Chapter 6: Deductions and Losses

Report
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DEDUCTIONS AND LOSSES
(1 of 2)
 Classifying
deductions as for vs. from
adjusted gross income
 Criteria for deducting business and
investment expenses
 General restrictions on the
deductibility of expenses
 Proper substantiation requirement
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DEDUCTIONS AND LOSSES
(2 of 2)
 When
an expense is deductible
 Special disallowance rules
 Tax planning considerations
 Compliance and procedural
considerations
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Classifying Deductions as for vs.
from Adjusted Gross Income (1 of 3)
 For AGI
 Taxpayer
benefits from deduction even
if she claims the standard deduction
 Reduces AGI: +/- benefits for taxpayer
+
Many deductions and credits phased out
above certain AGI thresholds
+ Reduces AGI floors for certain categories
of itemized deductions
- Reduces certain deduction ceilings
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Classifying Deductions as for vs.
from Adjusted Gross Income (2 of 3)
 Most
common deductions for AGI
 Trade
 IRAs
or business expenses
 Alimony
 Losses
on sale of bus/invest property
 Moving expenses
 Interest paid on qualified education loans
 1/2 of self-employment tax
 Health insurance paid by self-employeds
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Classifying Deductions as for vs.
from Adjusted Gross Income (3 of 3)
 From
AGI
 Itemized
deduction only will have tax
benefit if total deductions exceed the
taxpayer’s standard deduction
Deduct
the higher of the standard deduction
or sum of itemized deductions
 Phaseout
of itemized deductions
scheduled to resume in 2011 at a 3% rate
Fate
of phaseout for 2010 still uncertain.
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Criteria for Deducting Business
and Investment Expenses
 Business
or investment requirement
 Ordinary expense
 Necessary expense
 Reasonable expense
 Expenses and losses must be incurred
directly by the taxpayer
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Business or Investment
Requirement (1 of 2)
 Activity
Use
engaged in for profit
facts and circumstances test
 Trade
or business (ToB) vs.
investment classification
ToB
losses are ordinary losses
ToB
expenses are for AGI
Investment
losses are capital
Investment
 Subject
expenses are from AGI
to 2% of AGI floor
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Business or Investment
Requirement (2 of 2)
 Losses
and expenses related to rents and
royalties are for AGI deductions
 Legal and accounting fees
For
AGI deduction for ToB if incurred in
ordinary course of business
Fees
related to taxes also for AGI for ToB
fees related to taxes from AGI
deduction subject to 2% of AGI floor
Nonbusiness
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Ordinary Expense
 To
be ordinary, an expense must be
Reasonable
in amount
Bear reasonable proximate relationship
to income-producing activity or property
Must be customary or usual course of a
particular industry or business community
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Necessary Expense
 An
expense is considered necessary if
it is “appropriate and helpful” in the
taxpayer’s business
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Reasonable Expense
 Problems
often occur with salaries
for shareholder-employees of closely
held businesses
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Expenses and Losses Must Be
Incurred Directly by the Taxpayer
 Generally,
a taxpayer cannot take a
deduction for a loss or expense of
another person
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General Restrictions on the
Deductibility of Expenses
 Capitalization
vs. expense deduction
 Expenses related to exempt income
 Expenditures that are contrary to
public policy
 Other expenditures specifically
disallowed
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Capitalization vs. Expense
Deduction
 General
capitalization requirements
 Election to deduct currently
E.g,
certain research and experimental
expenditures, cost of qualified tangible
personal property
 Capitalization
of deduction items
E.g.,
carrying charges on unproductive
unimproved real estate
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Expenses Related to
Exempt Income
 Deduction
disallowed because
related income is not taxable
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Expenditures that Are
Contrary to Public Policy
 Cannot
deduct illegal payments or
payment resulting from an illegal act
Fines
and penalties
Bribes and Kickbacks
 Expenses
from an illegal trade or
business are deductible
If
taxpayer reports income from activity
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Other Expenditures Specifically
Disallowed (1 of 2)
 Political
contributions and lobbying
expenses
 Business investigation and preopening
expenses
Include
investment expenses
May immediately expense up to $5,000
Deduction
phased out $ for $ if > $50,000
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Other Expenditures Specifically
Disallowed (2 of 2)
 Business
investigation and
preopening expenses (continued)
Amortize
remainder over 180 months
beginning when business commences
No
amortization if business not begun
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Proper Substantiation
Requirement (1 of 2)
 The
taxpayer has the burden of proof
 The Cohan rule
Certain
expenses may be estimated
 More
restrictive substantiation
requirements for travel,
entertainment, business gifts
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Proper Substantiation
Requirement (2 of 2)
 Documentation
requirements for
travel, entertainment, gifts, etc.
