Chapter 5
Business Deductions
Essentials of Taxation
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1
The Big Picture (slide 1 of 4)
• Michael Forney operates his small engine service and
repair business as a C corp. with a December 31 yearend, uses the accrual method of accounting, and has
$435,500 of gross income.
• Forney owns 80% of the corp’s stock, while his wife,
Kathleen, and his mother, Terry, each own 10% of
the stock.
• Michael is a full-time employee at his business.
– His mother helps out with the books for about two hours a
week.
– At this time, Kathleen does not work at the business.
2
The Big Picture (slide 2 of 4)
• Michael Forney reports the following expense information
from his small engine service and repair business.
Salaries and wages (including Michael’s salary
of $55,000 and Terry’s salary of $3,000)
Building rent
Depreciation of machinery, equipment, and office
furnishings*
Insurance (coverage for all assets)
Consulting Fees
Utilities
Taxes and licenses
Advertising
Interest expense
Charitable contributions
Dues –Small Engine Repair Institute
Political contributions
•
$150,000
24,000
13,000
6,000
6,000
12,000
6,000
3,000
3,000
3,000
10,000
2,000
*$130,000 of new machinery and equipment were purchased this year. The financial reporting
system depreciation is based on straight-line depreciation over 10 years. The MACRS cost
recovery period for tax purposes is 7 years. Prior year assets have been fully depreciated.
3
The Big Picture (slide 3 of 4)
• Michael would like to know the amount of his
deductible expenses for tax purposes and would like
your advice on another matter.
• Because his business has been very profitable over
the years, it has built up large cash reserves, and its
cash flow continues to be strong.
– His business has never paid any dividends to the
shareholders.
• For next year, he is considering paying himself a
salary of $140,000 and his mother a salary of
$30,000.
– This would give them more cash to spend for planned
vacations and home improvements.
4
The Big Picture (slide 4 of 4)
• Finally, during the current year, Michael
purchased another personal residence for
$300,000 and converted his original residence
to rental property.
– The original residence cost $250,000 five years
ago and has a current market value of $180,000.
• He also purchased a condo for $170,000 near
his business, which he will rent out to tenants.
• Read the chapter and formulate your response.
5
Trade or Business Deductions
(slide 1 of 2)
• Section 162(a) permits a deduction for all
ordinary and necessary expenses paid or
incurred in carrying on a trade or business
including:
– Reasonable salaries paid for services
– Expenses for the use of business property
– One-half of self-employment taxes paid
• Such expenses are deducted for AGI
6
Trade or Business Deductions
(slide 2 of 2)
• In order for expenses to be deductible, they
must be:
– Ordinary: normal, usual, or customary for others in
similar business, and not capital in nature
– Necessary: prudent businessperson would incur
same expense
– Reasonable: question of fact
– Incurred in conduct of business
7
Trade or Business Deductions
(slide 2 of 2)
• In order for expenses to be deductible, they
must be:
– Ordinary: normal, usual, or customary for others in
similar business, and not capital in nature
– Necessary: prudent businessperson would incur
same expense
– Reasonable: question of fact
– Incurred in conduct of business
8
Trade or Business Deductions
(slide 2 of 2)
• In order for expenses to be deductible, they
must be:
– Ordinary: normal, usual, or customary for others in
similar business, and not capital in nature
– Necessary: prudent businessperson would incur
same expense
– Reasonable: question of fact
– Incurred in conduct of business
9
The Big Picture - Example 3
Ordinary and Necessary Requirement
• Return to the facts of The Big Picture on p. 5-1.
• The business, a closely held C corp, is owned by
Michael Forney, his wife, Kathleen, and his mother,
Terry.
• The company has been highly profitable.
– It has never paid dividends.
• Michael is the key employee of the business.
– His mother plays a very minor role.
• Assume their current salaries of $55,000 and $3,000
are comparable to what they could earn at similar
companies for the work they do.
10
The Big Picture - Example 3
Ordinary and Necessary Requirement
• If Mr. Forney’s plan to double his salary and increase
his mother’s salary by tenfold is implemented, the
amounts in excess of their current salaries may be
deemed unreasonable.
– If so, the excess would be disallowed as deductible salary
and treated as dividends to Michael and Terry.
• Salaries are deductible by the corporation, but dividends
are not.
• Salaries would be taxed at ordinary income rates and are
subject to payroll taxes.
– However, dividend income would be taxed at long-term
capital rates if qualified.
