Business Expenses

Business Expenses Chapter5

Code Sections • Sec. 161 - deductions are only 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 includes in 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 mail • 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 is 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 merchandize 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 corporation with average annual gross receipts of more than $5 million cannot use the cash method for tax • Personal service corporations can use the cash method

Prepaid Expenses • Prepaid assets must be 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 but expenses incurred prior to the commencement of operations do not qualify as “carrying on” a business • 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 in a similar business - deduction allowed as current expenses • If taxpayer 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) • Expenses amortized over 60 months for taxpayers who are entering a business not related to an existing business • For taxpayer entering a new business related to an existing business, start-up costs are considered continuing costs and are currently deductible

Organization Costs • Costs relating to 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 • Organizational costs must be capitalized and can be amortized over 60 months

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 amount of qualified expenses • The 50% limit is imposed on whoever (employer or employee) ultimately pays for the expense

Meals & Entertainment • Directly-related expenses - costs incurred when a discussion takes place between the taxpayer and a customer about specific business activities in an atmosphere conducive to a serious business discussion. • Associated-with expenses - deductible only if directly preceded or followed by a substantial business discussion • Deduction for entertainment tickets is based on the ticket’s face value, then the 50% limit applies

Restriction on Deductions • No deduction for the costs of owning and maintaining entertainment facilities such as hunting lodges and yachts • No deduction 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 include lodging and meals while temporarily away from home on business, transportation to destination and back, and incidental expenses • A tax home is the location of the principal place of employment regardless of where the family residence is maintained

Temporary Assignments • Temporary is 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 of more than one year shifts tax home to the new location (no deduction for travel and living costs)

Transportation Expenses • Transportation expenses are incurred when the taxpayer is not away from home (includes cost of transportation from one work location to another, but excluding any meal costs) • The business portion of actual automobile expenses can be deducted or a standard mileage rate (36¢ for 2003) plus parking and tolls can be deducted

Transportation Expenses • Commuting expenses are personal nondeductible expenses except: • Transportation between home and temporary work location if taxpayer has a regular place of business • Travel from one job to another on the same day

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 • Meals & lodging deductible only for days on which business is conducted

Travel • If the primary reason the taxpayer remains in a temporary location is because it is less expensive then returning home as soon as business is completed, these costs are deductible • Saturday meals & lodging • Business meetings on Friday and Monday

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’s portion of taxes ends on 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 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 include specific identification, FIFO, LIFO, and average cost • A low inventory valuation results in tax savings through a higher cost of goods sold deduction • The LIFO conformity rule requires use of LIFO for financial statements if LIFO is used for tax

Home Office Expenses • Home office must be used exclusively on a regular basis and meet one of the following three tests to be deductible: 1. 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 and are limited to gross income from the business

Home Office Expenses • Expenses are deducted in this order: 1. Expenses directly related to the business other than home office expenses (supplies) 2. The allocated portion of otherwise deductible itemized deductions (mortgage interest and property taxes) 3. Operating 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 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 it is a hobby • Even with losses, taxpayer can deduct expenses by showing activity run in a businesslike manner • If a hobby, then expenses limited to hobby income

Hobby Expenses • Expenses must be taken 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

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 may include: advertising, cleaning, maintenance, utilities, insurance, taxes, interest, commissions for collection of rent, travel to collect rental income or to manager 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 • A home used for both rental and personal use purposes falls into one of 3 categories: 1. Less than 15 days rental 2. More than 2 week rental and primarily rental property 3. More than 2 week rental but primarily personal use property (mixed rental/personal use)

Rental of a Vacation Home • If the residence is rented out for less than 15 days during the year: • No rental income is reported but • No deductions are allowable (except mortgage interest and property taxes may still be deducted as itemized deductions)

Rental of a Vacation Home • Primarily rental - if rental period is greater than 14 days and personal use is equal to or less than the greater of 14 days or 10% of the rental days) • Expenses allocated between rental and personal-use • Rental expenses can exceed rental income and create a loss • No deduction for personal-use expenses

Rental of a Vacation Home • Mixed personal/rental use - if the rental period is greater than 14 days and personal-use more than 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 • Mortgage interest & real estate taxes for personal-use allowed as itemized deductible

Book/Tax Differences • Permanent differences • Interest income from municipal bonds • Fines and penalties • Life insurance proceeds • 50% of meals and entertainment • Temporary differences • Bad debts • Depreciation

Income Tax Expense • If only permanent differences, adjust book income by • Adding expenses that are not tax deductible • Subtracting tax-exempt income • Multiply adjusted book income by the tax rate • Temporary differences create • A deferred tax asset that is a prepayment of tax that will be refunded in a future year or • A deferred tax liability this is a current savings that will have to be paid in a future year

The End

Business Expenses