Amount
Time
and place (T & E)
Date and description of gift
Business purpose
Business relationship
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When an Expense Is Deductible
Cash Method (1 of 2)
 Generally
deductible when actually
paid
 Prepaid expenses
No
current deduction if expenditure
creates an asset with a life substantially
beyond end of tax year
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When an Expense Is Deductible
Cash Method (2 of 2)
 Prepaid
interest
Amortize
over period of loan to which
interest charge is allocated
Points deductible over life of loan
Points
paid in connection with purchase of
principal residence currently deductible
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When an Expense Is Deductible
Accrual Method (1 of 2)
 Allowed
to deduct expenses in period in
which expenses accrue under all-events
test & economic performance test
 All-events
test met
When amount of liability is established
Amount of liability is determined with
reasonable accuracy
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When an Expense Is Deductible
Accrual Method (2 of 2)
 Economic
performance test is met
When economic performance is
deemed to occur
See Topic Review 3
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Special Disallowance Rules
 Wash
sales
 Transactions between related parties
 Hobby losses
 Vacation home
 Expenses of an office in the home
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Wash Sales
 Wash
sales occurs when “substantially
identical” stock or securities acquired
by taxpayer within a 61 day period
Extends
from 30 days before date of sale
to 30 days after date of sale
 Loss
on wash sale disallowed
Disallowed
loss added to basis of
recently purchased stock or securities
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Transactions between
Related Parties (1 of 2)
 §267
defines related parties
 Loss on transaction between related
parties disallowed
Disallowed
loss may be used to offset
gain from subsequent sale to unrelated
party
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Transactions between
Related Parties (2 of 2)
 Unpaid
expenses
Accrual
basis taxpayer cannot deduct
expense to cash basis related party until
cash basis party recognizes payment as
income
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Hobby Losses
(1 of 3)
 Activity
has more personal attributes
than profit motive
IRS
factors to determine profit motive
Activity
conducted in businesslike manner
Time and effort expended
Expected asset appreciation
Taxpayer’s success in similar activities
Profits earned and profit history
Taxpayer’s financial status
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Hobby Losses
(2 of 3)
 Profit
motive assumed if activity
profitable in 3 of 5 years
 Three tiers of expenses
1
– Deductible even if no hobby exists
2 – Deductible if activity was for profit
But
3
do not reduce basis of any assets
– Deductible if activity was for profit
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Hobby Losses
(3 of 3)
 Deductible
hobby expenses
Hobby-related
expenses deductible up
to gross income of hobby activity
Deductible as miscellaneous itemized
deductions subject to 2% of AGI floor
Special
order of the deductions
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Vacation Home
 Deductions
on vacation home may be
limited or disallowed
 Vacation home if personal use greater of
14 days, or 10% of # of days property
used as rental
 Expenses allocated based on days of use
 Property rented < 15 days
No
taxable income and no deductions
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Expenses of an
Office in the Home
 Office
in the home expenses
deductible only if office regularly and
exclusively used for business AND
Principal
place of taxpayer’s business,
Place where taxpayer meets with clients,
OR a separate structure from house
 Employees
must also use office for
convenience of employer
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Tax Planning Considerations
 Hobby
losses
Control
timing of hobby losses
 Unreasonable
Compensation
If
IRS feels that a salary payment to an
officer is excessive
Often
recharacterize excess portion as a
dividend
 Timing
of deductions
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Compliance and Procedural
Considerations (1 of 2)
 Schedule
C for sole proprietorship
 Schedule E for rents and royalties
 Other
investment expenses reported
on Schedule A Proper substantiation
 IRS
scrutiny
 Statutory requirements
 Travel
and entertainment are of
particular interest to the IRS
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Compliance and Procedural
Considerations (2 of 2)
 Business
vs. hobby
 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
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Comments or questions about PowerPoint Slides?
Contact Dr. Richard Newmark at
University of Northern Colorado’s
Kenneth W. Monfort College of Business
[email protected]
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