Ten
H
CERTAIN H
Chapter BUSINESS DEDUCTIONS AND LOSSES
SOLUTIONS TO PROBLEM MATERIALS
DISCUSSION QUESTIONS
10-1
The issue in this situation is whether the loan will be classified as a business or nonbusiness bad debt. The distinction is significant because business bad debts can be deducted without limitation while the deduction for nonbusiness bad debts is limited to $3,000 annually as a short-term capital loss. Normally, a shareholders loan to a corporation is not considered a business debt because it does not arise in the course of the taxpayers trade or business. However, since R is in the business of being an employee for XYZ, the loan might be considered a business debt if he is able to establish that the primary motive for the loan was protection of his job rather than his investment in XYZ. (See Example 1, p. 10-2, and 166.) A cash basis taxpayer may deduct bad debts only if he has a basis in the debt. Because cash basis taxpayers do not include income until it is received, they normally do not have a basis for debt. If the cash basis taxpayer accepted a note for payment, he would be entitled to a bad debt deduction, since the note is equivalent to cash and the related income would have been included. An accrual basis taxpayer may deduct bad debts if the item was included in their income previously. An accrual basis taxpayer may not use the reserve method to account for bad debts. Instead, accrual basis taxpayers can deduct a bad debt only when it becomes worthless (i.e., use the specific charge-off or direct write-off method). (See Example 3 and p. 10-4.) a. The treatment of shareholder advances that become worthless is an extremely important topic because of the restrictions that may be imposed on the taxpayers deduction (e.g., at worst, the taxpayers deduction is $3,000 a year). For this reason, it is incumbent on the practitioner to make a client aware of the tax ramifications that result if the loans become worthless, as well as any planning opportunities available to minimize the problem. The first problem presented by a shareholder advance is determining whether in fact there was a bad debt. Advances to a closely held corporation that are not repaid may be treated as contributions to capital. In such case, the basis of the taxpayers stock would be increased, and thus would increase the shareholders capital loss when the stock is sold or when it becomes worthless. No loss would be available until there is a disposition of the stock. It should be noted that contributions to capital do not have the effect of increasing the basis of 1244 stock (i.e., they are not eligible for 1244 treatment unless 1244 stock is issued for the contribution). Consequently, the shareholder is prohibited from obtaining ordinary loss treatment for unpaid advances through 1244. If the taxpayer can demonstrate that the advances were in fact a loan rather than a contribution to capital, the issue is whether the advance is a business or nonbusiness bad debt. The distinction is significant because business bad debts can be deducted without limitations, while the deduction for nonbusiness bad debts as a short-term capital loss is limited to $3,000 plus the taxpayers capital gains. Based on the decision in Whipple, a shareholders loan to a corporation is normally not considered a business debt because it does not arise in the course of the taxpayers trade or business. (See Example 2 and p. 10-3.) Only a taxpayer who can show that he or she is in the business of organizing, promoting, and financing businesses will be able to salvage ordinary loss treatment.
10-2
10-3
10-1
10-2
Certain Business Deductions and Losses
b.
c.
On the other hand, if F is an employee for the corporation, the loan might be considered a business debt if he is able to establish that the primary motive for the loan was protection of his job rather than his investment. If protecting his job was the reason for making the loan, F must demonstrate that it was the primary and dominant motive. One of the most significant factors in making this determination is the size of the loan in relation to the salary that F is trying to protect. There is no deduction in this case for two reasons. First, no deduction is allowed because there is no valid debt. If the obligation to pay is contingent on the occurrence of an event (such as meeting a certain level of sales) and such event does not occur, there is no valid debt. Moreover, in this case, the taxpayer has no basis in the debt. Thus, no matter how badly the taxpayer feels about not receiving the bonus, he can find no relief from the tax law. (See pp. 10-3 and 10-4.) The issue in this case, like above, is whether there is a bona fide debt. From the Services perspective, the loans may very well be disguised dividends. In such case, not only would the corporation be unable to claim a deduction for the purported bad debt but C would also be charged with dividend income, or, if C is an employee of the corporation, the amount might be treated as compensation. Whether the loans are in fact loans depends on all the facts and circumstances. If the loans were evidenced by notes, and payments of interest and principal on such notes have been made in a timely manner, the corporation would have a reasonable basis for arguing that a true debtor-creditor relationship exists. (See pp. 10-3 and 10-4.) This question is a classic illustration of the problems that can arise when a loan is made to a relative or a friend. Such loans, particularly those to family members, generally are viewed by the Service as gifts for which the taxpayer did not expect to be repaid. The taxpayer must be extremely careful in this instance to act like a true creditor. This includes proper documentation of the loan (i.e., have a note signed), charging a reasonable rate of interest, and taking the necessary steps to enforce or collect the loan when it comes due. In this case, the taxpayer will find it extremely difficult to secure bad debt treatment for failure to take any of these steps. (See pp. 10-3 and 10-4.) Signing a note is a good first step in ensuring that bad debt treatment can be obtained. However, the taxpayer must also attempt to collect payment when the payment date arrives. Obviously, R may find this a difficult task to undertakeno one wants to get tough with their child. Unfortunately, the IRS is not sympathetic in this situation, and acting more like a father than a creditor may result in gift, rather than bad debt, treatment. (See pp. 10-3 and 10-4.)