11
Methods of Accounting
• The method of accounting affects when
deductions are taken
– Cash: expenses are deductible only when paid
– Accrual: expenses are deductible when incurred
• Apply the all events test and the economic performance
test
– Exception to the economic performance test for recurring items
12
Methods of Accounting
• The method of accounting affects when
deductions are taken
– Cash: expenses are deductible only when paid
– Accrual: expenses are deductible when incurred
• Apply the all events test and the economic performance
test
– Exception to the economic performance test for recurring items
13
Methods of Accounting
• The method of accounting affects when
deductions are taken
– Cash: expenses are deductible only when paid
– Accrual: expenses are deductible when incurred
• Apply the all events test and the economic performance
test
– Exception to the economic performance test for recurring items
14
Methods of Accounting
• The method of accounting affects when
deductions are taken
– Cash: expenses are deductible only when paid
– Accrual: expenses are deductible when incurred
• Apply the all events test and the economic performance
test
– Exception to the economic performance test for recurring items
15
Methods of Accounting
• The method of accounting affects when
deductions are taken
– Cash: expenses are deductible only when paid
– Accrual: expenses are deductible when incurred
• Apply the all events test and the economic performance
test
– Exception to the economic performance test for recurring items
16
Disallowance Possibilities
• The tax law disallows the deduction of certain types
of expenses for a variety of reasons
– e.g., May restrict taxpayer attempts to deduct certain items
that, in reality, are personal expenditures
• Certain disallowance provisions are a codification or
extension of prior court decisions
– e.g., After courts denied deductions for payments in
violation of public policy, tax law was changed to provide
specific authority for the disallowance
17
Expenditures Contrary
To Public Policy
• Deductions are disallowed for certain specific
types of expenditures that are considered
contrary to public policy
– Examples: penalties, fines, illegal bribes or
kickbacks, two-thirds of treble damage payments
for violation of anti-trust law
18
The Big Picture - Example 9
Violations of Public Policy
• Refer to the facts of The Big Picture on p. 5-1.
• Michael Forney had not instituted proper procedures
for disposing of used motor oil and other engine
fluids from his business.
– During the current tax year, he was fined $3,000 by the
city.
• Mr. Forney believes the fine should be deducted as an
ordinary business expense.
– However, because the fine was due to a violation of public
policy, the $3,000 is not deductible.
19
Legal Expenses Incurred In Defense
Of Civil Or Criminal Penalties
• To deduct legal expenses
– Must be directly related to a trade or business, an
income producing activity, or the determination,
collection, or refund of a tax
• e.g., Corporate officer’s legal fees in defending against
price-fixing charges
• e.g., Landlord’s legal fees associated with eviction of
tenant
20
Expenses Relating To
An Illegal Business
• Usual expenses of operating an illegal business
are deductible
– However, deduction for fines, bribes to public
officials, illegal kickbacks, and other illegal
payments are disallowed
• Trafficking in controlled substances: only cost
of goods sold can reduce gross income
21
Political Contributions And
Lobbying Activities
• Generally, no business deduction is allowed
for payments made for political purposes or for
lobbying
– Exceptions are allowed for lobbying:
• To influence local legislation,
• To monitor legislation, and
• De minimis in-house expenses (limited to $2,000)
– If greater than $2,000, none can be deducted
22
The Big Picture - Example 12
Political Contributions
• Refer to the facts of The Big Picture on p. 5-1.
• Michael Forney made political contributions to the
U.S. Senate campaigns of Tim Kaine & George Allen
– Mr. Forney made these contributions to encourage these
candidates to support a new bill that is beneficial to small
businesses.
– Therefore, he assumed that these would be deductible
business expenses.
• However, political contributions are not
deductible, so he will receive no tax benefit
from them.
23
The Big Picture - Example 13
Lobbying Expenditures
• Refer to the facts of The Big Picture on p. 5-1.
• Mr. Forney’s business made contributions to the
Small Engine Repair Institute, a trade association for
owners of similar-type businesses.
– The trade association estimates that 70% of its dues
are allocated to lobbying activities.
– Thus, the deduction on the corporate tax return is
limited to $3,000 ($10,000 30%).
