important changes for 2000 business expenses

ContentsIntroduction ........................................ 1

Important Changes for 2000 ............. 1

1. Deducting Business Expenses .. 2

2. Employees' Pay ........................... 5

3. Retirement Plans ......................... 8

4. Rent Expense .............................. 13

5. Interest ......................................... 15

6. Taxes ............................................ 20

7. Insurance ..................................... 22

8. Costs You Can Deduct orCapitalize ...................................... 24

9. Amortization ................................ 29

10. Depletion ...................................... 36

11. Business Bad Debts ................... 40

12. Electric and Clean-Fuel Vehicles 43

13. Other Expenses ........................... 46

14. How To Get Tax Help .................. 53

Index .................................................... 54

IntroductionThis publication discusses common businessexpenses and explains what is and is notdeductible. The general rules for deductingbusiness expenses are discussed in theopening chapter. The chapters that followcover specific expenses and list other publi-cations and forms you may need.

Comments and suggestions. We welcomeyour comments about this publication andyour suggestions for future editions.

You can e-mail us while visiting our website at www.irs.gov/help/email2.html .

You can write to us at the following ad-dress:

Internal Revenue ServiceTechnical Publications BranchW:CAR:MP:FP:P1111 Constitution Ave. NWWashington, DC 20224

We respond to many letters by telephone.Therefore, it would be helpful if you wouldinclude your daytime phone number, includ-ing the area code, in your correspondence.

Important Changesfor 2000The following items highlight some changesin the tax law for 2000.

New Publication 15–B. Information on thefollowing topics, previously contained in thispublication, has been moved to new Publica-tion 15–B, Employer's Tax Guide to FringeBenefits.

Departmentof theTreasury

InternalRevenueService

Publication 535Cat. No. 15065Z

BusinessExpensesFor use in preparing

2000 Returns

• Meals and lodging furnished to employ-ees.

• Fringe benefits.

• Employee benefit programs.

Standard mileage rate. The standard mile-age rate for the cost of operating your car,van, pickup, or panel truck in 2000 is 321/2cents a mile for all business miles. Seechapter 13.

Health insurance deduction for the self-employed. For 2000, this deduction is 60%of the amount you paid for health insurancefor yourself and your family. See chapter 7.

Meal expense deduction subject to “hoursof service” limits. For 2000, this deductionincreases to 60% of the reimbursed mealsyour employees consume while they aresubject to the Department of Transportation's“hours of service” limits. See chapter 13.

Marginal production of oil and gas. Thesuspension of the taxable income limit onpercentage depletion from the marginal pro-duction of oil and natural gas that wasscheduled to expire for tax years beginningafter 1999 has been extended to tax yearsbeginning before 2002. For more informationon marginal production, see section 613A(c)of the Internal Revenue Code.

Paid preparer authorization. Beginning withyour return for 2000, you can check a box andauthorize the IRS to discuss your Form 1040with your paid preparer who signed it. If youcheck the “Yes” box in the signature area ofyour return, the IRS can call your paidpreparer to answer any questions that mayarise during the processing of your return.Also, you are authorizing your paid preparerto perform certain actions. See your incometax package for details.

Photographs of missing children. TheInternal Revenue Service is a proud partnerwith the National Center for Missing and Ex-ploited Children. Photographs of missingchildren selected by the Center may appearin this publication on pages that would other-wise be blank. You can help bring thesechildren home by looking at the photographsand calling 1–800–THE–LOST (1–800–843–5678) if you recognize a child.

1.DeductingBusinessExpenses

IntroductionThis chapter covers the general rules for de-ducting business expenses. Business ex-penses are the costs of carrying on a trade

or business. These expenses are usuallydeductible if the business is operated to makea profit.

TopicsThis chapter discusses:

• What you can deduct

• How much you can deduct

• When to deduct

• Not-for-profit activities

Useful ItemsYou may want to see:

Publication

� 334 Tax Guide for Small Business

� 463 Travel, Entertainment, Gift, andCar Expenses

� 525 Taxable and Nontaxable Income

� 529 Miscellaneous Deductions

� 536 Net Operating Losses (NOLs) forIndividuals, Estates, and Trusts

� 538 Accounting Periods and Methods

� 542 Corporations

� 547 Casualties, Disasters, and Thefts(Business and Nonbusiness)

� 587 Business Use of Your Home(Including Use by Day-Care Pro-viders)

� 925 Passive Activity and At-Risk Rules

� 936 Home Mortgage InterestDeduction

� 946 How To Depreciate Property

Form (and Instructions)

� Sch A (Form 1040) Itemized De-ductions

� 5213 Election To PostponeDetermination as To Whether thePresumption Applies That anActivity Is Engaged in for Profit

See chapter 14 for information about get-ting publications and forms.

What Can I Deduct?To be deductible, a business expense mustbe both ordinary and necessary. An ordinaryexpense is one that is common and acceptedin your trade or business. A necessary ex-pense is one that is helpful and appropriatefor your trade or business. An expense doesnot have to be indispensable to be considerednecessary.

It is important to separate business ex-penses from the following expenses.

• The expenses used to figure the cost ofgoods sold.

• Capital expenses.

• Personal expenses.

TIPIf you have an expense that is partlyfor business and partly personal,separate the personal part from the

business part.

Cost of Goods SoldIf your business manufactures products orpurchases them for resale, some of your ex-penses are for the products you sell. You usethese expenses to figure the cost of the goodsyou sold during the year. You deduct thesecosts from your gross receipts to figure yourgross profit for the year. You must maintaininventories to be able to determine your costof goods sold. If you use an expense to figurethe cost of goods sold, you cannot deduct itagain as a business expense.

The following are types of expenses thatgo into figuring cost of goods sold.

• The cost of products or raw materials inyour inventory, including the cost of hav-ing them shipped to you.

• The cost of storing the products you sell.

• Direct labor costs (including contributionsto pension or annuity plans) for workerswho produce the products.

