basic income tax business expenses capx

7/30/2019 Basic Income Tax Business Expenses CAPX

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Basic Income TaxBusiness and Profit Seeking

Expenses

Professor Jack Williams


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Deductions

Various deductions and allowances arepermitted by the IRC based on tax logic or taxfavoritism

These deductions and allowances aresubtracted from gross income to arrive attaxable income, the tax base under the IRC

Deductions may be broadly clustered into two

categories: Profit-related activities

Personal activities


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General Rule: Business Expenses

Policy Point: Tax is imposed on net income

and not gross receipts from a business

venture

IRC 162 codifies that policy by providing thatthat it is appropriate to offset gross income by

expenditures incurred in earning that income

Business income (loss) is entered on Line 12,

Form 1040 through Schedule C, for an

individual


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Status of Deduction on Form 1040

IRC 162 is an above the line deduction

Adjustment to Adjusted Gross Income (AGI)

Not subject to standard deduction

No need to itemize deductions to use


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Section 162 Deductions

IRC permits a deduction for ordinary and

necessary expenses paid or incurred during a

taxable year in carrying on a trade or

business. IRC 162(a). Burden of proof on deductions shouldered by

the taxpayer.


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Methodology: IRC 162

Ordinary and Necessary

Expenses

Carry on

Trade or business


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ORDINARY AND NECESSARY

Ordinary:

Expenditure is ordinary if it is one that iscommon w ith in the indus tryeven if once-in-a-lifetime expenditure for the actual taxpayer.Courts employ a horizontal test.

Necessary:

Expenditure is necessary ifappropr iate andhelpfu lto the business. Court employs areasonableness test.

If expense can be reimbursed, then it is notnecessary.


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Proof Issue re Ordinary and Necessary

Ultimately, the resolution of these issues

turns on a careful consideration of the facts of

each case.

Because of changes in attitudes andbusiness norms, what may not have been

ordinary and necessary in the past may no

longer be controlling


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EXPENSES

Rule 1: A 162 deduction is allowed only foran item of expense and not a capitalexpenditure.

Rule 2: Capital expenditures (Cap X) maynot be deducted at the time the amount ispaid or incurred

Rather, the Cap X maygive rise to deductionsfor depreciation in later years.

Rule 3: Cap X are generally added to basisunder IRC 1016(a)(1).


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Deduction v. Cap X

Recognize, in the business context, the difference

between deduction and Cap X is one of timing and

the time value of money.

However, in personal context, the difference between

deduction and Cap X may be more substantively

important

Personal deductions generally not permitted

Cap X still added to basis

What is the difference between a current deduction

for an expense and a Cap X?

Courts hold that the difference is a fact question.


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Capital Expenditures: Clusters of Fact

Clusters of facts lead to certain results:

Cost of acquisition of assets (tangible or intangible)

that has a useful life beyond the taxable year

Cost that add to value of property, substantiallyprolong the useful life of property, or adapt the

property to a new or different use.

Business acquisition costs

Cost incurred in perfecting or clearing title to assets Prepaid expenses


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Deductions That Might Look

Like Cap X

Impro vement v . Repair: Incidental repair or

maintenance of business property are

expenses

Fact issueAdvertising costs are expenses

Product and service advertising

Goodwill or institutional advertising


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CARRY ON

Rule: Expenses are deductible only if

incurred while carrying on a trade or

business.

Expenses incurred in acquiring a new trade orbusiness or generally not deductible.

These expenses are generally added to basis.


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Expanding Existing Trade

What about the expansion of an exist ing

trade or business?

These expenses are generally deductible


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Investigating New Trade

What about investigating a new trade or

business?

These expenses are treated as a Cap X.

If the investigation reaches a t ransact ionalstageand is dropped before a trade or

business is developed or acquired, then the

transactional expenditures may give rise to a

loss deduction. IRC 165(c)(2).


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Start-Up Expenses

What about start-up expenditures?

Violate the carry on element and are not

deductible

Rule: Some expenses incurred in acquiringor starting a new trade or business may be

deducted as start-up expenditures if the

taxpayer elects. See IRC 195.

