of 7
Overview Deductions and Losses
Solutions to Problem Materials
DISCUSSION QUESTIONS
7-1 The general requirements for a deduction are contained in 162 and 212. If these requirements are met and the expense is not disallowed (or limited) by some other provision of the Code, the expense normally is deductible. Sections 162 and 212 set forth four requirements (see pp. 7-3 and 7-4): 1. Related to carrying on either a trade or business ( 162) or an income-producing activity ( 212). This requirement is satisfied only if (1) the expense is incurred in the proper activity (e.g., a trade or business or an income-producing activity), (2) the expense is properly related to the activity, and (3) the activity is being "carried on" by the taxpayer. Proper Activity. The expense must be incurred in a trade or business or an income-producing activity. The purpose underlying this requirement is to deny deductions for expenses that are primarily of a personal nature. The major factor distinguishing business and income-producing activities from personal activities is existence of a profit motive. Thus, this requirement demands that the expense be incurred in an activity entered into with an expectation of profit. The expectation, however, need not be reasonable. [See pp. 7-4 through 7-6 and Reg. 1.183-2(a).] Proper Relationship. The expense also must be properly related to the profit-oriented activity. Satisfaction of this test occurs when the expense was motivated by business needs. (For an interesting example illustrating the difficulty in determining whether the proper relationship exists, compare Example 4 with footnote 14, p. 7-6.) Carrying On. Expenses are deductible only if they are incurred while the taxpayer is carrying on the profit-oriented activity (e.g., expenses of investigating a business may not be deductible when the taxpayer is not carrying on the activity that he is investigating). [See p. 7-31 and 162(a).] 2. Ordinary and necessary. An expense is considered ordinary if it is customary to incur such expense in the type of business in which the taxpayer is engaged. The expense need not be recurring. It need only be routine for taxpayers in similar situations. Expenses are considered necessary if they are appropriate, helpful, or capable of making a contribution to the success of the taxpayer's profitseeking activities. One interesting case when these criteria were applied to deny a deduction was Kenneth M. Wells, 36 TCM 1698, T. C. Memo 197527-419. Here, the head of a public defender's office was not allowed to deduct the costs of lunch expenses for his staff that he paid for personally because it was not "ordinary" for a public defender to pay for such expenses vis-vis the head of a private law firm. (See pp. 7-7 and 7-8.) 3. Reasonable. According to 162(a)(1), only compensation must be reasonable. There is no explicit reasonableness requirement for other business expenses under 162(a). In Comm. v. Lincoln Electric Co.(footnote 23), however, the Court held that the term reasonableness is implicit in the phrase "ordinary and necessary." The reasonable restriction is generally imposed on the amount of the deduction. An amount is considered reasonable if it reflects the price at which an arm's length
7-1
7-2
Chapter 7
Overview of Deductions and Losses
4.
transaction would be consummated. For example, the limitation is often imposed when compensation is paid to a shareholder who is also an employee of a closely held corporation. In this case, its function has been to disallow deductions for purported salaries that are in reality nondeductible dividends or gifts to the shareholder-employee. (See p. 7-8.) Paid or incurred during the taxable year. A taxpayer may deduct currently only those expenses that were "paid" (in the case of a cash basis taxpayer) or "incurred" (in the case of an accrual basis taxpayer) during the taxable year. (See pp. 7-8 and 7-9.)
Losses are generally deductible under 165 if the loss is 1. Incurred in a trade or business; 2. Incurred in an activity engaged in for profit; or 3. Attributable to fire, storm, shipwreck, theft, or some other type of casualty. (See pp. 7-18 and 7-19.) 7-2 a. (This question attempts to emphasize the basic difference in the approach to defining income vis-vis deductions for tax purposes.) Income is a concept that has relevance outside the realm of taxation (e.g., in economics and accounting). The income of economics and accounting served as a guide for the courts in their early determinations as to what constituted income for tax purposes. Using these concepts, the courts were able to distill the "all inclusive" definition of income: income includes any type of gain, benefit, profit, or increase in wealth that has been realized and not exempted by statute. No comparable definition exists for "deductions" because the term concerns only those particular items that Congress has specifically allowed to reduce gross income to arrive at taxable income. In other words, deductions can be defined only procedurally as those items which in the aggregate constitute the difference between the quantity "gross income" and the quantity "taxable income." The term deduction is purely a legalistic concept that has no relevance or meaning outside taxation [see discussion on question 7-2(b) below concerning the notion that deductions are a matter of legislative grace]. (See p. 7-2.) Deductions are said to be matters of legislative grace because the taxpayer has no constitutional right to a deduction. Any right a taxpayer has to a deduction arises solely because Congress provided this right through legislation. (See p. 7-2.) (Having established in 7-2(a) and 7-2(b) that a deduction is only what Congress says it is, this question asks the student to design a general definition that is suitable for most situations.) Although a definition that encompasses all deductions may not be constructed, a general definition (similar to that given for income) may be fashioned from the criteria set forth in 162 and 212, which provide the authority for most deductions. Such a definition might be as follows: a deduction is any ordinary and necessary expense paid or incurred during the taxable year arising from an intention to make a profit. (See pp. 7-3 and 7-4.) Satisfaction of the general requirements for a deduction will not ensure deductibility because certain sections of the Code specifically limit or deny a deduction for expenses with certain additional characteristics. For example, trucking firms may regularly incur fines for transporting goods using overweight trucks, and such expense clearly might be profit-motivated. Although such an expense would meet the general requirements of 162(a), 162(e) disallows a deduction because it is contrary to public policy. (See pp. 7-34 and 7-35.) No. The test is not whether the expense is one related to personal pleasure but whether the expense satisfies the general requirements authorizing the deductions. The fact that an expense yields no pleasure does not make it deductible. Conversely, the fact that an expense yields personal satisfaction does not preclude deductibility if it otherwise satisfies the appropriate tests. (See p. 7-4.) Some of the purely personal expenses that are deductible are medical expenses (from), charitable contributions (from), alimony payments (for), certain state and local taxes (from), and interest on home mortgages (from). (See pp. 7-19 through 7-21.)
b.
c.
d.
7-3
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b.