10-4
a.
b.
10-5
IRS scrutinizes any debt between related parties to see if the transaction was a gift instead of a loan. The following factors are used to help determine if a bona fide loan exists: 1. 2. 3. 4. Loan is secured and payment schedules are present; Partial repayment of loan has been made; Interest is incurred; and Transactions are treated in a business-like manner.
Thus, if H collected some of the payments while her son was solvent and the other factors are present, a debtor-creditor relationship exists, and H will be allowed to classify the loan as a bad debt. Assuming the debt is treated as a nonbusiness bad debt, 166(d)(1)(B) treats the loss as arising from the sale or exchange of a capital asset. (See p. 10-4 and 267.) 10-6 A taxpayers casualty loss is limited to the lesser of the propertys fair market value or its adjusted basis. When fair market value exceeds basis, no deduction is allowed for the higher value, since the taxpayer is not required to recognize income as the value of the property appreciated. When the value of the property is less than its basis, the loss deduction is limited to value, since no deduction is allowed for the decrease in value that occurred before the casualty. On the other hand, when the property is a business asset, the taxpayer is allowed to claim a casualty loss deduction equal to the basis of the property, since a business could otherwise deduct the basis through depreciation or upon sale or other disposition. (See p. 10-8.)
Solutions to Problem Materials
10-3
10-7
a. b.
Yes. A deduction for a casualty arising from fire is specifically authorized in 165(c). (See p. 10-7.) Allowance of a deduction depends on whether the event is considered to be a sudden, unexpected, or unusual event. The courts have ruled that freezes in Southern California are an unusual event and have allowed a deduction for casualty losses arising from the freezes. (See p. 10-7.) c. No. Due to the gradual nature of this event a deduction has been denied. (See p. 10-7.) d. It depends on what clogged the sewer line. If it was a gradual buildup that regular maintenance could have corrected, then it would not be deductible because it would be neither sudden nor unexpected. (See p. 10-7.) e. No. This is not an unusual or unexpected event for a smoker. Moreover, the courts have indicated that losses suffered in common or everyday accidents such as dropping or misplacing an item are not deductible. (See p. 10-7.) f. The property must be owned by the taxpayer before a deduction is allowed. Thus, a deduction is allowed for the damage to his own car but not his neighbors. (See p. 10-7.) g. Losses sustained through confiscation or seizure of property by a foreign government do not qualify as casualty or theft losses. [See Powers, 36 T.C. 1191 (1961).] But if the loss is connected with a transaction entered into for profit, a deduction is allowed. (See p. 10-7.)
10-8
They would want the burglar to take all the property at once because of the $500 for 2009 floor. The $500 floor is applicable to each event, not each item. Also, by having everything stolen in the same year, the taxpayer has a better chance of exceeding the 10 percent of A.G.I. annual limitation. (See p. 10-10.) a. The major purpose of the net operating loss deduction is to reduce the inequity that exists from the use of an annual reporting period and a progressive tax rate structure. Without this deduction, a taxpayer would receive no benefit from his deductible expenses in the year in which they exceed income. (See p. 10-13) Net operating loss provisions are designed to permit a taxpayer a deduction for a true economic loss. Therefore, the complex calculation eliminates certain artificial deductions and limits the amount of nonbusiness expenses that can be deducted. (See pp. 10-14 and 10-15.) The loss in 2009 is carried back to the second prior year first (2007), and the taxable income is recalculated for that year. Any remaining loss is carried to the first prior year (2008). If the loss is not completely used during the carryback period, it may be carried forward for 20 years (2010 . . . 2029). The taxpayer may elect to carry the net operating loss forward only. Note, if the taxpayer fails to make the election and does not carry the loss back to the earliest prior year, the amount eligible for deduction will be limited to the amount that would not have been absorbed had the loss been correctly carried back. (See pp. 10-13 and 10-14.)
10-9
b.
c.
