Concepts in Federal Taxation Chapter 6: Business expense & Midterm review

1. Concepts in Federal TaxationChapter 6: Business expense&Midterm review October 5, 2012

2. administrative • Extra problems

3. Homework Problems 1. HW Problems Assignment #6 Chapter 6 P31, 36, 36, 39, 44, 54 2. Midterm Review

4. #31 You have just been hired as a tax accountant by a local public accounting firm. One partner is impressed by your writing skills and asks you to write a one-page memo to a client describing the general rules on the deductibility of meals and entertainment. The client also needs to know under what circumstances the cost of its skybox (with 10 tickets) at Optus Park is deductible.

5. #31 General rules for meals and entertainment expenses to qualify as deductible business expenses: • Business purpose—to make a profit • Ordinary, necessary, and reasonable in amount • Directly related to or associated with the active conduct of the taxpayer’s business activity • Adequately documented

6. #31 Directly related test: • General expectation of deriving income or a business benefit from the meals or entertainment • A bona fide business activity takes place during the meal or entertainment • The principal reason for providing the meal or entertainment is to conduct business • The expenses are related to the taxpayer and people involved in the business Associated with test: • Clear business purpose • Meal or entertainment must directly precede or follow substantial business discussions

7. #31 Skybox: • No portion of the skybox fee is deductible • Client can deduct the cost of the ten tickets • Deduction for each ticket is limited to the price of the most expensive non-luxury box seat • Only 50% of meal and entertainment expenses are deductible (you’re eating the food too!)

8. #36 Prudy is a recent college graduate who has taken a position with a real estate brokerage firm. Initially, Prudy will be selling both residential and commercial property. She is thinking about buying a new car at a cost of $14,500. However, the salesperson is trying to sell her a car that costs $18,000. He has assured her that because she is now self-employed, the entire cost of the car is tax-deductible. Prudy comes to you, her tax accountant, for advice about the purchase of the car. She tells you she expects that 65% of her driving will be for business purposes. She asks you to write her a letter specifying whether she can deduct the entire cost of the car, which expenses she needs to keep track of, and how these expenses are used in computing the business deduction for her car.

9. #36 • The information provided to Prudy by the car dealer is not correct! • Because Prudy will be using her car for business and personal purposes, the cost of the car and any expenditures associated with it must be allocated between the business and personal use in a reasonable manner • Only 65% of the cost of operating the automobile is deductible. The remaining 35% is a personal expense and is not deductible • The automobile is treated as two separate assets for tax purposes

10. #36 • Prudy may elect to use either the actual cost method or the standard mileage rate method to determine the allowable deductions on the automobile Standard Mileage Rate Method: • Deduct 55.5 cents per business mile driven • Deduct direct out of pocket expenses that are unrelated to the operating costs of the car: • Business portion of parking • Business portion of tolls • Business portion of interest (deductible only if tax payer is self employed) • Business portion of property taxes • May not be used by a business that operates more than 5 vehicles in the business at the same time

11. #36 Actual Cost Method: • Deduct direct out of pocket expenses that are unrelated to the operating costs of the car(same as Standard Method) • Also deduct business portion of: • Depreciation (Depreciation of automobiles is subject to special rules discussed in Chapter 10) • Gas and oil • Repairs • Insurance • License

12. #36 • Both methods require Prudy to substantiate the business miles driven (keep records) • Because she is self-employed, she can deduct the business portion of any ad valorem property taxes and interest she pays on her car loan • Remember, property taxes are referred to as ad valorem taxes because they are based on the value of the property being taxed (most property taxes are not based on the true fair market value of the property)

13. #39 Olga has to travel to Philadelphia for 2 days on business. She enjoys history and is planning to visit the Liberty Bell and other historic sights in the city. If time permits, she would like to make a side-trip to nearby Gettysburg. A friend of Olga’s tells her, “The best part of traveling on business is that once the business is over, you can sightsee all you want and the cost is tax-deductible.” Olga, who is self-employed, has scheduled her trip over the Labor Day weekend so that she can spend 3 days sightseeing. Write a letter to Olga in which you explain whether her friend’s advice is correct.