• Factory overhead expenses.

Under the uniform capitalization rules, youmay have to include certain indirect costs ofproduction and resale in your cost of goodssold. Indirect costs include rent, interest,taxes, storage, purchasing, processing, re-packaging, handling, and administrativecosts. This rule on indirect costs does notapply to personal property you acquire forresale if your average annual gross receipts(or those of your predecessor) for the pre-ceding 3 tax years are not more than $10million.

For more information, see the followingsources.

• Cost of goods sold—chapter 6 of Publi-cation 334.

• Inventories—Publication 538.

• Uniform capitalization rules—section263A of the Internal Revenue Code andthe related regulations.

Capital ExpensesYou must capitalize, rather than deduct, somecosts. These costs are a part of your invest-ment in your business and are called “capitalexpenses.” There are, in general, three typesof costs you capitalize.

1) Going into business.

2) Business assets.

3) Improvements.

Recovery. Although you generally cannottake a current deduction for a capital ex-pense, you may be able to take deductionsfor the amount you spend through depreci-ation, amortization, or depletion. These allowyou to deduct part of your cost each year overa number of years. In this way you are ableto “recover” your capital expense. SeeAmortization (chapter 9) and Depletion(chapter 10) in this publication. For informa-tion on depreciation, see Publication 946.

Going Into BusinessThe costs of getting started in business, be-fore you actually begin business operations,are capital expenses. These costs may in-clude expenses for advertising, travel, orwages for training employees.

Chapter 1 Deducting Business Expenses

If you go into business. When you go intobusiness, treat all costs you had to get yourbusiness started as capital expenses.

Usually you recover costs for a particularasset through depreciation. Generally, youcannot recover other costs until you sell thebusiness or otherwise go out of business.However, you can choose to amortize certaincosts for setting up your business. See GoingInto Business in chapter 9 for more informa-tion on business start-up costs.

If you do not go into business. If you arean individual and your attempt to go intobusiness is not successful, the expenses youhad in trying to establish yourself in businessfall into two categories.

1) The costs you had before making a de-cision to acquire or begin a specificbusiness. These costs are personal andnondeductible. They include any costsincurred during a general search for, orpreliminary investigation of, a businessor investment possibility.

2) The costs you had in your attempt toacquire or begin a specific business.These costs are capital expenses andyou can deduct them as a capital loss.

If you are a corporation and your attemptto go into a new trade or business is notsuccessful, you may be able to deduct allinvestigatory costs as a loss.

The costs of any assets acquired duringyour unsuccessful attempt to go into businessare a part of your basis in the assets. Youcannot take a deduction for these costs. Youwill recover the costs of these assets whenyou dispose of them.

Business AssetsThe cost of any asset you use in your busi-ness is a capital expense. There are manydifferent kinds of business assets, such asland, buildings, machinery, furniture, trucks,patents, and franchise rights. You must capi-talize the full cost of the asset, includingfreight and installation charges.

If you produce certain property for use inyour trade or business, capitalize the pro-duction costs under the uniform capitalizationrules. See section 1.263A–2 of the regu-lations for information on those rules.

ImprovementsThe costs of making improvements to abusiness asset are capital expenses if theimprovements add to the value of the asset,appreciably lengthen the time you can use it,or adapt it to a different use. You can deductrepairs that keep your property in a normalefficient operating condition as a businessexpense.

Improvements include new electric wiring,a new roof, a new floor, new plumbing,bricking up windows to strengthen a wall, andlighting improvements.

Restoration plan. Capitalize the cost of re-conditioning, improving, or altering yourproperty as part of a general restoration planto make it suitable for your business. Thisapplies even if some of the work would byitself be classified as repairs.

Replacements. You cannot deduct the costof a replacement that stops deterioration andadds to the life of your property. Capitalizethat cost and depreciate it.

Treat amounts paid to replace parts of amachine that only keep it in a normal operat-ing condition like repairs. However, if yourequipment has a major overhaul, capitalizeand depreciate the expense.

Capital or Deductible ExpensesTo help you distinguish between capital anddeductible expenses, several different itemsare discussed below.

Business motor vehicles. You usuallycapitalize the cost of a motor vehicle you buyto use in your business. You can recover itscost through annual deductions for depreci-ation.

There are dollar limits on the depreciationyou can claim each year on passenger auto-mobiles used in your business. See Publica-tion 463.

Repairs you make to your business vehi-cle are deductible expenses. However,amounts you pay to recondition and overhaula business vehicle are capital expenses.

Roads and driveways. The costs of buildinga private road on your business property andthe cost of replacing a gravel driveway witha concrete one are capital expenses you maybe able to depreciate. The cost of maintain-ing a private road on your business propertyis a deductible expense.

Tools. Unless the uniform capitalization rulesapply, amounts spent for tools used in yourbusiness are deductible expenses if the toolshave a life expectancy of less than 1 year.

Machinery parts. Unless the uniform cap-italization rules apply, the cost of replacingshort-lived parts of a machine to keep it ingood working condition and not add to its lifeis a deductible expense.

Heating equipment. The cost of changingfrom one heating system to another is a cap-ital expense and not a deductible expense.

Personal ExpensesGenerally, you cannot deduct personal, living,or family expenses. However, if you have anexpense for something that is used partly forbusiness and partly for personal purposes,divide the total cost between the businessand personal parts. You can deduct as abusiness expense only the business part.

For example, if you borrow money anduse 70% of it for business and the other 30%for a family vacation, generally you can de-duct as a business expense only 70% of theinterest you pay on the loan. The remaining30% is personal interest that is not deductible.See chapter 5 for information on deductinginterest and the allocation rules.

Business use of your home. If you use partof your home in your business, you may beable to claim part of the expenses of main-taining your home as a business expense.These expenses include mortgage interest,insurance, utilities, repairs, and depreciation.

The business use of your home must meetspecific requirements before you can take anyof these expenses as business deductions.