10-10 HHG must recognize that once its gross receipts are substantial in contrast to gross income, it is subject to the uniform capitalization rules. The unicap rules apply to all manufacturers. They also apply to retailers (like HHG) and wholesalers only if their average annual gross receipts for the past three years exceed $10 million. Under the unicap rules, HHG will be required to capitalize certain indirect costs that it previously expensed. Specifically, HHG will be required to capitalize costs related to off site storage (e.g., the operation of a warehouse), purchasing, handling, and an allocable portion of general and administrative costs. As a practical matter, HHG will be required to restate its opening inventory, including the capitalized costs. This change in accounting method typically results in a positive adjustment to income that the IRS permits the taxpayer to spread over four years. In addition, the taxpayer must revise its accounting system in order to capture the information necessary to comply with these rules. (See p. 10-21.) 10-11 Many companies adopt or switch to LIFO for one simple reason: it normally increases cash flow. This occurs because the use of LIFO usually cuts taxable incomes and concomitantly reduces the firms tax liability, thereby producing additional cash merely by changing an accounting method. This tax reduction occurs because LIFO matches current costs against current revenue. During periods of rising prices, this reduces the inflationary element of earnings. (See Example 15 and pp. 10-24 and 10-25.) Despite the merits of using LIFO, there are several disadvantages. One major disadvantage of LIFO is that inventory must be valued at cost. The lower of cost or market valuation approach is not available if
10-4
Certain Business Deductions and Losses
LIFO is used. Consequently, upon a switch from FIFO to LIFO, all previous write-downs to market must be restored to income. Although this adjustment may be spread over three years, the resulting tax cost may be sufficient to prohibit a business from switching to LIFO. (See pp. 10-28 and 10-29.) Another possible disadvantage of LIFO concerns the conformity requirement. Taxpayers who adopt LIFO for tax purposes are required to use LIFO for financial reporting purposes as well. Consequently, reported earnings and earnings per share will drop, a discomforting thought to the management of some businesses. (See p. 10-28.) Critics of LIFO often identify other disadvantages. They complain that it is complicated to use and costly to administer. In addition, they note that any possible tax savings may be lost if there is a liquidation of low-cost LIFO layers.
PROBLEMS
10-12 a.
b. c.
$500. In this case, AAA has a basis for the debt because it is an accrual basis taxpayer and has included the $1,500 in income. Under the direct write-off method, when the debt becomes partially worthless, the taxpayer is allowed to deduct the portion that it believes to be worthless but only if it is also charged off its books for financial accounting purposes. Should the remainder become worthless in a subsequent year, the balance can be deducted at that time. Alternatively, the company could wait until the debt becomes totally worthless and deduct the debt in that year. (See Example 4 and pp. 10-4 and 10-5.) Note that AAA is not required to accrue any amount which, based on experience, may be uncollectible. This rule only applies to service businesses such as AAA. (See p. 10-5.) There is no deduction for partial worthlessness where the debt is a nonbusiness bad debt. (See Example 1 and p. 10-2.) Assuming a $500 deduction was claimed in the prior year, the company may deduct the uncollectible amount of $800 ($1,500 $500 previously deducted $200 collected). If no deduction was claimed, the uncollectible amount of $1,300 may be deducted. (See Example 4 and p. 10-5.)
10-13 No deduction is allowed because D has no basis in the debt. D has no basis because he is a cash basis taxpayer, and as such, includes none of the amount in income until he collects it. (See Example 3 and p. 10-4.) 10-14 L has no deduction in 2009 and a $4,000 capital loss in 2010. Section 166 generally allows a taxpayer to deduct the loss from any debt that becomes worthless. The treatment of the debt depends on whether it is a business bad debt or a nonbusiness bad debt. A nonbusiness bad debt is one other than that created or acquired in connection with a trade or business of the taxpayer. In this case, Ls loan is treated as a nonbusiness bad debt because it was not made in connection with his business. In effect, the loss was incurred in a transaction that was entered into for profitan investment. As explained below, the treatment given this bad debt is the same as that given any investment (i.e., capital loss treatment). Under 166(d)(2), the loss from a nonbusiness bad debt is treated as arising from the sale or exchange of a capital asset held for not more than a year, (i.e., normally referred to as a short-term capital loss). In the case of a nonbusiness bad debt, no deduction is allowed when it becomes known that the debt is partially worthless. [See Reg. 1.166-5(a)(2)]. In essence, the Regulations require the lender to wait until the debt is settled. As a result, even though L can determine as early as 2009 that he will only collect 40 cents on the dollar or $2,000 of the $5,000 loan, no deduction is allowed in 2009. L must wait to recognize any loss until 2010 when the debt is settled and he receives $1,000. In 2010, he will recognize a $4,000 capital loss, which he can deduct to the extent of his capital gains, plus $3,000. (See Example 1 and p. 10-2.)
Solutions to Problem Materials
10-5
10-15 a.