14. #39 • Olga’s friend has provided her with poor advice! • Only the business portion of a combined business and personal trip is deductible • In determining whether the travel cost of a combined business and personal trip is deductible, the taxpayer must determine whether the primary purpose of the trip is business or pleasure—this is determined based on whether more days were spent on business than for pleasure: • Because only 2 days are spent on business while 3 days are for pleasure, the primary purpose of the trip is considered pleasure(40% business < 60% personal) • Olga will not able to deduct the cost of her travel to Philadelphia (nor Gettysburg) • She may deduct her lodging, meals (limited to 50%) and the cost of incidental expenses (laundry, tips, etc.) for the two business days • The costs of the remaining 3 days are considered nondeductible personal expenditures

15. #44 Paula is single and works as a high school science teacher. Each summer, she travels to a national conference on high school science curriculum. She also spends one week during the summer traveling to areas in the United States to further her science knowledge. This year, she spent one week exploring the caves and rock formations around Carlsbad, New Mexico. She plans on using the knowledge and information from this trip in her earth science class. The costs of each trip are as follows: Science Conference Carlsbad Trip Airfare $350 $450 Hotel 200 375 Meals 120 250 Incidentals 40 110 Rental car 75 190 Registration 100 - Tours - 90 Paula has asked for your advice on the deductibility of these costs as a business expense. Write her a letter explaining the allowable deduction for these costs. If any of the costs are not deductible, explain why she cannot deduct them.

16. #44 • Because Paula is a high school science teacher and attends the annual science conference to improve her skills as a science teacher, the cost of the conference qualifies as a deductible business expense • The amount she can deduct as an unreimbursed business expense is: Airfare $ 350 Hotel 200 Meals ($120 x 50%) 60 Incidentals 40 Car rental 75 Conference registration 100 Total deduction $ 825

17. #44 • Unreimbursed business expenses are treated as a miscellaneous itemized deduction, which is reduced by 2% of AGI • The expense would not qualify as an education expense deductible for AGI because the expense was not paid to a qualified educational institution ($5,250 deduction for reimbursement from a qualified educational assistance plan)

18. #44 • None of the costs that Paula incurs on her trip to Carlsbad are deductible travel expenses • Travel as a form of education is not deductible • In this case, the travel is intended to improve Paula’s job skills (a form of education) and is not deductible

19. #54 For each of the following situations, state whether the expense related to the transaction can be deducted as an insurance expense: Types of insurance premiums that qualify for deduction include: • Fire, theft, and other casualty insurance, and liability insurance • Employees’ group medical and group term life insurance, and workers’ comp • Employee performance and fidelity bonds to protect against losses caused by employees • Business interruption and overhead insurance to reimburse the business for lost profits and overhead from casualty or other unexpected event

20. #54 a. Baker Company pays the insurance premium to provide each of its employees with a $50,000 whole life insurance policy. Baker and the insurance company consider the employee the owner of the policy. As owner of the policy, the covered employee designates the beneficiary of the life insurance proceeds in the event of the employee’s death. Each employee’s policy costs $2,000 per year. • The $2,000 premium paid for each employee is not a deductible insurance expense • Only premiums on group-term life insurance qualify for deduction as life insurance expense • Because Baker does not benefit directly or indirectly from the policy, the insurance premiums can be deducted (by Baker) as additional compensation paid to the employees (the employees must include the $2,000 in gross income) • When the employee dies, the beneficiary of the policy excludes the insurance proceeds from gross income

21. #54 b. Baker Company has a nondiscriminatory self-insured medical reimbursement plan for the benefit of its employees. Once a month, Baker transfers $1,000 in cash from its general bank account to a special medical reimbursement checking account. The transfer is based on the premium an insurance company would demand to provide the same benefits to the employees. • The $1,000 per month deposited into the medical reimbursement checking account is not deductible as an insurance expense • The company still controls the money while it is in the checking account and can withdraw it for general business use at any time • The amount deposited represents an estimated expense that is not permitted as a tax deduction (reserve accounting—need to know who and what amount) • The amount actually reimbursed to employees from the medical reimbursement account can be deducted as a medical insurance expense and excluded from the employee’s gross income

22. #54 c. The employees’ of Baker Company receive large sums of cash in the mail. To protect against loss, Baker pays a $500 annual insurance premium for an employees fidelity bond. • The $500 premium paid for the employees fidelity bond is deductible as an insurance expense • The purpose of the fidelity bond is to protect Baker from losses due to an employee’s dishonesty

23. #54 d. Baker Company is owned by Ross. Baker pays a $1,500 annual premium for a sickness and disability income continuation insurance policy on Ross. The purpose of the policy is to give Ross $3,500 per month if he is unable to work for Baker because he is sick or disabled. • The $1,500 premium paid on the income continuation policy is not deductible as an insurance expense but as compensation expense (Baker directly benefits when the policy pays off on Ross’s death) • If Ross collects the $3,500 per month benefit because he becomes ill or disabled, the payments are excluded from his gross income • The income is excluded because when the company made the payments, the premium amount was already included in Ross’s income

