2013 cch basic principles ch06

Chapter 6

Deductions: General Concepts

and Trade or Business

Deductions©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com

CCH Federal Taxation Basic Principles 2 of 43

1. Classification of Deductions

2. Classification: “For” vs. “From” AGI

3. Trade or Business Expenses

4. Production of Income Deductions

5. Deductions for Losses

6. Other Allowable Deductions “For” AGI

7. Business Investigation and Start-Up Expenses

8. Deductibility of Business Investigation and Start-Up Expenses

9. Job Seeking Expenses

Chapter 6, Exhibit Contents A

Chapter 6 Exhibits


10. Business Gifts11. Travel & Transportation Expenses12. Moving Expenses13. Student Loan Interest—Qualified Education Expenses14. Student Loan Interest15. Qualified Education Expenses Deduction16. Health Insurance, HSAs, MSAs17. Employee Business-Related Expenses18. Employee v. Self-Employed19. Limitations on the Deductibility of Expenses and Losses

Chapter 6, Exhibit Contents B

Chapter 6 Exhibits


20. Other Limitations on the Deductibility of Expenses and Losses21. Business Deductions Related to Capital Expenditures 22. Depreciation of Tangible Property23. MACRS Depreciation of Tangible Property24. Limitations on Depreciation of Automobiles25. Depreciation Code Sec. 179 Election26. Bonus Depreciation Reintroduced by the Tax Relief, Unemployment Insurance

Reauthorization and Job Creation Act of 201027. Amortization28. Research and Experimental (R & E)29. Depletion

Chapter 6, Exhibit Contents C

Chapter 6 Exhibits


Classification of DeductionsThere are 4 categories of tax deductions allowed to individual taxpayers.

1. Trade or business deductions are generally deductible FOR AGI.

2. Deductions incurred for the production of income are generally deductible FROM AGI as miscellaneous itemized deductions subject to the 2% floor.

3. Deductions for losses incurred on the sale of business or investment assets are generally deductible FOR AGI (though they may be subject to capital loss limitation).

4. Personal expenses are generally NOT deductible unless expressly permitted. Allowable personal deductions, such as medical expenses, are deductible as itemized deductions, subject to various limitations.

Chapter 6, Exhibit 1


Classification: “For” vs. “From” AGI

Deductions “for” AGI are subtracted from income in calculating adjusted gross income These deductions often reduce earned income subject to self-

employment taxes as well In addition, state income taxes are often based on federal AGI Many tax benefits are available only for taxpayers whose AGIs

do not exceed specified levels (e.g., ability to contribute to Roth IRA, ability to deduct student loan interest, etc.)

Deductions “from” AGI are subtracted from AGI itself in computing taxable income This category of deductions is generally allowed as an alternative

to the standard deduction Deductions “from” AGI are often subject to limitations

calculated as a percentage of AGI



Business expenses are generally deductible without limitation when the following criteria are met:

1. Related to carrying on trade or business activity – taxpayer must demonstrate commitment to and substantial involvement in the activity and must have a legitimate profit motive.

2. Ordinary and necessary – commonly incurred by other businesses (not necessarily your own) and appropriate for a particular business.

3. Reasonable in amount. This is of main concern to closely held corporations, particularly regarding officers’ salaries. One way to substantiate reasonableness is by presenting documentation of similar expenses by comparable businesses.

Chapter 6, Exhibit 3a

Trade or Business Expenses


Trade or Business Expenses

4. Expense must be paid or incurred during the taxable year:

Expenses not deductible until paid for cash method taxpayers

Accrual method taxpayers generally must demonstrate that expense has been economically incurred

Cash method taxpayers face limitations on deductibility of prepaid expenses

Property taxes must be allocated between seller and buyer in year property is sold

Deduction for business bad debts allowed on partial worthlessness of debt

No deduction for non-business bad debts until debt is wholly worthless

Chapter 6, Exhibit 3b


Production of Income Deductions

Production of income expenses are generally deductible FROM AGI as miscellaneous itemized deductions, to the extent they exceed 2% of AGI.

