005. The result is a
long-term capital loss.
Individual Income Taxes
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Section 1244 Stock
(slide 1 of 3)
• Sale or worthlessness of § 1244 stock
results in ordinary loss rather than capital
loss for individuals
– Ordinary loss treatment (per year) is limited to
$50,000 ($100,000 for MFJ taxpayers)
• Loss in excess of per year limit is treated as capital
loss
Individual Income Taxes
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Section 1244 Stock
(slide 2 of 3)
• Section 1244 loss treatment is limited to
stock owned by original purchaser
• Corporation must meet certain
requirements to qualify
– Major requirement is limit of $1 million of
capital contributions
• Section 1244 does not apply to gains
Individual Income Taxes
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Section 1244 Stock
(slide 3 of 3)
• Example of § 1244 loss
– In 1994, Sam purchases from XYZ Corp. stock
costing $150,000. (Total XYZ stock
outstanding is $800,000.) In 2005, Sam sells
the stock for $65,000.
– Sam, a single taxpayer, has the following tax
consequences:
$50,000 ordinary loss
$35,000 long-term capital loss
Individual Income Taxes
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Losses of Individuals
• Only the following losses are deductible by
individuals:
– Losses incurred in a trade or business,
– Losses incurred in a transaction entered into for
profit,
– Losses caused by fire, storm, shipwreck, or
other casualty or by theft
Individual Income Taxes
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Definition of Casualty
& Theft (C & T)
• Losses or damages to the taxpayer’s
property that arise from fire, storm,
shipwreck, or other casualty or theft
– Loss is from event that is identifiable,
damaging to taxpayer’s property, and sudden,
unexpected, and unusual in nature
– Events not treated as casualties include losses
from disease and insect damage
Individual Income Taxes
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Definition of Theft
• Theft includes robbery, burglary,
embezzlement, etc.
– Does not include misplaced items
Individual Income Taxes
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When Casualty & Theft Is
Deductible
• Casualties: year in which loss is sustained
– Exception: If declared “disaster area” by
President, can elect to deduct loss in year prior
to year of occurrence
• Thefts: year in which loss is discovered
Individual Income Taxes
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Effect of Claim for
Reimbursement
• If reasonable prospect of full recovery:
– No casualty loss is permitted
– Deduct in year of settlement any amount not
reimbursed
• If only partial recovery is expected, deduct
in year of loss any amount not covered
– Remainder is deducted in year claim is settled
Individual Income Taxes
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Amount of C&T Deduction
• Amount of loss and its deductibility
depends on whether:
– Loss is from nonpersonal (business or
production of income) or personal property
– Loss is partial or complete
Individual Income Taxes
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Amount of Nonpersonal
C&T Losses
• Theft or complete casualty (FMV after = 0)
– Adjusted basis in property less insurance
proceeds
• Partial casualty
– Lesser of decline in value or adjusted basis in
property, less insurance proceeds
Individual Income Taxes
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C&T Examples
• Business and production of income losses
(no insurance proceeds received)
Adjusted
Item Basis
A
6,000
B
6,000
C
6,000
Individual Income Taxes
FMV
Before
8,000
8,000
4,000
FMV
After
5,000
1,000
0
Loss
3,000
6,000
6,000
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Nonpersonal C&T Losses
• Business, rental, and royalty properties
– Deduction will be FOR AGI
• Investment properties
– Deduction will be FROM AGI
• Misc. itemized deduction not subject to 2% of AGI
limitation
Individual Income Taxes
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Nonpersonal C&T Gains
• Depending on the property, gain can be
ordinary or capital
• Amount of nonpersonal gains
– Insurance proceeds less adjusted basis in
property
Individual Income Taxes
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Personal C&T Gains
• Net personal casualty gains and losses
– If gains exceed losses, treat as gains and losses
from the sale of capital assets
• Short term or long term, depending on holding
period
– Personal casualty and theft gains and losses are
not netted with the gains and losses on business
and income-producing property
Individual Income Taxes
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Personal C&T Losses
• Net personal casualty gains and losses
– If losses exceed gains, C&T deduction will be FROM
AGI (an itemized deduction)
• Amount of personal C&T losses
– Lesser of decline in value or adjusted basis in property,
less insurance proceeds
– C&T Limitation
• Each C&T occurrence is deductible to extent > $100, and
aggregate of C&T losses for year must be > 10% AGI
Individual Income Taxes
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Example of C&T Limitation
(slide 1 of 2)
•
Karen (AGI = $40,000) has the following
C&T (amounts are lesser of decline in
value or adjusted basis):
1. Car stolen ($6,000) with camera inside ($500)
2. Earthquake damage: house ($2,000), furniture
($1,000)
Individual Income Taxes
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Example of C&T Limitation
(slide 2 of 2)
• Example of C&T limitation (cont’d)
Karen has no insurance coverage for either
loss:
1. $6,000 + 500 = $6,500 – 100 = $6,400
2. $2,000 + 1,000 = $3,000 – 100 = $2,900
Karen’s deductible C&T loss is $5,300
[$6,400 + 2,900 – (10% $40,000)]
Individual Income Taxes
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Research and Experimental
Expenditures (slide 1 of 2)