24. Midterm Review – Fall 2011 Q1

25. Midterm Review – Q1 Loan Fee—$3,200 • Not deductible as an ordinary expense • Illegal kickback Home expenses related to business • 1/6 is used for business, so deduct 1/6 of these expenses: Utilities $ 6,400 x 1/6 = $ 1,067 Interest $ 2,400 x 1/6 = 400 Depreciation $ 2,900 x 1/6 = 483 Total $ 1,950 Mortgage Interest • The interest expense related to personal use of the home is an itemized deduction: • $2,400 x (5 ÷ 6) = $2,000

26. Midterm Review – Q1 Sales $110,000 Cost of cars sold 78,000 Gross profit $ 32,000 Interest expense on cars $ 4,200 Property tax on cars 700 Gas, oil, repairs 1,200 Loan fees -0- Depreciation on equipment 1,800 Business use of home 1,950(9,850) Net $ 22,150

27. Midterm Review – Q1 • Some may question whether Ray qualifies for a home office deduction… • Since the home is his principal place of business, the office should qualify for deduction (exclusive use test) • Ray should report $22,150 of adjusted gross income from his used car business

28. Midterm Review – Q2

29. Midterm Review – Q2 • Todd's gross income is $48,121.6: Salary $50,000  Less: Pension plan payment by Todd ($50,000 * 5%) (2,500) Flexible benefits plan payment (500) Group-term life coverage in excess of $50,000 (30 *$.72) 21.6 Free parking - $3,120 - (12 * $240) 240 Health club membership 860 Taxable income $48,121.6

30. Midterm Review – Q2 Employer contribution • Todd is not taxed on his employer's $2,500 contribution to his retirement plan Medical expenses, medical insurance, professional dues • He is not taxed on the reimbursement of medical expenses from the flexible benefits plan. The provision of medical insurance and the payment of his dues to professional organizations are also excludable fringe benefits

31. Midterm Review – Q3 Stephanie and Matt are married with 2 dependent children. During 2011, they have total gross income of $140,000. Their allowable deductions for adjusted gross income total $6,000 and they have $6,000 of allowable itemized deductions. Compute Stephanie and Matt's 2011 taxable income and 2011 income tax liability. Show calculations.

32. Midterm Review – Q2 • Stephanie and Matt have taxable income of $106,900. Their tax liability on $106,900 is $18,785 [$9,735 + 25% * ($106,900 - $70,700)] Gross income $140,000  Deductions for AGI  (6,000) AGI $134,000  Deductions from AGI (Standard deduction) (11,900) Personal exemptions (4 * $3,800) (15,200) Taxable income $106,900

33. Midterm Review – Q3 a. Assume that in addition to the above information, Stephanie sold some land that she had held as an investment at a gain of $5,000. What is the effect of the gain on their taxable income and income tax liability? You do not need to recalculate, just explain the general effect of the sale of the land. Capital asset: • Any asset other than inventory, receivables, and depreciable or real property used in a trade or business • Investment asset (stocks, bonds, rental property held for investments, etc.) • Assets used for personal use purposes (home, furniture, clothing, personal automobile, etc.) by individuals • A sale or other disposition of capital assets results in a capital gain or loss • Capital gains and losses receive special tax treatment

34. Midterm Review – Q3 Characterization of gain on sale • The gain on the sale of the land is a capital gain. The capital gain is included in their gross income, increasing taxable income by $5,000 Tax rate • The effect on their tax liability depends on whether the gain is short-term or long-term: • Short-term: If the gain is short-term, the $5,000 will be taxed at their 25% marginal tax rate • Long-term: If the gain is long-term, it will be taxed at the 15% long-term capital gains rate • Their tax liability will increase by $1,250 ($5,000 * 25%) if the gain is short-term or by $750 ($5,000 * 15%) if it is long-term

35. Midterm Review – Q3 b. Assume the same facts as in part (a) and that Matt also sold some stock he purchased several years ago at a $12,000 loss. What is the effect of the gain on the land and the loss on the stock on their taxable income? Explain. Characterization • The loss on the sale of the stock is a capital loss Tax effect • To determine the tax effect of the loss, it must be netted against other capital gains. This results in a net capital loss of $7,000 ($5,000 gain - $12,000 loss) • Capital losses are deductible, but are limited to $3,000 per year. Stephanie and Matt's taxable income will decrease by the $3,000 capital loss deduction. The remaining $4,000 of net capital loss is carried forward. The $3,000 capital loss deduction reduces their tax liability by $750 ($3,000 * 25%)

