Chapter 6
Deductions and Losses:
In General
Individual Income Taxes
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
1
The Big Picture (slide 1 of 3)
• Dr. Cliff Payne extracts the following information from his financial
reporting system associated with his dental practice.
Salaries including FICA (unpaid at year-end of $5,000)
$120,000
Building rent
24,000
Depreciation of dental equipment and office
furnishings and equipment
52,000
Insurance (malpractice and of dental equipment
and office furnishings and equipment)
22,000
Dental supplies (ending inventory of $7,000)
16,000
Office supplies (ending inventory of $1,500)
3,000
Contribution to U.S. Senate campaign fund of Tim Kaine
1,000
Contribution to U.S. Senate campaign fund of George Allen
1,000
Legal expenses associated with patient lawsuit (jury decision for
defendant)
4,000
Draw by Dr. Payne for living expenses ($5,000 monthly)
60,000
2
The Big Picture (slide 2 of 3)
• Dr. Payne calculates the deductible expenses that he can report on Schedule
C of Form 1040 as follows:
Salaries including FICA
Building rent
Depreciation of dental equipment and office
furnishings and equipment
Insurance (malpractice and of dental equipment and
office furnishings and equipment)
Dental supplies ($16,000 - $7,000)
Office supplies ($3,000 - $1,500)
Contribution to U.S. Senate campaign of Tim Kaine
Contribution to U.S. Senate campaign of George Allen
Legal expenses associated with patient lawsuit
(jury decision for defendant)
Draw by Dr. Payne for living expenses ($5,000 monthly)
$120,000
24,000
52,000
22,000
9,000
1,500
–0–
–0–
4,000
60,000
$292,500
3
The Big Picture (slide 3 of 3)
• Dr. Payne’s close relatives include the following:
Terry
Jack
Camille
Walter
Pauline
Neal
Mother
Father
Mother-in-law
Father-in-law
Sister (age 17)
Brother (age 18)
• Has Dr. Payne correctly calculated the business
expenses for his dental practice?
– Read the chapter and formulate your response.
4
Deductions
• Exclusive definition of deductions
– Deductions are allowed based on legislative grace
and defined narrowly
– Substantiation requirements
• Taxpayer has burden of proof for substantiating all
expenses deducted on return
• Thus, adequate records of expenses must be maintained
5
Deductions for and
from AGI (slide 1 of 3)
• Deductions for AGI
– Can be claimed even if taxpayer does not itemize
– Important in determining the amount of certain
itemized deductions
• Certain itemized deductions are limited to amounts in
excess of specified percentages of AGI
– e.g., Medial expenses (7.5% of AGI), misc. itemized
deductions ( 2% of AGI)
6
Deductions for and
from AGI (slide 2 of 3)
• Deductions from AGI:
– In total, must exceed the standard deduction to
provide any tax benefit
– Called “below the line” or itemized deductions
7
Deductions for and
from AGI (slide 3 of 3)
• Comparison of deductions for and from
AGI (2012 tax year)
– Single taxpayer has gross income of $45,000
and a $6,000 deduction
Gross income
Less: for AGI ded.
AGI
Less: from AGI ded.
Less: personal exempt.
Taxable income
For AGI
$45,000
6,000
$39,000
5,950
3,800
$29,250
From AGI
$45,000
0
$45,000
6,000
3,800
$35,200
8
Deductions for AGI
(slide 1 of 3)
• Partial list includes:
– Trade or business expenses
– Reimbursed employee business expenses
– Deductions from losses on sale or exchange of
property
– Deductions from rental and royalty property
– Alimony
– One-half of self-employment tax paid
9
Deductions for AGI
(slide 2 of 3)
• Partial list includes:
– 100% of health insurance premiums paid by a selfemployed individual
– Contributions to pension, profit sharing, annuity
plans, IRAs, etc.
– Penalty on premature withdrawals from time
savings accounts or deposits
– Moving expenses
10
Deductions for AGI
(slide 3 of 3)
• Partial list includes:
– Interest on student loans
– Qualified tuition and related expenses under § 222
– Up to $250 for teacher supplies for elementary and
secondary school teachers
11
Deductions from AGI
• Itemized deductions include:
–
–
–
–
Medical expenses (in excess of 7.5% of AGI)
Certain state and local taxes
Contributions to qualified charitable organizations
Personal casualty losses (in excess of 10 % of AGI and a
$100 floor per casualty)
– Certain personal interest expense (e.g., mortgage interest
on a personal residence)
– Miscellaneous itemized deductions (in excess of 2% of
AGI)
12
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
13
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
14
The Big Picture - Example 5
Ordinary and Necessary Requirement
• Return to the facts of The Big Picture on p. 6-1.