24
Excessive Executive Compensation
(slide 1 of 2)
• For publicly held corporations:
– Deduction for compensation of CEO and four
other highest compensated officers is limited to $1
million each
– Does not include:
• Certain performance-based compensation
• Payments to qualified retirement plans
• Payments excludible from gross income
25
Excessive Executive Compensation
(slide 2 of 2)
• An additional limitation applies only to
covered executives of companies receiving
Troubled Asset Relief Program (TARP)
assistance
– The deduction for compensation paid to a covered
executive is limited to $500,000
– Covered employees include the CEO, the CFO,
and the three other most highly compensated
officers
26
Investigation Of A Business
(slide 1 of 3)
• Investigation expenses - incurred to determine the
feasibility of entering a new business or expanding an
existing business
– Include costs such as travel, engineering, architectural
surveys, marketing reports, various legal and accounting
services
• Tax treatment of these expenses depends on:
–
–
–
–
The current business, if any, of the taxpayer
The nature of the business being investigated
The extent to which the investigation has proceeded
Whether or not the acquisition actually takes place
27
Investigation Of A Business
(slide 2 of 3)
• If the taxpayer is in a business the same as or
similar to that being investigated
– Investigation expenses are deductible in the year
paid or incurred
• The tax result is the same whether or not the taxpayer
acquires the business being investigated
28
Investigation Of A Business
(slide 3 of 3)
• When the taxpayer is not in a business the same as or
similar to that being investigated
– Tax result depends on whether new business is acquired
• If not acquired
– All investigation expenses generally are nondeductible
• If acquired
– Investigation expenses must be capitalized
– May elect to deduct the first $5,000 of expenses currently
– Any excess expenses can be amortized over a period of not less than
180 months (15 years)
– In arriving at the $5,000 immediate deduction allowed, a dollar-fordollar reduction must be made for those expenses in excess of
$50,000
29
The Big Picture - Example 15
Investigation Of A Business
• Return to the facts of The Big Picture on p. 5-1.
• Michael Forney investigates the purchase of
Southside Small Engine Services, LLC, a nearby
competitor that is for sale.
– Expenses paid to consultants and accountants as part of this
investigation totaled $6,000.
• He determined that Southside Small Engine Services
would not be a good investment, so he did not buy it.
– The $6,000 spent to investigate this business is deductible
as a business expense.
– Mr. Forney is already in the small engine service and repair
business.
30
Capital Expenditures
• Amounts are capitalized
• Asset may be subject to depreciation (or cost
recovery), amortization, or depletion
31
Capital Expenditures
• Amounts are capitalized
• Asset may be subject to depreciation (or cost
recovery), amortization, or depletion
32
Transactions Between Related Parties
(slide 1 of 2)
• Section 267 disallows losses from direct or
indirect sales or exchanges of property
between related parties
– Family and entity relationships apply
– Constructive ownership rules apply
– Loss disallowed may reduce gain on subsequent
disposition to unrelated third party
33
Transactions Between Related Parties
(slide 1 of 2)
• Section 267 disallows losses from direct or
indirect sales or exchanges of property
between related parties
– Family and entity relationships apply
– Constructive ownership rules apply
– Loss disallowed may reduce gain on subsequent
disposition to unrelated third party
34
Transactions Between Related Parties
(slide 1 of 2)
• Section 267 disallows losses from direct or
indirect sales or exchanges of property
between related parties
– Family and entity relationships apply
– Constructive ownership rules apply
– Loss disallowed may reduce gain on subsequent
disposition to unrelated third party
35
Transactions Between Related Parties
(slide 2 of 2)
• Section 267 also requires the matching
principle be applied for unpaid expenses and
interest when different accounting methods
used
– Example: An accrual basis, closely held
corporation, cannot deduct accrued, but unpaid,
salary to cash basis related party
employee/shareholder until it is actually paid
36
The Big Picture - Example 19
Related Parties – Disallowed Losses
• Return to the facts of The Big Picture on p. 5-1.
• Michael Forney, an 80% shareholder, sells a stock
investment in his personal portfolio with a basis of
$10,000 to his corporation for its fair market value of
$8,000.
– Michael’s $2,000 loss from the sale of the stock is
disallowed because the sale is to a related party.
• Michael’s business sells the stock several years later
for $11,000.
– Only $1,000 of gain is taxable to the business upon the
subsequent sale.
• $11,000 selling price - $8,000 basis - $2,000 previously disallowed
loss.
37
The Big Picture - Example 20
Related Parties – Disallowed Losses
• Assume the same facts as Example 19, except
that the corporation sells the stock for $9,000
to an unrelated party.