7-4
Both 162 and 212 allow deductions for profit-oriented expenses that are ordinary and necessary. The distinction between the two provisions concerns the nature of the activity in which the expense must be incurred before it is deductible. Section 212 allows a deduction for expenses that are related to an incomeproducing activity, while 162 requires the expense to be related to a trade or business. To qualify as an income-producing activity or a trade or business, a profit motive must be present. Business status, however, also requires a sufficient degree of taxpayer involvement (entrepreneurial effort) in the activity to distinguish the activity from a passive investment. The distinction was particularly significant prior to enactment of
Solutions to Problem Materials
7-3
212 in 1942 because only business expenses were allowed. Currently, the distinction is important because of the classification of the deduction as one for or from A.G.I. If the deduction is for A.G.I. (e.g., a Schedule C deduction), it is deductible without limitation. In contrast, if the expense is deductible under 212, the deduction may be classified as a miscellaneous itemized deduction. In such case, the expense is deductible only if the taxpayer itemizes--and then only to the extent it exceeds 2 percent of A.G.I. In addition, whether the activity constitutes a business may have an impact on the tax treatment the item receives under another provision of the Code. For example, a home office deduction is available only if it relates to an activity that constitutes a business. (See pp. 7-5 through 7-9.) 7-5 An employee is considered to be in the business of being an employee. As a result, the ordinary and necessary expenses incurred in connection with the taxpayer's employment are deductible under 162. Examples of deductible employee business expenses are union dues, subscriptions to professional journals, certain uniforms, and dues to professional societies. All deductible employee business expenses that are not reimbursed are treated as miscellaneous itemized deductions subject to the 2 percent floor. (See p. 7-9.) Generally, cash basis taxpayers may deduct expenses that are paid during the taxable year, while accrual basis taxpayers deduct expenses when they are incurred. However, several conditions must be observed in both cases. Cash Basis Taxpayers: Although these taxpayers normally deduct expenses when paid, there are several restrictions. First, if inventories are an income-producing factor, the accrual method generally must be used to account for inventory and sales (e.g., a hardware store may be on the cash basis for normal operating expenses but would have to use the accrual method for determining sales, receivables, and costs of goods sold). There are exceptions to this rule for small businesses. A second limitation imposed on cash basis taxpayers concerns deductions for prepaid expenses. As a general rule, there is no deduction for prepayments unless the following conditions are present: 1. The period for which the payment is made does not exceed one year, and 2. The taxpayer is contractually obligated to prepay an amount for a period extending beyond the close of the year. Prepayments of most expenses do not satisfy these criteria. Thus, as a general rule, prepayments are not deductible. For example, prepayments of interest (except points relating to mortgage on a primary residence) and medical expenses are not deductible in the year paid but over the period that they cover. Nevertheless, some prepayments such as cattle feed expense, insurance, and rents may be deducted when paid if they meet the above criteria. (See pp. 7-9 through 7-12.) Accrual Basis Taxpayers: In order for an expense to be considered incurred or accrued, it must satisfy the so-called all events test as well as the economic performance test. [See Reg. 1.446-1(c)(1)(ii) regarding the all events test.] The all events test is designed to allow accruals only when the following conditions are satisfied: 1. All the events have occurred that establish the fact of the liability, and 2. The amount of the liability can be established with reasonable accuracy. The all events test does not by itself prevent accruals of estimated expenses when the taxpayer is obligated to provide goods or perform services and the amount can be determined. To prevent the possibility of "premature accruals," Congress instituted the economic performance test. Under this test, deduction of an expense is deferred until the activities giving rise to the liability are performed. Economic performance is deemed to occur at different times depending on the nature of the liability as explained below. 1. Liability to provide property and services: deduction may be claimed when the taxpayer actually provides the goods or services (e.g., strip miner deducts expenses of back-filling required by federal law in the year he back-fills). 2. Liability to pay for property or services to be provided to the taxpayer: deduct when property or services are received (e.g., cost of management services to be received over 10 years can be deducted only when the taxpayer receives services). 3. Liability for payment arising under workmen's compensation laws or any tort: Obligations to pay such expenses may be deducted when paid. [See pp. 7-13 through 7-18 and 461(h).]
7-6
7-4
Chapter 7
Overview of Deductions and Losses
7-7
Any differences that exist will be attributed to the classification of the expense as either "for" or "from" A. G.I. Since F is self-employed, the deductible expenses relating to F's self-employment will be classified as deductions for A.G.I. Conversely, G being an employee will classify the deductions as from A.G.I., unless the expenses are reimbursed and included in the employee's income. Moreover, employee expenses that are not reimbursed are treated as miscellaneous itemized deductions subject to the two percent floor. Consequently, G must pay a larger tax liability solely because of her employment status. This appears to be an unwarranted distinction between those who are employees and those who are self-employed. (See pp. 7-19 and 7-21.) The reference to "above and below the line" is a common practitioner expression concerning the distinction between deductions for and from A.G.I. In this expression, the "line" is A.G.I., deductions above the line are those for A.G.I., and those below the line are itemized deductions. There is no such reference on Form 1040. On the 1040, deductions for A.G.I. are referred to as "adjustments to income." Others (e.g., the CCH and RIA tax services) often refer to deductions for A.G.I. as deductions from gross income. (See pp. 7-19 and 7-20 and p.1 of Form 1040.) There are numerous reasons for distinguishing deductions that are for A.G.I. from those that are from A.G.I. Deductions for A.G.I. are deductible in any event while deductions from A.G.I. reduce taxable income only if the taxpayer itemized deductions. In addition, the deductible amount of certain items is a function of the taxpayer's A.G.I. For example, a taxpayer is allowed to deduct miscellaneous itemized deductions only to the extent that they exceed 2 percent of A.G.I. Similar floors are imposed on medical expenses (7.5%) and personal casualty losses (10%). The annual deduction for charitable contributions is limited to 50 percent of A.G.I. In addition, itemized deductions and personal/dependent exemptions are reduced for taxpayers with A.G.I. in excess of certain amounts. Classification of deductions is also important for purposes of determining the taxpayer's self-employment. Further, many states do not allow itemized deductions but do allow the taxpayer to deduct any deductions that were claimed for A.G.I. on his or her Federal return. (See pp. 7-19 through 7-24.) Under the special rules for performing artists, V is allowed to claim certain deductions for A.G.I. that other taxpayers treat as itemized deductions. To qualify for the special exception, the individual must perform services in the performing arts as an employee for at least two employers during the taxable year, earning at least $200 from each. In addition, the individual's A.G.I. before business deductions cannot exceed $16,000. Lastly, the artist's business deductions must exceed 10 percent of his or her gross service income, otherwise they too are considered miscellaneous itemized deductions. (See p. 7-23.) a. The tax liabilities of J and K will differ because J will benefit from his deductions while K will not. K derives no benefit because his deductions are itemized deductions and do not exceed the standard deduction. In contrast, J's deductions are for A.G.I. and are deductible in addition to the standard deduction that he will be able to claim. The tax liabilities of J and K will differ because the amount of deductions that each may benefit from differs. J may deduct $7,000 plus the amount of the standard deduction while K may deduct only the $7,000 because it exceeds his standard deduction. (See pp. 7-19 through 7-22.)
7-8
7-9
7-10
b.
7-11
This problem deals with a variation on the typical unreasonable compensation scenario. D is no doubt trying to shift income to his children to be taxed at their lower rates. The sketchy facts suggest that the amounts paid to the children are unreasonable for any duties that they are capable of performing. In such case, the IRS may disallow the deductions for those amounts considered unreasonable, say $14,000. Accordingly, the IRS would treat D as having received a constructive dividend of $14,000 followed by a gift of such amount to the children. In addition, the IRS may impose a negligence penalty on D (20% of the tax due). (See Example 8 and p. 7-8.) C's tax advisor should make C aware of the reasonable compensation problem that may arise in this situation and that faces every employee-shareholder of a closely held corporation. In this case, C should be able to demonstrate that the upturn in the fortunes of the business are attributable to his services, thus justifying the handsome salary. C may find relief in the "catch-up" argument, which has been supported by the courts. Under this argument, the taxpayer's current salary simply represents salary that was not paid during the period when the business could not afford to pay the employee what he or she was worth. (See p. 7-8.)
7-12
Solutions to Problem Materials
7-5
7-13
a.
b.
