[PPT]Chapter 6: Deductions and Losses - Pearson Educationwps.prenhall.com/wps/media/objects/9603/9833873/ppt_ind/... · Web viewClassifying Deductions as for vs. from Adjusted Gross

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DEDUCTIONS AND LOSSES

(1 of 2)

Classifying deductions as for vs. from adjusted gross income

Criteria for deducting business and investment expenses

General restrictions on the deductibility of expenses

Proper substantiation requirement

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DEDUCTIONS AND LOSSES

(2 of 2)

When an expense is deductibleSpecial disallowance rulesTax planning considerationsCompliance and procedural

considerations

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Classifying Deductions as for vs. from Adjusted

Gross Income (1 of 3)

For AGITaxpayer benefits from deduction

even if she claims the standard deduction

Reduces AGI: +/- benefits for taxpayer+ Many deductions and credits

phased out above certain AGI thresholds

+ Reduces AGI floors for certain categories of itemized deductions

- Reduces certain deduction ceilings©2011 Pearson Education, Inc. Publishing as Prentice

Hall

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Classifying Deductions as for vs. from Adjusted

Gross Income (2 of 3)

Most common deductions for AGITrade or business expensesIRAsAlimonyLosses on sale of bus/invest

propertyMoving expensesInterest paid on qualified education

loans1/2 of self-employment tax Health insurance paid by self-

employeds

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Classifying Deductions as for vs. from Adjusted

Gross Income (3 of 3)

From AGIItemized deduction only will have

tax benefit if total deductions exceed the taxpayer’s standard deductionDeduct the higher of the standard

deduction or sum of itemized deductions

Phaseout of itemized deductions scheduled to resume in 2011 at a 3% rateFate of phaseout for 2010 still

uncertain.

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Criteria for Deducting Business and Investment

ExpensesBusiness or investment

requirementOrdinary expenseNecessary expenseReasonable expenseExpenses and losses must be

incurred directly by the taxpayer©2011 Pearson Education, Inc. Publishing as Prentice

Hall

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Business or Investment Requirement (1 of 2)

Activity engaged in for profitUse facts and circumstances test

Trade or business (ToB) vs. investment classificationToB losses are ordinary losses

ToB expenses are for AGIInvestment losses are capital

Investment expenses are from AGISubject to 2% of AGI floor

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Business or Investment Requirement (2 of 2)

Losses and expenses related to rents and royalties are for AGI deductions

Legal and accounting feesFor AGI deduction for ToB if incurred

in ordinary course of businessFees related to taxes also for AGI for ToB

Nonbusiness fees related to taxes from AGI deduction subject to 2% of AGI floor

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Ordinary ExpenseTo be ordinary, an expense must

beReasonable in amountBear reasonable proximate

relationship to income-producing activity or property

Must be customary or usual course of a particular industry or business community©2011 Pearson Education, Inc. Publishing as Prentice

Hall

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Necessary ExpenseAn expense is considered

necessary if it is “appropriate and helpful” in the taxpayer’s business

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Reasonable ExpenseProblems often occur with

salaries for shareholder-employees of closely held businesses

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Expenses and Losses Must Be Incurred Directly by the

TaxpayerGenerally, a taxpayer cannot

take a deduction for a loss or expense of another person

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General Restrictions on the Deductibility of

ExpensesCapitalization vs. expense

deductionExpenses related to exempt

incomeExpenditures that are contrary

to public policyOther expenditures specifically

disallowed©2011 Pearson Education, Inc. Publishing as Prentice

Hall

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Capitalization vs. Expense Deduction

General capitalization requirements

Election to deduct currentlyE.g, certain research and

experimental expenditures, cost of qualified tangible personal property

Capitalization of deduction itemsE.g., carrying charges on

unproductive unimproved real estate

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Expenses Related to Exempt Income

Deduction disallowed because related income is not taxable

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Expenditures that Are Contrary to Public Policy

Cannot deduct illegal payments or payment resulting from an illegal actFines and penaltiesBribes and Kickbacks

Expenses from an illegal trade or business are deductibleIf taxpayer reports income from

activity©2011 Pearson Education, Inc. Publishing as Prentice Hall

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Other Expenditures Specifically Disallowed (1 of 2)

Political contributions and lobbying expenses

Business investigation and preopening expensesInclude investment expenses May immediately expense up to

$5,000 Deduction phased out $ for $ if >

$50,000©2011 Pearson Education, Inc. Publishing as Prentice

Hall

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Other Expenditures Specifically Disallowed (2 of 2)