36. Midterm Review – Q3

37. Midterm Review – Q3 1 2

38. Midterm Review – MC 1. The rules that limit self-dealing through the related party provisions is a result of the: a. Ability to Pay Concept b. Administrative Convenience Concept c. Arm’s-Length Transaction Concept d. Capital Recovery Concept e. Pay-as-You-Go Concept

39. Midterm Review – MC Arm’s-length transaction: • Transaction in which all parties have bargained in good faith for their individual benefit • Transaction that are not at arm’s length are generally not given any tax effect or are not given the intended tax effect 1) Family 2) Entity

40. Midterm Review – MC 2. Susan purchased a lot for investment purposes. She paid $10,000 for the lot. Three years later she sold the lot to her daughter for $8,000. Susan cannot deduct the loss due to a. Ability to Pay Concept b. Administrative Convenience Concept c. Arm’s-Length Transaction Concept d. Capital Recovery Concept e. Pay-as-You-Go Concept

41. Midterm Review – MC 3. Withholding of taxes from the taxpayers wages and quarterly estimated tax payments are a result of the a. Ability to Pay Concept b. Administrative Convenience Concept c. Arm’s-Length Transaction Concept d. Capital Recovery Concept e. Pay-as-You-Go Concept • Pay-as-you-go: Taxpayers must pay as they generate income • Tax withholding and estimated tax payments (methods to insure)

42. Midterm Review – MC 4. The allowance of deductions in calculating taxable income and the use of a progressive tax rate structure are a direct application of the a. Ability to Pay Concept b. Administrative Convenience Concept c. Arm’s-Length Transaction Concept d. Capital Recovery Concept e. Pay-as-You-Go Concept Ability to pay: • Tax should be based on an amount that a taxpayer can afford to pay • Where do you see this concept: • Deductions • Exclusions • Credits • Progressive tax rates

43. Midterm Review – MC 5. Penelope purchased an annuity contract that cost $45,000. The contract will pay Penelope $600 per month for 10 years after she reaches the age of 62. During the current year, Penelope turns 62 and receives 4 payments under the contract. The amount Penelope may exclude from taxable income as a return of capital on this year's payments is: a. $ 692 b. $ 900 c. $1,500 d. $2,250 e. $2,400

44. Midterm Review – MC Annuity Rule

45. Midterm Review – MC 5. Penelope purchased an annuity contract that cost $45,000. The contract will pay Penelope $600 per month for 10 years after she reaches the age of 62. During the current year, Penelope turns 62 and receives 4 payments under the contract. The amount Penelope may exclude from taxable income as a return of capital on this year's payments is: a. $ 692 b. $ 900 c. $1,500 d. $2,250 e. $2,400

46. Midterm Review – MC 6. Benjamin has the following capital gains and losses for the current year: Long-term capital loss $(13,000) Long-term capital gain 6,000 Short-term capital loss (10,000) Short-term capital gain 12,000 What is Benjamin's net capital gain or loss for the year? a. Net long-term capital loss of $7,000 b. Net short-term capital gain of $2,000 c. Net long-term capital loss of $5,000 d. Net short-term capital gain of $1,000 e. Net long-term capital loss of $3,000

47. Midterm Review – MC Long-term capital loss $(13,000) Long-term capital gain 6,000 Short-term capital loss (10,000) Short-term capital gain 12,000 Net long-term capital loss $(7,000) Net short-term capital gain2,000 1 Net long-term capital loss $(7,000) - Net short-term capital gain2,000 = Net long-term capital loss $(5,000) Only net if signs in Step 1 are different 2

48. Midterm Review – MC 6. Benjamin has the following capital gains and losses for the current year: Long-term capital loss $(13,000) Long-term capital gain 6,000 Short-term capital loss (10,000) Short-term capital gain 12,000 What is Benjamin's net capital gain or loss for the year? a. Net long-term capital loss of $7,000 b. Net short-term capital gain of $2,000 c. Net long-term capital loss of $5,000 d. Net short-term capital gain of $1,000 e. Net long-term capital loss of $3,000

49. Midterm Review – MC 7. Nora receives a salary of $55,000 during the current year. She sells some land that she held as an investment at a loss of $15,000 and some stock at a gain of $10,000. Nora's adjusted gross income is: a. $50,000 b. $52,000 c. $55,000 d. $62,000 e. $65,000

50. Midterm Review – MC 1 2