The tax law is not concerned with the lawfulness of the activity in which income and expenses result. Under the general rules, all income is taxable regardless of its source, while the expenses incurred that are related to the illegal business are deductible. Q must report all of his income from the illegal gambling activity of $70,000. He is also entitled to deduct the expenses for rent, phone, and utilities. No deduction is allowed, however, for the bribe paid to the state legislator, assuming it is illegal under state law. Deductions for bribes are specifically disallowed under 162(c). (See pp. 7-34 and 7-35.) Q must still report all of the income from the activity; however, none of the expenses are deductible because 280E specifically denies the deduction of any expenses related to the trafficking in controlled substances. (See p. 7-36.)
7-14
Permanent and timing differences result because tax and financial accounting methods may treat particular items of income and expense differently. Although some accountants argue that accounting methods for book and tax should conform, such practice would result in the use of procedures that are selected to avoid or postpone taxes without considering the method's usefulness in portraying the financial well-being of the business. Moreover, there is no theoretical reason that suggests that the two should be the same, since they serve quite different objectives. Financial accounting methods try to provide information to decision makers about business that helps investors make decisions on whether to buy, hold, or sell securities. Tax accounting methods serve such objectives of the Federal government as raising revenue and regulating the economy. Although permanent and timing differences are not discussed specifically in the text, most students who have an accounting background should be able to identify some of these differences in light of the information discussed in Chapter 7 and previous chapters. Permanent differences include 1. Revenue recognized for financial accounting reporting purposes that are never taxable: a. Interest on municipal bonds; b. Life insurance proceeds payable to a corporation upon the death of an insured employee; and c. Gains and losses on the disposition of property due to different bases for book and tax (e.g., upon incorporation of a sole proprietorship, the basis carries over for tax while it is fair market value for the books). 2. Expenses recognized for financial accounting reporting purposes that are never deductible: a. Life insurance premiums paid on policies covering employees when the business is the beneficiary, and b. Interest paid on a loan used to purchase tax-exempt bonds. 3. Deductions allowed for income tax purposes that do not qualify as expenses under GAAP: a. Dividends-received deduction allowed to corporation (70% or 80% in the case of a more than 20% owned company), and b. Percentage depletion in excess of cost depletion. Timing differences include such items as a. Prepaid rent (reported as earned for GAAP and when received for tax); b. Gain on an installment sale (all reported at point of sale under GAAP and over the period when the sale proceeds are collected for tax); c. Depreciation (straight-line for books while accelerated for tax); and d. Reserves for bad debts, product warranty costs, and other expenses or losses including contingent liabilities (not allowed for tax purposes).
7-15
Expenditures for assets with a useful life that do not extend "substantially beyond" (more than one year) the close of the taxable year may be deducted by the cash basis taxpayer in the year paid. Because supplies normally would be consumed by the close of the following taxable year, a cash basis taxpayer could deduct year-end expenditures for these items, and thus reduce current taxable income. Note that a cash basis taxpayer generally cannot reduce taxable income by making year-end purchases of inventory because he is required to account for inventories using the accrual method (with exceptions for small businesses). (See p. 7-10.)
7-6
Chapter 7
Overview of Deductions and Losses
7-16
The major difference between self-employed persons and employees concerns the degree of control the individual has over their performance of the service. In an employer/employee relationship, the employer determines not only what will be done, but how the employee is to accomplish the result. In contrast, the self-employed individual controls the means by which the task is accomplished. The distinction is important for income tax purposes because all self-employment expenses are deductible "for" A.G.I., while unreimbursed employee business expenses are deductible "from" A.G.I. as miscellaneous itemized deductions. (See pp. 7-21 and 7-22.) The distinction for employment tax purposes is extremely important for the employer. If the person is not considered an employee, the employer is not required to pay employment taxes (social security or unemployment taxes) leading to a substantially reduced cost of labor. An activity is considered a hobby if no profit motive exists. To determine if the profit motive exists, the Regulations indicate the following factors should be considered: the business-like manner of the activity, the knowledge acquired about the activity, the financial status of the taxpayer, the history and relationship of the income and losses from the activity, the intent of the taxpayer to earn a profit, and the amount of personal or recreational pleasure derived from the activity. (For a discussion of these factors, see the article cited at footnote 130 and p. 7-44) If the activity is deemed a hobby, the expenses relating to that activity will be limited to the activity's gross income as reduced by any otherwise allowable deduction such as taxes. Moreover, the expenses of a hobby are treated as miscellaneous itemized deductions subject to the two percent floor. (See Example 28 and pp. 7-24 through 7-26.) It is arguable that this payment is more in the nature of interest than a penalty or fine. However, numerous cases and rulings deny deduction for penalties for failure to make timely payment of taxes. (See pp. 7-34 and 7-35 and Rev. Rul. 61-210, 1961-2 C.B. 31.) Constructive ownership rules treat taxpayers as actually owning the stock of another "related" taxpayer. Without constructive ownership rules, related parties could have "paper" transactions that would have tax consequences but would not affect the taxpayer's economic position. (See Example 51 and pp. 7-39 through 7-41.) The general thrust of 265 is to prohibit the deduction of expenses related to tax-exempt income. No interest expense or nonbusiness expense related to tax-exempt interest income may be deducted. Similarly, no expense related to tax-exempt income other than interest is deductible (e.g., premium on disability income insurance policies are nondeductible--see Example 46.) These restrictions, however, permit the deduction of any business expense related to tax-exempt interest. Thus, an investor could not deduct the cost of earning tax-exempt interest (because he is not in that business), but a financial institution could because it would be a business expense. (See Example 46 through 49 and pp. 7-37 and 7-38.) The Cohan rule provides that a deduction, other than one related to travel, entertainment, or gifts is allowable where a reasonable estimate of the amount can be made. Substantiation has traditionally been required only for expenses relating to travel and entertainment. The Deficit Reduction Act of 1984, however, introduced new recordkeeping requirements for so-called "listed property" (e.g., passenger vehicles, computers, and recreation equipment) discussed in Chapter 9. (See footnote 124 and p. 7-42.)
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7-18
7-19
7-20
7-21
PROBLEMS
7-22 The first three of these questions was derived from the facts of actual cases. The fourth is hypothetical. Their purpose is to illustrate the difficulty in interpreting and applying the general requirements. a. In this situation, the issue is whether the additional expenses of commuting are sufficiently related to the officer's trade or business to satisfy the test of 162. Although the expense would not be incurred "but for" the employer's requirement to carry a gun, the additional commuting resulted from the taxpayer's choice of where to live--a purely personal matter. For this reason, the Court held that the expenses were not directly connected with the pursuit of business, and thus not deductible. [See pp. 7-26 and 7-27, and Dennis McCabe, 82-1 USTC { 9331, 49 AFTR 2d 82-1192, 676 F2d 915 (CA-2, 1982).] b. In this case, there are several possible arguments supporting disallowance. The primary question is whether the expense is sufficiently related to, or incurred while "carrying on, " the duties of a union president. The courts have consistently ruled that campaign costs are not sufficiently related to the performance of the functions of an office, and thus, are not deductible. The expenses are incurred in
Solutions to Problem Materials
7-7
c.
d.