To qualify to claim expenses for the busi-ness use of your home, you must meet thefollowing tests.

1) The business part of your home must beused exclusively and regularly for yourtrade or business.

2) The business part of your home must beone of the following.

a) Your principal place of business.

b) A place where you meet or dealwith patients, clients, or customersin the normal course of your tradeor business.

c) A separate structure (not attachedto your home) you use in con-nection with your trade or business.

You do not have to meet the exclusive usetest for the part of your home that you regu-larly use in either of the following ways.

• For the storage of inventory or productsamples.

• As a day-care facility.

Your home office qualifies as your princi-pal place of business if you meet the followingrequirements.

• You use the office exclusively and regu-larly for administrative or managementactivities of your trade or business.

• You have no other fixed location whereyou conduct substantial administrative ormanagement activities of your trade orbusiness.

For more information, see Publication 587.

Business use of your car. If you use yourcar in your business, you can deduct car ex-penses. If you use your car for both businessand personal purposes, you must divide yourexpenses based on mileage. Only your ex-penses for the miles you drove the car forbusiness are deductible as business ex-penses.

You can deduct actual car expenses,which include depreciation (or lease pay-ments), gas and oil, tires, repairs, tune-ups,insurance, and registration fees. Instead offiguring the business part of these actual ex-penses, you may be able to use the standardmileage rate to figure your deduction. For2000, the standard mileage rate is 321/2 centsa mile for all business miles driven.

If you are self-employed, you can alsodeduct the business part of interest on yourcar loan, state and local personal property taxon the car, parking fees, and tolls, whetheror not you claim the standard mileage rate.You can use the nonbusiness part of thepersonal property tax to determine your de-duction for taxes on Schedule A (Form 1040)if you itemize your deductions.

For more information on car expenses andthe rules for using the standard mileage rate,see Publication 463.

How MuchCan I Deduct?You cannot deduct more for a business ex-pense than the amount you actually spend.There is usually no other limit on how muchyou can deduct if the amount is reasonable.However, if your deductions are large enoughto produce a net business loss for the year,the tax loss may be limited.


Recovery of amount deducted. If you re-cover part of an expense in the same tax yearfor which you would have claimed a de-duction, reduce your expense deduction bythe amount of the recovery. If you have a re-covery in a later year, include the recoveredamount in income. However, if part of thededuction for the expense did not reduce yourtax, you do not have to include all the recov-ery in income. Exclude the part that did notreduce your tax.

For more information on recoveries andthe tax benefit rule, see Publication 525.

Payments in kind. If you provide servicesto pay a business expense, the amount youcan deduct is the amount you spend to pro-vide the services. It is not what you wouldhave paid in cash.

Similarly, if you pay a business expensein goods or other property, you can deductonly the amount the property costs you. Ifthese costs are included in the cost of goodssold, do not deduct them as a business ex-pense.

Limits on losses. If your deductions for aninvestment or business activity are more thanthe income it brings in, you have a net loss.There may be limits on how much, if any, ofthe loss you can use to offset income fromother sources.

Not-for-profit limits. If you do not carryon your business activity with the intention ofmaking a profit, you cannot use a loss fromit to offset other income. See Not-for-ProfitActivities, later.

At-risk limits. Generally, a deductibleloss from a trade or business or otherincome-producing activity is limited to the in-vestment you have “at risk” in the activity. Youare “at risk” in any activity for the followingitems.

1) The money and adjusted basis of prop-erty you contribute to the activity.

2) Amounts you borrow for use in the ac-tivity if:

a) You are personally liable for repay-ment, or

b) You pledge property (other thanproperty used in the activity) as se-curity for the loan.

For more information, see Publication 925.Passive activities. Generally, you are in

a passive activity if you have a trade or busi-ness activity in which you do not materiallyparticipate during the year, or a rental activity.Deductions from passive activities can gen-erally offset your income from only passiveactivities. You cannot use any excess de-ductions to offset your other income. In addi-tion, you can take passive activity credits onlyfrom tax on net passive income. Any excessloss or credits are carried over to later years.For more information, see Publication 925.

Net operating loss. If your deductionsare more than your income for the year, youmay have a “net operating loss.” You can usea net operating loss to lower your taxes inother years. See Publication 536 for more in-formation. See Publication 542 for informationabout net operating losses of corporations.

When Can IDeduct an Expense?When you deduct an expense depends onyour accounting method. An accountingmethod is a set of rules used to determinewhen and how income and expenses are re-ported. The two basic methods are the cashmethod and an accrual method.

For more information on accountingmethods, see Publication 538.

Cash method. Under the cash method ofaccounting, you deduct business expenses inthe tax year you actually paid them, even ifyou incur them in an earlier year.

Accrual method. Under an accrual methodof accounting, you generally deduct businessexpenses when you become liable for them,whether or not you pay them in the sameyear. All events that set the amount of theliability must have happened, and you mustbe able to figure the amount of the expensewith reasonable accuracy.

Economic performance rule. Under anaccrual method, you generally cannot deductor capitalize business expenses until eco-nomic performance occurs. If your expenseis for property or services provided to you, oryour use of property, economic performanceoccurs as the property or services are pro-vided, or the property is used. If your expenseis for property or services you provide to oth-ers, economic performance occurs as youprovide the property or services.

Example. Your tax year is the calendaryear. In December 2000, the Field PlumbingCompany did some repair work at your placeof business and sent you a bill for $150. Youpaid it by check in January 2001. If you usean accrual method of accounting, deduct the$150 on your tax return for 2000 because allevents occurred to fix the fact of liability andeconomic performance occurred in that year.If you use the cash method of accounting, youcan deduct the expense on your 2001 return.

Prepayment. You cannot deduct expensesin advance, even if you pay them in advance.This rule applies to both the cash and accrualmethods. It applies to prepaid interest, pre-paid insurance premiums, and any other ex-pense paid far enough in advance to, in ef-fect, create an asset with a useful lifeextending substantially beyond the end of thecurrent tax year.

