cch federal taxation basic principles chapter 6 deductions: general concepts and trade or business...

CCH Federal TaxationBasic Principles

Chapter 6Deductions: General

Concepts and Trade or Business Deductions

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CCH Federal Taxation Basic Principles 2 of 48

Chapter 6 Exhibits

1. Four Types of Usage for Expenses and Property

2. Tax Treatment for the Four Types of Usage

3. Business Expenses—Seven Criteria

4. Defending Tax Treatment for a Business Activity

5. Hobby Expenses—Template for Problem Solving

6. Home Office Deductions—Template for Problem Solving

7. Computing Home Office Deductions for Self-Employed Persons

8. Computing Home Office Deductions for Employees

9. Interest Expense—An Overview

10. Investment Interest Expense—Example

11. Taxes—An Overview

12. Property Taxes—Allocation Between Buyer and Seller

13. Depreciation—Code Sec. 179 Election14. Amortization15. Research and Experimental16. Depletion17. Political Contributions and Lobbying18. Business Start-Up Expenses19. Meals and Entertainment20. Moving Expenses21. Student Loan Interest

Chapter 6, Exhibit Contents


Four Types of Usage for Expenses and Property

“Personal-use” property refers to the function of property. It means that the property is held for the taxpayer’s own enjoyment.

“Personal” property refers to the physical nature of the property. It means that the property is mobile, i.e., not affixed to “real” property.

The following examples illustrate the four types of usage for expenses, personal property, and real property.

Chapter 6, Exhibit 1a


Type of Usage Expense Personal Property

(property that is mobile)

Real Property (property that is immobile)

Tangible(value lies in its physical substance)

Intangible (value lies in its nonphysical substance)

Business Use Airfare to meet with client to discuss cost control

Lawnmower used by landscape firm

Stock held as inventory by dealer

Office building

Chapter 6, Exhibit 1b



Type of Usage Expense Personal Property

(property that is mobile)

Real Property (property that is immobile)

Tangible(value lies in its physical substance)

Intangible(value lies in its nonphysical substance)

Hobby Use Airfare to attend Barbie™ doll collectors convention

Lawnmower held by one who tinkers with old motors in spare time

N/A Home office used exclusively for stamp collecting

Chapter 6, Exhibit 1c



Type of Usage Expense Personal Property (property that is mobile)

Real Property (property that is immobile)Tangible

(value lies in its physical substance)


Investment Use Airfare to attend investment seminar

First lawnmower ever sold by John Deere Co. held by private individual

Stock held by investor

Raw land

Chapter 6, Exhibit 1d



Type of Usage Expense Personal Property (property that is mobile)

Real Property (property that is immobile)Tangible

(value lies in its physical substance)


Personal Use Airfare to visit grandmother

Lawnmower used for personal lawn care

N/A Principal residence

Chapter 6, Exhibit 1e



Tax Treatment for the Four Types of Usage

Usage Tax Treatment for Losses and Expenses

Business Unlimited deductions, except for passive activity losses (usually offers the most favorable tax treatment)

Hobby Limited to net hobby income

Investment Capital loss limited to $3,000; investment expenses limited to net investment income

Personal Generally not deductible unless specifically allowable as with itemized deductions (usually results in the least favorable tax treatment)

The tax treatment for losses and expenses varies according to their type of usage.

Chapter 6, Exhibit 2


Business Expenses—Seven Criteria

Business expenses are generally deductible without limitation when the following seven criteria are met:

1. Purpose is business related. If part business, part personal, use a reasonable allocation (e.g., mileage for automobiles).

2. Ordinary (common, acceptable response to a business situation) and necessary (helpful, but not essential). (Welch v. Helvering)

3. Reasonable in amount. This is of main concern to closely held corporations, particularly regarding officers’ salaries. One way to substantiate reasonableness is by presenting documentation of similar expenses by comparable businesses.

4. Capital expenditures are not deductible (but may be depreciable). Sales tax on capital expenditures must be capitalized.

