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Chapter 5

Chapter 5. Business Deductions. Trade or Business Deductions (slide 1 of 2). Section 162(a) permits a deduction for all ordinary and necessary expenses (pg. 5-2;ex 1) paid or incurred in carrying on a trade or business including: Reasonable salaries paid for services

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Chapter 5

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  1. Chapter 5 Business Deductions

  2. Trade or Business Deductions (slide 1 of 2) • Section 162(a) permits a deduction for all ordinary and necessary expenses (pg. 5-2;ex 1) paid or incurred in carrying on a trade or business including: • Reasonable salaries paid for services • Expenses for the use of business property

  3. Trade or Business Deductions (slide 2 of 2) • In order for expenses to be deductible, they must be: • Ordinary: normal, usual, or customary for others in similar business, and not capital in nature • Necessary: prudent businessperson would incur same expense • Reasonable: question of fact • Incurred in conduct of business

  4. Methods of Accounting • The method of accounting affects when deductions are taken • Cash: expenses are deductible only when paid (can prepay and accelerate deductions!) • Accrual: expenses are deductible when incurred • Apply the all events test and the economic performance test • Exception to the economic performance test for recurring items

  5. Expenditures Contrary To Public Policy • Deductions are disallowed for certain specific types of expenditures that are considered contrary to public policy • Examples: penalties, fines, illegal bribes or kickbacks

  6. Legal Expenses Incurred In Defense Of Civil Or Criminal Penalties • To deduct legal expenses • Must be directly related to a trade or business, an income producing activity, or the determination, collection, or refund of a tax • e.g., Corporate officer’s legal fees in defending against price-fixing charges (the corporate officer deducts as they are in the business of being an executive) • e.g., Landlord’s legal fees associated with eviction of tenant

  7. Expenses Relating To An Illegal Business • Usual expenses of operating an illegal business are deductible • However, deduction for fines, bribes to public officials, illegal kickbacks, and other illegal payments are disallowed • Trafficking in controlled substances: only cost of goods sold can reduce gross income

  8. Political Contributions And Lobbying Activities • Generally, no business deduction is allowed for payments made for political purposes or for lobbying • Exceptions are allowed for lobbying: • To influence local legislation, • To monitor legislation, and • De minimis in-house expenses (limited to $2,000) • If greater than $2,000, none can be deducted

  9. Excessive Executive Compensation (slide 1 of 2) • For publicly held corporations: • Deduction for compensation of CEO and four other highest compensated officers is limited to $1 million each • Does not include: • Certain performance-based compensation • Payments to qualified retirement plans • Payments excludible from gross income

  10. Investigation Of A Business(slide 1 of 3) • Investigation expenses - incurred to determine the feasibility of entering a new business or expanding an existing business • Include costs such as travel, engineering, architectural surveys, marketing reports, various legal and accounting services • Tax treatment of these expenses depends on: • The current business, if any, of the taxpayer • The nature of the business being investigated • The extent to which the investigation has proceeded • Whether or not the acquisition actually takes place

  11. Investigation Of A Business(slide 2 of 3) • If the taxpayer is in a business the same as or similar to that being investigated • Investigation expenses are deductible in the year paid or incurred • The tax result is the same whether or not the taxpayer acquires the business being investigated

  12. Investigation Of A Business(slide 3 of 3) • When the taxpayer is not in a business the same as or similar to that being investigated • Tax result depends on whether new business is acquired • If not acquired • All investigation expenses generally are nondeductible • If acquired • Investigation expenses must be capitalized • May elect to deduct the first $5,000 of expenses currently • Any excess expenses can be amortized over a period of not less than 180 months (15 years) • In arriving at the $5,000 immediate deduction allowed, a dollar-for-dollar reduction must be made for those expenses in excess of $50,000

  13. Transactions Between Related Parties (slide 1 of 2) • Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties • Family (brother/sister) and entity relationships (corp and 50% owners) apply • Constructive ownership rules apply • Loss disallowed may reduce gain on subsequent disposition to unrelated third party (example 17)

