Chapter 6

1. Chapter 6 Business Expenses Kevin Murphy Mark Higgins ©2008 South-Western

2. All deductions are a matter of Legislative Grace Just because GAAP allows a deduction, don’t assume tax law will too!

3. Business Expenses • All expenses must first meet the basic tests for deductibility - • Have a business purpose • Be ordinary, necessary, and reasonable • Be allowed under the Legislative Grace Concept

4. Business ExpensesSubstantiation Requirements • Expenses related to Meals, Entertainment, Automobile Usage, Travel, and Business Gifts are deductible subject to limitations and strict documentation requirements • Amount • Time and place • Date and description • Business purpose • Business relationship of other person(s)

5. Meals and Entertainment Meals and entertainment expenses must be directly related to or associated with the active conduct of a business activity.

6. Meals and EntertainmentDirectly Related Test • The “directly related to” test is met if • There is more than a general expectation of business benefit • A bona fide business activity takes place during the meal or entertainment • The principal reason for the meal or entertainment is business • The expenses are related to the taxpayer and people involved in the business activity

7. Meals and EntertainmentAssociated With Test • The “associated with” test is met if • There is a clear business purpose for the meal or entertainment • The meal or entertainment directly precedes or directly follows a substantial business discussion

8. Meals and EntertainmentCosts • Meal costs include food, beverage, tax, and tips • Entertainment costs include expenses for clubs, theaters, and sporting events • Only the face amount of a ticket is allowed • Club dues do not qualify

9. Meals and EntertainmentCost Limitations • Only 50% of the allowable costs may be deducted • Exceptions to the 50% limitation • Reimbursed expenses • Expenses that are taxable income to a non-employee recipient (awards, prizes) • Expenses for recreational or social activities which benefit employees

10. Auto ExpensesGeneral Requirements • The cost of using an automobile for business is deductible • Use of the automobile must be for travel • Out of town • From home to a temporary workplace • From the regular to a temporary workplace • From the workplace to a second job • The cost of commuting is never deductible.

11. Auto Expenses • Auto expenses may be computed under one of two methods: • Actual Cost • Standard Mileage Rate

12. Auto ExpensesActual Cost Method • The actual cost of using the automobile may be deducted • The business percentage of depreciation, gas and oil, repairs, insurance, interest, license fees, etc. is deductible • Deduction amount is often larger than the standard rate

13. Auto ExpensesStandard Mileage Rate Method • The administrative convenience concept allows a deduction based on the number of business miles driven during the year • Rate is $0.485 per mile (2007) • Tolls, parking, interest and property taxes may be added • Standard rate method is not allowed if multiple cars are used

14. Travel Expenses • Travel expenses incurred while on business away from the tax home overnight are deductible • Tax home is the principal area in which business is conducted • Overnight means longer than a regular workday

15. Travel ExpensesLimitations • Over 50% of the activity requiring travel must have a business purpose • Personal activity costs on a business trip are not deductible • Incidental business expenses on a personal trip are deductible • Travel for general educational purposes or for investment related meetings is not deductible

16. Business Gifts • The cost of a gift given to a business customer may not be fully deductible • There is an overall limitation of $25 per person, per year • Gifts are not subject to the 50% entertainment limits • Delivery, gift wrap, engraving, etc., do not count toward the $25

17. Education Expenses • Costs of education are deductible if • Required by law (or employer) to maintain employment, or • Maintains or improves current job skills • Costs of education are not deductible if • Necessary to meet minimum job requirements, or • Qualifies taxpayer for new trade or business

18. Education Expenses • Unreimbursed allowable costs are deductible as miscellaneous itemized deduction • Employee may exclude up to $5,250 of reimbursed expenses from a qualified plan

19. Compensation of Employees • Wages, salaries, bonuses and other compensation paid to employees is deductible if two basic tests are met: • Employees must perform actual service • Payment must be reasonable in amount

20. Compensation of EmployeesReasonable Compensation • Some factors considered when determining if compensation is reasonable are • Duties, responsibilities and pay history of the employee • Volume and complexity of the business • Time required to do the work • Ability and accomplishments of the employee • Company pay policy

21. Compensation of EmployeesReasonable Compensation • Payments to a related party may be examined closely for • Lack of a business purpose • An arms-length transaction • Reality of compensation in a closely-held business

22. Compensation of EmployeesReasonable Compensation • Size of deduction for salary paid to a covered employee is limited • CEO and the four highest paid officers are covered employees • $1,000,000 limit on compensation deduction per employee • Some amounts are exempt from the limit • commissions and performance based payments • pension plan contributions • fringe benefits

23. Bad Debts Bad debts are generally deductible under the capital recovery concept. • Business bad debts are deductible only under the accrual method • Nonbusiness (investment) bad debts are deductible if the debt is bona fide • Report as a short-term capital loss • No deduction is allowed if the debt is voluntarily forgiven

24. Qualified Production Activities Deduction • Amount Of Deduction • 6% of the lesser of: • Qualified Production Activities Income OR • Taxable Income before Qualified Production Activities Deduction • Cannot Exceed 50% of W-2 wages paid by Taxpayer

25. Qualified Production Activities Deduction Qualified Production Activities Income equals: Domestic Gross Production Receipts Less the allocable: Cost of Goods Sold Direct Expenses and Losses Indirect Expenses and Losses

26. Qualified Production Activities Deduction • Domestic Gross Production Receipts arise from • Sale, exchange, lease, rental or other disposition of: • Qualifying property manufactured, produced, grown, or extracted in the U.S. • Qualified films produced • Electricity, natural gas, or potable water produced in the U.S. • Construction activities performed in the U.S. • Engineering or architectural services performed in the U.S.

