Losses in General

1. Chapter 10 Certain Business Deductions and Losses

2. Losses in General Sec. 165 allows deductions for three types of losses for individuals if the loss is not compensated by insurance Losses incurred in a T/B Losses incurred in any transaction entered into for profit Casualty losses Additional rules govern certain types of losses: Bad debts - Sec. 166

3. Bad DebtsBusiness vs. Nonbusiness Effect of the Distinction Business bad debts are deductible as an ordinary deduction Nonbusiness bad debts are deductible only as a STCL Business Bad Debts Must be closely related to a business Loans made by a corporation are always treated as business debts Examples:

4. Bad DebtsBusiness vs. Nonbusiness Nonbusiness Bad Debts A nonbusiness bad debts is a bad debt unrelated to the TP’s business Deduct when the debt became worthless Loans made to protect investments are classified as nonbusiness debts. Problem areas: Loans made by employee shareholders to corporations Guaranteeing a loan: business purpose or something else? Examples 1, 2

5. Three requirements: 1. A Bona Fide Debtor-Creditor Relationship Must Exist A bona fide debt -- Reg.1.166 -1(e) Problem areas: “Loans” between related parties: gifts or loans? Loan from a shareholder to a controlled corporation Loan from a corporation to a shareholder

6. 2. TP Must Have Basis in the Debt Cash basis TP’s No bad debt deduction for accounts receivable Bad debt deduction is available for notes receivable Accrual basis TP’s Bad debt deduction available for accounts receivable Bad debt deduction is available for notes receivable 3. The Debt Must Be Worthless TP’s must show the debt is worthless Indicators of worthlessness must exist. No legal action necessary Example 3

7. Bad DebtsDeduction Methods Permitted Methods (for businesses) Reserve method generally not available except for small banks Specific write-off (direct write-off) required (not GAAP) Direct write-off has flexibility - page 5 Qualifying Service Businesses Allowed to reduce accruals for amounts not expected to be collected Qualifying businesses Example 4

8. Casualties General Rule: Casualty and Theft Losses Are Deductible FOR AGI: business/profit property FROM AGI: personal use property Definition of a Casualty: Unreimbursed losses of TP’s property caused by: Fire Shipwreck Storm Theft Any other casualty caused by an external force and sudden, unexpected or unusual event

9. Casualties Examples of what is or is not included: Slow vs. sudden Theft - Yes Progressive (slow) deterioration - Usually not included Misplacing/losing property - Example of lost ring Loss of land Farmer’s crops Loss of trees, shrubs Stretching the concept of unexpected or unusual When Deductible Generally, year it occurs Theft - year of discovery Other rules - page 10

10. Casualties Computing the Deduction Computation: Compute the loss, then subtract insurance reimbursement Business/Profit Property Partial destruction Deduct the smaller of adjusted basis or decline in FMV (less insurance proceeds) Complete destruction Deduct the adjusted basis less insurance proceeds Deduct FOR AGI

11. Casualties Personal Use Property Partial destruction Deduct the smaller of adjusted basis or decline in FMVless insurance proceeds $100 floor limitation for losses per casualty sum all casualties for year, deduct only to extent they exceed 10% AGI Complete destruction Same as partial destruction for personal use property Deduct FROM AGI The $100 Floor Limitation for Personal Use Items Destroyed by Casualty Apply one time per casualty Several items may be destroyed in a single casualty Example 6 Exhibit 10 -1

12. Casualties Insured Casualty Losses for Which No Claim Is Filed No deduction Casualty Gains and Losses What causes a casualty gain? Casualty gains and losses for personal use assets must be netted Net after applying $100 floor limitation If netting results in a loss, apply 10% of AGI limitation If netting results in a gain, treat as a 20% category capital gain Example 7

13. Casualties ComprehensiveExample 1

14. Casualties ComprehensiveExample 2

15. Inventory CapitalizationSection 263A Basic Problems With Inventory Reporting General Rules “Statutory” regulations to establish inventory methods. Two criteria for method: Tax method must clearly reflect income Tax method should conform to financial accounting method as much as possible TP must accrue inventory and sales when the production, purchase and/or sale of inventory is a material income producing factor Service businesses generally are not covered by this rule Example 13

16. Inventory CapitalizationSection 263A To Account for Inventory: 3 steps:

17. Inventory CapitalizationSection 263A Inventoriable Costs Definitions: “Product Costs” For “resellers” (retailers & wholesalers): all direct costs including purchase, transportation-in, set-up, etc. For manufacturers: DM, DL, & manuf. OH “Indirect Costs” Off-site storage & warehousing costs, purchasing dept. costs, handling, processing & labor costs, general & administrative costs, data processing, income taxes, etc. (See Exhibit 10-4 in text)

18. Inventory CapitalizationSection 263A

19. Inventory CapitalizationSection 263A Allocate Inventory Costs to EI or COGS Allowable methods Weighted average costs Specific ID FIFO LIFO Example 14

20. Inventory CapitalizationSection 263A If LIFO is used for tax purposes, it must be used for financial reporting purposes also. If LIFO election is made, LCM (lower of cost or market) cannot be used to write down inventory. Use of LCM If value of EI < original cost assigned to it, write down to LCM “Market’ means replacement/reproduction cost Apply LCM on item-by-item basis, not on aggregate basis LCM prohibited if LIFO is used Example 17