Chapter 7 Deductions and Losses: Certain Business Expenses and Losses Individual Income Taxes © 2011 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 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Worthless Securities (slide 2 of 2) • Example of worthless securities – On December 1, 2009, Sally purchased stock for $10,000. The stock became worthless on June 1, 2010. Sally’s loss is treated as having occurred on December 31, 2010. The result is a long-term capital loss. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Bad Debt Deductions Summary Concept Summary 7.2 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 2010, 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Definition of Theft • Theft includes robbery, burglary, embezzlement, etc. – Does not include misplaced items © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 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 FMV Before 8,000 8,000 4,000 FMV After 5,000 1,000 0 Loss 3,000 6,000 6,000 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 Example of C&T Limitation (slide 1 of 2) • Karen (AGI = $40,000) has the following C&T in 2010 (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6,000) with camera inside ($500) • Earthquake damage: house ($2,000), furniture ($1,000) © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 – $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)] © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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: • 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 Net Operating Losses (slide 1 of 7) • 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39 Net Operating Losses (slide 2 of 7) • No nonbusiness (personal) losses or deductions may be used in computing NOL • Exception: personal casualty and theft losses © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 40 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 • Small businesses with NOLs from Presidentially declared disasters – 5-year carryback period and a 20-year carryover period are allowed for a farming loss © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41 Net Operating Losses (slide 4 of 7) • Example of NOL carryovers – Ken has a NOL for 2010 – Ken must carryover his NOL in the following order: • Carryback to 2008 and 2009, then carryforward to 2011, 2012, ..., 2030 – Ken can elect to just carryforward his NOL • Carryover would be to 2011, 2012, ..., 2030 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 43 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 • Exception - charitable contribution deduction – Determined without regard to any NOL carryback but with regard to any other modification affecting AGI – All credits limited by or based on the tax liability must be recomputed © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 44 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45 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 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 46