5. Activity must be related to a business, not to investments, hobbies, or personal-use property. There must be (1) an intent to make a profit the IRS is generally satisfied if 3 of 5 years are profitable) and (2) an entrepreneurial effort.

6. Exempt income must not be connected with the business expense (e.g., business interest expense on a loan used to buy local utility bonds is not deductible).

7. Public policy must not be violated by the expense. Fines, kickbacks, bribes, etc. are not deductible. (Tank Truck Rentals)



Defending Tax Treatment for a Business Activity

Whether losses or expenses receive favorable business treatment is an issue of fact. The taxpayer wins if the facts meet the statutory requirements; the IRS wins if they do not. Reg. §1.183-2(b) provides the statutory framework. It states that all facts and circumstances of an activity are to be taken into account and that no one factor makes the determination. It lists the following nine factors that should normally be taken into account in making the determination. Taxpayers and the IRS should make their factual arguments within the context of these nine factors.



Defending Tax Treatment for a Business Activity

Nine Factors Cited in

Reg. §1.183-2(b)

Facts Supporting Business Status Facts Supporting Nonbusiness Status

1. Financial status of taxpayer No substantial income from other sources Substantial income from other sources

2. Asset appreciation potential Asset appreciation potential may satisfy the profit requirement

Neither profit potential nor asset appreciation potential are evident

3. Recreational elements Absence of personal or recreational motives

Evidence of personal or recreational motives

4. Manner of conducting activity

Complete and accurate records, separate bank account, separate phone line

Records compiled when annual return is filed, deposits and checks written out of personal account, no dedicated phone line

5. Time and effort Substantial personal time and effort Minimal time and effort devoted to the activity

6. History of success with similar/dissimilar businesses

Successful track record with other activities

No track record

7. Expertise of taxpayer Extensive personal study or hiring of outside consults to understand the activity

No concept of the economics underlying the activity

8. Profit frequency Consistent profits beyond start-up stage Inconsistent profits beyond start-up stage

9. Profit size Any past losses overshadowed by current profits

Future profit potential not sufficient to recoup accumulated losses



Hobby Expenses—Template for Problem Solving

Hobby income (Revenue - Cost of goods sold)

FIRST-TIER EXPENSES (reported on Schedule A)

– Taxes (property tax and state and local income tax allocable to hobby)

– Interest (interest on principal residence mortgages and home equity loans allocable to hobby)

– Casualty loss deductions (related to principal residence and allocable to hobby)

= First-Tier Limit

If an activity is a hobby, expenses are deductible in the following three tiers:



Hobby Expenses—Template for Problem Solving

= First-Tier Limit

SECOND-TIER EXPENSES (qpplied only if the first-tier limit is a positive value)

– Out-of-pocket expenses (reported on Schedule A as miscellaneous itemized deductions, subject to 2% AGI floor)

= Second-Tier Limit


– THIRD-TIER EXPENSES (only if the second-tier limit is a positive value)

–Depreciation expense (reported on Schedule A as a miscellaneous itemized deduction, subject to 2% AGI floor)

= Hobby income (A hobby loss is not allowed for tax purposes.)


Home Office Deductions—Template for Problem Solving

The rules for deducting home office expenses are similar to the hobby expense rules except as follows:

Business expenses not related to the home office (e.g., advertising, wages) are

deductible without limitation before the three-tiered limitations take effect; hobby expenses not related to the home office are subject to the second-tier limitation.

Self-employed persons report business expenses (deductible within the three-tiered limitations) on Schedule C, not on Schedule A as is the case with hobby expenses. Employed persons report unreimbursed business expenses (deductible within the three-tiered limitations) on Schedule A (similar to the hobby rules).