Production of income expenses are related to the production of non business income, such as investment expenses and tax planning and compliance expenses.

They must meet the same criteria for deductibility as trade or business expenses, except they do not have to relate to a trade or business.



Production of Income Deductions

The following is a list of typical production of income expenses which are deductible FROM AGI.

Safe deposit box rentals Subscriptions to investment related journals and newspapers Legal and accounting fees related to investments Cost of having a tax return prepared by a CPA Tax planning expenses Tax advice for divorce proceedings

There is an exception for expenses associated with the productionof rent and royalty income, which are deductible FOR AGI.



Deductions for Losses

For individual taxpayers, losses are restricted to the following (subject to limitations):

1. Business losses (including casualty and theft). 2. Investment losses.3. Personal casualty and theft losses.

Business and investment losses are deductible FOR AGI, while personal casualty and theft losses are deductible FROM AGI.

Business losses generally reduce ordinary income, while investment losses are classified as capital losses subject to more stringent limitations.

To be deductible, losses must be realized during the year and not compensated by insurance.



Other Allowable Deductions “For” AGI

Business investigation & start-up costs Business gifts Transportation expenses Travel expenses Moving expenses Student loan interest and qualified tuition expenses Health insurance premiums for self-employed taxpayers Contributions to Health Savings Accounts Manufacturing deduction



Type of Expense

Investigation Expenses Start-Up Expenses

Definition Expenditures that help determine whether to create or buy a business

Pre-operational costs

Timing Occur before a decision to make or buy is reached

Occur after a "go for it" decision is reached, but before the doors open for business

Examples Travel, marketing surveys, legal, accounting, and engineering

Employee training and stationery

Business Investigation and Start-Up Expenses



Type Pursue business? Decline?

Business Investigation Expenses

Similar business Deductible in the year paid or incurred.

New business $5,000 can be expensed, the remainder is capitalized and amortized over 180 months


New business Not deductible or capitalized, but lost

Business Start-up Expenses


New business $5,000 can be expensed, the remainder is capitalized and amortized over 180 months

N/A – if taxpayer declines to pursue the opportunity, there will be no start-up costs, only investigation expenses.

Deductibility of Business Investigation and Start-Up Expenses



Business Gifts

Deduction limited to $25 per client/customer Inexpensive (< $4) tokens not treated as gifts if taxpayer’s

name or business name is permanently imprinted on item. Promotional materials to be used on business premises not

treated as gifts Employment service/achievement awards not treated as

gifts if value < $400



Self-employed taxpayers – deductible “for” AGI Employees – deductible as miscellaneous itemized deductions

if qualified: Not reimbursed by employer “Temporarily” away from home (> 1 night; < 1 year) Travel between work sites during work day

No deduction for commuting expenses, regardless of distance


Travel & Transportation Expenses


Travel & Transportation Expenses

Deductible Expenses include: Lodging & meals (subject to 50% limit). Airfare, automobile expenses, etc.

For automobile expenses, taxpayer may choose standard mileage allowance rather than actual costs. For 2012, the mileage rate is 55.5 cents per mile.

Tax “home” is geographic location where taxpayer works.



Moving ExpensesMoving expenses are deductible FOR AGI.

Qualified moving expenses.

1. Transporting household goods and personal effects2. Traveling from old residence to new residence3. Lodging during the move

Nonqualified moving expenses.

1. Pre-move house hunting 2. Temporary living quarters at new location 3. Meals during a qualified move

4. Real estate commissions on sale of old residence



Time Requirement for the Moving Expense Deduction

Self-Employed Employee

Work full time at new job > 39 weeks during first 12 months, AND

Work full time at new job > 78 weeks during first 24 months

Work full time at new job > 39 weeks during first 12 months


Moving Expenses


Distance Requirement for the Moving Expense Deduction

If the move is due to a relocation:

Distance from the old residence to the new job must be

50 miles further than the

Distance from the old residence to the old job.

Chapter 6, Exhibit 12c

Moving Expenses


Student Loan InterestQualified Education Expenses

Tax Treatment. Deductible “for” AGI. Thus, a student can claim the student loan interest deduction even if the standard deduction is used.