Example. In 2000, you sign a 10-yearlease and immediately pay your rent for thefirst 3 years. Even though you paid the rentfor 2000, 2001, and 2002, you can deductonly the rent for 2000 on your current tax re-turn. You can deduct on your 2001 and 2002tax returns the rent for those years.

Contested liability. Under the cash method,you can deduct a contested liability only in theyear you pay the liability. Under an accrualmethod, you can deduct contested liabilities,such as taxes (except foreign or U.S. pos-session income, war profits, and excess pro-fits taxes), in the tax year you pay the liability(or transfer money or other property to satisfythe obligation) or in the tax year you settle thecontest. However, to take the deduction in theyear of payment or transfer, you must meet

certain conditions. See Contested Liability inPublication 538 for more information.

Related person. Under an accrual methodof accounting, you generally deduct expenseswhen you incur them, even if you have notpaid them. However, if you and the personyou owe are related and the person uses thecash method of accounting, you must pay theexpense before you can deduct it. The de-duction by an accrual method payer is al-lowed when the corresponding amount isincludible in income by the related cashmethod payee. See Related Persons in Pub-lication 538.

Not-for-ProfitActivitiesIf you do not carry on your business or in-vestment activity to make a profit, there is alimit on the deductions you can take. Youcannot use a loss from the activity to offsetother income. Activities you do as a hobby,or mainly for sport or recreation, come underthis limit. So does an investment activity in-tended only to produce tax losses for the in-vestors.

The limit on not-for-profit losses applies toindividuals, partnerships, estates, trusts, andS corporations. It does not apply to corpo-rations other than S corporations.

In determining whether you are carryingon an activity for profit, all the facts are takeninto account. No one factor alone is decisive.Among the factors to consider are whether:

1) You carry on the activity in a business-like manner,

2) The time and effort you put into the ac-tivity indicate you intend to make it prof-itable,

3) You depend on income from the activityfor your livelihood,

4) Your losses are due to circumstancesbeyond your control (or are normal in thestart-up phase of your type of business),

5) You change your methods of operationin an attempt to improve profitability,

6) You, or your advisors, have the knowl-edge needed to carry on the activity asa successful business,

7) You were successful in making a profitin similar activities in the past,

8) The activity makes a profit in someyears, and how much profit it makes, and

9) You can expect to make a future profitfrom the appreciation of the assets usedin the activity.

Limit onDeductions and LossesIf your activity is not carried on for profit, takedeductions only in the following order, only tothe extent stated in the three categories, and,if you are an individual, only if you itemizethem on Schedule A (Form 1040).

Category 1. Deductions you can take forpersonal as well as for business activities areallowed in full. For individuals, all nonbusi-ness deductions, such as those for homemortgage interest, taxes, and casualty losses,


belong in this category. Deduct them on theappropriate lines of Schedule A (Form 1040).You can deduct a casualty loss on propertyyou own for personal use only to the extentit is more than $100 and all these losses aremore than 10% of your adjusted gross in-come. See Publication 547 for more informa-tion on casualty losses. For the limits thatapply to mortgage interest, see Publication936.

Category 2. Deductions that do not result inan adjustment to the basis of property areallowed next, but only to the extent your grossincome from the activity is more than the de-ductions you take (or could take) for it underthe first category. Most business deductions,such as those for advertising, insurance pre-miums, interest, utilities, wages, etc., belongin this category.

Category 3. Business deductions that de-crease the basis of property are allowed last,but only to the extent the gross income fromthe activity is more than deductions you take(or could take) for it under the first two cate-gories. The deductions for depreciation,amortization, and the part of a casualty lossan individual could not deduct in category (1)belong in this category. Where more than oneasset is involved, divide depreciation andthese other deductions proportionally amongthose assets.

TIPIndividuals must claim the amounts incategories (2) and (3) as miscella-neous deductions on Schedule A

(Form 1040). They are subject to the2%-of-adjusted-gross-income limit. See Pub-lication 529 for information on this limit.

Example. Ida is engaged in a not-for-profit activity. The income and expenses ofthe activity are as follows.

Ida must limit her deductions to $3,200,the gross income she earned from the activ-ity. The limit is reached in category (3), asfollows.

The $300 for depreciation is divided be-tween the automobile and machine as fol-lows.

$600� $300 = $225 depreciation for the automobile$800

$200� $300 = $75 depreciation for the machine$800

The basis of each asset is reduced ac-cordingly.

The $1,600 for category (1) is deductiblein full on the appropriate lines for taxes and

interest on Schedule A (Form 1040). Ida addsthe remaining $1,600 (the total of categories(2) and (3)) to her other miscellaneous de-ductions on Schedule A (Form 1040) that aresubject to the 2%-of-adjusted-gross-incomelimit.

Partnerships and S corporations. If apartnership or S corporation carries on anot-for-profit activity, these limits apply at thepartnership or S corporation level. They arereflected in the individual shareholder's orpartner's distributive shares.

More than one activity. If you have severalundertakings, each may be a separate activityor several undertakings may be one activity.The following are the most significant factsand circumstances in making this determi-nation.

• The degree of organizational and eco-nomic interrelationship of various under-takings.

• The business purpose that is (or mightbe) served by carrying on the variousundertakings separately or together in abusiness or investment setting.

• The similarity of various undertakings.

The IRS will generally accept your char-acterization of several undertakings as oneactivity, or more than one activity, if supportedby facts and circumstances.

TIPIf you are carrying on two or moredifferent activities, keep the de-ductions and income from each one

separate. Figure separately whether each isa not-for-profit activity. Then figure the limiton deductions and losses separately for eachactivity that is not for profit.

Presumption of ProfitAn activity is presumed carried on for profit ifit produced a profit in at least 3 of the last 5tax years, including the current year. Activitiesthat consist primarily of breeding, training,showing, or racing horses are presumed car-ried on for profit if they produced a profit inat least 2 of the last 7 tax years, including thecurrent year. You have a profit when thegross income from an activity is more than thedeductions for it.

