Business Expenses

Business Expenses Chapter5

Code Sections • Deductions are permitted by “legislative grace” so they are allowed only if specifically authorized in the Code • 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 include: • 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 - 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 is deductible but income must also be recognized for FMV of services provided • 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 (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 regardless of size

Prepaid Expenses • Prepaid expenses must be capitalized as assets if their lives exceed one year and the items will not be consumed by the close of the following year (similar to accrual) • Prepaid rents must be capitalized unless paid for one year or less and prepayment is contractually required • 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 not acquired – no deduction • If new business acquired – expenses added to start-up expenses to determine deduction and amortization

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 new business is related to the taxpayer’s existing business, start-up costs are considered continuing costs and are deductible currently

Start-up Expenses • If the new business is not related to an existing business • Can deduct up to $5,000 (combined business investigation and start-up expenses) in the tax year in which the business begins • $5,000 amount is reduced by amount cumulative investigation and start-up expenses exceeds $50,000 • Remainder of investigation and start-up expenses amortized over a 15-year period

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 • Can deduct up to $5,000 in the year business begins • $5,000 deduction is reduced by amount organizational costs exceeds $50,000 • Remaining organizational costs amortized over 15 years (180 months)

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 Taxes Licenses, accounting fees & legal fees Salaries and wages Utilities Operating Expenses

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 • 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 • Qualifying expenses include lodging, 50% of meals, transportation to destination and back, and incidental expenses

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 • 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 • Meal costs are generally not deductible

Transportation Expenses • The prorated business portion of actual automobile expenses or a standard mileage rate (50¢ for 2010) plus related parking and tolls can be deducted • Commuting expenses (between home and the regular place of business) are personal nondeductible expenses

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 • 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 • Deduct accounts receivable or other business debts only when actually written off as uncollectible • 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

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 may be deductible 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 & personal use • All expenses related to the rental use are deductible (even if this creates a loss) • Personal portion of interest is not deductible as itemized deduction (but taxes are deductible) (# Rental Days / Total # Days Used) x Total Expense = Rental-use Expense

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 future years • Real estate taxes and mortgage interest for personal-use portion allowed as itemized deductions

Home Office Expenses • To be deductible, home office must be used exclusively on a regular basis and meet one of the following three tests: • The principal place of business for any business of taxpayer, or • A place for meeting with clients or customers in the normal course of business, or • Located in a separate structure

Home Office Expenses • Principal place of business - 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 are limited to gross income from the business and include • Portion of rent or mortgage interest, property taxes, insurance, utilities, repairs, & depreciation

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) • Other home expenses including utilities, insurance, and maintenance • Depreciation • Excess expenses are carried forward

Hobby Expenses • Hobbies - activities that earn income and incur expenses but do not meet the requirements to be a business or investment • 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 spent 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 may 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 • ASC 740 (FAS 109) states that income tax expense reported on financial statements must be based on financial statement income rather than taxable income • Actual taxes paid may differ significantly from expense recognized • 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

Reconciling Book/Tax Income • Schedule M-1 of Form 1120 reconciles accounting (book) income to taxable income • More detailed Schedule M-3 required if corporation has assets of $10 million or more

Calculating Tax Expense • If only permanent differences, adjust book income by • Adding expenses that are not tax deductible • Subtracting tax-exempt income • Then multiply adjusted book income by the tax rate to get the book tax expense • If there are both permanent and temporary differences, book income is first adjusted by permanent differences and then adjusted for temporary differences.

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 when the temporary difference reverses • A deferred tax asset that is a prepayment of tax that will be refunded in a future yearwhen the temporary difference reverses

Deferred Tax Liabilities • Deferred tax liabilities result when • Expense deductible for tax purposes before book • Income recognized for book purposes before tax • Effectively an interest-free loan from government • Tax savings can be invested until taxes are due • Adjusting the book tax expense prevents overstatement of financial statement income

Deferred Tax Assets • Deferred tax assets result when • Expense deductible for book purposes before tax • Income recognized for tax purposes before book • 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

Accounting for Uncertaintyin Income Taxes • FIN 48 (incorporated into ASC 740) provides guidance on accounting for deferred taxes when a business takes an uncertain tax position • Tax position refers to the manner of recognition of a transaction in a tax return that will result in a current or deferred tax asset or liability • The uncertainly refers to the question as to whether the position will be challenged by IRS • Example: a deduction taken on a tax return for a current expenditure that IRS may claim should be capitalized

Accounting for Uncertaintyin Income Taxes • A tax benefit from any uncertain tax position that reduces a business’s current or future tax liability can only be reported in the financial statements to the extent each benefit is recognized and measured under a two-step approach • Step 1: the business must evaluate each tax position to assess whether it is more likely than not (greater than 50%) that the position would be sustained upon examination by IRS

Business Expenses