"trying to become" president rather than in "being" president. See James B. Carey, 56 T.C. 477 (1971). In addition, it might be argued that the expenses are not deductible under the public policy doctrine, since the union position is of such public interest that government support through allowance of deductions contradicts public policy. The courts, however, have not accepted this argument--see Carey. It also could be argued that the union president is not in a trade or business, but the Courts have ruled otherwise--see Carey. [Also see pp. 7-4, 7-33 and 7-34, and 162(a).] In Trebilcock v. Comm., [77-2 USTC { 9530, 40 AFTR2d 77-5243 557 F2d 1226 (CA-6, 1977)], the Court denied the deduction for such expenditures. Although the minister's aid may have allowed the taxpayer to cope more easily with the strain of running a large business, it did not sharpen his business skills. The court believed that all the benefits to be derived from the expenses were inherently personal in nature, and thus, not deductible under 262. The court also believed that the expenditures for the minister's solutions to business problems, considering the method used (heightening spiritual awareness so that he could better understand the problems), were not ordinary in this line of business. (See pp. 7-7 and 7-8.) Under the general positive criteria of 162, the taxpayer's expenditures for "insurance" appear to qualify for deductibility, although this conclusion is subject to debate. First, the taxpayer is engaged in a trade or business. Second, the expenditures are probably ordinary because they are normally incurred by similar businesses in that particular geographic location. Third, they certainly are necessary (if not made, the taxpayer could be out of business very soon). And fourth, the expenditures appear to be reasonable under the circumstances. (See pp. 7-4 through 7-9.) No deduction is allowed for these costs until economic performance has occurred. In this case, economic performance is deemed to occur when R performs the services. Note that this expense is arguably deductible under the all events test, since the obligation is fixed and the cost can be determined with reasonable accuracy. However, the economic performance test prevents accrual of the estimate. Note that the exceptions for recurring items should not apply in this case, since not all of the activities are performed within eight and one-half months after the close of the taxable year. (See Examples 14 and 15 and pp. 7-13 through 7-15.) No deduction is allowed for the prepaid rent in 2011 because economic performance has not occurred (the taxpayer has not received the consideration bargained for, that is, use of the office space does not occur until the year following the payment). Deduction for the rent may be claimed in 2012. (See Example 19 on p. 7-16.) Contrast this result with that for the cash basis taxpayer in problem 729 where the deduction is allowed as long as the period for which payment is made does not exceed one year and the taxpayer is contractually obligated to prepay the amount. No deduction is allowed in 2011 because economic performance has not occurred. Economic performance occurs when the taxpayer receives the consideration bargained for. (See Example 13 and pp. 7-13 and 7-14.)
7-23
a.
b.
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7-24
KKO has incurred a prepaid expense in the amount of $6,000. Under the general rule for prepayments (See p. 7-10), prepaid expenses are deductible if the asset will be consumed by the close of the following tax year, there is a business purpose for the expenditure, and there is no material distortion of income. Since these criteria are met, KKO can deduct the expense in 2011. This conclusion is reinforced by the economic performance test that places payments for provision of work to the taxpayer under warranty or service contracts on the cash basis. (See pp. 7-13 and 7-14.) M Corporation can deduct $200,000 of the accrued $500,000 expense in 2011 because it meets the recurring item exception to the economic performance test. Specifically, the all events test is satisfied, $200,000 actual expenses occurred within eight and one-half months after the close of the taxable year, the item is recurring in nature, and the expense is matched against the income that generated the expense. (See p. 7-16.) a. Under the general economic performance rules, taxes are deductible only when paid. However, the recurring item exception allows a deduction if (1) the all events test is met; (2) economic performance occurs within eight and one-half months after the close of the taxable year; (3) the item is recurring; and (4) the item is immaterial or accrual in the earlier year results in a better match against income. Here, the recurring item exception applies since all of the tests are met and the payment is made within eight and one-half months after the close of the tax year. Therefore, M Corporation may deduct $12,000 in 2011. If M makes the election to accrue taxes under 461(c), it may deduct the property taxes over the period to which they relate. Based on the facts, it appears that the taxes relate to October 1, 2010 through September 30, 2011 so three months of taxes could be accrued in 2010 and nine months of taxes could be accrued in 2011 because all of the taxes relate to such period. (See Example 21 on p. 7-17.)
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7-26
b.
7-8
Chapter 7
Overview of Deductions and Losses
7-27
a.
Using the cash method of accounting, the taxable income is Cash receipts Less: Payments on payables Taxable income $140,000 (82,000) $ 58,000
b.
Using the accrual method of accounting, the taxable income is Cash receipts Less: Cost of sales Beginning inventory Purchases Less: Ending inventory Cost of sales Taxable income $140,000 $ ,000 90,000 (25,000) (65,000) $ 75,000
c.
Because D has inventory that is an income-producing factor, D generally must use the accrual method of accounting (at least for sales and cost of goods sold). There are exceptions to this rule for small businesses. This problem demonstrates the ability of cash basis taxpayers, in the absence of such a requirement, to control taxable income through cash payments for goods sold to customers. Using the cash method of accounting, D is allowed to deduct cash payments of $82,000 even though the cost of sales is only $65,000, thereby reducing taxable income by $17,000. (See p. 7-10.) $3,000 must be deducted in the following year, when the interest accrues. (See p. 7-12.) $2,000 in prepaid interest (points equal to 2% of $100,000) is deductible since it is related to acquisition financing. (See Example 12 and p. 7-12.) The IRS position is that points paid to refinance a primary residence are not deductible but must be amortized because 461(g) allows a deduction only for points incurred with a purchase or improvement. $2,000 must be deducted ratably over the period of the loan because the points are not related to acquiring financing for a principal residence. (See Example 12 and p. 7-12.) The treatment of the lease payment depends on whether F is an accrual or cash basis taxpayer. If F uses the cash method, the $12,000 is deductible. Under the cash method, special rules apply for virtually each type of prepaid item. Prepaid rent is deductible when paid if the period of the lease does not exceed one year and the taxpayer is obligated by the lease agreement to pay the entire year in advance. Because these conditions are satisfied in this case, F may deduct the entire $12,000 in the year in which it is paid. Note that is there no economic performance test for cash basis taxpayers as there is for accrual basis taxpayers (see discussion below). (See Example 11 and p. 7-12.) If F uses the accrual method, a different approach is required, which results in a deduction of four months of rent, or $4,000. Accrual basis taxpayers may deduct expenses if the all events test (i.e., the liability is fixed and determinable) has been satisfied and economic performance has occurred. In this case, the liability is fixed and determinable. However, economic performance has not totally occurred. Economic performance occurs when the taxpayer receives the consideration bargained for, which in this case is the office space. Because F has received use of the office space for four months, 4=12 of the annual payment of $12,000, or $4,000, is deductible. Note, however, that the full $12,000 could be deductible in the current year if the recurring item election has been made. (See Example 19 and pp. 7-13 through 7-17.) There is no deduction for the deposit under either method of accounting. The taxpayer has not incurred a cost because the deposit will ultimately be returned. If the $12,000 had been called an advance on last year's rent, there would be no immediate deduction for either the cash or accrual basis taxpayer. For the cash basis taxpayer, an asset has been created that extends substantially beyond the close of the taxable year (i.e., more than one year beyond the close of the taxable year), in which case no deduction is allowed until the services are received. For the accrual basis taxpayer, economic performance has not occurred. Regulation 1.446-1(c)(2) provides that any expenditure resulting "in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year may not be deductible when made, or may be deductible only in part." The courts have indicated that this means that an asset with a useful life that extends beyond the close of the following taxable year must be capitalized. Following this interpretation, the entire cost of the supplies purchased this year should be deductible. (See pp. 7-10 through 7-12.)
