chapter 5chapter 5
TRANSCRIPT
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Chapter 5Chapter 5
Deductions and Losses: In GeneralDeductions and Losses: In General
Eugene Willis, William H. Hoffman, Jr.,David M. Maloney and William A. RaabeEugene Willis, William H. Hoffman, Jr.,Eugene Willis, William H. Hoffman, Jr.,
David M. Maloney and William A. RaabeDavid M. Maloney and William A. RaabeCopyright ©2004 SouthCopyright ©2004 South--Western/Thomson LearningWestern/Thomson Learning
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DeductionsDeductions
• Exclusive definition of deductions– Deductions allowed based on legislative grace
and defined narrowly– Substantiation requirements
• Taxpayer has burden of proof for substantiating all expenses deducted on return
• Thus, adequate records of expenses must be maintained
• Exclusive definition of deductions– Deductions allowed based on legislative grace
and defined narrowly– Substantiation requirements
• Taxpayer has burden of proof for substantiating all expenses deducted on return
• Thus, adequate records of expenses must be maintained
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Deductions FOR and FROM AGI (slide 1 of 3)
Deductions FOR and FROM AGI (slide 1 of 3)
• Deductions FOR AGI– Those listed in § 62– Can be claimed even if taxpayer does not
itemize– Called “above the line” deductions
• Deductions FOR AGI– Those listed in § 62– Can be claimed even if taxpayer does not
itemize– Called “above the line” deductions
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Deductions FOR and FROM AGI (slide 2 of 3)
Deductions FOR and FROM AGI (slide 2 of 3)
• Deductions FROM AGI :– Those not listed in § 62– In total must exceed standard deduction to
provide any tax benefit– Called “below the line” or itemized deductions
• Deductions FROM AGI :– Those not listed in § 62– In total must exceed standard deduction to
provide any tax benefit– Called “below the line” or itemized deductions
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Deductions FOR and FROM AGI (slide 3 of 3)
Deductions FOR and FROM AGI (slide 3 of 3)
• Comparison of deductions FOR and FROM AGI (2003 tax year)– Single taxpayer has gross income of $45,000
and a $5,000 deductionFor AGI From AGI
Gross income $45,000 $45,000Less: for AGI ded. 5,000 0 AGI $40,000 $45,000Less: from AGI ded. 4,750 5,000Less: personal exempt. 3,050 3,050Taxable income $32,200 $36,950
• Comparison of deductions FOR and FROM AGI (2003 tax year)– Single taxpayer has gross income of $45,000
and a $5,000 deductionFor AGI From AGI
Gross income $45,000 $45,000Less: for AGI ded. 5,000 0 AGI $40,000 $45,000Less: from AGI ded. 4,750 5,000Less: personal exempt. 3,050 3,050Taxable income $32,200 $36,950
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Deductions for AGI (slide 1 of 2)
• Partial list includes:– Trade or business expenses– Reimbursed employee business expenses– Deductions from losses on sale or exchange of
property – Deductions from rental and royalty property – Alimony– One-half of self-employment tax paid
• Partial list includes:– Trade or business expenses– Reimbursed employee business expenses– Deductions from losses on sale or exchange of
property – Deductions from rental and royalty property – Alimony– One-half of self-employment tax paid
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Deductions for AGI (slide 2 of 3)
• Partial list includes:– 100% (in 2003) of health insurance premiums paid
by a self-employed individual– Contributions to pension, profit sharing, annuity
plans, IRAs, etc.– Penalty on premature withdrawals from time
savings accounts or deposits– Moving expenses
• Partial list includes:– 100% (in 2003) of health insurance premiums paid
by a self-employed individual– Contributions to pension, profit sharing, annuity
plans, IRAs, etc.– Penalty on premature withdrawals from time
savings accounts or deposits– Moving expenses
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Deductions for AGI (slide 3 of 3)
• Partial list includes:– Interest on student loans– Deduction for qualified tuition and related
expenses under § 222– Deduction for up to $250 for teachers’ supplies for
elementary and secondary school teachers
• Partial list includes:– Interest on student loans– Deduction for qualified tuition and related
expenses under § 222– Deduction for up to $250 for teachers’ supplies for
elementary and secondary school teachers
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Deductions from AGI
• Itemized deductions include:– Medical expenses (in excess of 7.5 percent of
AGI) – Certain state and local taxes – Contributions to qualified charitable organizations – Personal casualty losses (in excess of 10 % of