• Dr. Payne owns a small portfolio of investments,
including 10 shares of Hawk, Inc. common stock
worth $1,000.
– He incurred $350 in travel expenses to attend the annual
shareholders’ meeting where he voted his 10 shares against
the current management group.
• No deduction is permitted because a 10-share
investment is insignificant in value in relation to the
travel expenses incurred.
15
Section 212 Expenses (slide 1 of 2)
• Section 212 allows deductions for ordinary and
necessary expenses paid or incurred for the
following:
– The production or collection of income
– The management, conservation, or maintenance of
property held for the production of income
– Expenses paid in connection with the
determination, collection, or refund of any tax
16
Section 212 Expenses (slide 2 of 2)
• § 212 expenses that are deductions for AGI include:
– Expenses related to rent and royalty income
– Expenses paid in connection with the determination,
collection, or refund of taxes related to the income of sole
proprietorships, rents and royalties, or farming operations
• All other § 212 expenses are itemized deductions
(deductions from AGI)
– For example, investment-related expenses (e.g., safe
deposit box rentals) are deductible as itemized deductions
attributable to the production of investment income
17
Business And
Nonbusiness Losses
• Deductible losses of individual taxpayers are
limited to those:
– Incurred in a trade or business,
– Incurred in a transaction entered into for profit
• Individuals may also deduct casualty losses
from fire, storm, shipwreck, and theft
18
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
19
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
20
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
21
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
22
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
23
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
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 18
Investigation Of A Business
• Return to the facts of The Big Picture on p. 6-1.
• Dr. Payne’s mother, Terry, an accrual basis sole
proprietor, owns and operates three motels in
Georgia.
• In the current year, Terry incurs expenses of $8,500
in investigating the possibility of acquiring several
additional motels located in South Carolina.
– The $8,500 is deductible in the current year whether Terry
acquires the motels in South Carolina.
30
Hobby Losses (slide 1 of 8)
• Hobby defined
– Activity not entered into for profit
• Personal pleasure associated with activity
• Examples: raising horses, fishing boat charter
• If an activity is not engaged in for profit, the
hobby loss rules apply
– Hobby expenses are deductible only to the extent
of hobby income
31
Hobby Losses (slide 2 of 8)
• Profit activity
– If activity is entered into for profit, taxpayer can
deduct expenses for AGI even in excess of income
from the activity
• At-risk and passive loss rules may apply
• Often it is difficult to determine if an activity
is profit motivated or a hobby
• Regulations provide nine factors to consider in making
this determination
32
Hobby Losses (slide 3 of 8)
• Presumptive rule of § 183
– If activity shows profit 3 out of 5 years (2 out of 7
years for horses), the activity is presumed to be a
trade or business rather than a personal hobby
– Rebuttable presumption, shifts burden of proof to IRS
– Otherwise, taxpayer has burden to prove profit
motive
33
Hobby Losses (slide 4 of 8)
Year
Income (loss)
2006
2007
2008
2009
2010
2011
2012
$500
(1,500)
700
(1,000)
900
(500)
1,200
Hobby?
Yes
Yes
Yes
Yes
No, profit 3 of 5 years
Yes, profit only 2 of 5 years
No, profit 3 of 5 years
34
Hobby Losses (slide 5 of 8)
• If an activity is deemed to be a hobby
– Can only deduct expenses to extent of income
from activity (i.e., cannot deduct hobby losses)
35
Hobby Losses (slide 6 of 8)
• If an activity is a hobby:
– Expenses are deductible from AGI
• Treated as miscellaneous itemized deductions subject to
the 2% of AGI limitation
• Exception: expenses that are deductible without regard
to profit motive are deductible in full, such as
– Home mortgage interest
– Property taxes
36
Hobby Losses (slide 7 of 8)
• Order in which hobby expenses are deductible:
– First: Those otherwise deductible: e.g., home
mortgage interest and property taxes
– Then: Expenses that do not affect adjusted basis:
e.g., maintenance, utilities
– Then: Expenses that affect adjusted basis: e.g.,
depreciation (or cost recovery)
37
Hobby Losses (slide 8 of 8)
• Example of hobby expenses: Taxpayer sells
horses raised as a hobby for $15,500
Amount
Order
Amount
Income
$15,500
Interest
6,000
1
$ 6,000
Taxes
3,000
1
3,000
Vet Bills
2,000
2
2,000
Feed
4,000
2
4,000
Depreciation
1,000
3
Ltd. to 500
Total
15,500
38
The Big Picture - Example 21
Hobby Losses (slide 1 of 2)
• Return to the facts of The Big Picture on p. 6-1.
