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Chapter10 - Chapter 10 Certain Business Certain Deductions...

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Unformatted text preview: Chapter 10 Certain Business Certain Deductions and Losses Losses 1 Losses in General Types of losses (§ 165) Losses incurred in a trade or business Losses incurred in any transaction entered into for Losses profit profit Casualty losses Additional rules govern certain types of losses: Bad debts – § 166 Worthless securities – § 165(g) Sec. 1244 stock (Chapter 16) Wagering losses – § 165(d) 2 Bad Debts: Business vs. Nonbusiness Business Bad Stakes Business bad debts: deductible as ordinary deduction Nonbusiness bad debts: deductible only as a STCL Business Bad Debts Must be closely related to a business Loans made by a corporation are always treated as Loans business debts business Examples 3 Bad Debts: Nonbusiness Nonbusiness bad debt defined Bad debt unrelated to taxpayer’s business either when the debt was created, or when the debt became worthless Examples Loans made to protect investments are classified as Loans nonbusiness debts nonbusiness Problem areas: Loans made by employee shareholders to corporations Guaranteeing a loan: business purpose or other? Loans regularly made by TP for profit, when the TP is Loans not in the business of lending full-time not 4 Bad Debts: Deduction Requirements Three requirements: 1. Bona fide debtor-creditor relationship must exist A bona fide debt Problem areas: “Loans” between related parties: gifts or loans? Loan from a shareholder to a controlled corporation Loan from a corporation to a shareholder 5 Bad Debts: Deduction Requirements 2. Must have basis in the debt Cash basis No bad debt deduction for accounts receivable Bad debt deduction is available for loans Accrual basis Bad debt deduction available for accounts receivable Bad debt deduction is available for loans 3. The debt must be worthless Must show the debt is worthless Indicators of worthlessness: No legal action necessary 6 Bad Debts: Deduction Methods Deduction Bad Permitted Methods for Deduction (for businesses) Reserve method not available except for small banks Specific write-off (direct write-off) required Qualifying Service Businesses Allowed to reduce accruals for amounts not expected to Allowed be collected be Qualifying businesses 7 Worthless Securities Capital Loss as of last day of tax year When is a security worthless? 8 Section 1244 Stock Loss on Sale or Disposal of § 1244 Stock $50,000 ordinary deduction $100,000 if file jointly Losses greater than this amount are capital losses Ordinary loss deduction available only to original Ordinary owners owners Qualifications for § 1244 stock Small business corporation Not greater than $1,000,000 in outstanding stock at Not the time the stock was issued the 9 Casualties General Rule: Casualty and Theft Losses Are General Deductible Deductible FOR AGI: business/profit property FROM AGI: personal use property Definition of a Casualty: Unreimbursed losses of TP’s property caused by: Fire Shipwreck Storm Theft Any other casualty caused by an external force and Any external sudden, unexpected or unusual event sudden unexpected unusual 10 Casualties Examples of what is or is not included: Examples is is Theft Progressive (slow) deterioration Misplacing/losing property Loss of land Farmer’s crops Loss of trees, shrubs Stretching the concept of unexpected or unusual: When Deductible Theft Presidentially declared disasters Others 11 Casualties Computing the Deduction Compute the loss Reduce loss by insurance Business/Profit Property Partial destruction Deduct the smaller of adjusted basis or decline in Deduct FMV (less insurance proceeds) FMV Complete destruction Deduct the adjusted basis less insurance proceeds Deduct FOR AGI 12 Casualties Personal Use Property Partial destruction Deduct the smaller of adjusted basis or decline in FMV Deduct or $100 floor limitation for losses per casualty $100 per $500 for 2009 but scheduled to decrease to $100 in 2010 Deduct total personal casualties only to extent they exceed 10% Deduct Complete destruction Same as partial destruction for personal use property Deduct FROM AGI AGI AGI The $100 Floor Limitation for Personal Use Items The Destroyed by Casualty Destroyed Apply one time per casualty Apply one Several items may be destroyed in casualty Example 13 Casualties Insured Casualty