Business Expenses

Business Expenses Chapter5

Code Sections • Sec. 161 - deductions permitted only for those expenses and losses for which a deduction is authorized • Sec. 162(a) authorizes deductions for ordinary and necessary expenses, that are reasonable in amount, and incurred in actively carrying on a trade or business • Sec. 212 authorizes deductions for expenses related to production of income (investment-related expenses)

Disallowed Deductions • Unless provided for otherwise in the Code, a deduction will be disallowed if it is • Contrary to public policy (fines, penalties) • Related to tax-exempt income • Accrued to related party (no deduction until related party recognizes income) • The obligation of another taxpayer

Substantiation • All taxpayers must maintain records that substantiate their expense deductions • Stringent substantiation requirements for travel, entertainment, and gifts • Amount of expenditure • Time and place (or date & description of gift) • Business purpose of expenditure • Business relationship of person entertained or receiving a gift

Timing of Deductions • Accrual method – expenses deductible when • “All events” have occurred that fix liability and • “Economic performance” occurs (property or services provided or used) • Cash basis taxpayer - expenses deductible when paid • Date check is mailed • Date charged on credit card

Cash Method • When an expense is paid by providing services, the expense can be deducted but the value of the services provided is also income • Assets with useful lives extending substantially beyond the end of the year must be capitalized with their cost recovered through depreciation, amortization, or depletion • When considering whether to make an early payment of year-end expenses, the tax rates for both years and the time value of money should be considered

Use of Cash Method • Businesses that sell merchandise to their customers must use the accrual method to account for purchases and sales of inventory • Cash method can be used for other than inventory and cost of goods sold • Large corporations with average annual gross receipts of more than $5 million cannot use the cash method for tax reporting • All personal service corporations can use the cash method

Prepaid Expenses • Prepaid expenses must be capitalized as assets and their costs prorated if their lives exceed one year and the items will not be consumed by the close of the following year • Prepaid interest must generally be prorated over the life of the loan • OID is a form of prepaid interest and must be amortized over term of loan

Costs of Starting a Business • Sec. 162 allows deductions for “carrying on” a business. Expenses incurred prior to the commencement of operations do not qualify as “carrying on” a business but may be deductible as one of the following: • Business investigation expenses • Start-up expenses • Organization costs

Business Investigation • Investigation expenses incurred while preparing to enter business include travel, market surveys, and feasibility studies • If the taxpayer is in a similar existing business - deduction allowed as a current expense • If taxpayer is not in a similar existing business • If new business acquired - expenses amortized over 60 months • If new business not acquired - no deduction

Start-up Expenses • Start-up expenses are incurred after the decision to proceed with the new business, but before beginning actual operations (employee training and advertising) • If the business is related to the taxpayer’s existing business, start-up costs are considered continuing costs and are deductible currently • If the business is not related to an existing business, expenses are amortized by the taxpayer over 60 months

Organization Costs • Defined as costs related to the formation of a corporation or partnership (fees paid to the state for incorporation, legal fees, and accounting fees) and incurred before end of first year • Organization costs are capitalized and amortized over 60 months • Excludes partnership syndications costs and stock issuance costs

Operating Expenses • Most operating expenses shown on a GAAP income statement are deductible on a business tax return • Examples include: advertising, bank service charges, commissions, office supplies, repairs, taxes, licenses, accounting fees, legal fees, salaries and wages, travel, and utilities

Meals & Entertainment • The deduction for business meals and entertainment expenses is limited to 50% of the qualified expenses • The 50% limit is imposed on whoever (employer or employee) ultimately pays the expense

Meals & Entertainment • Directly-related expenses - costs incurred when a significant business discussion takes place between the taxpayer and a customer in atmosphere conducive to the serious conduct of business. • Associated-with expenses - deductible when directly preceded or followed by a substantial business discussion • Deduction for entertainment tickets is limited to 50% of the tickets’ face value

Restriction on Deductions • No deduction allowed for the costs of owning and maintaining entertainment facilities such as hunting lodges and yachts • No deduction allowed for membership dues and fees paid to social, athletic, or sporting clubs • Deductions are allowed for dues to professional organizations, public service organizations, and trade associations • Deduction for business gifts limited to $25 per donee per year