7-28
a. b.
c.
7-29
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b.
7-30
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Solutions to Problem Materials
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b.
D should be able to deduct all of the cost this year under the Service's view contained in Rev. Rul. 79-229. In this ruling, the IRS authorized the deduction of prepaid expenses of a cash basis taxpayer if (1) the prepayment was made for a business purpose, (2) the payment did not materially distort income, and (3) it was not merely a deposit. (See pp. 7-10 through 7-12.)
7-31
Despite the fact that advertising costs may benefit future periods, courts have rejected capitalization and amortization of such expenditures because of the difficulty in identifying the period benefitted. Note that if the taxpayer wishes to defer recognition of the expense, the courts have so allowed if it can be demonstrated with reasonable certainty that the benefits of the advertising would be recognized in later years. (See p. 7-28.) The costs would be considered capital expenditures. Capital expenditures include those that add to the value or prolong the life of property. In this case, the expenses for carpeting and painting appear to be part of a major overhaul of the vacant units, suggesting that the painting should be capitalized. Note that if the painting costs had not been part of a major renovation they might be deductible as routine maintenance. (See footnote 76 and p. 7-29.) a. b. c. Sales tax must be capitalized. (See p. 7-29.) Although the cost of the pencil may benefit future periods, the cost of small tools is deductible. (See p. 7-28.) The cost of small tools used in a business normally does not have to be capitalized because it does not have a useful life extending substantially beyond the taxable year or because the cost is so small that expensing such items would not materially distort income. Items costing a small amount may normally be expensed as long as a consistent policy is followed. [See p. 7-28 and Reg. 1.263(a)-2.] Freight must be capitalized as part of the acquisition cost of the machine. (See p. 7-29.) Because the painting cost is not incurred as a part of a major renovation it is deductible as a repair. (See p. 7-29.) The cost of a permanent improvement such as replacing the dirt parking lot with a concrete one is a capital expenditure. (See p. 7-29.) The commission is a cost of acquiring new office space; therefore, it should be capitalized and amortized over the term of the lease. (See p. 7-29.) The cost of rewiring to adapt the space for a new use (i.e., to accommodate the new equipment) should be capitalized as part of the cost of the building. (See p. 7-29.) C must report $3,000 as income, but she may deduct all of her $3,800 expenses. The $3,800 would offset $3,000 of her race winnings and $800 of her other $100,000 of income. (Note that the passive loss rules do not apply in this instance because the taxpayer materially participates in the activity.) If the activity constituted a trade or business, the deductions would be for A.G.I. (See p. 7-24.) If the activity is a hobby, C may deduct expenses to the extent of hobby gross income as reduced by otherwise allowable expenses. (See Example 28 and pp. 7-24 through 7-26.) Gross income from hobby Otherwise allowable expenses: Property taxes Amount of other expenses deductible 11Thus, the total deduction is $3,000, consisting of $2,800 property taxes and $200 of fuel. The deduction for the taxes would be from A.G.I. The deduction for the fuel, supplies, and maintenance of $200 is a miscellaneous itemized deduction subject to the two percent floor. Assuming that this $200 amount represents the only miscellaneous itemized deduction, none of the expense would be deductible because it does not exceed $2,060 (2% $103,000 A.G.I.). $ 3,000 (2,800) $ 200
7-32
7-33
d. e. f. g. h.
7-34
a.
b.
7-10
Chapter 7
Overview of Deductions and Losses
c.
Same approach as in (b). (See Example 29 and p. 7-26.) Gross income from hobby Otherwise allowable expenses: Property taxes Amount of other expenses deductible $ 3,000 (4,000)* $ 0
*All $4,000 would be an itemized deduction, and thus, deductible only if the taxpayer itemizes. d. 11- e. The taxpayer must establish that the reason for engaging in the activity is to make a profit. (See p. 7-24.) In the absence of profitable years, an activity is more likely to be treated as a business than a hobby if it is conducted like a business. This requirement suggests that the taxpayer keep adequate books and records, devote substantial time to the activity, try new business techniques when old ones fail, consult experts in the area, and take other steps that imply that the taxpayer is in business for a profit. (See pp. 7-24 and 7-25.) R, the taxpayer, has the burden of proof and must show that a profit motive exists. (See p. 7-24.) Yes. The taxpayer may elect to postpone challenges from the IRS until sufficient time (five years) has elapsed to determine who bears the burden of proof. Under the three-of-five-year rule (the wait-and-see rule), if the taxpayer shows profit in three of five years, the burden shifts to the IRS to prove that the activity is a hobby. R must file the election no later than 60 days after he has received notice from the IRS that the expense will be disallowed. (See p. 7-25 and 183.) The three years of profit merely shift the burden of proof to the IRS. When profits are shown for three of five consecutive years, the IRS must show that the activity was not profit-motivated. Note that the three years of profit do not bar the IRS from asserting that the activity is a hobby. In contrast, failure to show three years of profit does not mean that the taxpayer's case is lost automatically. In one study involving an analysis of 151 gentlemen farmers (see footnote 130 and p. 7-44), over 50 percent had never shown a profit but more than half had won their cases.
7-35
a. b.
c.
7-36
Because R filed an election for 2011 to defer application of the presumptive rule, the statute of limitations is extended to enable the IRS to challenge the presumption at a later time. In this case, the statute of limitations will expire two years after the due date of the return for the last taxable year in the five-year presumptive period. (i.e., April 15, 2017). (See p. 7-25.) a. Any expenses related to investigating a business that is the same or similar to a taxpayer's current business are deductible in full. Because H is presently engaged in the optical business and is investigating similar businesses, he may deduct all $875 ($175 $200 $500) of the expenses for A.G.I. The fact that H did not enter the business in Tacoma is irrelevant. (See Example 33, footnotes 86 and 87 and pp. 7-31 and 7-32.) Because the investigation expenses are related to a new business--the ice cream business--and H entered that business, 195 governs. Thus, all $7,100 ($400 $500 $2,400 $3,000 $800) of the expenses qualify as start-up expenses. In this case, $5,000 is expensed in the year H begins the ice cream business, and the remaining $2,100 must be amortized over a 180-month period ($2,100/ 180 = $16.67 per month), beginning with the month that H starts the new business. Although H did not acquire a franchise from P, the related expenses may be deducted, since such expenses fall within the definition of start-up expense: an expense that is connected with acquisition or creation of a business and would be deductible if the taxpayer had expanded an existing business in the same field. (See Examples 34 and 35, p. 7-32, and 195.) In this case, the taxpayer investigates a business different from the one in which he is currently engaged, and does not enter the business. Because he does not enter the business, 195 is not applicable and case law governs. The Tax Court suggests that the taxpayer may deduct the costs as a loss if the investigation activities are sufficient to constitute a transaction. The IRS has interpreted this decision to mean that the costs for a general search are not deductible; only the costs incurred after the taxpayer has focused on the acquisition of a particular business are deductible. Under the IRS interpretation, only the attorney's fee of $800 would be deductible, since the other expenses were of a general nature, and this expense is incurred after a taxpayer has decided to acquire the business. (See footnotes 91 and 92, Example 38, and pp. 7-32 and 7-33.)