If a taxpayer dies before the end of the5-year (or 7-year) period, the period ends onthe date of the taxpayer's death.

If your business or investment activitypasses this 3- (or 2-) years-of-profit test, pre-sume it is carried on for profit. This means itwill not come under these limits. You can takeall your business deductions from the activity,even for the years that you have a loss. Youcan rely on this presumption in every case,unless the IRS shows it is not valid.

Using the presumption later. If you arestarting an activity and do not have 3 (or 2)years showing a profit, you may want to takeadvantage of this presumption later, after youhave the 5 (or 7) years of experience allowedby the test.

You can choose to do this by filing Form5213. Filing this form postpones any deter-mination that your activity is not carried on forprofit until 5 (or 7) years have passed sinceyou started the activity.

The benefit gained by making this choiceis that the IRS will not immediately questionwhether your activity is engaged in for profit.Accordingly, it will not restrict your de-ductions. Rather, you will gain time to earna profit in 3 (or 2) out of the first 5 (or 7) yearsyou carry on the activity. If you show 3 (or2) years of profit at the end of this period, yourdeductions are not limited under these rules.If you do not have 3 (or 2) years of profit, thelimit can be applied retroactively to any yearin the 5-year (or 7-year) period with a loss.

Filing Form 5213 automatically extendsthe period of limitations on any year in the5-year (or 7-year) period to 2 years after thedue date of the return for the last year of theperiod. The period is extended only for de-ductions of the activity and any related de-ductions that might be affected.

TIPYou must file Form 5213 within 3years after the due date of your returnfor the year in which you first carried

on the activity, or, if earlier, within 60 daysafter receiving written notice from the InternalRevenue Service proposing to disallow de-ductions attributable to the activity.

2.Employees' Pay

IntroductionYou can generally deduct the pay you giveyour employees for the services they performfor your business. The pay may be in cash,property, or services. It may include wages,salaries, vacation allowances, bonuses,commissions, and fringe benefits. This chap-ter provides information about deductions al-lowed for various kinds of pay.

For information about determining who isan employee and about employment taxeson your employees' wages, see Publication15, Circular E, Employer's Tax Guide, Publi-cation 15–A, Employer's Supplemental TaxGuide, and Publication 15–B, Employer's TaxGuide to Fringe Benefits. For informationabout deducting employment taxes paid onyour employees' wages, see chapter 6.

TIPYou can claim the following employ-ment credits if you hire individualswho meet certain requirements.

• Empowerment zone employment credit.

• Indian employment credit.

• Welfare-to-work credit.

• Work opportunity credit.

However, you must reduce your deduction foremployee wages by the amount of any em-ployment credits you claim. For more infor-mation about these credits, see Publication954, Tax Incentives for Empowerment Zonesand Other Distressed Communities.

Gross income ............................................... $3,200

Minus expenses:Real estate taxes ........................... $700Home mortgage interest ................ 900Insurance ........................................ 400Utilities ............................................ 700Maintenance ................................... 200Depreciation on an automobile ...... 600Depreciation on a machine ............ 200 3,700

Loss ............................................................. $ 500

Limit on deduction ....................................... $3,200

Category 1: Taxes and interest ...... $1,600Category 2: Insurance, utilities, andmaintenance .................................... 1,300 2,900

Available for Category 3 ........................... $ 300

Chapter 2 Employees' Pay


• Tests for deducting pay

• Kinds of pay


Publication

� 15 Circular E, Employer's Tax Guide

� 15–A Employer's Supplemental TaxGuide

� 15–B Employer's Tax Guide to FringeBenefits


Tests for DeductingPayTo be deductible, your employees' pay mustbe an ordinary and necessary expense andyou must pay or incur it in the tax year. Theseand other requirements that apply to all busi-ness expenses are explained in chapter 1.

In addition, the pay must meet both thefollowing tests.

• Test 1. The pay must be reasonable.

• Test 2. The pay must be for servicesperformed.

If these tests are met, the form or method offiguring the pay does not affect its deductibil-ity. For example, bonuses and commissionsbased on sales or earnings and paid underan agreement made before the services wereperformed are generally deductible.

Employee-shareholder salaries. If a cor-poration pays an employee who is also ashareholder a salary that is unreasonablyhigh considering the services actually per-formed, the excessive part of the salary maybe treated as a constructive distribution ofearnings to the employee-shareholder. Formore information on corporate distributions toshareholders, see Publication 542, Corpo-rations.

Test 1—ReasonableDetermine the reasonableness of pay by thefacts. Generally, reasonable pay is theamount that like enterprises ordinarily wouldpay for the services under similar circum-stances.

You must be able to prove the pay isreasonable. Base this test on the circum-stances that exist when you contract for theservices, not those existing when the rea-sonableness is questioned. If the pay is ex-cessive, you can deduct only the part that isreasonable.

Factors to consider. To determine if pay isreasonable, consider the following items andany other pertinent facts.

• The duties performed by the employee.

• The volume of business handled.

• The character and amount of responsi-bility.

• The complexities of your business.

• The amount of time required.

• The general cost of living in the locality.

• The ability and achievements of the indi-vidual employee performing the service.

• The pay compared with the gross and netincome of the business, as well as withdistributions to shareholders if the busi-ness is a corporation.

• Your policy regarding pay for all youremployees.

• The history of pay for each employee.

Individual salaries. You must base the testof whether a salary is reasonable on eachindividual's salary and the service performed,not on the total salaries paid to all officers orall employees. For example, even if the totalamount you pay to your officers is reason-able, you cannot deduct an individual officer'sentire salary if it is not reasonable based onthe items listed above.

Test 2—For ServicesPerformedYou must be able to prove the payment wasmade for services actually performed.

Kinds of PaySome of the ways you may provide pay toyour employees are discussed next.