AGI and a $100 floor per casualty)– Certain personal interest expense (e.g., mortgage
interest on a personal residence)– Miscellaneous itemized deductions (in excess of
2% of AGI)
• Itemized deductions include:– Medical expenses (in excess of 7.5 percent of
AGI) – Certain state and local taxes – Contributions to qualified charitable organizations – Personal casualty losses (in excess of 10 % of
AGI and a $100 floor per casualty)– Certain personal interest expense (e.g., mortgage
interest on a personal residence)– Miscellaneous itemized deductions (in excess of
2% of AGI)
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Trade or Business DeductionsTrade or Business Deductions
• In order for expenses to be deductible, they must be:– Ordinary: normal, usual, or customary for
others in similar business, and not capital in nature
– Necessary: prudent businessperson would incur same expense
– Reasonable: question of fact– Incurred in conduct of business
• In order for expenses to be deductible, they must be:– Ordinary: normal, usual, or customary for
others in similar business, and not capital in nature
– Necessary: prudent businessperson would incur same expense
– Reasonable: question of fact– Incurred in conduct of business
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Business And Nonbusiness Losses
Business And Nonbusiness Losses
• Deductible losses of individual taxpayers are limited to those:– Incurred in a trade or business,– Incurred in a transaction entered into for
profit• Individuals may also deduct casualty
losses from fire, storm, shipwreck, and theft
• Deductible losses of individual taxpayers are limited to those:– Incurred in a trade or business,– Incurred in a transaction entered into for
profit• Individuals may also deduct casualty
losses from fire, storm, shipwreck, and theft
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Methods of AccountingMethods of Accounting
• The method of accounting affects when deductions are taken– Cash: expenses are deductible only when paid– Accrual: expenses are deductible when incurred
• Apply the all events test and the economic performance test
– Exception to the economic performance test for recurring items
• The method of accounting affects when deductions are taken– Cash: expenses are deductible only when paid– Accrual: expenses are deductible when incurred
• Apply the all events test and the economic performance test
– Exception to the economic performance test for recurring items
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Disallowance Possibilities(slide 1 of 6)
Disallowance Possibilities(slide 1 of 6)
• Contrary to public policy– Examples: penalties, fines, illegal bribes or
kickbacks, two-thirds of treble damage payments for violation of anti-trust law
• Contrary to public policy– Examples: penalties, fines, illegal bribes or
kickbacks, two-thirds of treble damage payments for violation of anti-trust law
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Disallowance Possibilities(slide 2 of 6)
Disallowance Possibilities(slide 2 of 6)
• Legal expenses for business or production of income related activities may be deductible– E.g., Corporate officer’s legal fees in defending
against price-fixing charges– E.g., Landlord’s legal fees associated with
eviction of tenant
• Legal expenses for business or production of income related activities may be deductible– E.g., Corporate officer’s legal fees in defending
against price-fixing charges– E.g., Landlord’s legal fees associated with
eviction of tenant
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Disallowance Possibilities(slide 3 of 6)
Disallowance Possibilities(slide 3 of 6)
• Illegal business expenses– Deductible as if business were legal– Fines, bribes, etc., still nondeductible– Trafficking in controlled substances: only cost
of goods sold can reduce gross income
• Illegal business expenses– Deductible as if business were legal– Fines, bribes, etc., still nondeductible– Trafficking in controlled substances: only cost
of goods sold can reduce gross income
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Disallowance Possibilities(slide 4 of 6)
Disallowance Possibilities(slide 4 of 6)
• Political and lobbying expenditures– Generally, no business deduction is allowed for
payments made for political purposes or for lobbying
– Exceptions are allowed for lobbying:• To influence local legislation, • To monitor legislation, and • De minimis in-house expenses (limited to $2,000)
– If greater than $2,000, none can be deducted
• Political and lobbying expenditures– Generally, no business deduction is allowed for
payments made for political purposes or for lobbying
– Exceptions are allowed for lobbying:• To influence local legislation, • To monitor legislation, and • De minimis in-house expenses (limited to $2,000)