• Definition of research and experimental
(R&E) expenditures
– Costs for the development of an experimental
model, plant process, product, formula,
invention, or similar property and improvement
of such existing property
Individual Income Taxes
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Research and Experimental
Expenditures (slide 2 of 2)
• Three alternatives are available for R&E
expenditures
– Expense in year paid or incurred,
– Defer and amortize over period of 60 months or more,
or
– Capitalize (deductible when project abandoned or
worthless)
• Credit of 20% of certain R&E expenditures
available
Individual Income Taxes
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Manufacturers’ Deduction
(slide 1 of 5)
• The American Jobs Creation Act of 2004
created a new deduction based on the
income from manufacturing activities
– The manufacturers’ deduction is based on the
following formula:
• 3% × Lesser of
– Qualified production income
– Taxable (or adjusted gross) income
• The deduction cannot exceed 50% of an employer’s
W–2 wages
Individual Income Taxes
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Manufacturers’ Deduction
(slide 2 of 5)
• Qualified production income is the total of qualified
production receipts reduced by:
– Cost of goods sold that are attributable to such receipts
– Other deductions, expenses, or losses that are directly allocable to
such receipts
– A share of other deductions, expenses, and losses that are not
directly allocable to such receipts or another class of income
• The term also includes receipts for certain services
rendered in connection with construction projects in the
United States
• Qualified production receipts do not include proceeds from
the sale of food and beverages prepared at a retail
establishment
Individual Income Taxes
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Manufacturers’ Deduction
(slide 3 of 5)
• A phase-in provision increases the
applicable rate for the manufacturer’s
deduction as follows:
Rate
Years
3%
2005-2006
6%
2007-2009
9%
2010 and thereafter
Individual Income Taxes
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Manufacturers’ Deduction
(slide 4 of 5)
• Eligible taxpayers include:
– Individuals, partnerships, S corporations, C
corporations, cooperatives, estates, and trusts
• For a pass-through entity (e.g., partnerships, S
corporations), the deduction flows through to the
individual owners
• For sole proprietors, a deduction for AGI results and
probably will be reflected as a Schedule C item
Individual Income Taxes
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Manufacturers’ Deduction
(slide 5 of 5)
• Observations and operational problems
– Concepts introduced by the manufacturers’
deduction are unique
• Current tax law offers little assistance in resolving
the problems that are bound to arise
– The IRS can be expected to issue guidelines
that will aid taxpayers in utilizing the
manufacturers’ deduction correctly
Individual Income Taxes
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Net Operating Losses
(slide 1 of 7)
• Definition of net operating loss (NOL)
– Business losses from any one year can be taken
as a FOR AGI deduction and offset past or
future income
– Losses from trade or business operations,
casualty and theft losses, or losses from foreign
government confiscations can create a NOL
Individual Income Taxes
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Net Operating Losses
(slide 2 of 7)
• Definition of NOL (continued)
– No nonbusiness (personal) losses or deductions
may be used in computing NOL
• Exception: personal casualty and theft losses
Individual Income Taxes
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Net Operating Losses
(slide 3 of 7)
• Carryover period
– Must carryback to 2 prior years, then carryforward to
20 future years
• May make an irrevocable election to just carryforward
• When there are NOLs from two or more years, use on a FIFO
basis
– 3 year carryback is available for:
• Individuals with NOL from casualty or thefts
• Farming businesses and small businesses with NOLs from
Presidentially declared disasters
Individual Income Taxes
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Net Operating Losses
(slide 4 of 7)
• Example of NOL carryovers
– Ken has a NOL for 2005
– Ken must carryover his NOL in the following
order:
• Carryback to 2003 and 2004, then carryforward to
2006, 2007, ..., 2025
– Ken can elect to just carryforward his NOL
• Carryover would be to 2006, 2007, ..., 2025
Individual Income Taxes
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Net Operating Losses
(slide 5 of 7)
• Computing NOL amount
– Individual must start with taxable income and
add back:
1.
2.
3.
4.
5.
Personal and dependency exemptions
NOLs from other years
Excess nonbusiness capital losses
Excess nonbusiness deductions
Excess business capital losses
Individual Income Taxes
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Net Operating Losses
(slide 6 of 7)
• Effect of NOL in carryback year
– Taxpayer must recompute taxable income and
the income tax
– All limitations and deductions based on AGI
must be recomputed with the exception of
charitable contribution deduction
– All credits limited by or based on the tax
liability must be recomputed
Individual Income Taxes
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Net Operating Losses
(slide 7 of 7)
• Calculating remaining NOL after carryovers
– After using the NOL in the initial carryover
year, the taxpayer must determine how much
NOL remains to carry to other years
Individual Income Taxes
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If you have any comments or suggestions concerning this
PowerPoint Presentation for West Federal Taxation, please
contact:
Dr. Donald R. Trippeer, CPA
TRIPPEDR@oneonta.edu
SUNY Oneonta
Individual Income Taxes
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