Losses and No Claim Is Filed No deduction Casualty Gains and Losses What causes a casualty gain? Casualty gains and losses for personal use assets must Casualty be netted be Net after applying $100 floor limitation If netting results in a loss, apply 10% of AGI limitation If netting results in a gain, treat as a 20% category If capital gain capital Exception: Reinvestment under Sec. 1033 14 Casualties Comprehensive Example 1 Individual Z has two casualties in 199A Asset W X Y Date of Casualty 1/20/A 1/20/A 8/30/A Reduction in FMV 10,000 4,000 2,000 Adj. Basis 3,000 5,000 3,000 Insurance Reimbursement 10,000 2,000 0 G/L after Insurance Single casualty net G/L After $100 floor Single After W 7,000 7,000 5,000 5,000 5,000 X (2,000) Y (2,000) (2,000) (1,900) Casualties Comprehensive Casualties Example 2 Same facts as above, except loss on asset X is 12,000, and Same Z’s AGI = 50,000. No insurance reimbursement on X. Z’s G/L after Insurance Single casualty net G/L After $100 floor Single After W 7,000 (5,000) (4,900) (5,000) X (12,000) (12,000) Y (2,000) (2,000) (1,900) (2,000) (6,800) 10% AGI Deduction: 5,000 5,000 (1,800) (1,800) Net Operating Losses Purpose of NOL deduction: NOLs are normally created by one of the following: Loss from operating a sole proprietorship Casualty or theft loss or Losses attributable to a P/S or S-Corp, and LLCs Note: x x The only nonbusiness items that may create NOLs for individuals are casualties and thefts A NOL from the above is reported on the individual’s tax return 17 Net Operating Losses: Computation NOL = excess of deductions over losses and expenses Certain modifications must be made the true economic or business loss 18 NOLs: Computation Modifications No deduction for exemptions Nonbusiness CLs only offset nonbusiness CGs Cannot add to NOL Nonbusiness deductions only offsets nonbusiness income including excess of nonbusiness CGs over nonbusiness CLs Business income includes salaries, wages, rents Casualty losses are business deductions and are not limited Standard deduction is nonbusiness expense Nonbusiness deductions: contributions to IRAs, Keogh plans, alimony Business CLs offset any business CGs Any excess offsets excess of nonbusiness CGs over nonbusiness CLs and nonbusiness expenses No deduction for NOL carried to the current year No deduction for contributions to a qualified plan 19 NOL Carryback & Carryforward Years NOL Deduct Over 18 or 22 Year Period Pre 8/5/97 3 yr. Carryback 15 yr. Carryforward Post 8/4/97 2 yr. carryback 20 yr. carryforward May elect to forgo carryback period x Elect by due date of loss return (including Elect extensions) extensions) x Election is irrevocable once made NOL Carryback & Carryforward Years Statute of limitations for carryback year extended to Statute coincide with that of the loss year coincide 1990 4/15/91 4/15/94 4/15/94 4/15/94 Loss year Due date for loss year return 3 year statute of limitations for loss year Statute of limitations for 1987 year (3rd Statute carryback year) extended to 4/15/94 carryback 21 Accounting for Inventory 22 Accounting for Inventory Reg. § 1.471-1 “[I]n order to reflect taxable income correctly, inventories….are necessary in every case in which the production, purchase, or sale of merchandise is an income producing factor.” Reg. § 1.446-1(c)(2) adds that “in any case in which it is necessary to use an inventory the accrual method of accounting must be used with regard to purchases and sales…” 23 Accounting for Inventory Knight-Ridder Newspapers, Inc. v. U.S. (743 F.2d 781) (CA-11, 1984) According to accounting wisdom the income realized from the sale of merchandise is most clearly measured by matching the cost of the merchandise with the revenue from its sale. In order to achieve such matching of revenue and cost, it is necessary to keep an inventory account reflecting the costs of merchandise, raw materials, and manufacturing expenses. These costs are not deducted immediately when paid but are deferred until the year when the resulting merchandise is sold. 24 Accounting for Inventory Knight-Ridder Newspapers, Inc. v. U.S. (743 F.2d 781) (CA-11, 1984) To make the matching complete, the taxpayer must report income on the accrual method. That method helps to ensure that income from the sale (like the inventory costs) is reflected in the year of the sale. For example, if the sale is made on credit, the accrual method nevertheless treats the income as