7-37
b.
c.
Solutions to Problem Materials
7-11
7-38
a.
b.
c.
Because this was P's initial entry into this specific business, she is not allowed a deduction if she does not enter into this business. However, if she made expenditures that focused on the acquisition of a specific business subsequent to the decision to enter into the business (as opposed to those expenditures for a general search), the expenditures may be deductible. (See footnotes 91 and 92, Example 38, and pp. 7-31 through 7-33.) If P makes an election under Code 195, she may partially deduct the expenditures beginning with the first month in business. The amount deductible in 2011 will be $6,333 [$5,000 $1,333 ($20,000 remaing expense = 180 months 12 months (assuming she's in business for 12 months in her first tax year))]. (See Example 36 and p. 7-32.) P may deduct the full amount of the investigation costs related to an existing same or similar business. This is true whether or not the new business is acquired. (See footnotes 86 and 87, Example 33, and p. 7-31.) Example 7 is derived from the facts of Welch v. Helvering. In that case, the Supreme Court indicated not only that the expenses were not ordinary but suggested that they were in the nature of a capital outlay to acquire goodwill. In later cases, however, similar expenses have been allowed where the court believed they were made to protect and promote the taxpayer's existing business. In Dunn & McCarthy, Inc. v. Comm. the corporation was permitted to deduct the reimbursements to employees who had loaned money to the corporation's president. The Court emphasized that the expenses were to prevent loss of earnings and to protect goodwill rather than to acquire goodwill. (See Example 7 and pp. 7-7 and 7-8.) Because land and investment securities do not have a determinable useful life, these assets cannot be depreciated or amortized. The cost of these assets is recovered at the time of disposition. (See p. 7-28.) The taxpayer can recover the cost of acquired goodwill ratably over a 15-year period. (See Example 31 and pp. 7-28 and 7-29.) An expenditure is a repair if it maintains the normal operating state of the property and does not materially increase the value or appreciably prolong the life of the property. A repair may be expensed in the current year. Conversely, any expenditure that substantially prolongs the property's useful life, materially increases the property's value, or provides a permanent improvement to the property is considered a capital expenditure. Capital expenditures normally may be deducted ratably over their useful life. (See p. 7-32, 167 and 168, and Reg. 1.162-4.)
7-39
a.
b.
c. d.
7-40
The first consideration in this question should be the determination of whether the expense is in fact deductible. Once that determination has been made, the expense should be classified. a. Assuming the uniform is not suitable for wear elsewhere, M may deduct it as an ordinary and necessary business expense. The deduction would be for A.G.I. because he is self-employed. The deduction would appear on Schedule C. (See pp. 7-21 and 7-22.) b. The deduction for the uniform--an unreimbursed employee business expense--is considered a miscellaneous itemized deduction and is deductible only to the extent that it and other miscellaneous itemized deductions taken in the aggregate exceed 2 percent of A.G.I. (See pp. 7-21 and 7-22.) c. M may deduct $70 for A.G.I. Employee business expenses are deductible for A.G.I. to the extent reimbursed and included in the employee's income. The remaining $30 is considered a miscellaneous itemized deduction and is deductible only to the extent that it and other miscellaneous itemized deductions taken in the aggregate exceed 2 percent of A.G.I. (The instructor might want to point out that because the expense is reimbursed does not necessarily mean it is deductible.) (See Examples 24 and 25, and pp. 7-22 and 7-23.) a. The AICPA dues, State Society of Accountants dues, CPA license fee, subscriptions to tax journals, and the continuing education course are all deductible employee business expenses under the general rules of 162. Both the cost of purchasing and the expense for cleaning her business suits are considered nondeductible personal expenses because the clothing is suitable for wear other than business. T may deduct the portion of the AICPA dues that were reimbursed, $100, as a deduction for A.G.I. The remaining $100 is treated along with the other employee business expenses as miscellaneous itemized deductions. The legal fees for preparation of a will are personal, nondeductible expenses, but the legal fees paid to collect alimony are deductible under 212 as an expense of producing income. The job-hunting expenses are also deductible under 212 under the same expense of producing income rationale. Likewise, the cost of tax return preparation is deductible under 212. This provision allows a deduction for the determination, collection, or refund of any tax. All three of these deductions are treated as miscellaneous itemized deductions. Note, however, that her subway expenses are nondeductible commuting expenses.
7-41
7-12
Chapter 7
Overview of Deductions and Losses
The cost of the safe deposit box and the annual brokerage fee are also deductible as investment expenses under 212. These costs are also treated as miscellaneous itemized deductions. The qualified residence interest (i.e., interest on a mortgage on the taxpayer's primary or second home) is deductible as an itemized deduction. T's taxable income would be as follows: Compensation Alimony Gross income Deductions for A.G.I. Reimbursed AICPA dues Adjusted gross income Itemized deductions Qualified residence interest Miscellaneous itemized deductions Unreimbursed AICPA dues State society dues license ($315 $345) Subscriptions to tax journals Course on new tax law Legal fees to collect alimony Job hunting expenses Safe deposit box Brokerage fee Total 2% $82,000 A.G.I. Deduction allowed Personal exemption Taxable income (See pp. 7-20 through 7-24.) b. Due to the limitation on miscellaneous itemized deductions, T is unable to deduct $1,640 of her expenses, losing a tax benefit of about $410 (25% of $1,640). She should consider prepaying next year's dues and subscriptions to avoid the limitation for these items. Payment of rent on the safe deposit box for a period beyond the close of the next taxable year would not generally be deductible under the rules applying to prepaid rent (with a possible exception under the "one-year" rule). T might also try to get her employer to reimburse her for the full amount of her dues and subscriptions. (See p. 7-9.) Z's A.G.I. is $19,750 ($20,000 gross wages $250 for the reimbursed expense). Note that the cost of commuting to and from work, although reimbursed and included in Z's gross wages, is not a deductible expense. Code 62 controls the classification of an expense as deductible for or from A.G.I. It does not determine the deductibility of expenditures. In this case, commuting is considered to be a nondeductible personal expenditure. (See pp. 7-20 through 7-24, 7-26 and 7-27.) Z's itemized deductions equal $5,305, as follows: Charitable contributions Interest and taxes Miscellaneous itemized deductions [$1,100 $395 ($19,750 AGI 2%)] Total itemized deductions $ 700 3,900 705 $ 5,305 $ 80,000 2,100 $ 82,100 (100) $ 82,000 (6,000) $300 660 225 600 250 150 90 130 $ 2,405 (1,640) (765) (3,650) $ 71,585
7-42
a.
b.
Note that since Z's standard deduction (for a single taxpayer) of $5,800 is greater than her $5,305 total itemized deductions, she should not itemize her deductions. (See pp. 7-19 through 7-21.)
