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Chapter 4 Business Deductions

Chapter 4 Business Deductions. Learning Objective 1. Understand the meaning and application of the ordinary, necessary, and reasonableness requirements for the deduction of business expenses. Ordinary Expenses. An expense is ordinary if it is

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Chapter 4 Business Deductions

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  1. Chapter 4 Business Deductions

  2. Learning Objective 1 Understand the meaning and application of the ordinary, necessary, and reasonableness requirements for the deduction of business expenses.

  3. Ordinary Expenses • An expense is ordinary if it is • Normal, usual, or customary in the type of business conducted by the taxpayer, and • Not capital in nature • Ordinary expenses need not be recurring in order to be deductible

  4. Necessary Expenses • An expense is necessary if • A prudent businessperson would incur the same expense, and • The expense is expected to be appropriate and helpful in the taxpayer’s business • Some expenses that are necessary are not ordinary, and therefore are not deductible

  5. Reasonable Expenses • The Code applies the reasonableness requirement only to salaries and other compensation • The courts have applied the reasonableness requirement to all ordinary and necessary business expenses • Expenses in excess of reasonable amounts are not deductible

  6. Learning Objective 2 • Describe the cash and accrual methods of accounting for business deductions.

  7. Cash Method Requirements • Cash basis taxpayers can deduct expenses only when they are actually paid with cash or property • Payments made with borrowed funds can be deducted, but issuing a note does not meet the “actually paid” requirement • For cash and accrual basis taxpayers, Capital expenditures can be deducted only through amortization, depletion, or depreciation

  8. Accrual Method Requirements (slide 1 of 2) • Deductions are allowed when the all events test and the economic performance test are met • All events test is met when: • All the events have occurred to create the taxpayer’s liability, and • The amount of the liability can be determined with reasonable accuracy

  9. Accrual Method Requirements (slide 2 of 2) • Economic performance test • Met when service, property, or use of property giving rise to the liability is actually performed for, provided to, or used by the taxpayer • Certain recurring, immaterial items can be deducted in year incurred if economic performance occurs within 8 1/2 months after close of year such expenses were incurred

  10. Learning Objective 3 Apply a variety of Internal Revenue Code deduction disallowance provisions.

  11. Disallowance Possibilities (slide 1 of 9) • Deductions are disallowed for specified expenses that are considered contrary to public policy, including: • Bribes and illegal kickbacks • Fines and penalties paid to a government for violation of law • Legal expenses incurred in defense of civil or criminal penalties are deductible only if directly related to a trade or business

  12. Disallowance Possibilities (slide 2 of 9) • The ordinary and necessary expenses of operating an illegal business are deductible • Expenses incurred in illegal drug trafficking are not deductible (except for cost of goods sold) • Political contributions are not deductible

  13. Disallowance Possibilities (slide 3 of 9) • Lobbying expenses may be deductible to a limited extent • Deduction is not allowed for: • Influencing legislation • Participating or intervening in any political campaign (for or against a candidate for public office) • Attempting to influence voters • Attempting to influence the actions of certain high-ranking public officials

  14. Disallowance Possibilities (slide 4 of 9) • Exceptions to disallowance of lobbying expenditures (i.e., expenditures are deductible): • Influencing local legislation (city or county) • Activities devoted solely to monitoring legislation • De minimis exception allows deduction of up to $2,000 of in-house expenditures (unless prohibited by rules discussed previously)

  15. Disallowance Possibilities (slide 5 of 9) • Executive compensation of covered employees in excess of $1 million per executive per year generally is not deductible by publicly held corporations • Exception: certain types of compensation (e.g., commissions based on individual performance) are not treated as executive compensation for purposes of this limitation • Covered employees include CEO and the four other most highly compensated officers

  16. Disallowance Possibilities (slide 6 of 9) • Expenses of investigating a business may or may not be deductible • If the taxpayer is in the same or a similar business, expenses are deductible, whether or not the business is acquired • If the taxpayer is not in the same or a similar business: • Expenses are deductible (amortized over 60 months or more) only if the business is acquired • Expenses are not deductible if the business is not acquired

  17. Disallowance Possibilities (slide 7 of 9) • A loss on a transaction between related parties is disallowed • This prevents close relatives from establishing deductible losses while keeping the property within the family unit • A gain realized on a subsequent sale by the related party purchaser is recognized only to the extent it exceeds the previously disallowed loss

  18. Disallowance Possibilities (slide 8 of 9) • Accrued expenses and interest owed to a related party are deductible by the accrual basis taxpayer only when actually paid to the cash basis taxpayer • The taxpayer has the burden of proof for substantiating expenses and must retain adequate records; otherwise, IRS can disallow the deductions

  19. Disallowance Possibilities (slide 9 of 9) • Expenses and interest related to tax exempt income are disallowed

  20. Learning Objective 4 Understand the limitations applicable to the charitable contribution deduction for corporations.