• Camille and Walter are Dr. Payne’s mother- and
father-in-law.
• Camille is an executive for a large corporation
– She earns a salary of $800,000.
• Walter is a collector of antiques.
– Several years ago, Walter opened an antique shop in a local
shopping center and spends most of his time buying and
selling antiques.
– He occasionally earns a small profit from the shop but
usually incurs substantial losses.
39
The Big Picture - Example 21
Hobby Losses (slide 2 of 2)
• Return to the facts of The Big Picture on p. 6-1.
• If Walter’s losses are business related, they are fully
deductible against Camille’s salary.
• In resolving this issue, consider the following:
– Initially determine if Walter’s antique shop meets the three
- of - five years profit test.
– If not, the activity may nevertheless qualify as a business
• Walter should show that his intent is to engage in a profit-seeking
activity.
• It is not necessary to show actual profits.
– Try to fit the operation within the 9 criteria prescribed in
the Regs.
• These criteria are the factors considered in trying to rebut the § 183
presumption
40
Rental Vacation Homes
(slide 1 of 9)
• May have both personal and rental use of a
vacation home
• Deduction of rental expenses may be limited to
rental income if primarily used for personal
purposes
• Determination of vacation home treatment is
dependent on personal use vs. rental use
41
Rental Vacation Homes
(slide 2 of 9)
• Rental days
– Less than 15 days: No gross income recognized
from rentals and no deductible rental expenses
• Mortgage interest and property taxes treated as if on
personal residence (generally deductible in full)
– More than 14 days: Treatment depends on amount
of personal use
42
Rental Vacation Homes
(slide 3 of 9)
• Primarily rental use
– If rented for 15 days or more and personal use
days NOT more than the greater of 14 days or 10
percent of fair rental days
– Can deduct all expenses allocated to rental use
even if loss results
• Rental loss subject to at-risk and passive loss rules
43
Rental Vacation Homes
(slide 4 of 9)
• Personal/rental use
– If rented for 15 days or more and personal use
days exceed the greater of 14 days or 10 percent of
fair rental days
– Treated similar to hobby
• Rental expenses deducted in three step process
• No rental loss allowed
• Carryforward of disallowed rental expenses
44
Rental Vacation Homes
(slide 5 of 9)
• Example of personal use
Rental days: 200 (10% = 20)
Personal use
7 days
18 days
25 days
Not Significant
X
X
Significant
X
45
Rental Vacation Homes
(slide 6 of 9)
• Example of personal use
Rental days: 100 (10% = 10)
Personal Use
7 days
14 days
18 days
Not Significant
X
X
Significant
X
46
Rental Vacation Homes
(slide 7 of 9)
• Allocation of expenses between personal and
rental
– Mortgage interest and real estate taxes
• IRS requires allocation based on total days used
• Courts have allowed allocation based on days in year
– Other expenses are allocated based on total days
used
47
Rental Vacation Homes
(slide 8 of 9)
• Tax treatment of income and expenses of a
primarily rental vacation home
– Rental income included in gross income
– Rental expenses deductible for AGI
– Rental income and expenses reported on Sch. E
48
Rental Vacation Homes
(slide 9 of 9)
• Treatment of allocated personal portion of
vacation home expenses
– Primarily rental use: taxes deductible from AGI,
mortgage interest nondeductible (personal interest)
– Personal/rental use: mortgage interest and taxes
deductible from AGI
– Personal portion of other expenses (e.g., insurance,
maintenance) nondeductible
49
The Big Picture - Example 24
Vacation Home - Primarily Personal Use
• Return to the facts of The Big Picture on p. 6-1.
• Camille, Dr. Payne’s mother-in-law, owns a vacation home
she used as follows last year:
– Rented it for $1,600 for 2 weeks,
– Lived in it 2 months, and
– Left it vacant the rest of the year.
• The year’s expenses amounted to $6,000 mortgage interest
expense, $500 property taxes, $1,500 utilities & maintenance,
and $2,400 depreciation.
• Since the property was not rented for at least 15 days, the
income is excluded from gross income
– The mortgage interest and property tax expenses are itemized
deductions
– The remaining expenses are nondeductible personal expenses.
50
The Big Picture - Example 25
Vacation Home - Primarily Rental Use
• Assume instead that Camille in Example 24
used the cottage for 12 days and rented it for
48 days for $4,800.
