business expenses

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Business Expenses

Chapter 5

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Code Sections

Deductions are permitted by “legislative grace” so they are allowed only if specifically authorized in the CodeSec. 162(a) authorizes deductions for ordinary

and necessary expenses, that are reasonable in amount, and incurred in actively carrying on a trade or business

Sec. 212 authorizes deductions for expenses related to production of income (investment-related expenses)

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Disallowed Deductions

Unless provided for otherwise in the Code, a deduction will be disallowed if it isContrary to public policy (fines, penalties)Related to tax-exempt incomeAccrued to related party (no deduction until

related party recognizes income)The obligation of another taxpayer

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Substantiation

All taxpayers must maintain records that substantiate their expense deductions

Stringent substantiation requirements for travel, entertainment, and gifts include:Amount of expenditureTime and place (or date & description of gift)Business purpose of expenditureBusiness relationship of person entertained or

receiving a gift

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Timing of Deductions

Accrual method – expenses deductible when“All events” have occurred that fix liability and“Economic performance” occurs (property or

services provided or used) Cash basis - expenses deductible when paid

Date check is mailedDate charged on credit card

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Cash Method

When an expense is paid by providing services, the expense is deductible but income must also be recognized for FMV of services provided

Assets with useful lives extending substantially beyond the end of the year must be capitalized with their cost recovered through depreciation, amortization, or depletion

When considering whether to make an early payment of year-end expenses, the tax rates for both years and the time value of money should be considered

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Use of Cash Method

Businesses that sell merchandise to their customers must use the accrual method to account for purchases and sales of inventoryCash method can be used for other than

inventory and cost of goods sold Large corporations (average annual gross

receipts of more than $5 million) cannot use the cash method for tax reporting

All personal service corporations can use the cash method regardless of size

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Prepaid Expenses

Prepaid expenses must be capitalized as assets if their lives exceed one year and the items will not be consumed by the close of the following year (similar to accrual)Prepaid rents must be capitalized unless paid for

one year or less and prepayment is contractually required

Prepaid interest must generally be prorated over the life of the loanOID is a form of prepaid interest and must be

amortized over term of loan

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Costs of Starting a Business

Sec. 162 allows deductions for “carrying on” a business. Expenses incurred prior to the commencement of operations do not qualify as “carrying on” a business but may be deductible as one of the following:Business investigation expensesStart-up expensesOrganization costs

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Business Investigation

Investigation expenses incurred while preparing to enter business include travel, market surveys, and feasibility studies

If the taxpayer is in a similar existing business, deduction allowed as a current expense

If taxpayer is not in a similar existing business If new business not acquired – no deduction If new business acquired – expenses added to

start-up expenses to determine deduction and amortization

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Start-up Expenses

Start-up expenses are incurred after the decision to proceed with the new business, but before beginning actual operations (employee training and advertising)

If the new business is related to the taxpayer’s existing business, start-up costs are considered continuing costs and are deductible currently

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Start-up Expenses

If the new business is not related to an existing businessCan deduct up to $5,000 (combined business

investigation and start-up expenses) in the tax year in which the business begins

$5,000 amount is reduced by amount cumulative investigation and start-up expenses exceeds $50,000

Remainder of investigation and start-up expenses amortized over a 15-year period

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Organization Costs

Defined as costs related to the formation of a corporation or partnership (fees paid to the state for incorporation, legal fees, and accounting fees) and incurred before end of first year

Can deduct up to $5,000 in the year business begins

$5,000 deduction is reduced by amount organizational costs exceeds $50,000

Remaining organizational costs amortized over 15 years (180 months)

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Operating Expenses

Most operating expenses shown on a GAAP income statement are deductible on a business tax return

Examples includeAdvertising Bank service chargesCommissionsOffice suppliesTaxesLicenses, accounting

fees & legal feesSalaries and wagesUtilities

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Meals & Entertainment

The deduction for business meals and entertainment expenses is limited to 50% of the qualified expenses

The 50% limit is imposed on whoever (employer or employee) ultimately pays the expense

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Meals & Entertainment

Directly-related expenses - costs incurred when a significant business discussion takes place between the taxpayer and a customer in atmosphere conducive to the serious conduct of business

Associated-with expenses - deductible when directly preceded or followed by a substantial business discussionDeduction for entertainment tickets is limited to

50% of the tickets’ face value

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Restriction on Deductions

No deduction allowed for the costs of owning and maintaining entertainment facilities such as hunting lodges and yachts

No deduction allowed for membership dues and fees paid to social, athletic, or sporting clubsDeductions are allowed for dues to

professional organizations, public service organizations, and trade associations

Deduction for business gifts limited to $25 per donee per year

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Travel Away From Home

Travel expenses incurred for temporary travel away from home on business are deductibleAway from home refers to the person’s tax

home; that is, the location of the principal place of employment regardless of where the family residence is maintained

Qualifying expenses include lodging, 50% of meals, transportation to destination and back, and incidental expenses

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Temporary Assignments

Temporary is defined as one year or less Employment away from home in a single

location that is realistically expected to last (and does in fact last) for one year or less, will be treated as temporary