Solutions to Problem Materials
7-13
7-43
Costs of obtaining a loan (including the $2,000 loan origination fee, $6,000 in points, and $500 of legal fees) that are paid by a cash basis taxpayer must be amortized over the term of the loan, or 20 years. Note that points paid in obtaining a business loan are not immediately deductible, as are points incurred to purchase a primary residence. The interest paid in advance is simply prepaid interest and is not deductible except over the term in which it accrues. In absence of better information regarding the nature of the loan, assume that 2=12 of the interest representing the months of November and December is deductible. The total deduction for the year would be $3,404 determined as follows: Points and origination fee Legal fee Total acquisition costs Current-year amortization of acquisition costs $8,500=240 months $35.42 2 months Prepaid interest which has accrued 2=12 $20,000 Total (See p. 7-12.) $ 8,000 500 $ 8,500
$
71 3,333
$ 3,404
7-44
Insurance costs related to business are normally deductible under the general rules of 162. However, premiums paid on life insurance policies covering key employees are not deductible when the business is the beneficiary. (See p. 7-38.) Thus, the premium paid for coverage of the life of Jose Greatfoot is not deductible. In contrast, the premium payments on the group-term coverage for all employees is deductible. (See p. 7-38.) The premium payment for the fire and theft coverage is deductible; however, prepayments of insurance premiums are not normally deductible when paid but must be apportioned over the period which the policy covers. Therefore, only the portion of the fire and theft insurance that is applicable to the current year is deductible currently. However, the premiums incurred to recover overhead expenses are deductible in the year paid under the 12-month rule because the benefits will not extend more than 12 months from the date of prepayment. Note that any amounts received to cover overhead would be taxable. No deduction is allowed for additions to the self insurance reserve; 162 allows deductions for expenses that are paid or incurred during the year, and because no expense is paid or incurred when a reserve is established, no deduction is allowed. (See pp. 7-8 and 7-38.) The deduction would be computed as follows: Fire and theft insurance $2,400 premium $100 1 month 24-month policy period Life insurance for Jose Greatfoot (no deduction for employee insurance when business is the beneficiary) Group-term life insurance Overhead insurance Self insurance reserve contribution (no expense actually paid or incurred) Total deduction $ 100
0
9,000 3,600 0 $12,700
7-45
No deduction is allowed for premiums on a life insurance policy covering the life of an employee if the taxpayer is directly or indirectly a beneficiary. These are typically known as "key-person" insurance policies. In this case, the company is the beneficiary of the policy and therefore no deduction is allowed. (See p. 7-38 and 264.) Although business reasons necessitate the premium payments (i.e., "but for" the business venture no insurance premiums would have been paid), no deduction is allowed. No deduction is allowed for premium payments on a life insurance policy when the taxpayer is the beneficiary of the policy either directly or indirectly. Because L would benefit indirectly if the insurance proceeds are used to pay off the loan (should she die), a deduction is prohibited. The deduction is prohibited because it is related to tax-exempt income (i.e., the life insurance proceeds). (See p. 7-38 and 264.)
7-46
7-14
Chapter 7
Overview of Deductions and Losses
7-47
a. b. c.
No deduction is allowed for the penalty. (See Examples 40 through 42, and pp. 7-34 and 7-35.) $200 is deductible ("grease" payments are not illegal under the Foreign Corrupt Practices Act). [See Example 43, p. 7-35, and 162(f).] The $100 advertising expense is not deductible because it was intended to influence the general public. [See Example 45, pp. 7-36 and 7-37, and 162(e)(2).] The $700 travel expense is not deductible because appearing before a Congressional Committee in Washington D.C. constitutes lobbying at the national rather than local level. [See Example 45, pp. 7-36 and 7-37, and 162(e)(1)(A).] The $100 dinner expense is not deductible because the proceeds were an indirect payment to a political candidate. [See p. 7-37 and 162(e)(2).]
7-48
According to Code 162(c), otherwise deductible expenditures are nondeductible if they are for "kickbacks, bribes, or other illegal payments to any other person if illegal under generally enforced U.S. or state laws." In the case at hand, the payments for "insurance" premiums are probably deductible because: (1) they are not bribes, but extorted payments; (2) although extortion is illegal, payment of extortion is not a crime; and (3) even if these payments were illegal, they must be illegal under "generally enforced" laws (it is possible that such laws in New York City are not generally enforced). (See p. 7-35.) a. The loss of $3,000 ($8,000 $11,000) is not deductible. Losses realized from sales to a "related party" are not deductible. A parent and child are considered related parties under 267. (See Example 51 and p. 7-40.) The son's recognized gain is $1,000 determined as follows: Amount realized Less adjusted basis Gain realized Less loss previously disallowed Gain recognized $12,000 (8,000) $ 4,000 (3,000) $ 1,000
7-49
b.
c.
[See Example 51, p. 7-40, and 267(d).] There is no gain recognized. The gain realized of $2,000 ($10,000 $8,000) is reduced by $2,000 of E's $3,000 loss, which was previously disallowed. The remaining $1,000 of E's loss is not deductible by either E or her son. [See Example 51, p. 7-40, and 267(d).] d. The son recognizes a $4,000 loss ($4,000 $8,000). E's original loss of $3,000 is ignored. [See Example 51, p. 7-40, and 267(d).] Because XYZ and G are related parties (G owns more than 50% of the stock of XYZ), the corporation deducts the payment in the year in which G reports it as income. Thus, XYZ is allowed the deduction in the current year because the payment was made by the close of its taxable year, and G, as a cash basis taxpayer, must report $1,000 of income in the current year. [See Example 53, pp. 7-40 and 7-41, and 267(a).] Because XYZ and G are related parties, XYZ may deduct the payment only in the year in which G includes it in income. Because G, as a cash basis taxpayer, would not include the payment in income until the following year, XYZ must wait until the following year before the deduction may be claimed. [See Example 53, p. 7-41, and 267(a)(2).] Yes; the corporation could deduct the accrued payment in the current year, since G is no longer a related party and 267 would not apply. G is not considered a related party since he does not own more than 50 percent of the stock. In addition, the more than 50 percent threshold is not waived under the special rule for a personal service corporation (PSC), since XYZ is not a PSC (i.e., it does not provide personal services). (See pp. 7-40 and 7-41.)
7-50
a.
b.
c.
7-51
B is treated as owning 150 shares. He owns 20 shares directly and 130 shares indirectly [30 shares (B's brother) 40 shares (B's partner) 60 shares (60% the 100 shares owned by E, a 60%-owned corporation)]. [See Example 50, p. 7-39, and 267(b).]
Solutions to Problem Materials
7-15
7-52
a.
b.
c.
If B could qualify as P's dependent, P could treat B's medical expenses as his own and deduct them accordingly. This is highly unlikely, however, since B is married and has earned income of $20,000. Recall that a child filing a joint tax return usually cannot be claimed as a dependent. [See p. 7-41 and 213(a)(1).] No deduction is allowed, since the interest is not P's obligation but that of B and his wife. Therefore, it would be more advantageous for P to give the money to B, who could pay the interest and deduct the payment. (See Examples 55 and 56, and p. 7-41.) Unless P lives in the home with B and his wife, the interest would be considered nondeductible personal interest. As discussed in Chapter 11, interest is deductible only if it is qualified residence interest, investment interest, or business interest. (See p. 7-41.) Z may deduct the loss for A.G.I. because it is incurred in a transaction entered into for profit. (See pp. 7-18 and 7-19.) Although she must report the $1,000 of income on the sale of the truck, no deduction is allowed for the loss on her personal car. A deduction is not permitted for the loss because the loss was not (1) incurred in a trade or business, (2) incurred in a transaction entered into for profit, or (3) attributable to a casualty or theft. (See pp. 7-18 and 7-19.) An itemized deduction for a personal casualty loss is allowed. As discussed in Chapter 8, the loss must be reduced by $100 and is deductible from A.G.I. along with other casualty losses only to the extent that all personal casualty losses exceed 10 percent of A.G.I. (See pp. 7-18 and 7-19.) No deduction is allowed because the loss has not been realized. Moreover, no loss is allowed on the sale of the home, as it is a personal loss rather than a business, investment, or casualty loss. (See pp. 7-18 and 7-19.)