• Since she rented the cottage for 15 days or
more but did not use it for more than 14 days,
the cottage is treated as rental property.
– The expenses must be allocated between personal
and rental days.
51
The Big Picture - Example 25
Vacation Home - Primarily Rental Use
• The expenses must be allocated between personal and rental
days.
Percentage of Use
Rental
Personal
80%
20%
Income
Expenses
Mortgage interest ($6,000)
Property taxes ($500)
Utilities and maintenance ($1,500)
Depreciation ($2,400)
Total expenses
Rental loss
$ 4,800
$ –0–
($ 4,800)
(400)
(1,200)
(1,920)
($ 8,320)
($ 3,520)
($1,200)
(100)
(300)
(480)
($2,080)
$ –0–
52
The Big Picture - Example 25
Vacation Home - Primarily Rental Use
• Example 25 (Cont’d)
• The tax treatment is as follows:
– Camille deducts the $3,520 rental loss for AGI
– She also has an itemized deduction for property taxes of
$100 associated with the personal use.
– The mortgage interest of $1,200 associated with the
personal use is not deductible as an itemized deduction
• The cottage is not a qualified residence (qualified residence
interest) for this purpose
– The utilities, maintenance, & depreciation attributable to
personal use are not deductible
53
The Big Picture - Example 26
Vacation Home - Primarily Rental Use
• Assume instead that Camille in Example 24
rented the cottage for 200 days and lived in it
for 19 days.
– The cottage is still primarily rental use
• She rented it for 15 days or more and did not use it for
personal purposes > 20 days (10% of rental days).
– The expenses must be allocated between personal
and rental days as illustrated in Example 25.
54
The Big Picture - Example 27
Vacation Home - Personal/Rental Use
• Assume instead that Camille in Example 24
rented the property for 30 days and lived in it
for 30 days.
– The residence is now classified as personal/rental
use property since she used it > 14 days and rented
it for 15 days or more.
• The expenses must be allocated between rental use and
personal use
• The rental expenses are allowed only to the extent of
rental income.
55
Expenditures Incurred for Taxpayer’s
Benefit or Obligation
• No deduction is allowed for payment of
another taxpayer’s expenses
– Must be incurred for taxpayer’s benefit or arise
from taxpayer’s obligation
– Exception: Payment of medical expenses for a
dependent
56
Personal Expenditures
• Unless otherwise provided in the Code,
personal expenses are not deductible
57
The Big Picture - Example 33
Disallowance Of Personal Expenditures
• Return to the facts of The Big Picture on p. 6-1.
• Terry and Jack, Dr. Payne’s parents, are divorced
near the end of the current tax year.
• They had been married for 28 years and have two
dependent children, Pauline (age 17), and Neal (age
18). (Dr. Payne is no longer his parents’ dependent.)
• As part of the divorce agreement, Jack paid all of the
legal fees, which amounted to $24,300.
58
The Big Picture - Example 33
Disallowance Of Personal Expenditures
• Return to the facts of The Big Picture on p. 6-1.
• The invoice from the divorce lawyer listed the
following charges:
Child custody agreement and determination of
amount of monthly child support
$ 3,000
Divorce decree proceedings
10,000
County court filing costs
1,800
Property settlement determination
6,000
Tax consequences of property settlement
2,000
Tax consequences of child custody and child
support payments and tax filing status
1,500
$24,300
• Only the $3,500 ($2,000 + $1,500) paid by Jack for
the charges relating to tax advice is deductible.
59
Capital Expenditures
• Amounts are capitalized
• Asset may be subject to depreciation (or cost
recovery), amortization, or depletion
60
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
61
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
62
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
63
Refocus On The Big Picture (slide 1 of 2)
• Using the accrual method, Dr. Payne has correctly
calculated the deductible business expenses of his
dental practice except for his monthly $5,000 draw
– Since the dental practice is a sole proprietorship, Dr. Payne
will report net income of the practice on his Form 1040.
– So a deduction for his monthly draw is not permitted.
• The $232,500($292,500- $60,000) amount will be
reported by Dr. Payne on Schedule C of Form 1040.
64
Refocus On The Big Picture (slide 2 of 2)
• Several of the items included in Dr. Payne’s
calculation of deductible business expenses
require clarification.
– Political contributions ($1,000 + $1,000) cannot be
deducted.
– The dental supplies expense and the office supplies
expense must be reduced by the amount of the
ending inventory (i.e., $7,000 and $1,500,
respectively) since Dr. Payne is using the accrual
method of accounting.
65
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
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
66