AwardsYou can generally deduct, as wages,amounts you pay to your employees asawards, whether paid in cash or property.(For awards paid in property, see Property,later.) However, if you give property to anemployee as an employee achievementaward, your deduction may be limited.

Achievement awards. An achievementaward is an item of tangible personal propertythat meets all the following requirements.

• It is given to an employee for length ofservice or safety achievement.

• It is awarded as part of a meaningfulpresentation.

• It is awarded under conditions and cir-cumstances that do not create a signif-icant likelihood of disguised pay.

Length-of-service award. An award willnot qualify as a length-of-service award if ei-ther of the following applies.

• The employee receives the award duringhis or her first 5 years of employment.

• The employee received another length-of-service award (other than one of verysmall value) during the same year or inany of the prior 4 years.

Safety achievement award. An awardwill not qualify as a safety achievement awardif it is given to either of the following.

1) A manager, administrator, clerical em-ployee, or other professional employee.

2) More than 10% of your employees dur-ing the year, excluding those listed in (1).

Deduction limit. Your deduction for thecost of employee achievement awards givento any one employee during the tax year islimited to the following amounts.

• $400 for awards that are not qualifiedplan awards.

• $1,600 for all awards, whether or notqualified plan awards.

Claim the deduction as a nonwage businessexpense on your return or business schedule.

A qualified plan award is an achievementaward given as part of an established writtenplan or program that does not favor highlycompensated employees as to eligibility orbenefits.

A highly compensated employee for 2000is an employee who meets either of the fol-lowing tests.

1) The employee was a 5% owner at anytime during the year or the precedingyear.

2) The employee received more than$85,000 in pay for the preceding year.

You can choose to ignore test (2) if the em-ployee was not also in the top 20% of em-ployees when ranked by pay for the preced-ing year.

An award is not a qualified plan award ifthe average cost of all the employeeachievement awards given during the tax year(that would be qualified plan awards exceptfor this limit) is more than $400. To figure thisaverage cost, do not take into account awardsof very small value.

TIPYou may be able to exclude the valueof achievement awards you provideto an employee from the employee's

wages. See Publication 15–B.

BonusesYou can generally deduct a bonus paid to anemployee as wages if you intended the bonusas additional pay for services, not as a gift,and the services were actually performed.However, the total bonuses, salaries, andother pay must be reasonable for the servicesperformed. If the bonus is paid in property,see Property, later.

Gifts of nominal value. If, to promote em-ployee goodwill, you distribute turkeys, hams,or other merchandise of nominal value to youremployees at holidays, you can deduct thecost of these items as a nonwage businessexpense. Your deduction for gifts of food ordrink are not subject to the 50% deductionlimit that generally applies to meals. For moreinformation on this deduction limit, see Mealsand lodging, later.

Education ExpensesIf you pay or reimburse education expensesfor an employee, you can deduct the pay-ments. Deduct payments for education that isnot related to the employee's job or that isnonqualifying education as wages. Deductpayments for education that is job related andis not nonqualifying education as a nonwagebusiness expense. Regardless of the natureof the education, deduct the payments on the“employee benefit programs” line of your taxreturn or business schedule if they are part


of a qualified educational assistance program.For information on educational assistanceprograms, see Educational Assistance inchapter 2 of Publication 15–B.

Nonqualifying education is education that:

1) Is needed to meet the minimum educa-tion requirements for the employee's job,or

2) Is part of a program of study that canqualify the employee for a different typeof job.

For a discussion on nonqualifying education,see Publication 508, Tax Benefits for Work-Related Education.

Fringe BenefitsA fringe benefit is a form of pay provided toany person for the performance of servicesby that person. The following are examplesof fringe benefits.

• Benefits under qualified employee benefitprograms.

• Meals and lodging.

• The use of a car.

• Flights on airplanes.

• Discounts on property or services.

• Memberships in country clubs or othersocial clubs.

• Tickets to entertainment or sportingevents.

You can generally deduct the cost offringe benefits you provide on your tax returnor business schedule in whatever categorythe cost falls. For example, if you allow anemployee to use a car or other property youlease, deduct the cost of the lease as a rentor lease expense. If you own the property,include your deduction for its cost or otherbasis as a section 179 deduction or a depre-ciation deduction.

TIPYou may be able to exclude all or partof the fringe benefits you provide fromyour employees' wages. For more in-

formation about fringe benefits and the ex-clusion of benefits, see Publication 15–B.

Employee benefit programs. Employeebenefit programs include the following.

• Accident and health plans.

• Adoption assistance.

• Cafeteria plans.

• Dependent care assistance.

• Educational assistance.

• Group-term life insurance coverage.

• Welfare benefit funds.

You can generally deduct amounts youspend on employee benefit programs on the“employee benefit programs” line of your taxreturn or business schedule. However, if youprovide dependent care by operating a de-pendent care facility for your employees, de-duct your costs in whatever categories theyfall (depreciation, utilities, salaries, etc.).

Group-term life insurance coverage.You cannot deduct the cost of group-term lifeinsurance coverage if you are directly or in-directly the beneficiary of the policy. SeeNondeductible Premiums in chapter 7.

Welfare benefit funds. A welfare benefitfund is a funded plan (or a funded arrange-ment having the effect of a plan) that provideswelfare benefits to your employees, inde-pendent contractors, or their beneficiaries.Welfare benefits are any benefits other thandeferred compensation or transfers of re-stricted property.

Your deduction for contributions to a wel-fare benefit fund is limited to the fund's qual-ified cost for the tax year. If your contributionsto the fund are more than its qualified cost,you can carry the excess over to the next taxyear.

Generally, the fund's qualified cost is thetotal of the following amounts, reduced by theafter-tax income of the fund.

• The cost you would have been able todeduct using the cash method of ac-counting if you had paid for the benefitsdirectly.

