ch5tax1 - Taxation of Business Entities Business Deductions...

C5 - 1
Taxation of Business Entities
Business Deductions
Text: Chapter 5

C5 - 2
Learning Objectives
•
Understand the meaning and application of the
ordinary, necessary, and reasonableness
requirements for the deduction of business expenses.
•
Describe the cash and accrual methods of accounting
for business deductions.
•
Apply a variety of Internal Revenue Code deduction
disallowance provisions.
•
Identify contributions that qualify for a charitable
contribution deduction, and determine the limitations
applicable to corporations.
•
Determine the rules for cost recovery using MACRS,
including Section 179 expensing and limitations on
listed property and automobiles.
•
Identify intangible assets that are eligible for
amortization and calculate the amount of the
deduction.

C5 - 3
Ordinary and Necessary
Expenses
•
There shall be allowed as a deduction all the
ordinary and necessary expenses paid or
incurred … in carrying on any trade or
business
•
What is an ordinary expense?
•
What is a necessary expense?
•
What is a trade or business ?

C5 - 4
Reasonable Expenses
•
The Code mentions reasonableness only
when referring to salaries and other
compensation.
•
However, the courts have applied the
reasonableness requirement to all ordinary
and necessary business expenses.
•
Expenses in excess of reasonable amounts
are not deductible.
•
The taxpayer has the burden of proof for
substantiating expenses and must retain
adequate records; otherwise, the IRS can
disallow any deduction.

C5 - 5
Cash Method Requirements
•
Cash basis taxpayers can deduct expenses
only when they are actually paid with cash or
property
–
Payments made with borrowed funds can be
deducted, but issuing a note does not meet the
“actually paid” requirement
•
For cash and accrual basis taxpayers, capital
expenditures can be deducted only through
amortization, depletion, or depreciation

C5 - 6
Accrual Method Requirements
•
Deductions are allowed when the all events
test and the economic performance test are
met.
•
All events test is met when:
–
All the events have occurred to create the
taxpayer’s liability, and
–
The amount of the liability can be determined with
reasonable accuracy
•
Economic performance test
–
Met when service, property, or use of property
giving rise to the liability is actually performed for,
provided to, or used by the taxpayer

C5 - 7
Accrual Method Requirements
•
Certain recurring, immaterial items can be
deducted in year incurred if economic
performance occurs within 8 1/2 months after
close of year.
•
Reserves for estimated expenses (e.g.
warranty expense, bad debt expense)
common in financial accounting, are not
allowed for tax purposes because the
economic performance test is not satisfied.

C5 - 8
Disallowance Possibilities
•
Deductions are disallowed for specified
expenses that are considered contrary to
public policy, including:
–
Bribes and illegal kickbacks
–
Fines and penalties paid to a government for violation of law
•