– If greater than $2,000, none can be deducted
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Disallowance Possibilities(slide 5 of 6)
Disallowance Possibilities(slide 5 of 6)
• Excessive executive compensation– For publicly held corporations: chief executive
officer’s and four highest compensated executives’ salaries deductible up to $1 million each
– Does not include:• Performance-based compensation and commissions • Payments to qualified retirement plans• Payments excludible from gross income
• Excessive executive compensation– For publicly held corporations: chief executive
officer’s and four highest compensated executives’ salaries deductible up to $1 million each
– Does not include:• Performance-based compensation and commissions • Payments to qualified retirement plans• Payments excludible from gross income
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Disallowance Possibilities(slide 6 of 6)
Disallowance Possibilities(slide 6 of 6)
• Investigation of business expenditures– Capitalize and elect to amortize over 60-month
period, if new line of business and acquired– Nondeductible, if new line of business and not
acquired– Deduct currently, if same line of business
• Investigation of business expenditures– Capitalize and elect to amortize over 60-month
period, if new line of business and acquired– Nondeductible, if new line of business and not
acquired– Deduct currently, if same line of business
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Hobby Losses (slide 1 of 8)Hobby Losses (slide 1 of 8)
• Hobby defined– Activity not entered into for profit
• Personal pleasure associated with activity• Examples: raising horses, fishing boat charter
– Often it is difficult to determine if an activity is profit motivated or a hobby• Regulations provide nine factors to consider in
making this determination
• Hobby defined– Activity not entered into for profit
• Personal pleasure associated with activity• Examples: raising horses, fishing boat charter
– Often it is difficult to determine if an activity is profit motivated or a hobby• Regulations provide nine factors to consider in
making this determination
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Hobby Losses (slide 2 of 8)Hobby Losses (slide 2 of 8)
• Profit activity– If activity is entered into for profit, taxpayer
can deduct expenses FOR AGI even in excess of income from the activity
– At-risk and passive loss rules may apply
• Profit activity– If activity is entered into for profit, taxpayer
can deduct expenses FOR AGI even in excess of income from the activity
– At-risk and passive loss rules may apply
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Hobby Losses (slide 3 of 8)Hobby Losses (slide 3 of 8)
• Presumptive rule of § 183– If activity shows profit 3 out of 5 years (2 out
of 7 years for horses), it is presumed that taxpayer has profit motive• Rebuttable presumption, shifts burden of proof to
IRS
– Otherwise, taxpayer has burden to prove profit motive
• Presumptive rule of § 183– If activity shows profit 3 out of 5 years (2 out
of 7 years for horses), it is presumed that taxpayer has profit motive• Rebuttable presumption, shifts burden of proof to
IRS
– Otherwise, taxpayer has burden to prove profit motive
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Hobby Losses (slide 4 of 8)Hobby Losses (slide 4 of 8)
No, profit 3 of 5 years1,2002003Yes, profit only 2 of 5 years(500)2002No, profit 3 of 5 years9002001Yes(1,000)2000Yes7001999Yes(1,500)1998Yes$5001997Hobby?Income (loss)Year
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Hobby Losses (slide 5 of 8)Hobby Losses (slide 5 of 8)
• Hobby activity– Can only deduct expenses to extent of income
from activity (i.e., cannot deduct hobby losses)
• Hobby activity– Can only deduct expenses to extent of income
from activity (i.e., cannot deduct hobby losses)
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Hobby Losses (slide 6 of 8)Hobby Losses (slide 6 of 8)
• If an activity is a hobby:– Expenses are deductible FROM AGI
• Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation
• Exception: expenses that are deductible without regard to profit motive, such as
– Mortgage interest – Property taxes
• If an activity is a hobby:– Expenses are deductible FROM AGI
• Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation
• Exception: expenses that are deductible without regard to profit motive, such as
– Mortgage interest – Property taxes
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Hobby Losses (slide 7 of 8)Hobby Losses (slide 7 of 8)
• Order in which hobby expenses are deductible:– First: Those otherwise deductible: e.g.,
home mortgage interest and property taxes – Then: Expenses that do not affect adjusted