  14. Transactions Between Related Parties(slide 2 of 2) • Section 267 also requires the matching principle be applied for unpaid expenses and interest when different accounting methods used • Example: An accrual basis, closely held corporation, cannot deduct accrued, but unpaid, salary to cash basis related party employee/shareholder until it is actually paid

  15. Expenses and Interest Relating to Tax-Exempt Income • Expenses relating to production of tax-exempt income are nondeductible • Example: interest expense on loan where funds used to acquire municipal bonds

  16. Charitable Contributions(slide 1 of 2) Individuals and corporations may deduct contributions made to qualified domestic organizations Contributor must have donative intent and expect nothing in return If contributor receives tangible benefit, the FMV of such benefit must be deducted from the amount of the contribution 16

  17. Charitable Contributions(slide 2 of 2) Contribution must be to qualified domestic nonprofit organization or state or possession of U.S. or any subdivisions thereof Many (but not all) qualified domestic charities are listed in IRS Publication #78 Let’s read pg 5-13 on lack of adequate substantiation. 17

  18. Ordinary Income Property Defined: assets that would produce ordinary income or short-term capital gain if sold Contribution amount FMV of asset less ordinary income (or STCG) potential; generally the lower of adjusted basis or FMV 18

  19. Capital Gain Property Defined: assets that would produce long-term capital gain or Section 1231 gain if sold Contribution amount Generally FMV of asset 19

  20. Exceptions to FMV Deduction of Capital Gain Property (slide 2 of 2) If a corporation contributes tangible personal property and the charitable organization puts the property to an unrelated use The appreciation on the property is not deductible Unrelated use is defined as use that is not related to the purpose or function that qualifies the organization for exempt status 20

  21. Example of Contributions of Tangible Personalty Taxpayer contributes painting to local charity: FMV $100,000 and adjusted basis $10,000 If charitable organization is a local museum that hangs the painting for patrons to view, taxpayer has $100,000 contribution deduction If charitable organization is a local church that sells the painting immediately to obtain funds for its operation, taxpayer has $10,000 contribution 21

  22. Exceptions Related to Contributions of Ordinary Income Property (slide 1 of 2) In general, the deduction for a contribution of ordinary income property is limited to the basis of the property On certain contributions of inventory by corps, the amount of the deduction is equal to the lesser of The property’s basis plus 50% of the appreciation on the property, or Twice the property’s basis 22

  23. Exceptions Related to Contributions of Ordinary Income Property (slide 2 of 2) This increased deduction amount is available for inventory contributions of Property to a charitable organization for use in its exempt function Such use is solely for the care of the ill, needy, or infants Tangible personal research property constructed by the corp. to a qualified educational or scientific organization Must use the property for research, experimentation, or for research training Property must be contributed within 2 years from date of construction by donor, and Its original use must begin with the donee 23

  24. Charitable ContributionLimitation A corporate taxpayer’s contribution deduction is limited to 10% of taxable income before The charitable contribution deduction (basically line 28 with $-0- on line 19 and 25; beware of DRD) Any NOL or capital loss carryback The dividends received deduction, and The domestic production activities deduction 24

  25. Charitable Contributions Carryover Contributions in excess of the 10% limit may be carried forward for 5 years Any carryforward is added to subsequent contributions subject to the 10% limit In carryforward year, current year contributions must be deducted first, with excess deductions from previous years deducted in order of time 25

  26. Domestic Production Activities Deduction Sec. 199 (slide 1 of 4) The American Jobs Creation Act of 2004 created a new deduction based on the income from manufacturing activities The Domestic Production Activities deduction is based on the following formula: 9% × Lesser of Qualified production activities income (QPAI) Taxable (or modified adjusted gross) income or AMTI The deduction cannot exceed 50% of an employer’s W–2 wages paid to employees engaged in qualified production activities 26

  27. Domestic Production Activities Deduction (slide 2 of 4) Qualified production activities income is the excess of domestic production gross receipts over the sum of: Cost of goods sold that are attributable to such receipts Other deductions, expenses, or losses that are directly allocable to such receipts A share of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income 27

