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ch 6 notes - CHAPTER 6 1 Importance of differentiating...

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Unformatted text preview: CHAPTER 6 1. Importance of differentiating between deductions “for” AGI and deductions “from” AGI (e.g. , itemize requirement, floors, reducing AGI) 2. General Classification of Deductions. a. Trade or Business Deductions. Expenses of a trade or business (think Schedule C: http://www.irs.gov/pub/irs-pdf/fl 0403c.pdf or see Table 3 on page 6-6) b. Production of Income Deductions. Expenses that relate to the production of nonbusiness income c. Personal Deductions. Personal in nature — understand that these are unique (i.e., most personal expenditures are not deductible) d. Deductions for Losses. Losses from disposition of property used in a T or B or an investment activity (and eligible personal casualty and theft losses) 3. SECTION 162: Trade orBusiness Deductions FOUR Requirements. i. Expenditure must relate to the carrying on of T or B ACTIVITY. Case by case basis; however, two main criteria to decide if hobby (more personal) or business: 0 TP has a profit “motive” o Sufficient involvement on the part of TP. a. Regular or continuous activities b. Section 212 Investment v. Section 162 T or B? Look to the amount of the activities (trades) and work involved (few long term investments versus continual short-term trades where such trades support TP’s livelihood). 0. Will depend on the facts of the particular situation (see also pages 7-23 and 7-24) Hobby deductions only allowed to the extent of hobby income (after deducting deductions available to all TPs — e. g., mortgage interest). THUS, T or B LOSSES MAY BE MORE “VALUABLE.” For example, if TP has income from a “normal” job, he/ she may offset such income with T or B losses (and thus reduce taxes) but he/ she would be prevented from using such losses if the activity were considered a hobby. 0 Also, some hobby-related expenses only allowed to extent they (with all other misc. itemized deductions) clear 2% of AGI. 0 Covered more on pages 7-23 & 7-24 ii. Expenditure must be ORDINARY & NECESSARY 0 Ordinary: Normally incurred by businesses that are of the same type as TP’s business (1'. e. , the expense is not too unusual). o Necessary. Appropriate, helpful, or capable of making a contribution to TP’s profit seeking activities. iii. Expenditure must be REASONABLE in amount. Not lavish (issue is common with executive pay for closely—held corporations). 0 Non deductible dividend vs. deductible salary (important to substantiate — e. g. , find comparables) iv. Expenditure must be PAID or INCURRED during the year. 0 PAID generally refers to cash basis TPs — but, there are limits on cash payments being currently expensed — e. g. , capital expenditures: a. Capital expenditure if useful life of > 1 year (if so, “expense” is taken over the life of the asset — i. e. , depreciation, amortization, depletion — more below). 0 INCURRED generally refers to accrual basis TPs (economic performance has occurred and the liability is fixed and its amount can be determined) BUT, satisfi/ing these four requirements does NOT ensure a tax deduction (e. g., expenditures relating to generation of tax-exempt income are typically not deductible) 3. SECTION 212: Production of Income Deductions Expenses that relate to the production of nonbusiness 1ncome (e. g. investment and rental activities) incurred: i. For the production or collection of 1ncome; ii. For the management, conservation, or maintenance of property held for production of income; or, iii. In connection with the determination, collection or refund of taxes (but businesses classify tax planning/compliance expenses as trade or business deductions). Must meet THREE of the FOUR above T or B requirements (i.e., iteml “ ” — the activity being a T or B — is NOT required). Typically these are deducted FROM AGI (as miscellaneous itemized deductions) with the exception of expenses connected to rents and royalties which are deducted FOR AGI (on the Schedule E). 4. Personal Deductions. See Chapter 8 5. SECTION 165: Loss Deductions Types of deductible losses for individuals: i. Losses incurred in a T or B; Deductible without as many limitations; Deductible FOR AGI. ii. Losses incurred in a transaction entered into from profit (and NOT connected with a T or B); Deductible as capital losses; Deductible FOR AGI. iii. Personal casualty/theft losses (i.e., not connected to (i) or (ii)) and gambling losses to extent of gambling winnings; Deducted as itemized deductions; Deductible FROM AGI. NOTE: Bad debts, under Section 166, will be covered later in our course. Some other potential FOR AGI deductions: 0 Business Investigation and Start-up costs: If TP is in same/similar business to one being started/investigated, current deduction for whole amount; If NOT (i.e., if a new business activity is being investigated/started), TP may still elect to deduct up to $5K of startup expenditures in the tax year T or B beings (subject to reduction to the extent the startup expenditures >$50K) — remainder amortized over 180 months starting in month T or B begins) 0 Business gifts: made by self-employed TPs in amounts up to $25 per recipient 0 Transportation and Travel i. Transportation: Cost of transporting TP from one location to another when TP is NOT in travel status (i.e., away from home overnight for business) (does NOT usually include commuting) ii. Travel: TP is away from home overnight for business (reasonable for TP to need sleep or rest to meet normal job requirements) 1. Mix of business/personal: For US travel (get you there) expenses, consider the primary purpose of the trip (and then allocate the costs at the destination) iii. Examples: air fare, taxi fare, parking fees, auto expenses (actual v. standard mileage rate), etc. iv. FOR AGI if self-employed; FROM AGI if unreimbursed employee expenses (and also subject to the 2% floor) 0 Moving Expenses: reasonable expenses of moving household’s goods and effects and travel and lodging (but n_ot meals, temporary living expenses, or house-hunting trips). i. Distance test. Distance from OLD residence and NEW job must be at least 50 miles farther than distance from the OLD residence and OLD job (if no OLD job, NEW job must be at least 50 miles from OLD residence). ii. Time test. TP must work full-time at least 39 weeks of 12 months following the move (78 weeks out of 24 months for self-employed). iii. Reimbursements. Amounts received by TP from employer are excluded as fringe benefits (so long as “qualified” — i.e., would be deductible if made by TP; however, not excludable if already deducted by TP in a prior tax year). 0 Up to $25K of Student Loan Interest: subject to AGI phase-out 0 Up to $4K of Qualified Higher Education Expenses: subject to AGI phase-out (and cannot be taken if in the same year education credits are taken for the same student) i. Not yet law for 2010 (but was for prior years and hopes for extension) 0 Health Insurance Premiums and Health Savings Accounts (if high deductible insurance) . Employee Business Expenses. Directly related to performance of employment duties or required by an employment agreement. Potential miscellaneous itemized deduction for unreimbursed employee business expenses (only if TP itemizes and only to the extent these and other miscellaneous itemized deductions exceed 2% of TP’s AGI). 0 Thus, important to determine if service provider is an employee (Schedule A) or an independent contractor (Schedule C) . Certain Limits on Deductibility of Expenses. Code specifically limits or prohibits deductions for certain items, including: 0 Hobby expenses (expenses deducted only to extent of activity’s gross income) 9. 10. 0 Personal deductions (Section 262 says “no” unless expressly permitted — for examples, see Table 6 on pages 6-27 and 6-28 and Chapter 8) 0 Public policy (e.g., fines, penalties, bribes) O Lobbying (deduction possible if influencing legislation at the local level) and political contributions (no deduction) 0 Meals and entertainment i. Meals and entertainment generally must be “directly related to” or “associate with” the active conduct of TP’s T or B (“associated wit ” is when it immediately precedes or follows a substantial business discussion). ii. Even if deductible, deduction is generally limited to 50% for meals and entertainment (subject to certain exceptions — e. g., traditional recreation expense paid for by ERs for EEs). 0 Expenses relating to tax-exempt income 0 Related party transactions (“related” is described on pages 6-33 and 6-34) (e. g., could be disallowed losses, issues with unpaid expenses and interest when one party uses cash basis and the other uses the accrual basis) 0 Capital expenditures (capital expenditures V. repairs) Depreciation. Process of allocating cost of tangible asset over its life. 0 Land does not qualify for depreciation 0 But, other REAL property and PERSONAL property will qualify 0 MACRS i. Applies to most tangible property placed in service for business or investment purposes after 1986 (disregards salvage value) ii. Property is based on class life — e.g., 3-year property, 5-year property, 7-year property iii. Class life specifies standard cost recovery method (e.g., 3-, 5-, 7-, and 10-year property is recovered using the 200% declining-balance method of depreciation) iv. Conventions 1. Half-year averaging applies to personal property (but, mid-quarter applies when >40% of cost of all personal property is placed in service during the last quarter of the taxable year) 2. Midmonth is used for real property v. Optional use of tables (see page 6-39) 0 Section 17 9,Election to expense certain tangible personal property used in a T or B i. For 2010, Section 179 expense amount may be as high as $250K 1. Also expense amount limited to taxable income from TP’s active T or B3 ii. For 2010, expense limit is reduced $ for $ if personal property investment amount exceeds $800K iii. Remaining amount (i.e., amount after the 179 expense) is subject to MACRS 0 Bonus Depreciation: In some prior years (including 2009), 50% “bonus depreciation” in the first year was allowed for certain assets (i.e., after any Section 179 amount and before MACRS) Amortization. Per financial accounting, allocating cost of intangible asset over its estimated useful life. Code does not use term “amortization” 0 Section 197 provides 15-year amortization for certain intangibles (e. g., goodwill, licenses/permits, franchises, marks, patents, copyrights). ll. Depletion. Even though land is not depreciated, resources on/in certain land (e.g., gold, oil) may be depleted (and trigger a deduction), two methods (TPs usually pick method that will produce the larger deduction): 0 Cost depletion method: Depletion = DPU x units sold (DPU = basis of the natural resource divided by the estimated number of units) 0 Percentage depletion method: Depletion = Gross income from the natural resource x specified % (from the Code) for the resource i. Depletion amount subject to a 50% net income limitations from the natural resource before the depletion deduction (but, there is a more generous 100% net income limit for oil and gas) ...
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