Chapter 6

Deductions and Losses

Learning Objectives

• Distinguish between deductions for and from AGI

• Discuss the criteria for deducting business and investment expenses

• List the substantiation requirements for deducting travel and entertainment expenses

• Explain the timing of deductions under both the cash and accrual methods

Learning Objectives

• Explain the tax consequences of wash sales

• Explain the tax consequences of transaction between related parties

• Discuss the criteria for determining whether an activity is a hobby or trade or business

• Determine the tax consequences of vacation homes.

For Versus From AGI Classification• For AGI

– Reduces AGI which affects the allowable deduction for itemized deductions

– Most common deductions for AGI• Trade or business expenses• IRAs• Alimony• Losses on investment• Interest paid by certain individuals

on qualified educational loans• 1/2 of self-employment tax and

100 % of health insurance costs paid by self-employed individuals

For Versus From AGI Classification

• From AGI– Itemized deduction

only will have tax benefit if the total deductions exceed the applicable standard deduction

Criteria For Deducting Business And Investment

Expenses• Related to a profit-

motivated activity• Ordinary expenses• Necessary expenses• Reasonable expenses• Properly documented• An expense of the

taxpayers(not someone else’s expense)

General Restrictions on the Deductibility of Expenses

• A capital expenditure• Expenses related to

exempt income• Illegal or in violation of

public policy• Specifically disallowed by

tax law

Proper Substantiation Requirement

• The taxpayer has the burden of proof

• The Cohan rule• More restrictive

substantiation requirements for travel, entertainment, business gifts

When An Expense Is Deductible

• Cash method– Deduct expenses when

paid– Prepaid expenses which

extend beyond the end of tax year must be amortized

– Points paid in principal residence

• Clearly disclosed• Secured by residence

When An Expense Is Deductible• Accrual method

– Allowed to deduct expenses in the period in which the expenses accrue under the all-events test and economic performance test

– All-events test is met • When amount of liability is

established• Amount of liability is determined

with reasonable accuracy– Economic performance test is met

• When economic performance is deemed to occur (see Table P6-1)

Special Disallowance Rules

• Wash sales occurs when “substantially identical” stock or securities are acquired by the taxpayer within a 61 day period of time that extends from 30 days before the date of sale to 30 days after the date of sale

Special Disallowance Rules

• Related parties transaction

• Losses on sales of property and expenses that remain unpaid at the end of the tax year.

Special Disallowance Rules

• Hobby losses– The IRS uses several factors to

determine whether an activity is profit-motivated

• Does the taxpayer conduct the activity in a businesslike manner

• The time and effort expended

• Whether the assets are expected to appreciate.

• Hobby Income must be reported on Form 1040 and Expenses are deducted on Schedule A.

Special Disallowance Rules

• Property used for personal and rental use (Vacation Home)– See allocation

formula on page 6-32 in textbook

• Home office

Tax Planning Considerations

• Control timing of hobby losses

• Unreasonable Compensation – If the IRS feels that a salary payment to an officer is excessive, it will often recharacterize the excess portion as a dividend

• Timing of deductions

Compliance And Procedural Considerations

• Schedule C for individual trade or business

• Schedule E for rents and royalties

• Other investment expenses are reported on Schedule A

Compliance And Procedural Considerations

• Proper substantiation– IRS scrutiny– Statutory requirements

• Travel and entertainment are of particular interest to the IRS

Compliance And Procedural Considerations

• Hobby Losses– Form 8829 to claim home office deduction

on Schedule C– Form 2106 to claim home office deduction

by employees– Taxpayer may be willing to extend statute

of limitation’s period to prove profit motive by filing Form 5231