6
Deductions Chapter and Losses: In General
Comprehensive Volume
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
1
Deductions
Exclusive definition of deductions
Deductions are allowed based on legislative grace and defined narrowly Substantiation requirements
Taxpayer has burden of proof for substantiating all expenses deducted on return Thus, adequate records of expenses must be maintained
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
2
Deductions for and from AGI (slide 1 of 3)
Deductions for AGI
Can be claimed even if taxpayer does not itemize Important in determining the amount of certain itemized deductions
Certain itemized deductions are limited to amounts in excess of specified percentages of AGI
e.g., Medial expenses (7.5% of AGI), misc. itemized deductions ( 2% of AGI)
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
3
Deductions for and from AGI (slide 2 of 3)
Deductions from AGI:
In total, must exceed the standard deduction to provide any tax benefit Called below the line or itemized deductions
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
4
Deductions for and from AGI (slide 3 of 3)
Comparison of deductions for and from AGI (2010 tax year)
Single taxpayer has gross income of $45,000 and a $6,000 deduction
Gross income Less: for AGI ded. AGI Less: from AGI ded. Less: personal exempt. Taxable income For AGI $45,000 6,000 $39,000 5,700 3,650 $29,650 6,000 3,650 $35,350 From AGI $45,000 0 $45,000
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
5
Deductions for AGI
(slide 1 of 3)
Partial list includes:
Trade or business expenses Reimbursed employee business expenses Deductions from losses on sale or exchange of property Deductions from rental and royalty property Alimony One-half of self-employment tax paid
6
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Deductions for AGI
(slide 2 of 3)
Partial list includes:
100% of health insurance premiums paid by a selfemployed individual Contributions to pension, profit sharing, annuity plans, IRAs, etc. Penalty on premature withdrawals from time savings accounts or deposits Moving expenses
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
7
Deductions for AGI
(slide 3 of 3)
Partial list includes:
Interest on student loans Qualified tuition and related expenses under 222 Up to $250 for teacher supplies for elementary and secondary school teachers
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
8
Deductions from AGI
Itemized deductions include:
Medical expenses (in excess of 7.5% of AGI) Certain state and local taxes Contributions to qualified charitable organizations Personal casualty losses (in excess of 10 % of AGI and a $100 floor per casualty) Certain personal interest expense (e.g., mortgage interest on a personal residence) Miscellaneous itemized deductions (in excess of 2% of AGI)
9
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Trade or Business Deductions
(slide 1 of 2)
Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including:
Reasonable salaries paid for services Expenses for the use of business property One-half of self-employment taxes paid
Such expenses are deducted for AGI
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
10
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
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
11
Section 212 Expenses (slide 1 of 2)
Section 212 allows deductions for ordinary and necessary expenses paid or incurred for the following:
The production or collection of income The management, conservation, or maintenance of property held for the production of income Expenses paid in connection with the determination, collection, or refund of any tax
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
12
Section 212 Expenses (slide 2 of 2)
212 expenses that are deductions for AGI include:
Expenses related to rent and royalty income Expenses paid in connection with the determination, collection, or refund of taxes related to the income of sole proprietorships, rents and royalties, or farming operations
All other 212 expenses are itemized deductions (deductions from AGI)
For example, investment-related expenses (e.g., safe deposit box rentals) are deductible as itemized deductions attributable to the production of investment income
13
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Business And Nonbusiness Losses
Deductible losses of individual taxpayers are limited to those:
Incurred in a trade or business, Incurred in a transaction entered into for profit
Individuals may also deduct casualty losses from fire, storm, shipwreck, and theft
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
14
Methods of Accounting
The method of accounting affects when deductions are taken
Cash: expenses are deductible only when paid 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
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
15
Disallowance Possibilities
The tax law disallows the deduction of certain types of expenses for a variety of reasons
e.g., May restrict taxpayer attempts to deduct certain items that, in reality, are personal expenditures
Certain disallowance provisions are a codification or extension of prior court decisions
e.g., After courts denied deductions for payments in violation of public policy, tax law was changed to provide specific authority for the disallowance
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
16
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, two-thirds of treble damage payments for violation of anti-trust law
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
17
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 officers legal fees in defending against price-fixing charges e.g., Landlords legal fees associated with eviction of tenant
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
18
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
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
19
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
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
20
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
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
21
Excessive Executive Compensation
An additional limitation applies only to covered executives of companies receiving Troubled Asset Relief Program (TARP) assistance
The deduction for compensation paid to a covered executive is limited to $500,000 Covered employees include the CEO, the CFO, and the three other most highly compensated officers
(slide 2 of 2)
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
22
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
23
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Investigation Of A Business
(slide 2 of 3)
If the taxpayer in is 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
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
24
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-fordollar reduction must be made for those expenses in excess of $50,000
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
25
Hobby Losses (slide 1 of 8)
Hobby defined
Activity not entered into for profit
Personal pleasure associated with activity Examples: raising horses, fishing boat charter
If an activity is not engaged in for profit, the hobby loss rules apply
Hobby expenses are deductible only to the extent of hobby income
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
26
Hobby Losses (slide 2 of 8)
Profit activity
If activity is entered into for profit, taxpayer can deduct expenses for AGI even in excess of income from the activity
At-risk and passive loss rules may apply
Often it is difficult to determine if an activity is profit motivated or a hobby
Regulations provide nine factors to consider in making this determination
27
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Hobby Losses (slide 3 of 8)
Presumptive rule of 183
If activity shows profit 3 out of 5 years (2 out of 7 years for horses), the activity is presumed to be a trade or business rather than a personal hobby
Rebuttable presumption, shifts burden of proof to IRS
Otherwise, taxpayer has burden to prove profit motive
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
28
Hobby Losses (slide 4 of 8)
Year Income (loss) Hobby?