Travel Away From Home • Travel expenses incurred for temporary travel away from home on business are deductible. • Qualifying expenses include lodging, 50% of meals, transportation to destination and back, and incidental expenses • Away from home refers to the person’s tax home; that is, the location of the principal place of employment regardless of where the family residence is maintained

Temporary Assignments • Temporary is defined as one year or less • Employment away from home in a single location that is realistically expected to last (and does in fact last) for one year or less, will be treated as temporary • Assignment for more than one year shifts tax home to the new location (no deduction for travel and living costs)

Transportation Expenses • Certain transportation expenses incurred when the taxpayer is not away from home are deductible and include • the cost of transportation from one work location to another • transportation between home and a temporary work location if the taxpayer has a regular place of business • any meal costs are excluded, however

Transportation Expenses • The prorated business portion of actual automobile expenses or a standard mileage rate (37.5¢ for 2004) plus related parking and tolls can be deducted • Commuting expenses (between home and the regular place of business) are a personal nondeductible expense

Combining Business with Pleasure Travel • For U.S. travel, if the trip is primarily for business, all transportation costs to and from destination are deductible • If primary purpose is pleasure, no deduction for transportation • Primary purpose is determined by the number of days on business versus personal days

Combining Business with Pleasure Travel • Meals & lodging are deductible only for days on which business is conducted • If a taxpayer remains in a temporary location to reduce costs as a result of • reduced airfare for Saturday night stays or • for business conducted on both Friday and Monday • the costs for additional days are deductible if they are less than the cost of returning home when business is completed

Foreign Travel • Transportation expenses must be allocated between business and personal days unless • Trip does not exceed one week or • Less than 25% of total time spent for personal purposes • If trip primarily personal, no deduction for transportation

Bad Debt Expense • Specific charge-off method must be used • Investment and personal loans are considered nonbusiness (capital losses) • Loan must be valid debt • No bad debt deduction for cash basis taxpayers who have not previously included amount in income

Insurance Expense • Premiums for fire, casualty, and theft insurance for business property are deductible • Payments into a self-insurance reserve are not deductible - only actual losses are deductible • Premiums for life insurance when business is beneficiary are not deductible

Legal Expenses • Legal Fees deductible only if related to a trade or business • Legal fees incurred to defend title to property are added to the asset’s basis • Criminal defense fees are deductible only if the legal action has a direct relationship to a profit-seeking activity • Personal legal expenses are not deductible

Taxes • Deductible taxes include • State, local, and foreign real property taxes • State and local personal property taxes • State, local, and foreign income taxes • Employer’s payroll taxes • Other federal, state, local, and foreign taxes incurred in a business or other income-producing activity • Federal income taxes are not deductible

Taxes • When real estate is sold, the seller is responsible for taxes through the day before the sale date • Assessments for improvements must be added to basis of property • Sales taxes are added to cost of business property or service

UNICAP Rules • Uniform capitalization rules apply to businesses whose average annual gross receipts for the preceding three years exceeds $10 million • UNICAP rules require inventory costs to include all direct costs of manufacturing, purchasing, or storing inventory, along with many indirect costs typically not included in full absorption costing • Nonmanufacturing costs (research, selling, advertising and distribution expenses) are not required to be included in inventory

Inventory • Acceptable methods for tax accounting include specific identification, FIFO, LIFO, and average cost • When prices are rising, the LIFO method results in a lower inventory valuation and tax savings through a higher deduction for cost of goods sold • The LIFO conformity rule requires use of LIFO for financial statements if LIFO is used for tax

Residential Rental Property • If rental of real estate is a business, all income is included and all expenses are deductible, even if it creates a loss • Expenses include: advertising, cleaning, maintenance, utilities, insurance, taxes, interest, commissions for collection of rent, travel to collect rental income or to manage the property or maintain the property

Residential Rental Property • When property is converted from personal to rental property, expenses must be divided between rental and personal use • No depreciation or insurance deduction allowed for personal-use part of year • Mortgage interest and real estate taxes for personal-use can be deducted as itemized deductions

Rental of a Vacation Home • If the residence is rented for less than 15 days during the year a de minimis exception applies • No rental income is reported but • No deductions are allowed for expenses other than mortgage interest and property taxes as itemized deductions