– The corporation’s gain of $1,000 ($9,000 selling price $8,000 basis) is not recognized because of the right of
offset from Michael’s sale of $2,000.
• The offset may result in only a partial tax benefit upon the
subsequent sale (as in this case).
• If Michael had sold the stock to an unrelated
party rather than to his corporation, he could
have recognized a $2,000 loss.
– However, aggregating the effect to Michael and his
corporation, they can benefit from only $1,000 of loss.
38
Expenses and Interest Relating to
Tax-Exempt Income
• Expenses relating to production of tax-exempt
income are nondeductible
– Example: interest expense on loan where funds
used to acquire municipal bonds
39
Charitable Contributions
(slide 1 of 2)
• Individuals and corporations may deduct
contributions made to qualified domestic
organizations
• Contributor must have donative intent and
expect nothing in return
– If contributor receives tangible benefit, the FMV
of such benefit must be deducted from the amount
of the contribution
40
Charitable Contributions
(slide 2 of 2)
• Contribution must be to qualified domestic
nonprofit organization or state or possession of
U.S. or any subdivisions thereof
– Many (but not all) qualified domestic charities are
listed in IRS Publication #78
41
Timing of Charitable Contribution
Deduction
• Generally, deductible in year in which the
payment is made
– Exception: An accrual basis corporation may take
deduction in year preceding payment if:
• The contribution is authorized by the board of directors
by the end of that year, and
• The contribution is paid on or before the fifteenth day of
the third month of the following year
42
Ordinary Income Property
• Defined: assets that would produce ordinary
income or short-term capital gain if sold
• Contribution amount
– FMV of asset less ordinary income (or STCG)
potential; generally the lower of adjusted basis or
FMV
43
Capital Gain Property
• Defined: assets that would produce long-term
capital gain or Section 1231 gain if sold
• Contribution amount
– Generally FMV of asset
44
Exceptions to FMV Deduction of Capital
Gain Property (slide 1 of 2)
• Private nonoperating foundations
– Deduction for contributions to certain private
nonoperating foundations must be reduced by the
amount of capital gain potential
– Thus, the amount is limited to the adjusted basis
45
Exceptions to FMV Deduction of Capital
Gain Property (slide 2 of 2)
• If a corporation contributes tangible personal
property and the charitable organization puts
the property to an unrelated use
– The appreciation on the property is not deductible
• Unrelated use is defined as use that is not
related to the purpose or function that qualifies
the organization for exempt status
46
Example of Contributions of
Tangible Personalty
• Taxpayer contributes painting to local charity:
FMV $100,000 and adjusted basis $10,000
– If charitable organization is a local museum that
hangs the painting for patrons to view, taxpayer
has $100,000 contribution deduction
– If charitable organization is a local church that
sells the painting immediately to obtain funds for
its operation, taxpayer has $10,000 contribution
47
Exceptions Related to Contributions of Ordinary
Income Property (slide 1 of 2)
• In general, the deduction for a contribution of
ordinary income property is limited to the
basis of the property
• On certain contributions of inventory by corps,
the amount of the deduction is equal to the
lesser of
– The property’s basis plus 50% of the appreciation
on the property, or
– Twice the property’s basis
48
Exceptions Related to Contributions of Ordinary
Income Property (slide 2 of 2)
• This increased deduction amount is available for
inventory contributions of
– Property to a charitable organization for use in its exempt
function
• Such use is solely for the care of the ill, needy, or infants
– Tangible personal research property constructed by the
corp. to a qualified educational or scientific organization
• Must use the property for research, experimentation, or for research
training
• Property must be contributed within 2 years from date of
construction by donor, and
• Its original use must begin with the donee
49
Charitable Contribution
Limitation
• A corporate taxpayer’s contribution deduction
is limited to 10% of taxable income before
–
–
–
–
The charitable contribution deduction
Any NOL or capital loss carryback
The dividends received deduction, and
The domestic production activities deduction
50
Charitable Contributions Carryover
• Contributions in excess of the 10% limit may
be carried forward for 5 years
– Any carryforward is added to subsequent
contributions subject to the 10% limit
– In carryforward year, current year contributions
must be deducted first, with excess deductions
from previous years deducted in order of time
51
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
52
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 is
also available
53
Domestic Production Activities Deduction
(slide 1 of 4)
• The American Jobs Creation Act of 2004
created a new deduction based on the income
from manufacturing activities
– The Domestic Production Activities deduction is
based on the following formula:
• 9% × Lesser of
– Qualified production activities income
– Taxable (or modified adjusted gross) income or AMTI
• The deduction cannot exceed 50% of an employer’s
W–2 wages paid to employees engaged in qualified
production activities
54
Domestic Production Activities Deduction
(slide 2 of 4)
• Qualified production activities income is the
excess of domestic production gross receipts
over the sum of:
– 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
55
Domestic Production Activities Deduction
(slide 3 of 4)
• Domestic production gross receipts include the following five
specific categories:
– The lease, license, sale, exchange, or other disposition of qualified
production property manufactured, produced, grown, or extracted in the
U.S.
