starting_a_business_2 - 1 TAX 6845 Tax Planning &...

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1 TAX 6845 – Tax Planning & Consulting (September 21) Topic: Operating a business: Business deductions, the DPAD, and inventory updated: September 10, 2010 I. Business deductions – In general, Sec. 162 provides a rather broad and ambiguous definition of what can be deducted from business income: A. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business… B. To be deductible in the current period an expense must be: 1. ordinary normal, usual, or customary in the type of business run by taxpayer NOT capital in nature based on common and accepted business practice an expense need not be recurring to be deductible 2. necessary appropriate, helpful, or conducive to the business activity it need not be essential or indispensible a prudent businessperson would incur the same expense 3. reasonable in amount while the Code refers to the reasonableness test when discussing salary & other compensation, the Courts have expanded the scope to include almost all other business expenses the amount cannot be excessive in the specific circumstances expenditures in excess of a reasonable amounts are NOT deductible; the excess is presumed to be for personal purposes the taxpayer has the burden of proof for substantiating expenses and must retain adequate records; otherwise, the IRS may disallow some deductions (the substantiation requirements are especially high with respect to travel, meals & entertainment, business gifts, and transportation (car expenses))
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C. Interestingly, the terms “ordinary”, “necessary”, “carrying on a trade or business” and “reasonable” have NOT been well defined, but instead have been left to interpretation: by the taxpayer relying on the language in the Code and Regulations, by the IRS, and by the Courts usually based on the “all the facts and circumstances” test. D. Under Sec. 162 a current deduction is not allowed for: capital expenditures, which add to the value or useful life of the property or adapts the property to new or different use personal expenditures expenses related to the production of tax exempt income expenses contrary to public policy expenses disallowed (or limited) by some specific rule (political contributions, related party transactions, wash sales, at-risk rules, passive activity loss limits, a mixed use vacation home, home office deduction, etc.) E. Although there is no comprehensive, exhaustive list of deductible (nondeductible) business expenses, CCH provides a good overview with their “Checklist for Deductions”. F. Mixed motive business expenditures – many small and closely-held businesses make expenditures that have a business purpose combined with some degree of personal involvement. The tax code tries to ensure that the taxpayer does not convert nondeductible personal expenditures into business deductions. Some examples include – meals and entertainment, transportation
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starting_a_business_2 - 1 TAX 6845 Tax Planning &...

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