accrued and reflects it when the sale occurs. The prophetic skills of the accrual shaman permit it to recognize both income and deductions in the same year. By contrast, the primal cash method is unable to achieve such a mystical joinder [matching] of inventory deductions and credit sale income. To be sure, the cash method could theoretically operate in tandem with inventories. The beast could conceivably close its eyes to deductions until the year of the sale. It could never learn, however, to prophesy future cash payments. If there were a credit sale, the beast could not grasp income and deductions simultaneously in its rugged paw. The goal of matching costs and revenues would fail. 25 Accounting for Inventory Reg. § 1.471-1 “[I]n order to reflect taxable income correctly, inventories….are necessary in every case in which the production, purchase, or sale of merchandise is an income producing factor.” •Is there merchandise? • Distinction between merchandise and materials/supplies •Is it an income producing factor or is there something else that is producing the income? If income producing, • Must capitalize cost of inventory purchases and expense such costs when the item is sold. • Must accrue and recognize income at the time of sale—regardless of when the cash is received. 26 Accounting for Inventory • Problems with the definition Problems definition of inventory • • • Stakes: If “inventory,” must capitalize purchases and accrue ,” revenues revenues If merely materials and supplies that are incidental If materials and supplies incidental to the primary function of business (e.g., the provision of services), then expense items and need not accrue income. services), If materials and supplies that are not incidental, If materials not then expense only as consumed but no need to accrue income. Is the inventory an income producing factor or an Is • • inseparable or indispensable part of the services that are rendered? services The difficulty is that there is no clear definition of inventory. The 27 • Accounting for Inventory What is inventory? Wilkinson-Beane Inc. v. Comm. (CA-11, 1970) 28 Accounting for Inventory Inventory v. Services Inventory Osteopathic Med. Oncology & Hematology—Drugs used for —Drugs cancer treatment did not need to be inventoried because they were “indispensable and inseparable” to providing the service. RACMP Enterprises—Concrete contractor that poured RACMP —Concrete foundation, slabs and walkways did not have to use accrual method because materials were indispensable part of services. part Von Euw & L.J. Nunes Trucking—Sand and gravel —Sand purchased for customers had to be inventoried because the supplies were not indispensable and inseparable in providing a service or product. providing 29 Accounting for Inventory Modified Cash Method: Small Business Exception Average annual gross receipts of less than $1 million can elect out of the accrual method. Certain taxpayers with annual average gross receipts between $1 million and $10 million can elect out of the accrual method but there are restrictions 30 Inventory: < $1,000,000 Gross Receipts < $1 million average annual gross receipts. If “inventories” ( items not inseparable from services) Use modified cash method Capitalize and expense as consumed; defer income Same as nonincidental materials and supplies Still expense incidental materials and supplies 31 Inventory: > $1,000,000 & < $10,000,000 $1,000,000 Gross receipts > $1,000,000 & < $10,000,000 If “inventories” (items not inseparable from services) Principal business activity is not Manufacturing, wholesale, retail, mining, etc. Exceptions available for manufacturing and mining if principal activity – Is providing services or – Fabrication/modification of property to meet customer specs Use modified cash method Capitalize and expense as consumed, defer income Same as nonincidental materials and supplies Still expense incidental materials and supplies Not available to C corps > $5,000,000 gross receipts 32 Inventory Capitalization § 263A Basic Problems With Inventory Reporting General Rules “Statutory” regulations to establish inventory methods. Statutory” Two criteria for method: Two Tax method must clearly reflect income Tax method should conform to financial accounting Tax method as much as possible method TP must accrue inventory and sales when the TP production, purchase and/or sale of inventory is a material income producing