7-53
a. b.
c.
d.
7-54
Because X's contributions in any one year do not exceed the standard deduction, she will receive no tax benefit from her generosity. She should try to bunch the deductions into a single year. For example, she could defer the 2011 gift until January 1, 2012 and accelerate the 2013 gift to December 31, 2012. By so doing, the aggregate amount of deductions, $6,000, exceeds the standard deduction and she will receive a tax benefit. Note that by doing this she will be able to give more to the charity at a smaller after-tax cost. (See pp. 7-42 and 7-43.) T is presented two options. If the asset is expensed this year, T will receive a current tax benefit of $1,091 (30% $4,000 $1,200 0.9091 PV factor) because the deduction will be claimed at the end of the current year. If the asset is capitalized and depreciated, the bulk of the depreciation will be claimed when T is in a higher bracket (presuming the tax law does not change!), thus providing a greater absolute benefit. But to properly make the comparison, T must take into account the time value of money and discount the future benefits of the depreciation deductions at the appropriate rate. Given that the computer is five-year property, MACRS is used, and the discount rate is 10 percent, the after-tax present value of the depreciation is $1,164 (greater than the $1,091 after-tax present value obtained from immediate expensing). Present Discounted Tax Tax Value Cash Depreciation Rate Benefit Factor Flow $800 30% $240 0.9091 $ 218 1,280 40% 512 0.8264 423 768 40% 307 0.7513 231 460 40% 184 0.6830 126 460 40% 184 0.6209 114 232 40% 93 0.5645 52 $ 1,164 11a. b. Not deductible because it is a personal expense. (See pp. 7-26 and 7-27 and 262.) In this situation, it is necessary to determine whether the expense is properly related to the taxpayer's trade or business. The test set forth by the Supreme Court in Gilmore, 63-1 USTC { 9285, 11 AFTR2d 758, 83 S. Ct. 623 (USSC, 1963), is whether the claim arises in connection with the taxpayer's profitseeking activities. Moreover, it does not depend on the possible consequences to the taxpayer's incomeproducing property (because deductibility would turn on whether the claim would be satisfied out of income or non--income-producing property). Thus, it would appear that the legal expense stemmed purely from personal considerations and would not be deductible. Note: in a case four years earlier, Lewis v. Comm., 58-1 USTC { 9420, 1 AFTR2d 1355, 253 F. 2d 821 (CA-2, 1958), this result was reached via identical facts by somewhat similar rationale. (See p. 7-27.) From A.G.I. as a miscellaneous itemized deduction subject to the 2 percent floor--employee business expense. (See pp. 7-20 and 7-21.)
7-55
7-56
c.
7-16
Chapter 7
Overview of Deductions and Losses
d.
e. f. g. h. i.
$70,000 deduction--corporate taxpayers do not classify deductions as being for or from A.G.I. The $30,000 would be deemed unreasonable salary and would be treated as a nondeductible dividend. (See Example 8 and p. 7-8.) The $2,000 prepaid rent is deductible in the year paid, based on the 12-month rule. The deduction is for A.G.I. (See pp. 7-11 and 7-12.) For A.G.I.--self-employed; both uniforms and maintenance. The $60 reimbursed is deductible for A.G.I. The remaining $105 ($150 $15 $60) is a miscellaneous itemized deduction and is deductible from A.G.I. subject to the 2 percent floor. (See Example 24 on p. 7-22.) For A.G.I. (See pp. 7-20 and 7-21.) Not deductible. Because the reimbursement was not included in the employee's income, it is not deductible. (See p. 7-22.) Not deductible--assuming wife is the only one who is legally obligated on the mortgage. (See p. 7-41.) The amount paid may qualify as deductible alimony if they are required under a divorce or separation agreement. (See Chapter 6) $600 from A.G.I. as a miscellaneous itemized deduction subject to the 2 percent floor. (See p. 7-21.) The $10,000 must be capitalized as part of the cost of the land. (See p. 7-29.) The $1,000 loss is not deductible at all because it is personal; moreover, the $1,000 loss may not be used to offset the $400 gain. Thus, the taxpayer reports $400 of income. (See pp. 7-18 and 7-19.) $300 from A.G.I. as a miscellaneous itemized deduction subject to the 2 percent floor--job-seeking expenses in the same profession are deductible. (See Example 39 and pp. 7-33 and 7-34.) Not deductible--a penalty is not deductible. [See Example 40, pp. 7-34 and 7-35, and 162(f).] From A.G.I. as a miscellaneous itemized deduction subject to the 2 percent floor--tax preparation expenses are deductible. [See 212(3).] B may not deduct the loss. B's mother may deduct the $400 loss for A.G.I. but is not entitled to deduct any of B's loss. (See Example 51, p. 7-40, and 267.) There is no deduction. B's mother may reduce her $500 gain by $500 of B's $700 loss previously disallowed. The remainder of B's loss is lost forever. [See Example 51, p. 7-40, and 267(d).] $1,000 for A.G.I.--investigation expenses in the same business are deductible. (See Example 33, and pp. 7-31 and 7-32.) Because the lobbying activities are not directed toward influencing legislation at the local level, none of the expenditures are deductible. [See Example 45, pp. 7-36 and 7-37, and 162(e).] $1,000 not deductible--expenses of illegal business are deductible unless related to trafficking in controlled substances. (See p. 7-36.) Not deductible--estimates of this type are prohibited and nondeductible because economic performance has not occurred. (See pp. 7-13 through 7-15.) Not deductible--expenses related to tax-exempt income are generally nondeductible. (See p. 7-37.)
7-57
a.
b. c. d. e. f. g.
7-58
a. b. c. d. e. f. g.
7-59
There are several tax factors that J should consider when purchasing the car. First, J should be aware that any business expenses related to the car (e.g., depreciation, gas, oil, and repairs) that are not reimbursed by his employer are deductible as miscellaneous itemized deductions subject to the 2 percent floor. Note also that the sales tax on the purchase must be capitalized. And, as discussed in Chapter 11, if he should finance the purchase, any interest related to the car loan would not be deductible. Although the interest is businessrelated, no deduction is allowed for the business interest of an employee. Consequently, he should consider obtaining the financing backed by a lien on a primary or secondary residence, since interest paid on such loans is deductible regardless of how the loan proceeds are used. In light of these rules limiting J's deductions, perhaps J and his fellow salesmen can convince his employer that the employer should own the car and reimburse the salesmen their expenses. J and other salesmen should be willing to take a slight pay decrease in light of the new arrangement, which would work out better for all concerned.
CUMULATIVE PROBLEMS
Solutions to the Cumulative Problems (7-607-61) are contained in the Instructor's Resource Guide and Test Bank for 2012.
TAX RESEARCH PROBLEMS
Solutions to the Tax Research Problems (7-627-66) are contained in the Instructor's Resource Guide and Test Bank for 2012.