  28. Domestic Production Activities Deduction (slide 3 of 4) Domestic production gross receipts include the following five specific categories: The lease, license, sale, exchange, or other disposition of qualified production property manufactured, produced, grown, or extracted in the U.S. Qualified films largely created in the U.S. The production of electricity, natural gas, or potable water Construction (but not self-construction) performed in the U.S. Engineering and architectural services for domestic construction Items specifically excluded from this definition include: The sale of food and beverages prepared by a taxpayer at a retail establishment and The transmission or distribution of electricity, natural gas, or potable water 28

  29. Domestic Production Activities Deduction (slide 4 of 4) Eligible taxpayers include: Individuals, partnerships, S corporations, C corporations, cooperatives, estates, and trusts For a pass-through entity (e.g., partnerships, S corporations), the deduction flows through to the individual owners For sole proprietors, a deduction for AGI results and is claimed on Form 1040, line 35 on page 1 29

  30. Cost Recovery Recovery of the cost of business or income-producing assets is through: Cost recovery or depreciation: tangible assets Amortization: intangible assets Depletion: natural resources 30

  31. Nature of Property Property includes both realty (real property) and personalty (personal property) Realty generally includes land and buildings permanently affixed to the land Personalty is defined as any asset that is not realty Personalty includes furniture, machinery, equipment, and many other types of assets Personalty (or personal property) should not be confused with personal use property Personal use property is any property (realty or personalty) that is held for personal use rather than for use in a trade or business or an income-producing activity Write-offs are not allowed for personal use assets 31

  32. General Considerations(slide 1 of 3) Basis in an asset is reduced by the amount of cost recovery that is allowed and by not less than the allowable amount Allowed cost recovery is cost recovery actually taken Allowable cost recovery is amount that could have been taken under the applicable cost recovery method If no cost recovery is claimed on property The basis of the property must still be reduced by the amount that should have been deducted i.e., The allowable cost recovery 32

  33. General Considerations(slide 2 of 3) If personal use assets are converted to business or income-producing use Basis for cost recovery and for loss is lower of Adjusted basis or Fair market value at time property was converted Losses that occurred prior to conversion can not be recognized for tax purposes through cost recovery 33

  34. General Considerations(slide 3 of 3) MACRS applies to: Assets used in a trade or business or for the production of income Assets subject to wear and tear, obsolescence, etc. Assets that have a determinable useful life or decline in value on a predictable basis Assets that are tangible personalty or realty 34

  35. The Big Picture - Example 39Cost Recovery Basis for Personal Use Assets Converted to Business Use Return to the facts of The Big Picture p. 5-1. Five years ago Michael Forney purchased his personal residence for $250,000. This year Michael found a larger home that he acquired for his personal residence. Unfortunately he cannot sell his original residence and recover his purchase price of $250,000. The residence was appraised at $180,000. Instead of continuing to try to sell the original residence, Michael converted it to rental property. The basis for cost recovery of the rental property is $180,000 because the fair market value is less than the adjusted basis. The $70,000 decline in value is deemed to be personal (since it occurred while the property was held for personal use by Michael) and therefore nondeductible. 35

  36. MACRS-Personalty MACRS characteristics: MACRS Personalty . Statutory lives: 3, 5, 7, 10 yrs 15, 20 yrs Method: 200% DB 150% DB Convention: Half Yr or Mid-Quarter DB = declining balance with switch to straight-line Straight-line depreciation may be elected 36

  37. Half-Year Convention General rule for personalty Assets treated as if placed in service (or disposed of) in the middle of taxable year regardless of when actually placed in service (or disposed of) 37

  38. Additional First-Year Depreciation (slide 1 of 2) 50% additional first-year depreciation has been allowed for several years The Small Business Jobs Act of 2010 extended additional first-year depreciation for one more year Effective for qualified property acquired and placed in service before January 1, 2011 Most recently, the Tax Relief Act of 2010 extended additional first-year depreciation for 2011 Increases the percentage from 50% to 100% Effective for qualified property placed in service after Sept. 8, 2010 and before Jan. 1, 2012 The Act also extends additional first-year depreciation through 2013, but at the 50% rate Effective for qualified property placed in service after Dec. 31, 2011 and before Jan. 1, 2014 (as extended by the American Taxpayer Relief Act of 2012) 38

