Chapter 7
Deductions and Losses:
Certain Business Expenses
and Losses
Individual Income Taxes
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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
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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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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
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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
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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
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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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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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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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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.
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11
Bad Debt Deductions Summary
Concept Summary 7.2
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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
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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
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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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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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Definition of Theft
• Theft includes robbery, burglary,
embezzlement, etc.
– Does not include misplaced items
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When Casualty & Theft Is Deductible
• Casualties: year in which loss is sustained
– Exception: If declared “disaster area” by President,
can elect to deduct loss in year prior to year of
occurrence
• Thefts: year in which loss is discovered
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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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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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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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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
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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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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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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
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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
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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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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
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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)]
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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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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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