First-Tier Limit=

Casualty loss deductions (related to principal residence and allocable to home office)

–

Interest (interest on principal residence mortgages and home equity loans allocable to home office)

–

Taxes (property tax and state and local income tax allocable to home office)

–

FIRST-TIER EXPENSES (reported on Schedule C, not Schedule A as is the case with hobbies)

–

Net business income before home office expenses=

Business expenses not related to home office (e.g., advertising, wages)–

Business income =(Revenue – Cost of goods sold)




First-Tier Limit

– SECOND-TIER EXPENSES (applied only if the first-tier limit is a positive value)

– Out-of-pocket expenses (e.g., utilities, maid service, pest control)

= Second-Tier Limit


– THIRD-TIER EXPENSES (applied only if the second-tier limit is a positive value)

– Depreciation expense (allocable to home office)

= Net business income


Computing Home Office Deductions forSelf-Employed Persons


Example 1. Home office maintained on an exclusive and regular basis that occupies 10% of the home’s total space.

Sales and Expenses Total Amount Allocable Amount

Sales $300,000 $ 300,000

Cost of goods sold 200,000 200,000

Business expenses not allocable to home office use (e.g., supplies, wages paid)

94,000 94,000

Real estate taxes 10,000 1,000

Mortgage interest 20,000 2,000

Utilities (water, electricity, gas, sewer) 8,000 800

Repairs, maintenance, and maid service 12,000 1,200

Depreciation 15,000 1,500


Computing Home Office Deductions ForSelf-employed Persons

Example 1 Calculation Allocable Amount

Sales $ 300,000

Cost of goods sold (200,000)

Gross income $ 100,000

Business expenses not allocable to home office use (94,000)

LIMIT ON ALLOCABLE TAXES AND INTEREST 6,000

Real estate taxes (1,000)*

Mortgage interest (2,000)*

LIMIT ON ALLOCABLE OUT-OF-POCKET EXPENSES 3,000

Utilities (water, electricity, gas, sewer) (800)*

Repairs, maintenance, and maid service (1,200)*

LIMIT ON DEPRECIATION 1,000

Depreciation allowed (of $1,500 total) (1,000)*

NET INCOME (LOSS) FROM RETAIL BUSINESS 0

*Total home office deduction (total of items marked “*”) 6,000

Unused depreciation expense carried over ($6,500 - $6,000) (500)



Note: The $500 unused depreciation expense may be deductible in the next year even if the home office is converted to residential use at the beginning of the next year, so long as the deduction does not create a business loss.

Computing Home Office Deductions ForSelf-Employed Persons



Example 2. Home office maintained for employer’s convenience occupies 10% of the home’s total space; employee’s AGI is $50,000

Example 2 CalculationTotal Amount Allocable

AmountDeductible Amount

LIMIT ON ALLOCABLE HOME OFFICE EXPENSES (i.e., employment income)

N/A $50,000

Fully deductible home office expenses:

Real estate taxes $ 10,000 $1,000

Mortgage interest 20,000 2,000

Total amount fully deductible 30,000 3,000 $3,000

Expenses subject to 2% AGI limitation:

Utilities (water, electricity, etc.) 8,000 800

Repairs, maid service, etc. 12,000 1,200

Depreciation 15,000 1,500

Total amount subject to 2% AGI limitation 35,000 3,500 2,500 *

Total home office deductions 5,500

* $2,500 = [$3,500 – ($50,000 AGI x 2% floor)]

Computing Home Office Deductions for Employees



Interest Expense—An Overview

Code Section Description Tax Treatment

Code Sec. 1662 Business interest expense Deductible “for” AGI

Code Sec. 163(d) Production of income (PI) interest expense ( i.e., investment interest expense or portfolio interest expense)

Deductible “from” AGI, limited to net investment income (NII)

Code Sec. 163(h)(2) Consumer interest Not deductible

Code Sec. 163(h)(3) Qualified residence interest Deductible “from” AGI

Code Sec. 221 Student loan interest Deductible “for” AGI, limited to $2,500 in 2003

Code Sec. 265(a)(2) Interest on funds used to buy tax-exempt securities

Not deductible

Code Sec. 469 Interest expense connected with passive activities

Deductible “for” AGI, limited to passive income



Investment Interest Expense—Example


Investment expense other then interest No 2% AGI Floor Limitation

Subject to 2% AGI Floor

State ad valorem tax on stock $3,000

Safe deposit box rental $120

Investment counseling fee 1,200

Noninvestment misc. expenses

Unreimbursed business travel expenses 850

Uniforms 600

CALCULATING THE DEDUCTION FOR PRODUCTION OF INCOME INTEREST EXPENSE

AGI (includes $10,000 dividend income from stock)