– Qualified films largely created in the U.S.
– The production of electricity, natural gas, or potable water
– Construction (but not self-construction) performed in the U.S.
– Engineering and architectural services for domestic construction
• Items specifically excluded from this definition include:
– The sale of food and beverages prepared by a taxpayer at a retail
establishment and
– The transmission or distribution of electricity, natural gas, or potable
water
56
Domestic Production Activities Deduction
(slide 4 of 4)
• 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 is
claimed on Form 1040, line 35 on page 1
57
Cost Recovery
• Recovery of the cost of business or incomeproducing assets is through:
– Cost recovery or depreciation: tangible assets
– Amortization: intangible assets
– Depletion: natural resources
58
Nature of Property
• Property includes both realty (real property) and
personalty (personal property)
– Realty generally includes land and buildings permanently
affixed to the land
– Personalty is defined as any asset that is not realty
• Personalty includes furniture, machinery, equipment, and many
other types of assets
• Personalty (or personal property) should not be
confused with personal use property
– Personal use property is any property (realty or personalty)
that is held for personal use rather than for use in a trade or
business or an income-producing activity
• Write-offs are not allowed for personal use assets
59
General Considerations
(slide 1 of 3)
• Basis in an asset is reduced by the amount of cost
recovery that is allowed and by not less than the
allowable amount
– Allowed cost recovery is cost recovery actually taken
– Allowable cost recovery is amount that could have been
taken under the applicable cost recovery method
• If no cost recovery is claimed on property
– The basis of the property must still be reduced by the
amount that should have been deducted
• i.e., The allowable cost recovery
60
General Considerations
(slide 2 of 3)
• If personal use assets are converted to business
or income-producing use
– Basis for cost recovery and for loss is lower of
• Adjusted basis or
• Fair market value at time property was converted
– Losses that occurred prior to conversion can not be
recognized for tax purposes through cost recovery
61
General Considerations
(slide 3 of 3)
• MACRS applies to:
– Assets used in a trade or business or for the
production of income
– Assets subject to wear and tear, obsolescence, etc.
– Assets that have a determinable useful life or
decline in value on a predictable basis
– Assets that are tangible personalty or realty
62
The Big Picture - Example 40
Cost Recovery Basis for Personal Use Assets
Converted to Business Use
• Return to the facts of The Big Picture p. 5-1.
• Five years ago Michael Forney purchased his personal
residence for $250,000.
– This year Michael found a larger home that he acquired for his personal
residence.
– Unfortunately he cannot sell his original residence and recover his
purchase price of $250,000.
• The residence was appraised at $180,000.
• Instead of continuing to try to sell the original residence,
Michael converted it to rental property.
– The basis for cost recovery of the rental property is $180,000 because
the fair market value is less than the adjusted basis.
– The $70,000 decline in value is deemed to be personal (since it
occurred while the property was held for personal use by Michael) and
therefore nondeductible.
63
MACRS-Personalty
• MACRS characteristics:
MACRS Personalty
Statutory lives:
Method:
Convention:
3, 5, 7, 10 yrs
200% DB
Half Yr
or
.
