chapter 5 introduction to business expenses ©2008 south-western kevin murphy mark higgins kevin...
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Chapter 5Chapter 5
Introduction to Business ExpensesIntroduction to Business Expenses
©2008 South-Western©2008 South-Western©2008 South-Western©2008 South-Western
Kevin MurphyKevin MurphyMark HigginsMark Higgins
Kevin MurphyKevin MurphyMark HigginsMark Higgins
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All tax deductions are a matter of Legislative Grace
All tax deductions are a matter of Legislative Grace
Deductions are part of Congress’ approach to implementation of
Ability-to-Pay
Concept Review Concept Review
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Review! Review!
From Chapter 1: All deductible amounts fall into one of three categories:Business Expenses (Chapters 5 & 6)Losses (Chapter 7)Deductions (Chapter 8)
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Business ExpenseBusiness Expense
The expenditure much have a business purpose that is unrelated to its tax effect.
Failure to establish a business purpose can result in the loss of the deduction.
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DeductionsDeductions
Trade or business expenses, expenses related to the production of rent and royalty income, losses on sales of property used in a trade or business and capital losses are deducted to arrive at gross income. These items are netted with the income to arrive at total income.
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DeductionsDeductions
Deductions for AGI There are specific items that are
deductions for AGI.
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DeductionsDeductions
Deductions from AGI Greater of standard deduction or
itemized deduction. Itemized deductions are allowable
personal expenditures and miscellaneous itemized deductions.
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Classification of DeductionsClassification of Deductions
All expenditures fall into two categories:Profit-motivated
Trade or business expensesExpenses for the production of income
(Investment)
PersonalSpecifically allowed itemized deductionsNondeductible personal expenses
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Profit-Motivated Expenditures
Profit-Motivated Expenditures
Show that the expense is related to a profit-motivated transaction
Show that the business purpose is the primary or dominant motive
To be deductible, an expenditure must have a business purpose unrelated to its tax effect.
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Trade or BusinessTrade or Business
Requirements to qualify as a trade or business:Primary purpose is to earn income or a
profitInvolvement is regular and continuousActivity is not merely a hobby
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Production of Income Expenses
Production of Income Expenses
Royalty Interest & Dividends
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Investment ActivitiesInvestment Activities
Have to determine whether individual is in the “business” of trading.
If so, expenses are deducted to arrive at total income.
If not, expenses are deducted as itemized deductions on Sch. A.
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Rental ActivityRental Activity
Rental activities may be either trade or business or for the production of incomeExpenses are always netted with gross
rental income Classification matters when property is
sold
Classification is determined by the scope of the taxpayer’s involvement
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Personal ExpendituresPersonal Expenditures
2 GroupsAllowable personal itemized deductionsNondeductible personal expenses
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Mixed-Use ( & ) Business and Personal Use
Mixed-Use ( & ) Business and Personal Use
Mixed-Use Assets Used both to earn income and for personal
purposesTreat as two separate assets by allocating
amount of use
Mixed-Use ExpendituresIncurred both for profit and personal
reasonsAllocate between business and personal
use and deduct as allowed
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3 Positive Tests for Deductibility
3 Positive Tests for Deductibility
To be deductible, expenses must be profit-motivated or specifically allowed, and alsoand also
OrdinaryNormal, common, generally accepted
NecessaryAppropriate, helpful, prudent
Reasonable in amountArm’s length
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5 Negative Tests for Deductibility
5 Negative Tests for Deductibility
To be deductible, expenses must not bePersonal
Business purpose is not primary motiveNot specifically allowed
Capital ExpendituresShould be capitalized as assets if useful life
extends beyond a yearStart-up costs
After 10/23/04 may expense $5,000 in first year; remainder is amortized over 180 months
Expense is phased-out if total costs > $50,000
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5 Negative Tests for Deductibility
5 Negative Tests for Deductibility
Against Public PolicyResulting from violation of a lawResulting from an illegal business
Cost of goods sold are always deductible under the capital recovery concept
Ordinary, necessary, and reasonable business expenses are deductible for all illegal businesses except sale of drugs
For lobbying and political activities Costs to influence local legislation are deductible Costs to monitor any legislation are deductible
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5 Negative Tests for Deductibility
5 Negative Tests for Deductibility
Related to Tax-Exempt IncomeIncurred to generate tax-exempt income
Another Person’s ObligationCannot recover another’s capital
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Mixed-Use ExpensesHobby Vs. Business
Mixed-Use ExpensesHobby Vs. Business
An income-earning activity without a predominant profit motive is a hobby.