$80,000

Production of income interest expense 8,000


1. How much of the miscellaneous investment expenses are deductible?

The lesser of: INVESTMENT miscellaneous itemized deductions, WITHOUT REGARD to the

2% AGI floor:

120 + 1,200 = 1,320

ALL miscellaneous itemized deductions AFTER SUBTRACTING the 2% AGI floor:

(120 + 1,200 + 850 + 600) – (2% x 80,000) = 1,170 [Answer]




2. How much is the net investment income? (This sets the limit on deductible investment interest expense for the tax year.)



Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Investment expense other than interest:

Fully deductible ad valorem taxes . . . . . . . . . . . . . . . . . . . (3,000)

Deductible miscellaneous investment expenses . . . . . . . . (1,170)

Net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,830

Interest expense that is deductible (of $8,000 production of income expense) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,830

Interest expense that is carried over to next year . . . . . . . . 2,170


Taxes—An OverviewMost Common Types of

TaxesBusiness Use Personal Use

Federal income tax Not deductible Not deductible

State income tax Deductible “for”AGI Deductible “from” AGI

FICA employee Not deductible N/A

FICA employer Deductible “for”AGI N/A

Sales tax on capital asset Capitalize and depreciate Capitalize only

Sales tax on deductible expenditure

Deductible “for”AGI Not deductible

Property taxes Deductible “for”AGI Deductible “from” AGI



Property Taxes—Allocation Between Buyer and Seller

Property taxes are generally deductible without limitation if they are “ad valorem” (i.e., based on value).

Property taxes should be allocated between seller and buyer

based on the number of days held, not the number of months held. Furthermore, property taxes allocable to the day of closing are attributable to the buyer, not the seller.



Depreciation–Code Sec. 179 Election

Expense election. In 2003, an election may be made to expense up to $25,000 of tangible business and personal property rather than capitalize and depreciate it. This election must be made when the return is filed; it cannot be made on an amended return. If an election is made and a portion of the $25,000 creates a business loss, that portion creating the loss must be carried over to the next year’s return.

Phaseout. The expense allowance is phased out on a dollar-for-dollar basis for purchases exceeding $200,000.



Amortization

Amortizable property. Intangible property that is used for business and is of limited life (e.g., goodwill, going-concern value, licenses, covenants not to compete, franchises, trademarks, patents, and copyrights).

Method. Straight-line method over a minimum of 15 years.



Research and Experimental (R & E)

Qualifying expenditures. Experimental and laboratory costs for pilot models, plant processes, products, formulas, inventions, or similar properties. These costs include R&E salaries.

Nonqualifying expenditures. Ordinary testing or inspection of materials or products for quality control, management studies, consumer surveys, advertising, or promotions.

Tax treatment. R&E expenditures may be expensed immediately, or if elected, amortized over a minimum of 5 years.



Depletion

Cost depletion method

Cost of natural resources excluding land x (Number of units Recoverable units

recovered AND sold)



% depletion method

Statutory % x Gross income from natural resources

(where gross income equals revenues without regard to cost of sales)


Depletion


Limitation of % Depletion

• Oil and gas properties: 100% of taxable income from natural resources BEFORE depletion. (Code Sec. 613A(c)(6)(H)).

• Other properties (e.g., phosphate, copper, gold): 50% of taxable income from natural resources BEFORE depletion.


Depletion


Political Contributions and Lobbying


Type of Expenditure Deductible Not Deductible

Direct or indirect political contributions by businesses for advertising, tickets to dinners, balls, etc.