15, 20 yrs
150% DB
Mid-Quarter
DB = declining balance with switch to straight-line
Straight-line depreciation may be elected
64
Half-Year Convention
• General rule for personalty
• Assets treated as if placed in service (or
disposed of) in the middle of taxable year
regardless of when actually placed in service
(or disposed of)
65
Example: Half-Year Convention
• Purchased and placed an asset in service on
March 15 (Tax year end is December 31)
– Treated as placed in service June 30
– Six months cost recovery in year 1 (and year
disposed of, if within recovery period)
66
Mid-Quarter Convention
• Applies when more than 40% of personalty is
placed in service during last quarter of year
• Assets treated as if placed into service (or
disposed of) in the middle of the quarter in
which they were actually placed in service (or
disposed of)
67
Example: Mid-Quarter Convention
• Business with 12/31 year end purchased and placed in
service the following used 5-year class assets:
• Asset 1: on 3/28 for $50,000, and
• Asset 2: on 12/28 for $100,000
• More than 40% placed in service in last quarter;
therefore, mid-quarter convention used:
• Asset 1: $50,000 × 35% (Table 5.2) = $17,500
• Asset 2: $100,000 × .05 (Table 5.2) = $5,000
68
MACRS-Realty
(slide 1 of 2)
• MACRS characteristics:
MACRS Realty
Residential Rental Nonresid. Realty
Statutory lives:
27.5 yrs
31.5 yrs or 39 yrs
Method:
Straight-line
Convention:
Mid-month
• Residential rental real estate
– Includes property where 80% or more of gross rental
revenues are from nontransient dwelling units
• e.g., Apartment building
– Hotels, motels, and similar establishments are not
residential rental property
69
MACRS-Realty
(slide 2 of 2)
• Mid-month Convention
– Property placed in service at any time during a
month is treated as if it was placed in service in the
middle of the month
– Example: Business building placed in service April
25 is treated as placed in service April 15
70
Optional Straight-line Election
• May elect straight-line rather than accelerated
depreciation on personalty placed in service
during year
– Use the class life of the asset for the recovery
period
– Use half-year or mid-quarter convention as
applicable
– Election is made annually by class of property
71
Additional First-Year Depreciation
(slide 1 of 2)
• Additional first-year depreciation has been
allowed for several years
– In 2012 and 2013, 50% additional first-year
depreciation was allowed
• Although the provision was written to expire at
the end of 2013, Congress may extend this
provision during 2015
72
Additional First-Year Depreciation
(slide 2 of 2)
• Additional first-year depreciation allows an
additional 50% of cost recovery in year asset is
placed in service
• Qualified property includes most types of new
property other than buildings
– Property that is used but new to the taxpayer does
not qualify
73
Example: Additional
First-Year Depreciation
Maple Company acquires a 5-year class asset on
April 25, 2015, for $20,000. Maple’s cost recovery
deduction for 2015 is computed as follows:
50% additional first-year
depreciation ($20,000 X .50)
MACRS cost recovery
[($20,000 - $10,000) X .20 (Exhibit 5.5)]
Total cost recovery
$10,000
2,000
$12,000
74
Election to Expense Assets
-Section 179 (slide 1 of 5)
• General rules
– Can elect to immediately expense up to $500,000
of business tangible personalty placed in service in
2015
– Cannot use § 179 for most realty or production of
income property
75
Election to Expense Assets
-Section 179 (slide 2 of 5)
• Section 179 general rules
– Amount expensed reduces depreciable basis
– Any elected § 179 expense is taken before
additional first-year depreciation is computed
• The base for calculating the standard MACRS
deduction is net of the § 179 expense and the additional
first-year depreciation (50% in 2015)
76
Election to Expense Assets
-Section 179 (slide 3 of 5)
• Annual limitations:
– Expense limitation ($500,000 for 2015) is reduced
by amount of § 179 property placed in service
during year that exceeds $2,000,000 in 2015
• Example: In 2015, taxpayer placed in service
$2,015,000 of § 179 property.
– The § 179 expense limit is reduced to $485,000
• [$500,000 – ($2,015,000 – $2,000,000)]
77
Election to Expense Assets
-Section 179 (slide 4 of 5)
• Annual limitations:
– Election to expense cannot exceed taxable income (before
§ 179) of taxpayer’s trades or businesses
• Any amount expensed under § 179 over taxable income limitation
may be carried over to subsequent year(s)
• Amount carried over still reduces basis currently
– The § 179 amount eligible for expensing in a carryforward
year is limited to the lesser of
• The statutory dollar amount ($500,000 in 2015) reduced by the cost
of § 179 property placed in service in excess of $2,000,000 (in
2015) in the carryforward year, or
• The business income limitation in the carryforward year.