basis: e.g., maintenance, utilities– Then: Expenses that affect adjusted basis:
e.g., Depreciation (or cost recovery)
• Order in which hobby expenses are deductible:– First: Those otherwise deductible: e.g.,
home mortgage interest and property taxes – Then: Expenses that do not affect adjusted
basis: e.g., maintenance, utilities– Then: Expenses that affect adjusted basis:
e.g., Depreciation (or cost recovery)
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Hobby Losses (slide 8 of 8)Hobby Losses (slide 8 of 8)
• Example of hobby expenses: Taxpayer sells horses raised as a hobby for $15,500
• Example of hobby expenses: Taxpayer sells horses raised as a hobby for $15,500
15,500TotalLtd. to 50031,000Depreciation
4,00024,000Feed2,00022,000Vet Bills3,00013,000Taxes
$ 6,00016,000Interest$15,500Income
AmountOrderAmount
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Rental Vacation Homes(slide 1 of 9)
Rental Vacation Homes(slide 1 of 9)
• May have both personal and rental use of a vacation home
• Rental expenses may be limited to rental income if primarily used for personal purposes
• Determination of vacation home treatment is dependent on personal use vs. rental use
• May have both personal and rental use of a vacation home
• Rental expenses may be limited to rental income if primarily used for personal purposes
• Determination of vacation home treatment is dependent on personal use vs. rental use
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Rental Vacation Homes(slide 2 of 9)
Rental Vacation Homes(slide 2 of 9)
• Rental days– Less than 15 days: No gross income from
rentals and no deductible rental expenses• Mortgage interest and property taxes treated as if on
personal residence (generally deductible in full)
– More than 14 days: Treatment depends on amount of personal use
• Rental days– Less than 15 days: No gross income from
rentals and no deductible rental expenses• Mortgage interest and property taxes treated as if on
personal residence (generally deductible in full)
– More than 14 days: Treatment depends on amount of personal use
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Rental Vacation Homes(slide 3 of 9)
Rental Vacation Homes(slide 3 of 9)
• Primarily rental use– If rented for 15 days or more and personal use
days NOT more than the greater of 14 days or 10 percent of fair rental days
– Can deduct all expenses allocated to rental use even if loss results
• Rental loss subject to passive loss rules
• Primarily rental use– If rented for 15 days or more and personal use
days NOT more than the greater of 14 days or 10 percent of fair rental days
– Can deduct all expenses allocated to rental use even if loss results
• Rental loss subject to passive loss rules
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Rental Vacation Homes(slide 4 of 9)
Rental Vacation Homes(slide 4 of 9)
• Personal/rental use– If rented for 15 days or more and personal use
days exceed the greater of 14 days or 10 percent of fair rental days
– Treated similar to hobby• Rental expenses deducted in three step process• No rental loss allowed• Carryforward of disallowed rental expenses
• Personal/rental use– If rented for 15 days or more and personal use
days exceed the greater of 14 days or 10 percent of fair rental days
– Treated similar to hobby• Rental expenses deducted in three step process• No rental loss allowed• Carryforward of disallowed rental expenses
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Rental Vacation Homes(slide 5 of 9)
Rental Vacation Homes(slide 5 of 9)
• Example of personal use
Rental days: 200 (10% = 20)
Personal use Not Significant Significant7 days X
18 days X25 days X
• Example of personal use
Rental days: 200 (10% = 20)
Personal use Not Significant Significant7 days X
18 days X25 days X
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Rental Vacation Homes(slide 6 of 9)
Rental Vacation Homes(slide 6 of 9)
• Example of personal use
Rental days: 100 (10% = 10)
Personal Use Not Significant Significant7 days X
14 days X18 days X
• Example of personal use
Rental days: 100 (10% = 10)
Personal Use Not Significant Significant7 days X
14 days X18 days X
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Rental Vacation Homes(slide 7 of 9)
Rental Vacation Homes(slide 7 of 9)
• Allocation of expenses between personal and rental– Mortgage interest and real estate taxes
• IRS requires allocation based on total days used• Courts have allowed allocation based on days in
year
– Other expenses are allocated based on total days used
• Allocation of expenses between personal and rental– Mortgage interest and real estate taxes
• IRS requires allocation based on total days used• Courts have allowed allocation based on days in
year