• The contributions added to a reserve ac-count that are needed to fund claims in-curred but not paid as of the end of theyear for supplemental unemploymentbenefits, severance pay, or disability,medical, or life insurance benefits.

For more information, see sections 419(c)and 419A of the Internal Revenue Code andthe related regulations.

Meals and lodging. You can usually deductthe cost of furnishing meals and lodging toyour employees. However, you can generallydeduct only 50% of the cost of furnishingmeals.

Deduct the cost on your tax return orbusiness schedule in whatever category theexpense falls. For example, if you operate arestaurant, deduct the cost of the meals youfurnish to your employees as part of the costof goods sold. If you operate a nursing home,motel, or rental property, deduct the cost offurnishing lodging to an employee as ex-penses for utilities, linen service, salaries,depreciation, etc.

Deduction limit on meals. You cangenerally deduct only 50% of the cost of fur-nishing meals to your employees. However,you can deduct the full cost of the followingmeals.

• Meals whose value you must include inan employee's wages.

• Meals that qualify as a de minimis fringebenefit, as discussed in chapter 2 ofPublication 15–B.

• Meals you furnish to your employees atthe work site when you operate a res-taurant or catering service.

• Meals you furnish to your employees aspart of the expense of providing recre-ational or social activities, such as acompany picnic.

• Meals you must furnish to crew membersof a commercial vessel under a federallaw. This includes meals furnished tocrew members of commercial vesselsoperating on the Great Lakes, the SaintLawrence Seaway, or any U.S. inlandwaterway if the meals would be requiredunder federal law had the vessel beenoperated at sea. This does not includemeals you furnish on vessels primarilyproviding luxury water transportation.

• Meals you furnish on an oil or gas plat-form or drilling rig located offshore or in

Alaska. This includes meals you furnishat a support camp that is near and inte-gral to an oil or gas drilling rig located inAlaska.

Loans or AdvancesYou generally can deduct as wages a loanor advance you make to an employee thatyou do not expect the employee to repay if itis for personal services actually performed.The total must be reasonable when you addthe loan or advance to the employee's otherpay. However, if the employee performs noservices, treat the amount you advanced tothe employee as a loan, which you cannotdeduct unless it becomes a bad debt. For in-formation on the deduction for bad debts, seechapter 11.

Below-market interest rate loans. On cer-tain loans you make to an employee orshareholder, you are treated as having re-ceived interest income and as having paidcompensation or dividends equal to that in-terest. See Below-Market Loan in chapter 5for more information.

PropertyIf you transfer property (including your com-pany's stock) to an employee as payment forservices, you can generally deduct it aswages. The amount you can deduct is its fairmarket value on the date of the transfer minusany amount the employee paid for the prop-erty.

You can claim the deduction only for thetax year in which your employee includes theproperty's value in income. Your employee isdeemed to have included the value in incomeif you report it on Form W–2 in a timelymanner.

You treat the deductible amount as re-ceived in exchange for the property, and youmust recognize any gain or loss realized onthe transfer. Your gain or loss is the differencebetween the fair market value of the propertyand its adjusted basis on the date of transfer.

CAUTION!

A corporation recognizes no gain orloss when it pays for services with itsown stock.

These rules also apply to property trans-ferred to an independent contractor, generallyreported on Form 1099–MISC.

Restricted property. If the property youtransfer for services is subject to restrictionsthat affect its value, you generally cannot de-duct it and do not report gain or loss until itis substantially vested in the recipient. How-ever, if the recipient pays for the property, youmust report any gain at the time of the trans-fer up to the amount paid.

“Substantially vested” means the propertyis not subject to a substantial risk of forfeiture.The recipient is not likely to have to give uphis or her rights in the property in the future.

Reimbursementsfor Business ExpensesYou can generally deduct the amount you payor reimburse employees for business ex-penses they incur for you for items such astravel and entertainment. However, your de-duction for meal and entertainment expensesis usually limited to 50% of the payment.


If you make the payment under an ac-countable plan, deduct it in the category ofthe expense paid. For example, if you pay anemployee for travel expenses incurred onyour behalf, deduct this payment as a travelexpense on your tax return or businessschedule. See the instructions for the formyou file for information on which lines to use.

If you make the payment under a nonac-countable plan, deduct it as wages on yourtax return or business schedule.

See Travel, Meals, and Entertainment inchapter 13 for more information about de-ducting reimbursements and an explanationof accountable and nonaccountable plans.

Sick PayYou can deduct amounts you pay to youremployees for sickness and injury, includinglump-sum amounts, as wages. However, yourdeduction is limited to amounts not compen-sated by insurance or other means.

Vacation PayVacation pay is an amount you pay to anemployee while the employee is on vacation.It includes an amount you pay an employeefor unused vacation leave. Vacation pay doesnot include any sick pay or holiday pay.

You can ordinarily deduct vacation payonly in your tax year in which the employeeactually receives it. This rule applies regard-less of whether you use the cash method oran accrual method of accounting.

However, you can deduct vacation pay inyour tax year in which the employee earns itif it is vested by the end of that year and theemployee actually receives it within 21/2months after the end of that year. Generally,vacation pay is vested if it is payable underan oral or written vacation pay plan that youtold your employees about before the tax yearand its amount and your liability for it arecertain.

3.RetirementPlans

IntroductionThis chapter discusses retirement plans youcan set up and maintain for yourself and youremployees. Retirement plans are savingsplans that offer you tax advantages to setaside money for your own and your employ-ees' retirement.

In general, a sole proprietor or a partneris treated as an employee for participating ina retirement plan.

SEP, SIMPLE, and qualified plans offeryou and your employees a tax favored wayto save for retirement. You can deduct con-tributions you make to the plan for your em-ployees. If you are a sole proprietor, you candeduct contributions you make to the plan for

yourself. You can also deduct trustees' feesif contributions to the plan do not cover them.Earnings on the contributions are generallytax free until you or your employees receivedistributions from the plan in later years.