Under 195, these expenditures are deducted

ratably over at least 60 months (time period

selected by taxpayer) and begins in the month

in which the active business begins.


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Special Case: Employee Seeks

Employment

What about the expenses incurred in obtaining

employment as an employee?

Individual may be in the trade of business of

providing services as employee.

Expenses incurred in obtaining another job in the same

line of work are deductible

Expenses incurred in obtaining another job in a new

line of work are not deductible

Expenses incurred in obtaining ones first job notdeductible

Section 195 does not seem applicable.


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TRADE OR BUSINESS

Does the taxpayers profit-seeking

activities constitute a t rade or business?

Taxpayer must have a profit motive for

engaging in the activity that gives rise tothe expense

Personal expenses are generally not

deductible


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STATUTORY EXAMPLES UNDER

SECTION 162

Reasonable Allowance for Salaries

Traveling Expenses While Away From Home

Rentals of Property for Purpose of Trade or

Business


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Reasonable Allowance of Salaries

Section 162(a)(1) permits a deduction for

reasonable allowance of salaries

Salaries must be:

Reasonable

For personal services performed


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Factors of Reasonable Compensation

Factors:

Position

Hours worked

Duties performed

Importance of the employee to business Comparison of past duties and performance to present

Horizontal comparison with comparable companies

Size of company, complexity of business, and generaleconomic conditions

Potentially exploitable relationship (cuts against)

Existence of bonus system that distributes nearly all ofpre-tax earnings of company (cuts against)


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Contingent Compensation

If employment agreement provides forcompensation based on future events, suchas percentage of profits, then amount actuallypaid is reasonable if fruits of arms lengthbargain and reasonable when the agreementwas made.

If agreement is not product of arms lengthbargaining, then it must be reasonable at time

it was paid

Concern: Compensation may bedisguised dividend or de facto dividend.


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Personal Service Performed

Payment of salary must be for personal

services actual ly rendered.

Payment to taxpayer as partial payment for

property transferred or as disguised dividenddo not qualify as salary


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Traveling Expenses While Away

From Home

Rule: Deduction is permitted for traveling expenses,

including lodging and a portion of the cost of meals,

incurred while a taxpayer is away from home in the

pursuit of a trade or business. IRC 162(a)(2).

Three requirements:

Expense must be reasonable and necessary traveling

expense (cannot be extravagant or lavish)

Expense must be incurred while away from home

Expense must be incurred in the pursuit of business

Further limit with meals: 50% limit on deductibility


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Travel Expenses

Airplane

Rental car

Train

Taxis Meals and lodging

Incidentals

Tips, telephone calls, internet access,baggage charges, postage, laundry,handicapped traveler aid

Commuter expense do not qualify


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Away From Home

Taxpayer must have a tax home for federal income

tax purposes

A taxpayer may not have a tax home

Presumption is that the principal place of business

(and not her abode) is a taxpayers tax home

Principal place of business:

Amount of income earned at each location

Nature and extent of business activity that takes place

in each location

Amount of time spent at each location


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Temporary Assignment

TAD must be expected to be less than one

year and must in fact be less than one year.

If temporary assignment is greater than one

year (regardless of intent), then no portion ofexpenses may be deducted.


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Overnight Rule

Rule: Deduction permitted for expenses

incurred in lodging and 50% of meals only if

taxpayer is away from home overnight.

Overnight means: Taxpayer is away from home long enough to

require her to stop for substantial sleep or rest

no matter what distance she travels or mode

of transportation she employs.

Otherwise, nondeductible personal expense

under 262.


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Travel for Business and Personal

Rule 1: Expenses for travel to and from arefully deductible if the primary reason for thetrip is business.

There is no allocation requirement for travelexpense to and from.

Rule 2: Expenses once present aredeductible only to the extent they are properlyallocable to the business.

Special rules for foreign travel.

No deduction for spouse or dependents.


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Meals

Away from home: 50% if not extravagant or

lavish

Not away from home: 50% but only if present

and related directly to trade or business, thatis, an entertainment expense (more restrictive

test)

IRC 274 (50% limitation)


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Rentals of Property for Purpose of

Trade or Business

Rule 1: Deductions permitted for rentals or

other payments for use of property in a

taxpayers trade or business. IRC 162(a)(3).

