Module 9

1. Module 9 Business Deductions

2. Module Topics • Statutory Scheme for Deductions • §162 Business Deductions: The Basic Requirements • Prohibited Deductions • Deductions Common to Most Businesses • Special Deductions for Corporations • Capitalization Issues

3. Statutory Scheme for Deductions Key Learning Objective • Apply the three-tier expense deduction classification scheme

4. Tax Concept • No expenditure is deductible unless allowed by a provision in the tax law • Specifically authorized by the Code, or • Satisfies general criteria

5. General Criteria for Deductibility • Expense must be: • Ordinary, necessary, and reasonable in amount • Incurred in connection with a trade or business or in the production of income • Expense is not: • A capital expenditure • A personal expenditure • Related to tax-exempt income • Contrary to public policy

6. Deduction Classification Scheme • Trade or business deductions--§162 • Production of income deductions--§212 • Statutory personal deductions

7. Trade or Business Deductions(§162) • Must be ordinary and necessary and reasonable in amount • Profit must be primary motive of the activity • Net loss from “hobby” not deductible • Activity must be ongoing and entrepreneurial in nature

8. Production of Income Deductions (§212) • Must be ordinary and necessary and reasonable in amount • Must be for the: • Production or collection of income • Management, conservation, or maintenance of property held for the production of income • Determination, collection, or refund of any tax

9. Statutory Personal Deductions • §262 disallows the deduction of personal, living, or family expenses • Other Code sections allow deductions for specific items • e.g., medical expenses, charitable contributions, mortgage interest, state and local income taxes, property taxes (Module 27)

10. §162 Business Deductions: The Basic Requirements Key Learning Objective • Apply the ordinary, necessary, and reasonableness requirements for business deductions

11. Basic Requirements • Ordinary • Acceptable, given the circumstances • Necessary • Appropriate when incurred • Reasonable • Not lavish

12. Research Query: Political Office-A Trade or Business? • A senator's administrative assistant incurred expenses of more than $100,000 over a four- year period despite the fact his salary had been only $1,200 a year • Should he be allowed to deduct these as ordinary and necessary business expenses?

13. Solution--Research Query: Political Office-ATrade/BusinessFrank, Gerald v. U.S., (1978, CA9) 42 AFTR 2d 78-5309 • Performing functions of public office is a trade or business • No requirement that a public employee intends to earn a livelihood from his government job in order to deduct his expenses • Deductions were allowed

14. Paid or Incurred Requirement • Cash-basis taxpayers • Expenses deductible when paid • Prepayments extending beyond one year generally must be accrued • Accrual-basis taxpayers • Expenses deductible when incurred • All-events test • Economic performance test

15. Prohibited Deductions Key Learning Objective • Distinguish between allowable deductions and those which are prohibited

16. Prohibited Deductions • Expenditures in violation of public policy • Are fines, penalties, illegal bribes, etc. • Lobbying expenses • Influence legislation, public opinion, or political elections at the state or national level • Expenditures associated with tax-exempt income • Prevents arbitrage

17. Compliance Query: Which Illegal Business is Best? • T operates an illegal smuggling operation • T incurred the following expenses: Salaries $ 50,000 Illegal kickbacks 20,000 Bribes to U. S. border guards 25,000 Cost of goods sold 150,000 • How much is deductible if T smuggles • Guns • Drugs

18. Gun smuggler--treated like any other business. Cost of goods sold $150,000 Salaries 50,000 $200,000 Other items against public policy Drug smuggler--limited to cost of goods sold. Cost of goods sold $150,000 $150,000 Solution--Compliance Query: Which Illegal Business is Best?

19. Deductions Common to Most Businesses Key Learning Objective • Identify and compute common business deductions

20. Deferred Compensation-- Potential Benefits • Immediate deduction for employer • Nontaxable to employee until payments are received • Deferral of tax on earnings until funds are distributed • Reduced or deferred tax on lump-sum distributions

21. Deferred Compensation--Types(covered in later modules) • Qualified pension plans • Nonqualified plans • Fewer potential benefits • Keogh plans • SEPs • IRAs

22. Interest • Generally deductible if business related • Must capitalize construction period interest and taxes • Prepaid interest must be accrued • Related party borrowings • Accrual-basis payer and cash-basis payee • Imputed interest

23. Taxes • Generally deductible if business related • Sales taxes capitalized as part of cost • Employer portion of payroll taxes deductible • Federal income taxes not deductible

24. Charitable Contributions • Deductible by corporations subject to 10% limit • 5-year carryover for unused deductions • Amount deductible (basis or FMV) depends on type of property donated • “Ordinary income” or “capital gain” property • Special rules for certain inventory, scientific equipment, and tangible personal property

25. Business Gifts • Limited to $25 per donee per year • Special rules for safety or length of service awards to employees

26. Travel • Generally deductible if business related • Includes incidental expenses • “Away from home” requirement for meals and lodging • 50% limit for meals • Strict substantiation requirements

27. Research Query: Where is a Traveling Man’s Home? • An unmarried salesman who spends almost all of his time on the road keeps some stuff at his sister’s home. • Will be be treated as “away from home” and entitled to deduct travel expenses if • He pays his sister a fair rent for the room? • He has free use of the room?

28. Solution--Research Query: A Traveling Man’s Tax Home • He is “away from home” and entitled to deduct travel expenses if he rents a room in his sister's home to use whenever he wants to and he pays his sister. • Sapson, Irving, (1968) 49 TC 636, acq(1973) 1973-2 CB 3 39 • IRS doesn't allow “away from home” treatment if the salesman pays no rent • Rev Rul 73-529, 1973-2 CB 37

29. Entertainment • Deductible if “directly related to” or “associated with” active conduct of business • 50% limit • Cost of entertainment facilities generally not deductible • No deduction for club membership dues • Strict substantiation requirements

30. Special Deductions for Corporations Key Learning Objective • Calculate deductions for corporate organizational costs and dividends received

31. Organization Costs • Includes first year attorney, accountant, and filing fees, etc., related to corporate formation • Does not include costs of issuing stock • Not currently deductible • Can capitalize and amortize over 60 months • Must make election

32. Dividend Received Deduction • Mitigates triple taxation • Applies generally to dividends from domestic corporations • Percent deductible (70%; 80%; 100%) depends on ownership percentage • Taxable income limitation may apply

33. Capitalization Issues Key Learning Objective • Classify expenditures that contain both repair and capitalization attributes

34. Issues • Deductible repair or capital expenditure? • Not always clear-cut • The Indopco decision • Creation of a separate asset is not a necessary condition for capitalization • Future benefit key factor for capitalization • Environmental cleanup costs • Present or future benefit? • Generally must capitalize

35. Research Query:Capital Expenditure or Repair? • The taxpayer’s road has several potholes. What are the tax consequences of each of the following alternatives? • Replacing gravel driveway with a cement driveway • Recrowning and resurfacing with the same materials

36. Solution--Research Query: Capital Expenditure or Repair? • Replacing gravel driveway with a cement driveway will be treated as a capital expenditure. • Jones, A. Raymond, (1956) 25 TC 1100 • Recrowning and resurfacing with the same materials should be a deductible repair. • Pennock Plantation Inc, (1951) PH TCM ¶51341