Business investigation and preopening expenses (continued)Amortize remainder over 180

months beginning when business commencesNo amortization if business not

begun

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Proper Substantiation Requirement (1 of 2)

The taxpayer has the burden of proof

The Cohan ruleCertain expenses may be

estimatedMore restrictive substantiation

requirements for travel, entertainment, business gifts

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Proper Substantiation Requirement (2 of 2)

Documentation requirements for travel, entertainment, gifts, etc.AmountTime and place (T & E)Date and description of giftBusiness purposeBusiness relationship

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When an Expense Is Deductible

Cash Method (1 of 2)

Generally deductible when actually paid

Prepaid expensesNo current deduction if

expenditure creates an asset with a life substantially beyond end of tax year

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When an Expense Is Deductible

Cash Method (2 of 2)

Prepaid interestAmortize over period of loan to

which interest charge is allocatedPoints deductible over life of loan

Points paid in connection with purchase of principal residence currently deductible

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When an Expense Is Deductible

Accrual Method (1 of 2)

Allowed to deduct expenses in period in which expenses accrue under all-events test & economic performance testAll-events test met

When amount of liability is established

Amount of liability is determined with reasonable accuracy©2011 Pearson Education, Inc. Publishing as Prentice

Hall

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When an Expense Is Deductible

Accrual Method (2 of 2)

Economic performance test is metWhen economic performance is deemed to occur

See Topic Review 3

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Special Disallowance Rules

Wash salesTransactions between related

partiesHobby lossesVacation homeExpenses of an office in the

home©2011 Pearson Education, Inc. Publishing as Prentice

Hall

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Wash SalesWash sales occurs when

“substantially identical” stock or securities acquired by taxpayer within a 61 day periodExtends from 30 days before date

of sale to 30 days after date of saleLoss on wash sale disallowed

Disallowed loss added to basis of recently purchased stock or securities

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Transactions between Related Parties (1 of 2)

§267 defines related partiesLoss on transaction between

related parties disallowedDisallowed loss may be used to

offset gain from subsequent sale to unrelated party

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Transactions between Related Parties (2 of 2)

Unpaid expensesAccrual basis taxpayer cannot

deduct expense to cash basis related party until cash basis party recognizes payment as income

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Hobby Losses(1 of 3)

Activity has more personal attributes than profit motiveIRS factors to determine profit

motiveActivity conducted in businesslike

mannerTime and effort expendedExpected asset appreciationTaxpayer’s success in similar

activitiesProfits earned and profit historyTaxpayer’s financial status

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Hobby Losses(2 of 3)

Profit motive assumed if activity profitable in 3 of 5 years

Three tiers of expenses1 – Deductible even if no hobby

exists2 – Deductible if activity was for

profitBut do not reduce basis of any assets

3 – Deductible if activity was for profit

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Hobby Losses(3 of 3)

Deductible hobby expensesHobby-related expenses

deductible up to gross income of hobby activity

Deductible as miscellaneous itemized deductions subject to 2% of AGI floorSpecial order of the deductions

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Vacation HomeDeductions on vacation home may

be limited or disallowedVacation home if personal use

greater of 14 days, or 10% of # of days property used as rental

Expenses allocated based on days of use

Property rented < 15 daysNo taxable income and no deductions©2011 Pearson Education, Inc. Publishing as Prentice

Hall

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Expenses of an Office in the Home

Office in the home expenses deductible only if office regularly and exclusively used for business ANDPrincipal place of taxpayer’s

business,Place where taxpayer meets with

clients,OR a separate structure from

houseEmployees must also use office

for convenience of employer

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Tax Planning Considerations

Hobby lossesControl timing of hobby losses

Unreasonable CompensationIf IRS feels that a salary payment

to an officer is excessiveOften recharacterize excess portion

as a dividend Timing of deductions

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Compliance and Procedural

Considerations (1 of 2)

Schedule C for sole proprietorship

Schedule E for rents and royalties

Other investment expenses reported on Schedule A Proper substantiationIRS scrutinyStatutory requirements

Travel and entertainment are of particular interest to the IRS

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Compliance and Procedural

Considerations (2 of 2)

Business vs. hobby Form 8829 to claim home office

deduction on Schedule CForm 2106 to claim home office

deduction by employeesTaxpayer may be willing to extend

statute of limitation’s period to prove profit motive by filing Form 5231 ©2011 Pearson Education, Inc. Publishing as Prentice

Hall

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