27. Qualified Production Activities Deduction • Qualified Production Property • Tangible Personal Property • Computer Software • Sound Recordings

28. Qualified Production Activities Deduction • Retailers who buy from taxpayers with qualified production activities may not claim sales of those products as gross production receipts

29. Insurance • Fire, theft, casualty or liability • Group medical, term-life and worker’s compensation • Performance and fidelity bonds • Business interruption Insurance premiums paid to protect a business from the following losses are deductible.

30. Taxes • Exceptions: • Sales taxes related to long-lived assets must be capitalized • Property taxes related to real estate bought or sold during the year must be allocated between buyer and seller • Assessments for local benefits are added to the property’s basis Most business related taxes are deductible unless paid to the federal government.

31. Legal Fees Legal fees are deductible if they were paid to defend business income, reputation, or goodwill • If fees are related to property ownership, they are capitalized with the cost of the property

32. Individual DeductionsFor Adjusted Gross Income Expenses paid by individuals • for a business purpose, or • specifically allowed by Congress to create equity in tax treatment are allowed as deductions for AGI.

33. Accountable Plan Employees are required to make an adequate accounting of their expenses. • Reimbursements = expenses • nothing is reported • Reimbursements < expenses • reimbursement is reported as income • expenses = reimbursement income are deducted for AGI • excess expenses are deducted from AGI • Reimbursements > expenses and excess is not returned • excess reimbursement is reported as income

34. Nonaccountable Plan Employees are not required to make an adequate accounting of their expenses. • All reimbursements are included in income • All expenses are deducted from AGI

35. Deductions for Self-Employed Taxpayers To provide self-employed taxpayers equity with the tax treatment of employees, they are allowed to deduct: • The cost of health insurance premiums paid for themselves • 50% of the amount of self-employment tax paid

36. Retirement Plan Contribution Deductions Taxpayers who do not have access to an employer sponsored pension plan are allowed several options: • Keogh or H.R.10 plans (for self-employed taxpayers only) • Individual Retirement Accounts (for all taxpayers)

37. Individual Retirement AccountsContributions • All taxpayers may contribute a maximum of $4,000 of their earned income to a Deductible or a Roth IRA. • Special “Catch-up” rule allows up to $5,000 if 50 or older • A married couple may contribute $8,000 in total ($10,000 if over 50), but not more than $4,000 ($5,000) to any one account.

38. Three Major IRA Types • Conventional • Roth • Coverdell Educational

39. 1. Conventional IRA • Contributions limited to lesser of $4,000 ($5,000 if > 50) or amount of earned income • Fully deductible if not covered by an employer’s plan • Not linked to spouse’s coverage • If covered, maximum deduction equals: (Maximum contribution) X [1 - {(AGI - phase-out) / $10,000}]

40. Conventional IRA: Phase-out Amounts

41. Conventional IRA - Example • Single taxpayer with AGI = $58,000 contributes $4,000 to an IRA. How much is deductible if the t/p is covered by a qualified plan? $4,000 X [ 1 - ($58,000 - $50,000)/10,000] = $4,000 X [ 1 - 0.80] = $4,000 X 0.20 = $600 maximum deduction

42. 2. Roth IRA • Contributions are not deductible • Earnings distributions are tax-free if • IRA has existed for 5 years, and • Taxpayer is >59 1/2 years old • No age limit to begin distributions • Contributions are phased-out like Conventional IRA • Married, between $150,000 to $160,000 • Others, between $95,000 to $110,000

43. 3. Education IRA • Set up as a trust for the benefit of any person under age 18 • $2,000 nondeductible contribution per student per year • Phased-out for AGI greater than • Married, from $190,000 • Others, from $95,000 Max. contribution X [1 - {(AGI - phase-out) / 15,000}]

44. 3. Education IRA Continued • Tax-free growth in the IRA • No tax at time of withdrawal if used for qualified expenses • Tuition and fees of student

45. Higher Education Expense Deduction (legislation was pending on this issue; check the text’s website for updates.) • May deduct up to $4,000 of qualifying higher education expense • Qualifying = tuition and fees • Must have AGI < $65,000 if single ($130,000 for MFJ) • Cannot claim in addition to HOPE or Lifetime Learning Credits

46. Educational Loan Interest • May deduct up to $2,500 for interest paid on education loans • Taken as a “for” deduction • Only for payments made during first 60 months of the loan • Deduction phased-out when AGI exceeds • Married, from $110,000; Others, from $55,000 Deduction = Amt. Paid X[1 - {(AGI - phase-out) / 15,000}]

47. Moving Expenses Moving expenses are deductible if they meet two tests. 1. Distance test Old job New job x + 51 miles x miles Old house

48. Moving ExpensesTime Test 2. Time Test • Employee taxpayers must be employed in the new area for 39 weeks of the 12 months after moving • Self-employed taxpayers must be employed in the new area for 78 weeks of the 24 months after moving • Waived for death, disability, or required transfer

49. Moving ExpensesQualifying Expenses • Only two types of expenses are deductible: • Costs of moving household goods and personal items to the new location • Transportation and lodging costs of moving the taxpayer and family to the new location • Mileage is allowed at $0.20 per mile • None of the cost of meals is deductible

50. Moving ExpensesReimbursements • Any reimbursement of moving expenses received from an employer is included as income