As determined below (it is assumed the floor is $100), M would report a casualty loss of $1,300 in 2009 and $0 in 2010. Fur coat: Personal casualty gain* ($7,000 $6,000) Computer: Lesser of (1) Basis $4,000 or (2) Value $3,000 Insurance Loss Couch: Lesser of (1) Basis $1,200 or (2) Decline in value as measured by cost of repairs Insurance Loss Van: Lesser of (1) Basis $7,000 or (2) Value $5,000 Insurance (expected) Loss Total loss after insurance Floor Personal casualty loss Net personal casualty loss 10 percent floor (10% $18,000) Casualty loss deduction
$ 1,000
$ 3,000 ,000) ( $3,000
$ ,700 ( 500) , ,200
$ 5,000 (4,000) 1,000 $4,200 (,100) (4,100) $(3,100) (1,800) $(1,300)
(See Example 6 and pp. 10-8 through 10-10.) *Because M opted not to replace her fur coat, she has a personal casualty gain of $1,000 ($7,000 $6,000). (See Example 7 and pp. 10-9 and 10-10.) As explained in concerning nontaxable exchanges under 1033, M could postpone recognition of the gain by investing all of the $7,000 reimbursement in another coat or similar property. Note. In determining the loss on the van, the expected amount of insurance reimbursement is used, $4,000. (See Example 9 and p. 10-11.) In 2010, when M actually receives $2,000 (instead of the $4,000 estimated), she has an additional $2,000 casualty loss subject to the 10 percent floor. Because the loss in 2010 does not exceed the 10 percent floor [($2,000 (10% of 20,000) $0], no deduction is allowed. If M had properly estimated the amount of insurance recovery, the entire $2,000 would have been deductible. Although the loss occurs in 2010, the designation of the casualty as an official disaster area enables M to deduct the loss on her 2009 return. (See Example 10 and p. 10-11.) With the loss occurring in 2010, the loss on the van can be determined with certainty because M actually receives a $2,000 insurance reimbursement. As a result, her casualty loss on the van is increased by $2,000 to $3,000. This increases her total casualty loss to be claimed on the 2009 return to $5,100.
11-
b.
10-6 10-16
Certain Business Deductions and Losses
In the case of a casualty of business or investment property, the amount of the deduction is the taxpayers basis in the property. However, when the property has only been partially damaged, the casualty loss cannot exceed the decline in value of the property. The ($500 in 2009) floor and the 10 percent of A.G.I. limitation do not apply to business or investment property. (See Example 6 and pp. 108 through 10-10.) Car: Adjusted basis Painting: Adjusted basis Insurance reimbursement Loss Rental property: Lesser of (1) Decline in value: $50,000 (2) Basis: $30,000 Insurance Loss Total loss
$12,000 $ 1,500 ( 800) , ,700
$ 30,000 (20,000) 10,000 $22,700
11-
Note that the ($500 in 2009) and 10 percent floors do not apply to business or investment casualties because the taxpayer would have been able to recover his investment through depreciation. A casualty loss can create an NOL. (See pp. 10-14 and Exhibit 10-3 on p. 10-18.) C realizes a personal casualty gain of $6,000 (assuming the floor is $100). As a result, she must report the gain and loss as arising from the sale of a capital asset. The gain and loss are determined below. Jewelry: Personal casualty gain ($19,000 $10,000) Camera: Lesser of (1) Basis $3,500 or (2) Value $3,100 Insurance Loss Floor Personal casualty loss Net personal casualty gain
10-17 a.
$ 9,000
$ $
3,100 ,000 3,100 ( 100) , (3,000) $ 6,000
11-
b.
To determine the tax treatment, C must first determine her casualty gain and casualty loss separately. The loss is computed after the $100 floor but before the 10 percent limitation. If the gains exceed the losses as is the case here, each gain and each loss is treated as gain or loss from the sale or exchange of a capital asset. (See Example 7 and pp. 10-9 and 10-10.) Note that this treatment allows C to obtain a benefit from the loss that would normally be unavailable because of the 10 percent limitation. If the jewelry was worth $11,000, her casualty gain would be $1,000 ($11,000 $10,000). In such case, she would have a net personal casualty loss of $2,000 ($3,000 $1,000). In the case of a net loss, the loss is deductible as an itemized deduction to the extent it exceeds 10 percent of A.G.I. Here, C would be able to deduct $500 [$2,000 (10% $15,000)]. (See Example 7 and pp. 10-9 and 10-10.)
Solutions to Problem Materials
10-7
10-18 a.
Gs deductible loss would be $30,100 determined as follows (assuming the floor is $100): House: Loss before insurance reimbursement: Lesser of (1) Decline in value, $80,000 (2) Adjusted basis, $60,000 $ 60,000 Less insurance reimbursement (30,000) Loss $ 30,000 Skiing equipment: Loss: Lesser of (1) Decline in value, $90 (2) Adjusted basis, $300 Total loss on personal use property Less floor Deductible loss on personal use property from A.G.I. Business calculator (not subject to 10% limitation): Loss: Adjusted basis
,090 $ 30,090 (,100) $ 29,990
$
,110
b.
c.
d.