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Election to Expense Assets
-Section 179 (slide 5 of 5)
Example:
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Listed Property (slide 1 of 4)
• There can be substantial limits on cost
recovery of assets considered listed property
• Listed property includes the following:
– Passenger automobile
– Other property used as a means of transportation
– Property used for entertainment, recreation, or
amusement
– Computer or peripheral equipment
– Cellular telephone
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Listed Property (slide 2 of 4)
• To be considered as predominantly used for
business, business use must exceed 50%
• Use of asset for production of income is not considered
in this 50% test
• However, both business and production of income use
percentages are used to compute cost recovery
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Listed Property (slide 3 of 4)
• To be considered as predominantly used for
business (cont’d)
• If 50% test is met, then allowed to use statutory
percentage method of cost recovery with some
limitations
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Listed Property (slide 4 of 4)
• If asset is not used predominantly for business
i.e., business use does not exceed 50%
– Must use straight-line method
– If business use falls to 50% or lower after year
property is placed in service, must recapture excess
cost recovery
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Passenger Auto Cost
Recovery Limits (slide 1 of 7)
For autos placed in service in 2014, cost recovery limits are:
Year
Recovery Limitation
1
$3,160
2
5,100
3
3,050
Succeeding years until
the cost is recovered
1,875
• If a passenger auto used predominantly for
business qualifies for additional first-year
depreciation
– First-year recovery limitation is increased by $8,000
• Limit increases from $3,160 to $11,160 ($3,160 + $8,000).
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Passenger Auto Cost
Recovery Limits (slide 2 of 7)
• Limits are for 100% business use
– Must reduce limits by percentage of personal use
• Limit in the first year includes any amount the
taxpayer elects to expense under § 179
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Passenger Auto Cost
Recovery Limits (slide 3 of 7)
Example: Taxpayer acquired an auto in 2014 for
$30,000 and used it 80% for business, and elects not
to take additional first-year depreciation.
2014 cost recovery allowance:
($30,000 × 20%) × 80%
$4,800
But deduction is limited to
× Business use %
Cost recovery allowance
$3,160
× 80%
$2,528
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Passenger Auto Cost
Recovery Limits (slide 4 of 7)
• Limit on § 179 deduction
– For certain vehicles not subject to the statutory
dollar limits imposed on passenger automobiles the
§ 179 deduction is limited to $25,000
• The limit applies to sport utility vehicles with an
unloaded GVW rating of more than 6,000 pounds and
not more than 14,000 pounds
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Passenger Auto Cost
Recovery Limits (slide 5 of 7)
• Listed property that fails the >50% business usage
test in year property is placed in service must be
recovered using the straight-line method
– Such property does not qualify for additional first-year
depreciation
• If the >50% business usage test is failed in a year
after the property is placed in service, straight-line
method must be used for remainder of property’s life
– Cost recovery of passenger auto under straight-line listed
property rule still subject to annual limits
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Passenger Auto Cost
Recovery Limits (slide 6 of 7)
• Change from predominantly business use
– If the business use percentage falls to 50% or
lower after the year the property is placed in
service, the property is subject to cost recovery
recapture
– The amount recaptured as ordinary income is the
excess cost recovery
• Excess cost recovery is the excess of the cost recovery
deductions taken in prior years using the statutory
percentage method over the amount that would have
been allowed if the straight-line method had been used
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Passenger Auto Cost
Recovery Limits (slide 7 of 7)
• Leased autos subject to inclusion amount rule
– Using IRS tables, taxpayer has gross income equal
to each lease year’s inclusion amount
– Purpose is to prevent avoidance of cost recovery
dollar limits applicable to purchased autos by
leasing autos
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Farm Property (slide 1 of 2)
• Generally, for farm assets use:
– MACRS 150% declining-balance method for
personalty
• MACRS straight-line method is required for any tree or
vine bearing fruits or nuts
– Straight line method over the normal periods (27.5
years and 39 years) for real property
– If the election is made to not have the uniform
capitalization rules apply, alternative depreciation
system (ADS) straight-line method must be used
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Farm Property (slide 2 of 2)
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Alternative Depreciation
System (ADS) (slide 1 of 2)
• ADS is an alternative depreciation system that
is used in calculating depreciation for:
– Alternative minimum tax (AMT)
– Assets used predominantly outside the U.S.
– Property owned by the taxpayer and leased to tax
exempt entities
– Earnings and profits
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Alternative Depreciation
System (ADS) (slide 2 of 2)
• Generally, use straight-line recovery without
regard to salvage value
– For AMT, 150% declining balance is allowed for
personalty
– Half-year, mid-quarter, and mid-month
conventions still apply
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Amortization (slide 1 of 2)
• Can claim amortization deduction on § 197
intangibles
– Use straight-line recovery over 15 years (180
months) beginning in month intangible is acquired
• Section 197 intangibles include acquired
goodwill, going-concern value, trademarks,
trade names, etc.