Assignment for more than one year shifts tax home to the new location (no deduction for travel and living costs)

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Transportation Expenses

Certain transportation expenses incurred when the taxpayer is not away from home are deductible and includeCost of transportation from one work location

to another Transportation between home and a temporary

work location if the taxpayer has a regular place of business

Meal costs are generally not deductible

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Transportation Expenses

The prorated business portion of actual automobile expenses or a standard mileage rate (55¢ for 2009) plus related parking and tolls can be deducted

Commuting expenses (between home and the regular place of business) are personal nondeductible expenses

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Combining Business with Pleasure Travel

For U.S. travel, if the trip is primarily for business, all transportation costs to and from destination are deductible

If primary purpose is pleasure, no deduction for transportation

Primary purpose is determined by the number of days on business versus personal days

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Combining Business with Pleasure Travel

Meals & lodging are deductible only for days on which business is conducted

If a taxpayer remains in a temporary location to reduce costs as a result ofReduced airfare for Saturday night stays or for

business conducted on both Friday and Monday

Costs for additional days are deductible if they are less than the cost of returning home when business is completed

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Foreign Travel

Transportation expenses must be allocated between business and personal days unlessTrip does not exceed one week orLess than 25% of total time spent for personal

purposes If trip primarily personal, no deduction for

transportation

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Bad Debt Expense

Specific charge-off method must be usedDeduct accounts receivable or other business

debts only when actually written off as uncollectible

Investment and personal loans are considered nonbusiness (capital losses)Loan must be valid debt

No bad debt deduction for cash basis taxpayers who have not previously included amount in income

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Insurance Expense

Premiums for fire, casualty, and theft insurance for business property are deductible

Payments into a self-insurance reserve are not deductible - only actual losses are deductible

Premiums for life insurance when business is beneficiary are not deductible

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Legal Expenses

Legal Fees deductible only if related to a trade or businessLegal fees incurred to defend title to property

are added to the asset’s basisCriminal defense fees are deductible only if

the legal action has a direct relationship to a profit-seeking activity

Personal legal expenses are not deductible

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Taxes

Deductible taxes includeState, local, and foreign real property taxesState and local personal property taxesState, local, and foreign income taxesEmployer’s payroll taxesOther federal, state, local, and foreign taxes

incurred in a business or other income-producing activity

Federal income taxes are not deductible

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Taxes

When real estate is sold, the seller is responsible for taxes through the day before the sale date

Assessments for improvements must be added to basis of property

Sales taxes are added to cost of business property or service

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Residential Rental Property

If rental of real estate is a business, all income is included and all expenses are deductible, even if it creates a lossExpenses include: advertising, cleaning,

maintenance, utilities, insurance, taxes, interest, commissions for collection of rent, travel to collect rental income or to manage the property or maintain the property

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Residential Rental Property

When property is converted from personal to rental property, expenses must be divided between rental and personal use

No depreciation or insurance deduction allowed for personal-use part of year

Mortgage interest and real estate taxes for personal-use may be deductible as itemized deductions

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Rental of a Vacation Home

If the residence is rented for less than 15 days during the year, a de minimis exception appliesNo rental income is reported butNo deductions are allowed for expenses

other than mortgage interest and property taxes as itemized deductions

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If rental period is greater than 14 days and If personal use does not exceed the greater of 14 days

or 10% of the rental daysAll rent is included in incomeExpenses are allocated between rental & personal use

All expenses related to the rental use are deductible (even if this creates a loss)

Personal portion of interest is not deductible as itemized deduction (but taxes are deductible)

(# Rental Days / Total # Days Used) x Total Expense = Rental-use Expense

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If rental period is greater than 14 days but Personal use exceeds the greater of 14 days or

10% of the rental daysRental expenses limited to rental income (no loss)Nondeductible rental expenses can be carried

forward to future yearsReal estate taxes and mortgage interest for

personal-use portion allowed as itemized deductions

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Home Office Expenses

To be deductible, home office must be used exclusively on a regular basis and meet one of the following three tests:

1) The principal place of business for any business of taxpayer, or

2) A place for meeting with clients or customers in the normal course of business, or

3) Located in a separate structure

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Principal place of business - place used for the administrative or management activities of the business if there is no other fixed location available

Employee must also show that the office is maintained for the convenience of the employer

Deductible expenses are limited to gross income from the business and include Portion of rent or mortgage interest, property taxes,

insurance, utilities, repairs, & depreciation

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Expenses are deducted in this order:1) Expenses directly related to the business other

than home office expenses (supplies)2) The allocated portion of otherwise deductible

itemized deductions (mortgage interest and property taxes)

3) Other home expenses including utilities, insurance, and maintenance

4) Depreciation Excess expenses are carried forward

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Hobby Expenses

Hobbies - activities that earn income and incur expenses but do not meet the requirements to be a business or investment

Regulations list factors to consider in determining if activity is a hobby including:Manner in which activity carried onExpertise of taxpayer and/or consultantsTime and effort spent in activityActual profits earned in one or more yearsElements of pleasure or recreation