Transfer/Lease-Back: Is there a legitimate business purpose for the

transaction?


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Miscellaneous Business Deductions

Interest (IRC 163)

Education

Entertainment

Uniforms Dues

Periodicals

Utilities

Taxes (IRC 164) Health insurance for self-employed individuals

Charitable donations (IRC 170)


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Payment of Interest

Deduction for interests payments on business

loans (IRC 163).

Generally no deduction for payments of

interest on personal loans with severalimportant exceptions:

Home mortgage interest deductions

Certain qualified student loans for qualifying

taxpayers


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Payment of Educational Expenses

Deduction permitted ifeitherthe education

maintains or improves skills required by a

taxpayer in his employment orother trade or

business or if education meets expressrequirements imposed by law or a taxpayers

employment, status, or rate of compensation.

Treas. Reg. 1.162-5(a).

No deduction if education is necessary toqualify for trade or business or meet minimum

educational requirements.


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Travel and Education

Travel as education: No deduction.

Travel to obtain education: Deductible if

162 requirements are met.


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Miscellaneous Deductions contd

Entertainment Meals and entertaining:

Must show demonstrablebusiness benefit.

Generally 50% limit.

Section 274 limitation.

Uniforms Work clothing specifically

required as condition ofemployment and notadaptable to general use.

Think police, nurses,sports uniforms, Mr.Goodwrench, firefighters, etc.

Do not think militaryuniforms of full-timeactive duty personnel

If uniform cost isdeductible, thenmaintenance isdeductible.


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Dues

Deduction permitted

for dues directly

related to taxpayers

employment or othertrade or business.

Periodicals

Deduction permitted

for periodicals and

books whose useful

life is short if theyrelate to taxpayers

business.


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Utilities

Deductible if they are

necessary for carrying

on trade or business.

Taxes

Deductible if

specifically

enumerated under IRC

164, including certainstate and local and

foreign taxes.


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Health insurance for

self-employed

individuals

Self-employed

taxpayer may deductthe costs of medical

insurance coverage for

himself, spouse, and

dependents


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Substantiation

Rule: If a taxpayer does not have

substantiation of a deduction, then a court

may allow an estimate of the expense unless

the IRC specifically requires substantiation. Estimation is known as the Cohan rule.

IRC 274(d) requires substantiation for the

following expenses:

Traveling expenses (including lodging and mealsaway from home), business gifts, entertainment

expenses, and business meals.


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Section 212: Profit-Seeking Activity

Section 212 permits a deduction in certain

circumstances for ordinary and necessary

expenses incurred or paid in furtherance of

profit-seeking activity, specifically: The production or collection of income

Dealing with property that is being held for the

production of income

Dealing with tax matters


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212: General Rule

Item must be:

Ordinary and necessary

Expense

Must not be inherently personal in nature Must be individual (or by extension, estate or

trust by personal representative or trustee)

Cannot be a corporation and use 212


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212: Production or Collection of

Income

Ordinary and necessary expenses incurred in

a taxable year for the production or collection

of income are deductible by individual

taxpayer. Expenses need not match income in the

same year.


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212: Management of Income

Producing Property

Ordinary and necessary expenses incurred in

a taxable year for the management,

conservation, or maintenance of property

held for the production of income aredeductible.

This is the case even where the property is

not currently producing income or even where

the property may be sold for a loss.


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212: Expense in Connection with

Taxes

Deduction for expenses incurred in

connection with the determination, collection,

or refund of any tax.

Includes: Preparing return, contesting tax liability, or

determining tax consequences of proposed

action


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Key Differences Between 162 and

212

Section 212 deduction is below the line, thatis, that a taxpayer must itemize deductions toreceive any tax benefit.

Section 162 is an above the line deduction no need to itemize to receive a tax benefit.

Section 212 does not require that taxpayer isactually carrying on trade or business toqualify.

Section 162 requires carrying on trade orbusiness.


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Conclusion

Questions?

basic income tax business expenses capx

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