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Mixed-Use ExpensesHobby Vs. Business
Mixed-Use ExpensesHobby Vs. Business
Factors considered in determining profit-motive areManner of conducting activityExpertise or reliance on expert adviceTime and effort spent on activityHistory of income and lossAmount of occasional profitElements of personal pleasureSuccess in similar activities
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Mixed-Use ExpensesHobby
Mixed-Use ExpensesHobby
Losses from a hobby are not deductibleExpenses allowed up to amount of income
generatedDeductions taken using three tier system:
Expenses also allowed as personal itemized deductions
Other expenses that qualify as business expensesDepreciation on assets used
Allowable expenses are deducted from AGI
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Mixed-Use ExpensesVacation Home
Mixed-Use ExpensesVacation Home
A residence used for personal vacations and also rented to unrelated people is a mixed-use asset and first must be classified as either:Personal residence if rented less than 15
days in a yearVacation home if used personally
more than 14 days, ormore than 10% of the number of days rented
Rental property if used personally less than 15 days, orless than or equal to 10% of the days rented
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Vacation HomeTax TreatmentVacation HomeTax Treatment
If classification is: Personal residence
Vacation home
Rental property
Then tax treatment is:• Report no income or
expense• Report income and
allocate expenses using three tier system (no loss allowed)
• Report income and allocate all expenses; Loss allowed
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Mixed-Use ExpensesHome Office
Mixed-Use ExpensesHome Office
A taxpayer who operates a trade or business from home may be able to deduct a portion of the home’s expenses.
Expenses of the home are allocated between business and personal use
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Mixed-Use ExpensesHome Office
Mixed-Use ExpensesHome Office
A specific portion of the home must be usedExclusively and regularly,As the principal place of business or as a
place to meet clients, but If taxpayer has no other available location to do
administrative or management activities, this requirement will not disqualify the deduction
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Mixed-Use ExpensesHome Office
Mixed-Use ExpensesHome Office
Employees must also show that the use Is for the convenience of their employerRequired as a condition of employment
Allowed expenses are deducted using the three tier system
Deduction is limited to the amount of net income from the businessHome-office deduction may not create a lossExcess may be carried-forward
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Timing of DeductionsTiming of Deductions
The taxpayer’s accounting method is used to determine the timing of deductions.
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Timing of DeductionsCash Method
Timing of DeductionsCash Method
Cash Method: claim a deduction in the year an expense is paidDate of mailing for checksDate of charge for credit cardsPrepaid expenses are deductible if used
within one tax year (prepaid interest does not qualify)
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Timing of DeductionsAccrual Method
Timing of DeductionsAccrual Method
Accrual Method: claim a deduction in the year two tests are metAll-events test is met when a liability exists
and the amount can be determinedEconomic performance test is met when
services or property are provided
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Timing of DeductionsRelated Party Accrued
Expenses
Timing of DeductionsRelated Party Accrued
ExpensesDeductions for accrued expenses payable to a cash basis related party are limited.
Related parties include family members and businesses owned or controlled by the taxpayer
Unless both parties are accrual basis, both report using the cash method; until income is reported no expense may be deducted
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Financial Accounting Income Vs. Taxable Income
Financial Accounting Income Vs. Taxable Income
Matching and Conservatism are not tax concepts
Estimates of expenses are not permitted for tax purposesUse specific write-off for bad debtsDo not estimate warranty expense