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Amortization (slide 2 of 2)
• Startup expenditures are also partially amortizable
under § 195
– Treatment is available only by election
• Allows the taxpayer to deduct the lesser of:
– The amount of startup expenditures, or
– $5,000, reduced by the amount startup expenditures exceed
$50,000
– Any amounts not deducted may be amortized ratably over
180-months beginning in month trade or business begins
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Depletion
(slide 1 of 4)
• Two methods of natural resource depletion
– Cost: determined by using the adjusted basis of the
resource and allocating over the recoverable units
– Percentage: determined using percentage provided
in Code and multiplying by gross income from
resource sales
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Depletion
(slide 2 of 4)
• Cost depletion
– Depletion is computed on a per unit basis
– Per unit amount is determined by dividing the
basis of the resource by the estimated recoverable
units of resource
• Number of units sold in year × per unit depletion =
depletion for year
– Total depletion can not exceed total cost of the
property
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Depletion
(slide 3 of 4)
• Percentage depletion
– Depletion is computed by using the statutory
percentage rate for the type of resource
– Rate is applied to the gross income from the
property
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Depletion
(slide 4 of 4)
• Percentage depletion
– Percentage depletion cannot exceed 50% of the
taxable income (before depletion) from the
property
– Percentage depletion reduces basis in property
– However, total percentage depletion may exceed
the total cost of the property
• Example: Property with zero basis but still generating
income
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Intangible Drilling Costs
(IDC)
• Intangible drilling costs include
– Costs for making the property ready for drilling
– Costs of drilling the hole
• Treatment of IDC
– Expense in the year incurred, or
– Capitalize and write off through depletion
• It is generally advantageous to write off IDC
immediately
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Refocus On The Big Picture (slide 1 of 4)
• In general, the expenses incurred in Michael Forney’s
small engine service and repair business are
deductible as long as they are ordinary and necessary
expenses.
• In addition, the salaries and wages paid must be
reasonable.
– His plan to increase salaries radically next year for himself
and his mother probably should not be pursued, because
most or all of the increase could be considered
unreasonable.
• Charitable contributions generally are limited to 10%
of taxable income before the charitable contribution
deduction.
• Political contributions are not deductible.
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Refocus On The Big Picture (slide 2 of 4)
• Michael can elect to expense the costs of the machinery and equipment
under § 179. For 2015, the § 179 deduction is limited to $500,000 and
cannot exceed the taxable income derived from the business (before the
§ 179 deduction). In this case, the entire $130,000 is deductible.
Gross income
Less: Salaries and wages
Building rent
§ 179 deduction
Insurance
Consulting fees
Utilities
Taxes and licenses
Advertising
Dues- Small Engine Repair Institute
Interest expense
TI before the charitable contribution deduction
Less: Charitable contributions (limited to 10%
of taxable income)
Taxable income
$435,500
(150,000)
(24,000)
(130,000)
(6,000)
(6,000)
(12,000)
(6,000)
(3,000)
(3,000)
(3,000)
$ 92,500
(3,000)
$ 89,500
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Refocus On The Big Picture (slide 3 of 4)
• As to Michael’s rental properties, he will be required to report all
associated rent income and expenses, including depreciation on the house
he converted from personal use to rental use and on the rental condo he
purchased.
• What If?
• Instead assume that Mr. Forney placed in service $142,000 of new
machinery and equipment that qualifies for the § 179 deduction.
• In addition, Michael thinks that he can justify increasing his salary to
$115,500, which will increase total salaries and wages to $210,500.
• Michael can elect to expense $142,000 of the cost of the machinery under
§ 179.
• As a result of the increased salary and MACRS deductions, the charitable
contribution deduction now is limited to $2,000.
– The remainder ($1,000) is carried over to the next tax year.
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Refocus On The Big Picture (slide 4 of 4)
Gross income
$ 435,500
Less: Salaries and wages
(210,500)
Building rent
(24,000)
§ 179 deduction
(142,000)
Insurance
(6,000)
Consulting Fees
(6,000)
Utilities
(12,000)
Taxes and licenses
(6,000)
Advertising
(3,000)
Dues
(3,000)
Interest expense
(3,000)
TI before the charitable contribution deduction $ 20,000
Less: Charitable contributions (limited to 10%
of taxable income)
(2,000)
Taxable income
$ 18,000
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If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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