Rental of a Vacation Home • If rental period is greater than 14 days and • If personal use does not exceed the greater of 14 days or 10% of the rental days • All rent is included in income • Expenses are allocated between rental and personal use • All expenses related to the rental use are deductible (even if this creates a loss)

Rental of a Vacation Home • If rental period is greater than 14 days but • Personal use exceeds the greater of 14 days or 10% of the rental days • Rental expenses limited to rental income (no loss) • Nondeductible rental expenses can be carried forward to the future years • Real estate taxes and mortgage interest for personal-use portion allowed as itemized deductions

Home Office Expenses • Home office must be used exclusively on a regular basis and meet one of the following three tests to be deductible • the principal place of business for any business of taxpayer, or 2. a place for meeting with clients or customers in the normal course of business, or 3. located in a separate structure

Home Office Expenses • Principal place of business includes a place used for the administrative or management activities of the business if there is no other fixed location available • Employee must also show that the office is maintained for the convenience of the employer • Deductible expenses include portion of rent or mortgage interest, property taxes, insurance, utilities, repairs, depreciation but are limited to gross income from the business

Home Office Expenses • Expenses are deducted in this order: • Expenses directly related to the business other than home office expenses (supplies) • The allocated portion of otherwise deductible itemized deductions (mortgage interest and property taxes) 3. Other home expenses including utilities, insurance, and maintenance 4. Depreciation • Excess expenses are carried forward

Hobby Expenses • Activities that earn income and incur expenses but do not meet the requirements to be a business or investment are hobbies • Regulations list factors to consider in determining if activity is a hobby including: • Manner in which activity carried on • Expertise of taxpayer and/or consultants • Time and effort spend in activity • Actual profits earned in one or more years • Elements of pleasure or recreation

Hobby Expenses • If a profit is realized in 3 out of 5 years (2 out of 7 years for horses) then burden of proof shifts to IRS to prove activity is a hobby • Taxpayer can deduct expenses, even if a net loss results, by showing activity is run in a businesslike manner • If activity is a hobby, the deduction for expenses is limited to hobby income

Hobby Expenses • Expenses must be deducted in this order: • Otherwise allowable expenses (mortgage interest, taxes, and casualty losses) • Expenses that do not reduce the tax basis of the assets used in the hobby (advertising, insurance, utilities and maintenance) • Depreciation and amortization • Excess expenses are lost - no carryover

Accounting for Income Taxes • FAS 109 states that income tax expense reported on financial statements must be based on financial statement income rather than taxable income • Differences fall into two categories • Permanent differences • Temporary differences

Permanent Differences • Income that is not taxed but is reported for financial accounting purposes • Interest income from municipal bonds • Expenses that can never be deducted on the tax return • Fines and penalties • Expenses that have limited deductibility • 50% of meals and entertainment

Temporary Differences • Income or expense items that are reported in one year for accounting income and in a different year for taxable income • Examples: depreciation expense, bad debt expense, warranty expenses, and prepaid income • Schedule M-1 of Form 1120 reconciles accounting (book) income to taxable income

Schedule M-1

Calculating Tax Expense • If only permanent differences, adjust book income by • Adding expenses that are not tax deductible and • Subtracting tax-exempt income, then • Multiply adjusted book income by the tax rate

Deferred Taxes • Temporary differences create • A deferred tax liability that is a current tax savings that will have to be paid in a future year • A deferred tax asset that is a prepayment of tax that will be refunded in a future year

Deferred Tax Assets • To realize the benefit of a deferred tax asset (tax prepayment) the business must have future income and a related tax liability • A more-likely-than-not test is used to determine if a valuation account (contra asset) is needed

ConsolidatedFinancial Statements • Under FAS 109, income tax expense reported on consolidated financial statements should include the total of all federal, state, local, and foreign income taxes including both current and deferred income taxes

ConsolidatedFinancial Statements • Exception under APB 23 allows parent to exclude future U.S. income tax on foreign subsidiary income if these earnings are permanently reinvested outside the U.S. • Allows U.S. corporation to report higher financial statement income because its income statement includes the foreign income but excludes the deferred U.S. tax that could eventually be due on this income • Earnings repatriated later can cause a spike in the corporation's effective tax rate in that year

Business Expenses