The business loss is generally deductible for A.G.I. See Forms 4684 and 4797 in Appendix B. (See Example 6 and pp. 10-8 through 10-9.) B may deduct $5,000 [the lesser of the decline in value of $5,000 ($45,000 $40,000) or the adjusted basis $30,000]. The deduction is for A.G.I. because it is related to rents. The $100 floor ($500 in 2009) and 10 percent limitation do not apply because the asset income-producing. is Because this is a disaster area B may deduct the loss on his prior years return. (See pp. 10-8 through 10-11.) Bs loss before reimbursement is still $5,000 [the lesser of the decline in value of $5,000 ($45,000 $40,000) or the adjusted basis $30,000]. The $5,000 loss is reduced by the $2,000 insurance reimbursement and the ($500 in 2009) floor that applies to casualties of personal use property, resulting in a $2,900 loss deductible from A.G.I. (subject to the A.G.I. limitation). (See pp. 10-8 through 10-9.) In this situation, the issue is whether the loss is unusual in nature and thus deductible. In Rev. Rul. 72-592, 1972-2 C.B. 101, the IRS ruled that for a loss to be unusual it must be extraordinary and nonrecurring, one that does not commonly occur during the activity in which the taxpayer was engaged when the destruction or damage occurred, and one that does not commonly occur in the ordinary course of day-to-day living (e.g., a child tearing out the knee of a new suit on his way to church). It would seem that this event is not one that is recurring and thus would be considered unusual. In such case, the loss is $200 (the lesser of the decline in value of $300 or the adjusted basis of $300 less the $100 floor). No, a business capital loss first offsets any business capital gains. Any remaining loss offsets nonbusiness net capital gain as reduced by nonbusiness expenses. None of the remaining loss is deductible. Thus, if the taxpayer had only a business capital loss during the year, it would not create an NOL. (See p. 10-15.) No, a nonbusiness bad debt is treated as a capital loss, a nonbusiness capital loss. As such it is allowed only to offset nonbusiness capital gains. Thus, if the taxpayer had only a nonbusiness capital loss, it would not create an NOL. (See p. 10-15.) Yes, a casualty loss is treated as a business loss in all cases. (See pp. 10-14 and 10-15.) No, qualified residence interest is considered a nonbusiness expense. Nonbusiness expenses can only offset nonbusiness income. (See Chapter 10-3 and p. 10-15.) Yes, 172(d)(4) limits only deductions that are not attributable to a taxpayers trade or business. [See 172(d)(4).] Because a taxpayer who is an employee is treated as being in a trade or business, employee business expenses are business expenses. The text indicates that nonbusiness expenses include the taxpayers itemized deductions, which would include any employee business expenses that
10-19 a.
b.
c. d. e.
10-8
Certain Business Deductions and Losses
are itemized deductions. To the extent that itemized deductions include employee business expenses, this statement is incorrect. (See Exhibit 1-3.) f. No, a contribution to an IRA is considered a nonbusiness expense. Nonbusiness expenses can only offset nonbusiness income. (See Exhibit 10-3 on p. 10-18 and p. 10-16.) g. No, alimony is considered a nonbusiness expense. Nonbusiness expenses can only offset nonbusiness income. (See Exhibit 10-3 on p. 10-18 and p. 10-16.) h. No, personal exemptions are added back to taxable income in deriving the NOL deduction. (See Exhibit 10-3 on p. 10-18 and p. 10-16.) 10-20 a. The taxpayers salary is treated as business income. It is included in taxable income and no modifications are necessary. The distinction between business and nonbusiness income is important because nonbusiness expenses can be deducted in computing the NOL only to the extent of nonbusiness income. (See Exhibit 1-3 and p. 10-15.) A nonbusiness capital gain is included in the taxpayers taxable income. It may be offset by business expenses as well as any nonbusiness capital loss, business capital losses, and nonbusiness expenses. (See Exhibit 10-3 on p. 10-18 and p. 10-15.) Interest income is included in the taxpayers taxable income. It may be offset by business expenses as well as any nonbusiness expenses. It is not reduced by nonbusiness or business capital losses. Nonbusiness capital losses offset only nonbusiness capital gains. Business capital losses offset business capital gains and nonbusiness capital gains. (See p. 10-15.) Qualified residence interest is a nonbusiness expense. Nonbusiness expenses may offset nonbusiness income and nonbusiness capital gains. Nonbusiness expenses in excess of nonbusiness income must be added back to taxable income in arriving at the NOL. (See p. 10-15 and Exhibit 10-3 on p. 10-18.) The net operating loss is $63,000 computed as follows: Taxable income computation: Net business loss ($150,000 $210,000) Interest earned Net long-term capital loss: ($1,000 $3,000 $5,000) Adjusted gross income Less itemized deductions: Casualty loss Interest paid Total deductions Less personal exemption (2009) Taxable income (loss) Taxable loss Modifications: Add Personal exemption Nonbusiness deduction ($9,000 $7,000)* Nonbusiness capital loss** Net operating loss $(60,000) 7,000 (1,000) $(54,000) $4,000 9,000 (13,000) (3,650) $(70,650) $(70,650)
b.
c.
d.
