Chapter 7
Deductions and Losses: Certain
Business Expenses and Losses
Comprehensive Volume
Copyright ©2010 Cengage Learning
Comprehensive Volume
C7-1
Bad Debts
• If an account receivable arising from credit sale of
goods or services becomes worthless
– A bad debt deduction is permitted only if income
arising from creation of the receivable was previously
included in income
– No deduction is allowed if taxpayer is on the cash basis
since no income is reported until the cash has been
collected
Comprehensive Volume
C7-2
Business Bad Debts
(slide 1 of 4)
• 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
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Business Bad Debts
(slide 2 of 4)
• If a business bad debt previously deducted
as partially worthless becomes totally
worthless in a future year
– Only the remainder not previously deducted can
be deducted in the future year
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Business Bad Debts
(slide 3 of 4)
• In the case of total worthlessness, deduction is
allowed for entire amount in the year the debt
becomes worthless
• Deductible amount depends on basis in bad debt
– If debt arose from sale of services or products and the
face amount was previously included in income
• That amount is deductible
– If the taxpayer purchased the debt
• Deduction is equal to amount paid for debt instrument
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C7-5
Business Bad Debts
(slide 4 of 4)
• If a receivable has been written off
– The collection of the receivable in a later tax
year may result in income being recognized
– Income will result if the deduction yielded a tax
benefit in the year it was taken
Comprehensive Volume
C7-6
Nonbusiness Bad Debts
(slide 1 of 2)
• Nonbusiness bad debt
– Debt unrelated to the taxpayer’s trade or
business
• Deduct as short-term capital loss in year
amount of worthlessness is known with
certainty
– No deduction is allowed for partial
worthlessness of a nonbusiness bad debt
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C7-7
Nonbusiness Bad Debts
(slide 2 of 2)
• Related party (individuals) bad debts are
generally suspect and may be treated as
gifts
– Regulations state that a bona fide debt arises
from a debtor-creditor relationship based on a
valid and enforceable obligation to pay a fixed
or determinable sum of money
– Thus, individual circumstances must be
examined to determine whether advances
between related parties are gifts or loans
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C7-8
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
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C7-9
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
– Capital losses may be of limited benefit due to
the $3,000 capital loss limitation
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C7-10
Worthless Securities
(slide 2 of 2)
• Example of worthless securities
– On December 1, 2008, Sally purchased stock
for $10,000. The stock became worthless on
June 1, 2009. Sally’s loss is treated as having
occurred on December 31, 2009. The result is a
long-term capital loss.
Comprehensive Volume
C7-11
Bad Debt Deductions Summary
Comprehensive Volume
C7-12
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
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C7-13
Section 1244 Stock
(slide 2 of 3)
• Section 1244 loss treatment is limited to stock
owned by original purchaser who acquired the
stock from the corporation
• Corporation must meet certain requirements for
stock to qualify
– Major requirement is limit of $1 million of capital
contributions
• Section 1244 does not apply to gains
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C7-14
Section 1244 Stock
(slide 3 of 3)
• Example of § 1244 loss
– In 2004, Sam purchases from XYZ Corp. stock
costing $150,000. (Total XYZ stock
outstanding is $800,000.) In 2009, 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
Comprehensive Volume
C7-15
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
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C7-16
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
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C7-17
Definition of Theft
• Theft includes robbery, burglary,
embezzlement, etc.