Deductible Limitation: $2,500 for student loan interest up to $4,000 qualified tuition & fees

Qualified Student Loans. To be eligible for the deduction, the education loan must be used solely to pay for any of the following expenses: tuition, student activity fees, room and board, books and supplies, and other related expenses.



Student Loan Interest

N/AN/AN/AMarried filing separately

$30,000$150,000$120,000Married filing jointly

$15,000$75,000$60,000Single, head of household, surviving spouse

Phaseout RangeCeilingFloor

Threshold for Modified AGIFiling Status

Phaseout of Student Loan Interest Deduction



Qualified Education Expenses Deduction

Amount of deduction depends on taxpayer’s filing status and income: Single taxpayers:

AGI < $65,000 $4,000 AGI > $65,000, < $80,000 $2,000 AGI > $130,000 zero

Married taxpayers: AGI < $130,000 $4,000 AGI > $130,000, < $160,000 $2,000 AGI > $160,000 zero

Married filing separate return – no deduction allowed



Health Insurance and HSAs

Self-employed taxpayers allowed to deduct health insurance premiums “for” AGI

Self-employed taxpayers and small employers (< 50 employees) with “high deductible” insurance may deduct contributions to health savings accounts of up to $6,250 for 2012 ($3,100 if taxpayer has “self-only” high deductible medical insurance).

Neither earnings nor qualified distributions of HSAs are taxable.



Employee Business-Related Expenses

If an individual is an employee, unreimbursed employment expenses are deductible as miscellaneous itemized deductions, to the extent they exceed 2% of the taxpayer’s AGI.

The following are examples of typical employment related expenses deductible as miscellaneous itemized deductions:

Professional society duesSubscriptions to professional journalsTravel expensesHome office expenses

Note: Commuting expenses incurred going to and from work are not deductible. However, the expenses of going from one job to another job on the same workday are deductible.



Employee v. Self-Employed

Independent contractors sell services to the public, and are considered self-employed. All trade or business expenses are deductible FOR AGI.

The following criteria should be considered when determining if an individual is an employee or self-employed:

1. Does the individual work for many clients, or just one?2. Does the individual make services available to the public?3. Does the individual determine work hours and schedules?4. Does the individual received payments from one firm, or many

firms?



Limitations on the Deductibility of Expenses and Losses

Hobby expenses and losses – expenses deducted to extent of income only

Personal expenses and losses – generally not deductible, unless specifically authorized by Code

No deduction for expenses that frustrate public policy: Fines or penalties paid to government Illegal kickbacks, bribes, and other illegal payments Illegal trafficking in controlled substances (although

expenses incurred in other illegal businesses are generally deductible)



Lobbying – expenses deductible only if incurred to influence legislation at local level in which taxpayer has direct interest (e.g., local business lobbying city officials on local zoning laws)

Political contributions – no deduction Meals & entertainment – fifty percent deductible for expenses

“directly related to” or “associated with” taxpayer’s business, if such expenses are substantiated.




Meals and Entertainment

Tax Treatment

Self-Employed Individuals Nonreimbursed Employees

50% deductible 50% deductible, and limited to the 2% AGI floor

“For” AGI “From” AGI as a miscellaneous itemized deduction




Other Limitations on the Deductibility of Expenses and Losses

Expenses and interest related to tax-exempt income are not deductible (because income is not taxable)

Transactions between related parties: Losses not deductible, but may be used to offset gain

subsequently realized by buyer on “re-sale” of property Payment by accrual method taxpayer to related cash method

taxpayer may not be deducted by payer until tax year in which recipient reports payment in income.

No deduction allowed for payment of expenses of another (e.g., payment by shareholder of corporate business expense).



Business Deductions Related to Capital Expenditures

Capital expenditures are expenditures that will benefit more than one tax year. Generally, capital expenditures do not qualify as deductions in the year the expenditure is made, but must be allocated to the tax years expected to benefit from the expenditure.

Tangible capital expenditures placed in service for business or investment purposes after 1986 should be depreciated using MACRS depreciation.