  39. Additional First-Year Depreciation (slide 2 of 2) Additional first-year depreciation allows an additional percentage (50% ) of cost recovery in year asset is placed in service Qualified property includes most types of new property other than buildings Property that is used but new to the taxpayer does not qualify 39

  40. Mid-Quarter Convention Applies when more than 40% of personalty is placed in service during last quarter of year Assets treated as if placed into service (or disposed of) in the middle of the quarter in which they were actually placed in service (or disposed of) 40

  41. MACRS-Realty (slide 1 of 2) MACRS characteristics: MACRS Realty Residential RentalNonresid. Realty Statutory lives: 27.5 yrs 31.5 yrs or 39 yrs Method: Straight-line Convention: Mid-month Residential rental real estate Includes property where 80% or more of gross rental revenues are from nontransient dwelling units e.g., Apartment building 41

  42. MACRS-Realty (slide 2 of 2) Mid-month Convention Property placed in service at any time during a month is treated as if it was placed in service in the middle of the month Example: Business building placed in service April 25 is treated as placed in service April 15 42

  43. Optional Straight-line Election May elect straight-line rather than accelerated depreciation on personalty placed in service during year Use the class life of the asset for the recovery period Use half-year or mid-quarter convention as applicable Election is made annually by class of property 43

  44. Leasehold Improvement Property (slide 1 of 3) • If lessor is owner of leasehold improvement property, depreciation is calculated as follows: • Real Property – Use straight-line method over 27.5 or 39 year statutory recovery periods • Tangible personal property – Use the shorter MACRS lives and accelerated methods • When these improvements are disposed of or abandoned by the lessor due to lease termination • Property is treated as disposed of by the lessor • A loss can be taken for the unrecovered basis

  45. Leasehold Improvement Property (slide 2 of 3) • If lessee is owner of leasehold improvement property • Costs of leasehold improvements are recovered in accordance with the general cost recovery rules • Cost recovery period is determined without regard to the lease term • Any unrecovered basis in the leasehold improvement property not retained by the lessee is deducted in the year the lease is terminated

  46. Leasehold Improvement Property (slide 3 of 3) The ATRA of 2012 extends through 2013 the 50% additional first-year depreciation for qualified leasehold improvements A qualified leasehold improvement is an improvement to an interior portion of a nonresidential building by the lessee or lessor, and Placed in service more than 3 years after date building was first placed in service. The ATRA of 2012 also extends through 2013 the use of a 15-year straight-line recovery period for qualified leasehold improvements 46

  47. Election to Expense Assets -Section 179 (slide 1 of 5) • General rules • Can elect to immediately expense up to $500,000 of business tangible personalty placed in service in 2013 • Cannot use § 179 for most realty or production of income property • The ATRA of 2012 extended through 2013 the definition of property qualifying for § 179 to include qualified leasehold improvement property • The maximum amount that may be expensed is $250,000

  48. Election to Expense Assets -Section 179 (slide 2 of 5) • Section 179 general rules • Amount expensed reduces depreciable basis • Any elected § 179 expense is taken before additional first-year depreciation is computed • The base for calculating the standard MACRS deduction is net of the § 179 expense and the additional first-year depreciation (50% in 2013)

  49. Election to Expense Assets -Section 179 (slide 3 of 5) • Annual limitations: • Expense limitation ($500,000 for 2013) is reduced by amount of § 179 property placed in service during year that exceeds $2,000,000 • Example: In 2013, taxpayer placed in service $2,075,000 of § 179 property. • The § 179 expense limit is reduced to $425,000 • [$500,000 – ($2,075,000 – $2,000,000)]

  50. Election to Expense Assets -Section 179 (slide 4 of 5) • Annual limitations: • Election to expense cannot exceed taxable income (before § 179) of taxpayer’s trades or businesses • Any amount expensed under § 179 over taxable income limitation may be carried over to subsequent year(s) • Amount carried over still reduces basis currently • The § 179 amount eligible for expensing in a carryforward year is limited to the lesser of • The statutory dollar amount ($500,000 in 2013) reduced by the cost of § 179 property placed in service in excess of $2,000,000 (in 2013) in the carryforward year, or • The business income limitation in the carryforward year.

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