10-21 a.
3,650 2,000 2,000 $(63,000)
*Nonbusiness expenses consisting solely of $9,000 of interest may be deducted only to the extent of nonbusiness income, $7,000 interest income, plus nonbusiness capital gains, $0. Thus, the excess $2,000 must be added back. **Nonbusiness capital losses may be deducted only to the extent of nonbusiness capital gains. In computing taxable income, the excess nonbusiness capital loss of $2,000 reduced taxable income by $2,000 ($1,000 against the business capital gain of $1,000 and $1,000 against ordinary income). Thus, $2,000 is added back. (See Example 12 and pp. 10-14 through 10-17.)
Solutions to Problem Materials
10-9
b.
The statute of limitations for the carryback year 2007 is extended to the date when the statute runs on the loss year. In this case, that date is April 15, 2013 which is three years after April 15, 2010, the date the loss-year return is filed. If R decides to use Form 1045, the so-called quick refund form, he must file the form before December 31, 2010, one year after the close of the loss year. (See Example 11 and p. 10-14.)
10-22 The net operating loss is $48,500, determined as follows: Net business loss ($180,000 $230,000) Royalties Long-term capital gain ($5,000 $3,000 $3,500) Adjusted gross income Less: Nonbusiness expenses* Less: Exemptions ($3,650 4) Taxable loss Taxable income (loss) Modifications: Exemptions ($3,650 4) $(50,000) 6,000 4,500 $(39,500) (9,000) (14,600) $(63,100) $(63,100) 14,600 $(48,500)
*The nonbusiness expenses generally represent itemized deductions. Note that the taxpayer may have claimed the standard deduction of $11,400 for 2009 in which case the same adjustment would be made (i.e., a deduction of $11,400) to arrive at taxable income which is added back to taxable income to determine the NOL. (See Example 12 and pp. 10-14 through 10-17.) 10-23 A company that elects to value its inventory at the lower of cost or market (replacement cost) is generally allowed to claim deductions for write-downs of its inventory to market. If the estimated sales price is less than market (i.e., replacement cost), a further write-down is allowed, but only if the goods are subnormal goods and are actually offered for sale at the lower price 30 days after the inventory date. Subnormal goods are those items in inventory that cannot be sold at normal prices because of damage, imperfections, style changes, and so on. In this case, the books would not be considered subnormal goods. Moreover, even if the books were considered subnormal, the second requirementan actual offer to sell the excess stock at reduced priceswas not satisfied. In contrast to financial accounting, the mere expectation that the books will not be sold is insufficient for a write-down. Consequently, the company must carry its inventory at original cost. As emphasized in Thor Power Tool, the different goals of the tax system and financial accounting justify a different approach to this issue. Thus, the tax rule must be followed despite the fact that the procedure is accepted for financial accounting purposes. Note that the company might be better off destroying its obsolete inventories rather than maintaining them. (See Example 18 and pp. 10-29 and 10-30.) 10-24 a. Using the lower of cost or market rule, ending inventory is valued at $72,000 as determined below. In contrast to the rule for financial accounting, the value of each similar item must be compared to its cost, rather than comparing aggregate cost to aggregate value. Lower of Cost Merchandise Cost Market or Market Weight machines $40,000 $43,000 $40,000 Stationary bicycles 10,000 8,000 8,000 Stair climbers 24,000 27,000 24,000 $74,000 $78,000 $72,000
10-10 Certain Business Deductions and Losses 11b. Note that the inventory is valued at $72,000 even though the total market value exceeds cost. (See Example 17 and p. 10-29.) When a corporation switches from FIFO to LIFO, it must restore any previously deducted writedowns to income. This positive income adjustment may be spread over three years. It is this requirement that often discourages some taxpayers from switching to LIFO. (See p. 10-28.)