  21. Charitable Contributions (slide 1 of 6) • Contributions are not deductible unless made to qualified domestic charitable organizations • See list on p. 4-14 of text

  22. Charitable Contributions (slide 2 of 6) • Contributions are generally deductible when the payment is made, both for cash and accrual basis taxpayers • Exception: Accrual basis corporations may deduct contribution in year of accrual if: • Authorized by the board of directors, and • Actually paid within 2 1/2 months of end of year

  23. Charitable Contributions (slide 3 of 6) • The deduction for a charitable contribution of property depends on the type of property contributed • Ordinary income property • Deduction generally is adjusted basis • Long-term capital gain property • Deduction generally is fair market value (FMV)

  24. Charitable Contributions (slide 4 of 6) • Exceptions for certain contributions of long-term capital gain property: • Basis (rather than FMV) is used if the property is tangible personal property and is put to an unrelated use by the donee • Basis (rather than FMV) is used for contributions to certain private nonoperating foundations

  25. Charitable Contributions (slide 5 of 6) • Deduction is equal to basis plus half of appreciation for contributions of certain types of property: • Inventory used solely for care of the ill, the needy, or infants • Scientific property donated to colleges and certain scientific research organizations for use in research

  26. Charitable Contributions (slide 6 of 6) • Corporate contribution deductions are limited to 10% of taxable income computed without regard to: • The charitable contribution deduction • Any NOL or capital loss carryback • The dividends received deduction • Individuals may be subject to limits of 20%, 30%, or 50% (see Chapter 15)

  27. Learning Objective 5 Recognize and apply the alternative tax treatments for research and experimental expenditures.

  28. Research & Experimental Expenditures (slide 1 of 2) • R & E expenditures are defined in the Regulations (see p. 4-17 in text) • Includes costs of developing a model, a plant process, a product, a formula, or an invention • Includes costs of improving an existing property of type mentioned above • Excludes costs for ordinary testing, quality control, efficiency surveys, etc

  29. Research & Experimental Expenditures (slide 2 of 2) • Alternative treatments for R & E expenditures: • Expense in the year paid or incurred • Defer and amortize over a period of not less than 60 months • Capitalize

  30. Other Expense Rules - Interest • Corporations may generally deduct all business interest incurred (unless associated with a passive activity) • Individuals may deduct some type of interest but not others • Deductible: business interest, home mortgage interest (to a limited extent), and investment interest (to a limited extent) • Not deductible: personal interest (unless the loan is secured by the taxpayer’s home)

  31. Other Expense Rules - Taxes (slide 1 of 2) • Taxes of all types incurred by business entities are generally deductible (unless incurred in a passive activity) • Most Federal taxes are not deductible

  32. Other Expense Rules - Taxes (slide 2 of 2) • Taxes incurred by individuals are generally deductible if related to business or investments • Taxes on realty and personalty generally are deductible, even if the property is for personal use • When real property is sold during the year, real estate taxes must be apportioned between the buyer and seller on the basis of days owned during the tax year

  33. Learning Objective 6 Determine the amount of cost recovery under MACRS, and apply the § 179 expensing election and the deduction limitations on listed property and automobiles when making the MACRS calculation.

  34. Depreciation vs. Cost Recovery Allowances • Depreciation rules applied to assets before 1980 and continue to apply to pre-1981 assets and certain assets placed in service after 1980 • The accelerated cost recovery system (ACRS) generally applied to assets acquired after 1980 and before 1987 • ACRS cost recovery lives were shorter than depreciation lives and used more accelerated methods

  35. MACRS (slide 1 of 2) • MACRS applies to post-1986 property • Depreciation and ACRS rules, which are applicable to pre-1987 property, are not covered in the text • Different cost recovery tables apply to personalty and realty • Realty includes land, buildings, etc. (real estate) • Personalty includes assets that are not realty (machines, equipment, furniture, etc.)

