Download - Basic Income Tax Business Expenses CAPX
-
7/30/2019 Basic Income Tax Business Expenses CAPX
1/47
Basic Income TaxBusiness and Profit Seeking
Expenses
Professor Jack Williams
-
7/30/2019 Basic Income Tax Business Expenses CAPX
2/47
2
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
3/47
3
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
4/47
4
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
5/47
5
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
6/47
6
Methodology: IRC 162
Ordinary and Necessary
Expenses
Carry on
Trade or business
-
7/30/2019 Basic Income Tax Business Expenses CAPX
7/47
7
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
8/47
8
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
9/47
9
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).
-
7/30/2019 Basic Income Tax Business Expenses CAPX
10/47
10
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
11/47
11
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
12/47
12
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
13/47
13
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
14/47
14
Expanding Existing Trade
What about the expansion of an exist ing
trade or business?
These expenses are generally deductible
-
7/30/2019 Basic Income Tax Business Expenses CAPX
15/47
15
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).
-
7/30/2019 Basic Income Tax Business Expenses CAPX
16/47
16
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
17/47
17
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
18/47
18
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
19/47
19
STATUTORY EXAMPLES UNDER
SECTION 162
Reasonable Allowance for Salaries
Traveling Expenses While Away From Home
Rentals of Property for Purpose of Trade or
Business
-
7/30/2019 Basic Income Tax Business Expenses CAPX
20/47
20
Reasonable Allowance of Salaries
Section 162(a)(1) permits a deduction for
reasonable allowance of salaries
Salaries must be:
Reasonable
For personal services performed
-
7/30/2019 Basic Income Tax Business Expenses CAPX
21/47
21
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)
-
7/30/2019 Basic Income Tax Business Expenses CAPX
22/47
22
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
23/47
23
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
24/47
24
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
25/47
25
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
26/47
26
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
27/47
27
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
28/47
28
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
29/47
29
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
30/47
30
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)
-
7/30/2019 Basic Income Tax Business Expenses CAPX
31/47
31
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?
-
7/30/2019 Basic Income Tax Business Expenses CAPX
32/47
32
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)
-
7/30/2019 Basic Income Tax Business Expenses CAPX
33/47
33
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
34/47
34
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
35/47
35
Travel and Education
Travel as education: No deduction.
Travel to obtain education: Deductible if
162 requirements are met.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
36/47
36
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
37/47
37
Miscellaneous Deductions contd
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
38/47
38
Miscellaneous Deductions contd
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
39/47
39
Miscellaneous Deductions contd
Health insurance for
self-employed
individuals
Self-employed
taxpayer may deductthe costs of medical
insurance coverage for
himself, spouse, and
dependents
-
7/30/2019 Basic Income Tax Business Expenses CAPX
40/47
40
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
41/47
41
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
42/47
42
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
43/47
43
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
44/47
44
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
45/47
45
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
-
7/30/2019 Basic Income Tax Business Expenses CAPX
46/47
46
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.
-
7/30/2019 Basic Income Tax Business Expenses CAPX
47/47
47
Conclusion
Questions?