– Does not include misplaced items
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C7-18
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
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C7-19
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
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C7-20
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
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C7-21
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
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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
Comprehensive Volume
FMV
Before
8,000
8,000
4,000
FMV
After
5,000
1,000
0
Loss
3,000
6,000
6,000
C7-23
Nonpersonal C&T Losses
• Losses on business, rental, and royalty properties
– Deduction will be for AGI
– Not subject to the $100 ($500 for 2009) per event and
the 10% of AGI limitation
• Losses not connected with business, rental, and
royalty properties
– Deduction will be from AGI
– Example - theft of a security
• Theft losses of investment property are not subject to the 2% of
AGI floor on certain miscellaneous itemized deductions
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C7-24
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
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Personal C&T Gains and Losses
(slide 1 of 4)
• Casualty and theft losses attributable to personal
use property are subject to the $100 ($500 for
2009) per event and the 10% of AGI limitations
– These losses are itemized deductions, but they are not
subject to the 2% of AGI floor
• Amount of personal C&T losses
– Lesser of decline in value or adjusted basis in property,
less insurance proceeds
• Insurance proceeds may result in gain recognition
on certain casualty and thefts
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C7-26
Personal C&T Gains and Losses
(slide 2 of 4)
• If a taxpayer has both personal casualty and theft
gains as well as losses, a special set of rules
applies
– A personal casualty gain is the recognized gain from a
casualty or theft of personal use property
– A personal casualty loss for this purpose is a casualty or
theft loss of personal use property after the application
of the $100 ($500) floor
• Taxpayer must first net (offset) the personal
casualty gains and personal casualty losses
– Tax treatment depends on the results of this netting
process
Comprehensive Volume
C7-27
Personal C&T Gains and Losses
(slide 3 of 4)
• If netting personal casualty gains and losses
results in a net gain
– 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
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C7-28
Personal C&T Gains and Losses
(slide 4 of 4)
• If netting personal casualty gains and losses
results in a net loss
– All gains and losses are treated as ordinary
items
• The gains—and the losses to the extent of gains—
are treated as ordinary income and ordinary loss in
computing AGI
• Losses in excess of gains are deducted as itemized
deductions to the extent the losses exceed 10% of
AGI
Comprehensive Volume
C7-29
Example of C&T Limitation
(slide 1 of 2)
•
Karen (AGI = $40,000) has the following
C&T in 2009 (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)
Comprehensive Volume
C7-30
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 – $500 = $6,000
2. $2,000 + $1,000 = $3,000 – $500 = $2,500
Karen’s deductible C&T loss is $4,500
[$6,000 + $2,500 – (10% $40,000)]
Comprehensive Volume
C7-31
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
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C7-32
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)
• Tax credit of 20% of certain R&E expenditures is
available
Comprehensive Volume
C7-33
Domestic Production Activities
Deduction (slide 1 of 5)
• 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:
• 6% × 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
Comprehensive Volume
C7-34
Domestic Production Activities
Deduction (slide 2 of 5)
• 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
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C7-35
Domestic Production Activities
Deduction (slide 3 of 5)
• 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
Comprehensive Volume
C7-36
Domestic Production Activities
Deduction (slide 4 of 5)
• A phase-in provision increases the
applicable rate for the Domestic Production
Activities deduction as follows:
Rate
Years
6%
2007-2009
9%
2010 and thereafter
Comprehensive Volume
C7-37
Domestic Production Activities
Deduction (slide 5 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
is claimed on Form 1040, line 35 on page 1
Comprehensive Volume
C7-38
Net Operating Losses
(slide 1 of 6)
• NOLs from any one year can be offset
against taxable income of other years
– The NOL provision is intended as a form of
relief for business income and losses
– Only losses from trade or business operations,
casualty and theft losses, or losses from foreign
government confiscations can create a NOL
Comprehensive Volume
C7-39
Net Operating Losses
(slide 2 of 6)
• No nonbusiness (personal) losses or
deductions may be used in computing NOL
• Exception: personal casualty and theft losses
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C7-40
Net Operating Losses
(slide 3 of 6)
• 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
• Small businesses with NOLs from Presidentially declared
disasters
– 5-year carryback period and a 20-year carryover period
are allowed for a farming loss
Comprehensive Volume
C7-41
Net Operating Losses
(slide 4 of 6)
• Example of NOL carryovers
– Ken has a NOL for 2009
– Ken must carryover his NOL in the following
order:
• Carryback to 2007 and 2008, then carryforward to
2010, 2011, ..., 2029
– Ken can elect to just carryforward his NOL
• Carryover would be to 2010, 2011, ..., 2029
Comprehensive Volume
C7-42
Net Operating Losses
(slide 5 of 6)
• 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
Comprehensive Volume
C7-43
Net Operating Losses
(slide 6 of 6)
• 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
Comprehensive Volume
C7-44
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
Comprehensive Volume
C7-45