– Other expenses are allocated based on total days used
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Rental Vacation Homes(slide 8 of 9)
Rental Vacation Homes(slide 8 of 9)
• Tax treatment of income and expenses of a primarily rental vacation home– Rental income included in gross income– Rental expenses deductible FOR AGI– Rental income and expenses reported on Sch. E
• Tax treatment of income and expenses of a primarily rental vacation home– Rental income included in gross income– Rental expenses deductible FOR AGI– Rental income and expenses reported on Sch. E
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Rental Vacation Homes(slide 9 of 9)
Rental Vacation Homes(slide 9 of 9)
• Treatment of allocated personal portion of vacation home expenses– Primarily rental use: taxes deductible FROM
AGI, mortgage interest nondeductible (personal interest)
– Personal/rental use: mortgage interest and taxes deductible FROM AGI
– Personal portion of other expenses (e.g., insurance, maintenance) nondeductible
• Treatment of allocated personal portion of vacation home expenses– Primarily rental use: taxes deductible FROM
AGI, mortgage interest nondeductible (personal interest)
– Personal/rental use: mortgage interest and taxes deductible FROM AGI
– Personal portion of other expenses (e.g., insurance, maintenance) nondeductible
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Expenditures Incurred for Taxpayer’s Benefit or Obligation
Expenditures Incurred for Taxpayer’s Benefit or Obligation• No deductions is allowed for payment of
another taxpayer’s expenses– Must be incurred for taxpayer’s benefit or arise
from taxpayer’s obligation– Exception: Payment of medical expenses for a
dependent
• No deductions is allowed for payment of another taxpayer’s expenses– Must be incurred for taxpayer’s benefit or arise
from taxpayer’s obligation– Exception: Payment of medical expenses for a
dependent
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Personal ExpendituresPersonal Expenditures
• Unless otherwise provided in the Code, personal expenses are not deductible
• Unless otherwise provided in the Code, personal expenses are not deductible
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Capital ExpendituresCapital Expenditures
• Amounts are capitalized• Asset may be subject to depreciation (or
cost recovery), amortization, or depletion
• Amounts are capitalized• Asset may be subject to depreciation (or
cost recovery), amortization, or depletion
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Transactions Between Related Parties (slide 1 of 2)
Transactions Between Related Parties (slide 1 of 2)
• Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties– Family and entity relationships apply– Constructive ownership rules apply– Loss disallowed may reduce gain on subsequent
disposition to unrelated third party
• Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties– Family and entity relationships apply– Constructive ownership rules apply– Loss disallowed may reduce gain on subsequent
disposition to unrelated third party
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Transactions Between Related Parties (slide 2 of 2)
Transactions Between Related Parties (slide 2 of 2)
• Section 267 also requires the matching principle be applied for unpaid expenses and interest when different accounting methods used– Example: An accrual basis, closely held
corporation, cannot deduct accrued, but unpaid, salary to cash basis related party employee/shareholder until it is actually paid
• Section 267 also requires the matching principle be applied for unpaid expenses and interest when different accounting methods used– Example: An accrual basis, closely held
corporation, cannot deduct accrued, but unpaid, salary to cash basis related party employee/shareholder until it is actually paid
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Expenses and Interest Relating to Tax-Exempt Income
Expenses and Interest Relating to Tax-Exempt Income
• Expenses relating to production of tax-exempt income are nondeductible– Example: interest expense on loan where funds
used to acquire municipal bonds
• Expenses relating to production of tax-exempt income are nondeductible– Example: interest expense on loan where funds
used to acquire municipal bonds
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If you have any comments or suggestions concerning this PowerPoint Presentation for West's Federal Taxation, please contact:
Dr. Donald R. Trippeer, [email protected]
Colorado State University-Pueblo
If you have any comments or suggestions concerning this PowerPoint Presentation for West's Federal Taxation, please contact:
Dr. Donald R. Trippeer, [email protected]
Colorado State University-Pueblo