10-25 Ending inventories for 2008 and 2009 are computed below. (See Exhibit 1-5, Example 16, and pp. 10-24 through 10-28.) Pool Items Records Tapes CDs Total base year cost Date 1-1-08 Ending Quantity 5,000 4,000 2,000 Current Cost Per Unit $2 3 6 Total at Current Cost $10,000 12,000 12,000 $34,000
Steps 1 and 2: Double-extend ending inventory. Ending Inventory at BaseYear Prices Base-Year Total at Cost Per Base-year Unit Cost $2 $ 6,000 3 18,000 6 30,000 $54,000 $2 3 6 $ 4,000 9,000 24,000 $37,000
Date 12-31-08
Ending Inventory at Current-Year Prices Current Total at Pool Ending Cost Per Current Items Quantity Unit Cost Records 3,000 $2 $ 6,000 Tapes 6,000 4 24,000 CDs 5,000 7 35,000 $65,000 Records Tapes CDs 2,000 3,000 4,000 $3 5 7 $ 6,000 15,000 28,000 $49,000
12-31-09
Step 3: Determine quantity increase (decrease) at base-year price. 2008 $ 54,000 (34,000) $ 20,000 2009 $ 37,000 (54,000) $(17,000)
Ending inventory base-year price Beginning inventory base-year price Quantity increase at base-year price
11-Step 4: Calculate current year price index. Index= Ending inventory at current-year price $65,000 =1:20 Ending inventory at base-year price $54,000 Decrease : use index at which =1:20 units were added 2008
Solutions to Problem Materials
10-11
Step 5: Compute quantity increase or decrease to be added or subtracted from beginning inventory. 2008 $20,000 1.20 $24,000 2009 $(17,000) 1.20 $(20,400)
Quantity increase at base-year price Index Increase or decrease to beginning inventory
11-Step 6: Compute ending inventory. Base year 2008 layer Total ending inventory 2008 $34,000 24,000 $58,000 2009 $34,000 3,600* $37,600
11-
*$24,000 $20,400 $3,600
10-26 In periods of rising prices, the use of fewer pools will translate into greater tax benefits through LIFO. The use of fewer pools allows inventory reductions of some items to be offset by inventory increases in others. In contrast, the use of more pools increases the likelihood that old, low-cost inventory layers will be liquidated and the tax consequences will be negative since the lower costs become part of costs of goods sold, resulting in higher taxable income. 10-27 a. VE must use the accrual method. This question is based on the facts of Von Euw & L.J. Nunes Trucking, Inc. v. Comm. TC Memo 2000-114. This decision was issued before the government began relaxing its position on the inventory requirement. Note, however, that this problem casts the first question in terms of a corporation that is an S corporation which is not required to use the accrual method (as would a C corporation if it had average annual gross receipts exceeding $5,000,000). In Von Euw, the court held that VE must use the accrual method to account for inventory, notwithstanding the fact that the corporation did not have any materials on hand at the beginning and ending of each business day. Consequently, the issue is not concerned with the treatment of the costs of the materials but rather the timing of income recognition. In Von Euw, the taxpayer argued that the sand and gravel was not merchandise acquired and held for sale and, therefore, was not subject to the inventory rule. The taxpayer argued that it was in the business of procuring and delivering rather than acquiring and holding sand and gravel for sale. Moreover, the taxpayer asserted that because it did not have any materials on hand at the beginning or end of the day, it did not hold the sand and gravel for sale. In addition, the taxpayer argued that it considered itself a service provider rather than a seller of goods. In acquiring the goods, it was merely accommodating its customers. Finally, the taxpayer argued that it did not mark up the cost of the sand and gravel and that it made the same profit whether it procured and delivered the requested sand and gravel or simply deliver the materials which the customer owned separately. The court rejected the taxpayers arguments on several grounds. The court believed that the taxpayer did sell a product, and although there was no particular mark up of the sand and gravel acquired, the taxpayer effectively made a higher profit since its bill was based on a percentage of the underlying cost. The court rejected the taxpayers argument that just because the taxpayer could generate profits solely from transporting the sand and gravel, this did not mean that sand and gravel was indispensable to and inseparable from the provision of a service. Indeed, the court saw the taxpayer as a seller of sand and gravel, and the services were incidental. Interestingly, the court sidestepped the issue of whether the taxpayer actually acquired title to the sand and gravel. (See p. 10-22.)
10-12 Certain Business Deductions and Losses b. Under Rev. Proc. 2002-28, taxpayers with more than $1,000,000 and less than $10,000,000 of average annual gross receipts and whose principal business is not in manufacturing, wholesale, retail or the information industry need not use the accrual method. However, nonincidental materials and supplies must be capitalized and expensed as they are used or consumed. The issue here is whether VE is in the wholesale or retail industry. If not, then VE is not required to use the accrual method and can defer its income from sales until the cash is collected. In contrast, if VE is considered in the retail or wholesale business, it must accrue the accounts receivable from its sales. Based on Rev. Proc. 2002-28, notwithstanding that a taxpayers business activity is one of the above, the taxpayer may still avoid the accrual method if it determines that its principal business activity is the provision of services, including the provision of property incident to those services. The taxpayers principal business activity is determined by the sources of gross receipts. The principal business activity is the activity from which the largest percentage of gross receipts was derived during the prior taxable year (even if this amount is less than 50 percent of the aggregate gross receipts of the taxpayer). In this situation, there are insufficient facts to determine whether the gross receipts were primarily attributable to the purchase and sales of the sand and gravel or simply the delivery of the sand and gravel. Since VE is now a C corporation and has more than $5,000,000 in average annual gross receipts, it is required to use the accrual method. In effect, VE now must report its revenues when earned rather than when received. The taxpayer now falls within the exception of Rev. Proc. 2000-22 for taxpayers