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Hobby Expenses

If a profit is realized in 3 out of 5 years (2 out of 7 years for horses) then burden of proof shifts to IRS to prove activity is a hobbyTaxpayer may deduct expenses, even if a

net loss results, by showing activity is run in a businesslike manner

If activity is a hobby, the deduction for expenses is limited to hobby income

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Hobby Expenses

Expenses must be deducted in this order:1) Otherwise allowable expenses (mortgage

interest, taxes, and casualty losses)

2) Expenses that do not reduce the tax basis of the assets used in the hobby (advertising, insurance, utilities and maintenance)

3) Depreciation and amortization Excess expenses are lost - no carryover

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Accounting for Income Taxes

FAS 109 states that income tax expense reported on financial statements must be based on financial statement income rather than taxable incomeActual taxes paid may differ significantly from

expense recognized Differences fall into two categories

Permanent differencesTemporary differences

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Permanent Differences

Income that is not taxed but is reported for financial accounting purposesInterest income from municipal bonds

Expenses that can never be deducted on the tax returnFines and penalties

Expenses that have limited deductibility50% of meals and entertainment

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Temporary Differences

Income or expense items that are reported in one year for accounting income and in a different year for taxable incomeExamples: depreciation expense, bad debt

expense, warranty expenses, and prepaid income

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Reconciling Book/Tax Income

Schedule M-1 of Form 1120 reconciles accounting (book) income to taxable income

More detailed Schedule M-3 required if corporation has assets of $10 million or more

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Calculating Tax Expense

If only permanent differences, adjust book income byAdding expenses that are not tax deductibleSubtracting tax-exempt income

Then multiply adjusted book income by the tax rate to get the book tax expense

If there are both permanent and temporary differences, book income is first adjusted by permanent differences and then adjusted for temporary differences.

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Deferred Taxes

Temporary differences createA deferred tax liability that is a current tax

savings that will have to be paid in a future year when the temporary difference reverses

A deferred tax asset that is a prepayment of tax that will be refunded in a future year when the temporary difference reverses

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Deferred Tax Liabilities

Deferred tax liabilities result whenExpense deductible for tax purposes before book Income recognized for book purposes before tax

Effectively an interest-free loan from governmentTax savings can be invested until taxes are due

Adjusting the book tax expense prevents overstatement of financial statement income

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Deferred Tax Assets

Deferred tax assets result whenExpense deductible for book purposes before tax Income recognized for tax purposes before book

To realize the benefit of a deferred tax asset (tax prepayment), the business must have future income and a related tax liability A more-likely-than-not test is used to

determine if a valuation account (contra asset) is needed

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FIN 48

FIN 48 provides guidance on accounting for deferred taxes when a business takes an uncertain tax positionTax position refers to the manner of recognition of

a transaction in a tax return that will result in a current or deferred tax asset or liability

The uncertainly refers to the question as to whether the position will be challenged by IRSExample: a deduction taken on a tax return for a current

expenditure that IRS may claim should be capitalized

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FIN 48

A tax benefit from any uncertain tax position that reduces a business’s current or future tax liability can only be reported in the financial statements to the extent each benefit is recognized and measured under a two-step approachStep 1: the business must evaluate each tax

position to assess whether it is more likely than not (greater than 50%) that the position would be sustained upon examination by IRS

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FIN 48

Step 2: if a tax position satisfies the 1st step, the business can then measure the tax benefit If no single amount is more likely than not (MLTN)

to be realized, then a cumulative probability analysis of the possible outcomes is required

The business records the largest tax benefit that meets a greater than 50% cumulative probability

The business must review & modify its reporting of uncertain tax positions if new information becomes available

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FIN 48

If a business determines that a tax position no longer meets the MLTN threshold, then the business must derecognize the benefit (it cannot use a valuation allowance as a substitute for derecognition)

Expanded disclosure requirements include tables identifying unrecognized tax benefits and details on the tax uncertainties for which it is possible that the amount of unrecognized tax benefit will change within the next year

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ConsolidatedFinancial Statements

Under FAS 109, income tax expense reported on consolidated financial statements should include the total of all federal, state, local, and foreign income taxes including both current and deferred income taxes

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ConsolidatedFinancial Statements

APB 23 exception allows parent to exclude future U.S. income tax on foreign subsidiary income earnings if permanently reinvested outside the U.S.Allows U.S. corporation to report higher

financial statement income because its income statement includes the foreign income but excludes the deferred U.S. tax that could eventually be due on this income

Earnings repatriated later can cause a spike in the corporation's effective tax rate in that year

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UNICAP Rules

Uniform capitalization rules apply to businesses whose average annual gross receipts for the preceding three years exceed $10 millionUNICAP rules require inventory costs to include all

direct costs of manufacturing, purchasing, or storing inventory, along with many indirect costs typically not included in full absorption costing

Nonmanufacturing costs (research, selling, advertising and distribution expenses) are not required to be included in inventory

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Inventory

Acceptable methods for tax accounting include specific identification, FIFO, LIFO, and average cost

When prices are rising, the LIFO method results in a lower inventory valuation and tax savings through a higher deduction for cost of goods sold

The LIFO conformity rule requires use of LIFO for financial statements if LIFO is used for tax

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The End

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