factor material Service businesses generally are not covered by this Service rule rule 33 Inventory Capitalization § 263A Accounting for inventory: 3 steps Identify costs to be inventoried “Uniform Capitalization Rules” § 263A Evaluate ending inventory for possible reduction to LCM Allocate inventory costs to ending inventory and costs of good sold LIFO, FIFO, Specific ID, Weighted Average Costs, etc.) 34 Inventory Capitalization § 263A Inventoriable Costs Definitions: “Product Costs” For “resellers” (retailers & wholesalers): all For direct costs including purchase, transportation-in, set-up, etc. transportation-in, For manufacturers: DM, DL, & manuf. OH “Indirect Costs” Indirect Off-site storage & warehousing costs, Off-site purchasing dept. costs, handling, processing & labor costs, general & administrative costs, data processing, income taxes, etc. (See Exhibit 10-4 in text) Exhibit 35 Inventory Capitalization § 263A Capitalize vs. Deduct Currently RESELLERS Product Costs Capitalize ALL MANUFACTURERS Capitalize Indirect Costs Capitalize unless last 3-years’ average annual revenues ≤ 10 million. If this exception holds, DEDUCT CURRENTLY Capitalize 36 Inventory Capitalization § 263A Use of LCM If value of EI < original cost assigned to it, write down If to LCM to “Market’ means replacement/reproduction cost Apply LCM on item-by-item basis, not an aggregate Apply basis basis LCM prohibited if LIFO is used 37 Inventory Capitalization § 263A Allocate Inventory Costs to EI or COGS Allowable methods Weighted average costs Specific ID FIFO LIFO 38 Domestic Manufacturing Deduction Deduction 39 Deduction for U.S. Production Activities §199 Special deduction: % of lesser of: Qualified production activities income (QPAI) or Taxable income (or modified AGI for individuals) 3% for 2005 and 2006 6% for 2007-2009 9% after 2009 40 § 199 Production Deduction Calculation of the Deduction Domestic production gross receipts – Allocable costs of goods sold – Directly allocable deductions – Ratable allocation of other deductions Qualified production activities income (QPAI) (not > taxable income) x 3% (6% in 2007-2009, 9% in 2010 and thereafter) Qualified production activities deduction* *not > 50% of W-2 wages paid by employer 41 Deduction for U.S. Production Activities Domestic production gross receipts from 1. Any lease, rental, license, sale, or exchange, of Any qualifying production property that includes qualifying • Tangible personal property, software, & sound Tangible recording that is manufactured, produced, grown, manufactured produced grown or extracted by the taxpayer in whole or significant part in U.S. part • Qualified film produced by the taxpayer (motion Qualified film picture, TV production or video tape if 50 percent of compensation costs for services performed in U.S.) • Electricity, natural gas or potable water produced Electricity, in U.S. in 42 Deduction for U.S. Production Activities Domestic production gross receipts from: 2. Construction performed in the U.S. (erection or substantial renovation of residential or nonresidential buildings and infrastructure) or nonresidential Engineering or architectural services performed Engineering services in the U.S. for construction projects in the U.S. in 3. 43 Deduction for U.S. Production Activities Domestic production gross receipts Does not include: Sale of food and beverages prepared by the taxpayer Sale at a retail establishment at Transmission or distribution of electricity, natural gas, Transmission or potable water 44 Deduction for U.S. Production Activities Deduction is limited to 3, 6, 9% of taxable income 50% of total wages for yr Deduction allowed for Deduction Regular tax Regular AMT Deduction not allowed for SE tax 45 Deduction for U.S. Production Activities What is a Qualified Production Activity? Example: Starbucks International provisions: Substantial transformation Activities by which a new & different article emerges; distinctive name, Activities character and use character Assembly of vacuum cleaners, orange concentrate into orange juice Assembly were not were Substantial conversion costs Direct labor and overhead at least 20% of costs of goods sold Unicap § 263A Applies to real or personal property “produced” by the taxpayer Produce means to construct, build, install, manufacture, develop, improve, Produce create, raise or grow create, 46 ...
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