with gross receipts less than $1,000,000 and the accrual method is not required. It is allowed to report its accounts receivables when they are collected rather than when they are earned. Note that if VE had sand and gravel on hand at the end of its taxable year, it would still be required to capitalize such costs. A deduction would be allowed only when the items are provided to the buyer. The firm does not qualify for the production deduction since it is in the business of providing consulting services. To qualify for the 199 deduction, a taxpayer must have QPAI (Qualified production activities income). To have QPAI the business must lease, rent, license, sell qualifying production property which includes tangible personal property, computer software and sound recordings, not services. The company does not qualify for the production deduction. To qualify for the 199 deduction, a taxpayer cannot be merely a reseller. It must manufacture, produce, grow or extract the product that it is selling, leasing or renting. It may be appropriate here to consider whether a company that produces and publishes books qualifies for the deduction. Several issues must be addressed in this simple set of facts. It would appear that the question concerns whether Microsoft Corporation and companies like it would qualify for the production deduction. Technically, these companies license the use of their software products to a user who pays a fee. Section 199 expressly provides that computer software is qualifying production property just like tangible personal property. Moreover, the product need not be sold. A licensing arrangement is permissible. A more important issue concerns how the software was produced. Was the computer code written primarily in the U.S. or was it outsourced to a foreign country (e.g., India)? Does it make a difference whether the foreign based company is owned by a U.S. based corporation? See http://www.americansteelspan.us/construction.htm. This problem addresses whether major construction companies like Centex and other production home builders as well as the many small home builders, renovators and remodelers qualify for the 199 deduction. Construction and substantial renovation performed in the U.S. qualify. It makes no difference the size of the operation or whether it is residential or nonresidential. One question that should be raised is whether all of the activities are performed in the U.S. as required. Since the company is located in Detroit, it is possible
c.
d.
10-28 a.
b.
c.
d.
Solutions to Problem Materials
10-13
that it does work in Canada. In addition, this problem raises the issue of vertical integration and subcontracting. If RYL contracts with a plumbing or electrical company to install plumbing or electricity, would it be better to use a subcontract or to form its own company. e. The facts suggest several issues. For example, is it best for the company to operate as a single member LLC which is treated as a sole proprietorship. If it had no employees, there would be no wages. Perhaps it may be better to be an S corporation. Also do spots produced for TV and radio etc. qualify as qualified film or sound recordings. Do restaurants qualify? Gross receipts from the sale of food and beverages prepared by the taxpayer at a retail establishment (e.g., restaurants) do not qualify. What about selling to another restaurant? Although OMG is primarily a reseller it can qualify for the 199 deduction to the extent that it has production activities. As a general rule, a taxpayer may not claim the 199 deduction unless the taxpayer accounts for its costs as a producer under the Unicap rules of 263A. However, the preamble to the proposed regulations provides that such resellers may continue to be treated as resellers for purposes of the Unicap rules, while claiming the 199 deduction for their production activities. (See p. 10-37 discussing the treatment if there are nonqualifying activities.) The question here is whether the products manufactured at the bakery such as the bread, cakes, donuts and similar items qualify if they are sold at the manufacturers store to its retail customers. In determining whether a company has DPGR, none of the gross receipts arising the sales of items at the retail store qualify if the items sold were produced at the retail store. Consequently, bread that it bakes on the store premises and sells to retail customers does not qualify. This rule may cause the company to restructure their baking and selling activities so they are separate. Also note that wholesale sales of such items would qualify. (See p. 10-37.) While items manufactured at a retail locations do not qualify, sale of the same items to wholesale customers do qualify. The bread sold to those customers would qualify. (See p. 10-37.) Sales of items produced at one location and sold to retail customers at a retail establishment which is at a different location qualify. (See p. 10-37.) Under the shrinkback rule, the receipts from sales of the bread that are allocable to the doughmaking and baking that occurred off-site qualify as DPGR but the proceeds that are allocable to the instore baking do not qualify. In other words, the grocer that bakes bread to sell in various manners must allocate its receiptsand costsrelated to the loaf of bread between qualifying and nonqualifying production. The portion of the receipts allocated to the qualifying production is eligible for the section 199 deduction. OMG will not be able to claim the 199 deduction for its construction activities immediately since it does not have gross receipts from the construction activity. It must sell the stores constructed in order to have gross receipts that qualify. It must also be in the construction business on a regular and continuous basis. In addition, OMG must have at least a general contractor level of involvement in the construction activities. It is insufficient to have stores constructed by a third party under a contract for the grocer. Consequently, there will be no 199 benefit during the time the grocer is using the stores in its business, or leasing out other stores in a strip mall that it anchors. However, when the store or the strip mall is ultimately sold, the gross receipts would qualify. (See p. 10-36 that merely indicates that QPAI includes gross receipts from construction activities in the U.S.)
f.
10-29 a.
b.
c.
d.
e.
f.
RESEARCH PROBLEMS
Solutions for the Research Problems (10-30 through 10-33) are contained in the Instructors Guide for 2010.