2004 2005 2006 2007 2008 2009 2010
$500 (1,500) 700 (1,000) 900 (500) 1,200
Yes Yes Yes Yes No, profit 3 of 5 years Yes, profit only 2 of 5 years No, profit 3 of 5 years
29
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Hobby Losses (slide 5 of 8)
If an activity is deemed to be a hobby
Can only deduct expenses to extent of income from activity (i.e., cannot deduct hobby losses)
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
30
Hobby Losses (slide 6 of 8)
If an activity is a hobby:
Expenses are deductible from AGI
Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation Exception: expenses that are deductible without regard to profit motive are deductible in full, such as
Home mortgage interest Property taxes
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
31
Hobby Losses (slide 7 of 8)
Order in which hobby expenses are deductible:
First: Those otherwise deductible: e.g., home mortgage interest and property taxes Then: Expenses that do not affect adjusted basis: e.g., maintenance, utilities Then: Expenses that affect adjusted basis: e.g., depreciation (or cost recovery)
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
32
Hobby Losses (slide 8 of 8)
Example of hobby expenses: Taxpayer sells
horses raised as a hobby for $15,500
Amount Income Interest Taxes Vet Bills Feed Depreciation Total
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Order
Amount
$15,500 6,000 3,000 2,000 4,000 1,000 1 1 2 2 3 $ 6,000 3,000 2,000 4,000 Ltd. to 500 15,500
33
Rental Vacation Homes
(slide 1 of 9)
May have both personal and rental use of a vacation home Deduction of rental expenses may be limited to rental income if primarily used for personal purposes Determination of vacation home treatment is dependent on personal use vs. rental use
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
34
Rental Vacation Homes
(slide 2 of 9)
Rental days
Less than 15 days: No gross income recognized from rentals and no deductible rental expenses
Mortgage interest and property taxes treated as if on personal residence (generally deductible in full)
More than 14 days: Treatment depends on amount of personal use
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
35
Rental Vacation Homes
(slide 3 of 9)
Primarily rental use
If rented for 15 days or more and personal use days NOT more than the greater of 14 days or 10 percent of fair rental days Can deduct all expenses allocated to rental use even if loss results
Rental loss subject to at-risk and passive loss rules
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
36
Rental Vacation Homes
(slide 4 of 9)
Personal/rental use
If rented for 15 days or more and personal use days exceed the greater of 14 days or 10 percent of fair rental days Treated similar to hobby
Rental expenses deducted in three step process No rental loss allowed Carryforward of disallowed rental expenses
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
37
Rental Vacation Homes
(slide 5 of 9)
Example of personal use
Rental days: 200 (10% = 20) Personal use 7 days 18 days 25 days Not Significant X X Significant
X
38
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Rental Vacation Homes
(slide 6 of 9)
Example of personal use
Rental days: 100 (10% = 10) Personal Use 7 days 14 days 18 days Not Significant X X Significant
X
39
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Rental Vacation Homes
(slide 7 of 9)
Allocation of expenses between personal and rental
Mortgage interest and real estate taxes
IRS requires allocation based on total days used Courts have allowed allocation based on days in year
Other expenses are allocated based on total days used
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
40
Rental Vacation Homes
(slide 8 of 9)
Tax treatment of income and expenses of a primarily rental vacation home
Rental income included in gross income Rental expenses deductible for AGI Rental income and expenses reported on Sch. E
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
41
Rental Vacation Homes
(slide 9 of 9)
Treatment of allocated personal portion of vacation home expenses
Primarily rental use: taxes deductible from AGI, mortgage interest nondeductible (personal interest) Personal/rental use: mortgage interest and taxes deductible from AGI Personal portion of other expenses (e.g., insurance, maintenance) nondeductible
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
42
Expenditures Incurred for Taxpayers Benefit or Obligation
No deduction is allowed for payment of another taxpayers expenses
Must be incurred for taxpayers benefit or arise from taxpayers obligation Exception: Payment of medical expenses for a dependent
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
43
Personal Expenditures
Unless otherwise provided in the Code, personal expenses are not deductible
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
44
Capital Expenditures
Amounts are capitalized Asset may be subject to depreciation (or cost recovery), amortization, or depletion
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
45
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 and entity relationships apply Constructive ownership rules apply Loss disallowed may reduce gain on subsequent disposition to unrelated third party
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
46
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
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
47
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
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
48
If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA [e-mail] SUNY Oneonta
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
49