  36. MACRS (slide 2 of 2) • Trade or business or production of income assets are eligible for cost recovery • Assets that do not decline in value or have a determinable useful life are not eligible (e.g., land, antiques, stock) • Basis of property must be reduced by cost recovery allowed and by not less than the allowable amount • Basis for cost recovery of personal-use assets converted to business or income-producing use is the lower of adjusted basis or FMV at time property is converted

  37. MACRS - Personalty (slide 1 of 3) • Determine cost recovery period of asset (Exhibit 4-2, p. 4-24 in text) • Look up rate in appropriate table • Table 4-1 (Half-year convention) • Table 4-2 (Mid-quarter convention) • Table 4-4 (Straight-line election, half-year convention) • Multiply rate times basis • Generally, allowed 1/2 year of cost recovery in year of acquisition and disposition

  38. MACRS Personalty (slide 2 of 3) • Example 1 - Acquisition • Acme acquires a computer on 1/1/01 for $10,000 • 5-year property (see Exhibit 4-2) • Rate from Table 4-1 = 20% • Cost recovery allowance for 2001: $10,000 x 20% = $2,000 • Cost recovery allowance for 2002: $10,000 x 32% = $3,200

  39. MACRS Personalty (slide 3 of 3) • Example 2 - Disposition • Acme sells the computer on 1/1/03 for $6,000 • Half-year convention applies (half-year of cost recovery is allowed in year of disposition) • Cost Recovery Allowance for 2003: • $10,000 x 19.20% from Table 4-1 x 1/2 = $960 • Accumulated Cost Recovery Allowance: • [20% + 32% + (1/2 x 19.20%)] = ($2,000 + $3,200 + $960) = $6,160 • Basis is $10,000 - $6,160 = $3,840

  40. MACRS - Realty (slide 1 of 3) • MACRS for Post-1987 Realty • Based on SL method, mid-month convention • 27.5 year life for residential property • 39 year life for nonresidential property (31.5 year life from 1/1/87 through 5/12/93) • Multiply base x rate from Table 4-3

  41. MACRS - Realty (slide 2 of 3) • Example – Acquisition • Taxpayer acquires a warehouse for $100,000 on April 1, 2001 • 2001 Cost Recovery Allowance (CRA) • $100,000 X 1.819% from Table 4-3 = $1,819

  42. MACRS - Realty (slide 3 of 3) • CRA in year of disposition is based on the mid-month convention • Example – Disposition • Taxpayer disposes of above warehouse on October 1, 2002 • 2002 Cost Recovery Allowance • ($100,000 x 2.564%) [from Table 4-3] x (9.5/12) = $2,030

  43. Mid-Quarter Convention • Applies if > 40% of personalty is placed in service during last quarter of the year • Must group property by quarter acquired • Property acquired in1st quarter is allowed 10.5 months of cost recovery; 2nd quarter, 7.5 months; 3rd quarter 4.5 months; 4th quarter, 1.5 months • Use Table 4-2 (Mid-quarter convention)

  44. The MACRS Straight-Line Election (Personalty) • MACRS allows accelerated depreciation for personalty placed in service after 1986 (Table 4-1) • The taxpayer may elect straight-line depreciation for personalty placed in service after 1986 (Table 4-4) • Taxpayer may wish to take slower write-offs for various reasons (e.g., tax bracket is expected to be higher in later years)

  45. Election to Expense Assets Under § 179 (slide 1 of 3) Maximum amount allowed: 2000 $20,000 2001 or 2002 $24,000 2003 and thereafter $25,000

  46. Election to Expense Assets Under § 179 (slide 2 of 3) Example: Corporation buys a $100,000 truck (5-year property) on February 15, 2001 and elects immediate expensing of the maximum amount Cost of machine $100,000 § 179 deduction 24,000 Amount subject to ACRS $ 76,000 MACRS rate .20 Cost recovery allowance $ 15,200 • Total cost recovery allowed in 2001 is $39,200 ($24,000 + $15,200)

  47. Election to Expense Assets Under § 179 (slide 3 of 3) • Annual limitations on § 179 expense • The § 179 deduction is reduced dollar-for-dollar to the extent eligible property placed in service during the year exceeds $200,000 • The amount expensed under § 179 cannot exceed the aggregate amount of taxable income derived from the conduct of any trade or business by the taxpayer

  48. Limits on Autos and Other Listed Property (slide 1 of 6) • Limits on MACRS deductions apply to • Automobiles • Listed property (see next slide) used for both business and personal purposes • Types of limits • Restrictions on allowable cost recovery method (depends on predominant use); applies to autos and listed property • Dollar limits apply to autos

  49. Limits on Autos and Other Listed Property (slide 2 of 6) • Listed property includes: • Passenger automobiles • Certain other property used for transportation • Property used for entertainment, recreation, or amusement • Certain computer equipment and peripherals • Cellular phones and similar telecommunications equipment • Other property specified in the regulations

  50. Limits on Autos and Other Listed Property (slide 3 of 6) • Methods for determining cost recovery allowance • Statutory percentage method–may be used if property is predominantly (>50%) used for business; results in faster write-off than straight-line method • Straight-line method–required if property is not used predominantly for business

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