Tangible property placed after 1980 and before 1987 should be depreciated using ACRS depreciation.



Depreciation of Tangible Property

Personal property refers to the physical nature of the property. It means that the property is mobile.

This is different than “Personal-use” property which refers to the function of property. This is property held for the taxpayer’s own enjoyment.

Real property also refers to the physical nature of the property. It means the property is immobile.



MACRS Depreciation of Tangible Property

Class of property

Personal property is divided into 6 classes:

3-year, 5-year, 7-year, 10-year, 15-year and 20-year property.

Real property is divided into 3 classes:

27.5-year residential rental property

39-year non-residential real property (ex. office buildings)

50-year property railroad gradings and tunnel bores




Depreciation method

200% declining balance applies to 3-year, 5-year, 7-year and 10-year classes of property.

150% declining balance applies to 15-year and 20-year classes of property.

Straight-line is used for 27.5-year and 39-year classes of property. Do not consider salvage value.




Convention

A half-year convention applies to personal property. Under this convention, property placed in service (or disposed of) during the tax year is considered placed in service (or disposed of) at the midpoint of the tax year.

A mid-month convention applies to real property. Under this convention, property is considered placed in service (or disposed of) in the middle of the month for the first month of service and the last month of service.



Convention

A mid-quarter convention applies when more than 40% of the cost of all personal property is placed in service during the last quarter of the taxable year. Under the mid-quarter convention, personal property is treated as placed in service (or disposed of) in the middle of the quarter.

In determining whether 40% of the aggregate basis of MACRS property is placed in service during the last 3 months of the tax year, property placed in service and disposed of within the same tax year is disregarded.


Chapter 6, Exhibit 23d


Limitations on Depreciation of Automobiles

Depreciation (including Code Sec. 179 deduction) for cars purchased in 2012 limited to:

Passenger Cars Trucks and Vans

First year $3,060 $3,260

Second year $4,900 $5,200

Third year $2,950 $3,150

Subsequent years $1,775 $1,875



Depreciation Code Sec. 179 Election

For 2012, an election may be made to expense up to $139,000 of tangible personal property used in a trade or business, rather than capitalize and depreciate it.

Phaseout. The expense allowance is phased out on a dollar-for-dollar basis for purchases exceeding $560,000.



Bonus Depreciation Reintroduced by the Tax Relief, Unemployment Insurance Reauthorization and Job

Creation Act of 2010 Bonus Depreciation

2011 – 100% 2012 – 50%

First year Code Sec. 280F limitation increased by $8,000 Sec. 179 deduction for autos between 6,000 and 14,000

pounds -- $25,000 Relevant only for 2012 (100% bonus allowed for 2011) No limit on depreciation or 179 for vehicles weighing more

than 14,000 pounds



Amortization

Amortizable property is intangible property that is used for business and is of limited life. For example, goodwill, going-concern value, licenses, covenants not to compete, franchises, trademarks, patents, and copyrights.

Method. Straight-line method over 15 years. (Code Section 197).



Research and Experimental (R & E)

Qualifying expenditures. Experimental and laboratory costs for pilot models, plant processes, products, formulas, inventions, or similar properties. These costs include R&E salaries.

Non qualifying expenditures. Ordinary testing or inspection of materials or products for quality control, management studies, consumer surveys, advertising, or promotions.

Tax treatment. R&E expenditures may be expensed immediately, or if elected, amortized over a minimum of 5 years.



Depletion

There are 2 methods available to compute the depletion deduction. The taxpayer should compute the proper deduction under both methods and claim the deduction that is higher.

Cost depletion method

Cost of natural resources excluding land x (Number of units Recoverable units recovered AND sold)

% depletion method

Statutory % x Gross income from natural resource*

*Gross income equals revenues without regard to cost of sales



Limitation of % Depletion

Oil and gas properties: 100% of taxable income from natural resources BEFORE depletion.

Other natural resources (copper and gold): 50% of taxable income from natural resources BEFORE depletion.


Depletion

2013 cch basic principles ch06

Technology

miscellaneous

tangible property

moving expense

allowable

real property

tax relief

personal casualty

business investigation