Lobbying expenses to influence federal and state legislation Lobbying expenses to monitor federal and state legislation Lobbying expenses to influence local legislation


Business Investigation Expenses

Definition Expenditures that help determine whether to create or buy a business

Timing Occur before a decision to make or buy is reached

Examples Travel, marketing surveys, legal, accounting, and engineering


Business Start-Up Expenses



Definition Preoperational costs

Timing Occur after a "go for it" decision is reached, but before the doors open for business

Examples Employee training and stationery




Deductibility

Type Similar business? “Go for it” decision?

Business Investigation Expenses

Yes deductible

No No

Yes Capitalize and amortize 60 months

No Not deductible or capitalized, but lost

Business Start-up Expenses

Yes deductible

No Capitalize and amortize > 60 months




Tax Pointer. Avoid being trapped into capitalizing business start-up costs attributed to a dissimilar business. Instead, try to postpone as much of them as possible until after the doors are open for business. The postponement may result in immediate expensing.




Meals and Entertainment

Tax Treatment

Self-Employed Individuals Nonreimbursed Employees

50% deductible 50% deductible, and limited to the 2% AGI floor

“For” AGI “From” AGI as a miscellaneous itemized deduction



Moving Expenses

Amount Limitation. None.

Qualified moving expenses.

1. Transporting household goods and personal effects2. Traveling from old residence to new residence3. Lodging during the move



Nonqualified moving expenses.

1. Premove house hunting

2. Temporary living quarters at new location

3. Meals during a qualified move

4. Real estate commissions on sale of old residence

Moving Expenses



Time Requirement for the Moving Expense Deduction

Self-Employed Employee

Work full time at new job > 39 weeks during first 12 months, AND Work full time at new job > 78 weeks during first 24 months

Work full time at new job > 39 weeks during first 12 months

Moving Expenses



Distance Requirement for the Moving Expense Deduction


If the move is due to a relocation:

Distance, which must be 50 miles, between

(b) and Distance from the old residence to the new

job, and the Distance from the old residence to the old

job.

Same as for self-employed

Moving Expenses



Reporting Requirement for the Moving Expense Deduction:


“For” AGI “For” AGI (i.e., same tax treatment)

Moving Expenses



Student Loan InterestTax Treatment. Deductible “for” AGI. Thus, a student can claim the student loan interest deduction even if the standard deduction is used.

Deductible Limitation: $2,500



Time Limitation. The deduction for interest paid on a student loan is allowed for all months in which interest payments are required.

Student Loan Interest



Qualified Student Loans. To be eligible for the deduction, the education loan must be used solely to pay for any of the following expenses: tuition, student activity fees, room and board, books and supplies, and other related expenses.

Note: The qualified purpose of a student loan is similar in scope to the qualified purpose of “education withdrawals” from ordinary IRAs and education IRAs. On the other hand, the student loan is much broader in scope than the Hope Scholarship or Lifetime Learning Credits.



CCH Federal Taxation Basic Principles 47 of 48Chapter 6, Exhibit 21d


N/AN/AN/AMarried filing separately

$30,000$130,000$100,000Married filing jointly

$15,000$65,000$50,000Single, head of household, surviving spouse

Phaseout Range

CeilingFloor

Threshold for Modified AGIFiling Status

Phaseout of Student Loan Interest Deduction


Example: Phaseout of Student Loan Interest Deduction

FACTS: A married couple files jointly. The wife has been paying interest on a student loan for 3 years. In the current year, $6,000 of interest was paid. If the couple’s modified AGI is $110,000, how much of the interest may be deducted?

(a) Actual student loan interest paid during the year $ 6,000

(b) Deductible limitation for the current year 2,500

(c) = lesser of (a) or (b) Amount subject to phaseout 2,500

(d) Modified AGI 110,000

(e) Modified AGI threshold, floor 100,000

(f) = (d) – (e) Excess modified AGI 10,000

(g) Phaseout range 30,000

(h) = (f) (g) Phaseout percentage ($10,000 $30,000) 33.3%

(i) = (c) x (h) Phaseout amount ($2,500 x 33.3%) 833

(j) = (c) – (i) Allowable interest deduction ($2,500 – $833 = $1,667) 1,667



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