Under certain plans, employees can haveyou contribute limited amounts of theirbefore-tax pay to a plan. These amounts (andthe earnings on them) are generally tax freeuntil your employees receive distributionsfrom the plan in later years.

In general, individuals who are employedor self-employed can also set up and con-tribute to individual retirement arrangements(IRAs).


• Simplified employee pension (SEP)

• SIMPLE retirement plan

• Qualified plan

• Individual retirement arrangement (IRA)


Publication

� 560 Retirement Plans for Small Busi-ness (SEP, SIMPLE, and Qual-ified Plans)

� 590 Individual Retirement Arrange-ments (IRAs) (Including RothIRAs and Education IRAs)


� W–2 Wage and Tax Statement


Simplified EmployeePension (SEP)A simplified employee pension (SEP) is awritten plan that allows you to make deduct-ible contributions toward your own and youremployees' retirement without getting in-volved in more complex retirement plans. Acorporation also can have a SEP and makedeductible contributions toward its employ-ees' retirement. But certain advantagesavailable to qualified plans, such as the spe-cial tax treatment that may apply to lump-sumdistributions, do not apply to SEPs.

Under a SEP, you make the contributionsto a traditional individual retirement arrange-ment (called a SEP-IRA) set up for each eli-gible employee.

SEP-IRAs are set up for, at a minimum,each eligible employee. A SEP-IRA mayhave to be set up for a leased employee, butneed not be set up for an excludable em-ployee. For more information, see Publication560.

Form 5305–SEP. You may be able to useForm 5305–SEP, Simplified EmployeePension-Individual Retirement AccountsContribution Agreement, in setting up yourSEP.

Contribution LimitsContributions you make for a year to a com-mon-law employee's SEP-IRA are limited tothe lesser of $30,000 or 15% of the employ-ee's compensation. Compensation generallydoes not include your contributions to theSEP, but does include certain elective defer-rals unless you choose not to include them.

Annual compensation limit. You generallycannot consider the part of an employee'scompensation over $170,000 when you figureyour contribution limit for that employee.

More than one plan. If you also contributeto a defined contribution retirement plan (de-fined later), annual additions to all a partic-ipant's accounts are limited to the lesser of$30,000 or 25% of the participant's compen-sation. When you figure this limit, you mustadd your contributions to all defined contri-bution plans. A SEP is considered a definedcontribution plan for this limit.

Contributions for yourself. The annuallimits on your contributions to a common-lawemployee's SEP-IRA also apply to contribu-tions you make to your own SEP-IRA.

Deduction LimitThe most you can deduct for employer con-tributions for a common-law employee is 15%of the compensation paid to him or her duringthe year from the business that has the plan.

Deduction of contributions for yourself.When figuring the deduction for employercontributions made to your own SEP-IRA,compensation is your net earnings from self-employment minus the following amounts.

1) The deduction for one-half your self-employment tax.

2) The deduction for contributions to yourown SEP-IRA.

The deduction for contributions to yourown SEP-IRA and your net earnings dependon each other. For this reason, you determinethe deduction for contributions to your ownSEP-IRA indirectly by reducing the contribu-tion rate called for in your plan. Use the RateWorksheet for Self-Employed shown underQualified Plan, later, to figure the rate.

SEP and profit-sharing plan. If you alsocontributed to a qualified profit-sharing plan,you must reduce the 15% deduction limit forthat plan by the allowable deduction for con-tributions to the SEP-IRAs of those partic-ipating in both the SEP plan and the profit-sharing plan.

SEP and another qualified plan. If you alsocontributed to any other type of qualified plan,treat the SEP as a separate profit-sharingplan when applying the overall 25% deductionlimit described in section 404(h)(3) of theInternal Revenue Code.

TIPIf your SEP contribution is more thanthe deduction limit (nondeductiblecontribution), you can carry over and

deduct the difference in later years. However,the contribution carryover, when combinedwith the contribution for the later year, issubject to the deduction limit for that year.

Chapter 3 Retirement Plans

Employee contributions. Employees canalso make contributions of up to $2,000 totheir SEP-IRAs independent of the employer'sSEP contributions. However, the employee'sdeduction for IRA contributions may be re-duced or eliminated because the employee iscovered by an employer retirement plan (theSEP plan). See Publication 590 for details.

Salary ReductionSimplified EmployeePension (SARSEP)

CAUTION!

An employer is no longer allowed toset up a SARSEP. However, partic-ipants in a SARSEP set up before

1997 (including employees hired after 1996)can continue to have their employer contrib-ute part of their pay to the plan.

A SARSEP is a SEP set up before 1997that included a salary reduction arrangement.Under the arrangement, employees canchoose to have you contribute part of theirpay to their SEP-IRAs rather than receive itin cash. This contribution is called an “electivedeferral” because employees choose (elect)to set aside the money and the tax on themoney is deferred until it is distributed.

This choice is available only if all the fol-lowing requirements are met.

• The SARSEP was set up before 1997.

• At least 50% of the eligible employeeschoose the salary reduction arrangement.

• You had 25 or fewer eligible employees(or employees who would have been eli-gible if you had maintained a SEP) at anytime during the preceding year.

• Each eligible highly compensated em-ployee's deferral percentage each year isno more than 125% of the averagedeferral percentage (ADP) of all non-highly compensated employees eligibleto participate (the ADP test). See Publi-cation 560 for the definition of a highlycompensated employee and informationon how to figure the deferral percentage.

Limit on elective deferrals. In general, thetotal income an employee can defer under aSARSEP and certain other elective deferralarrangements for 2000 is limited to the lesserof $10,500 or 15% of the employee's com-pensation (as defined in Publication 560).This limit applies only to amounts that reducethe employee's pay, not to any contributionsfrom employer funds.

Employment taxes. Elective deferrals thatmeet the ADP test are not subject to incometax in the year of deferral, but they are in-cluded in wages for social security, Medicare,and federal unemployment (FUTA) tax.

Reporting SEPContributions on Form W–2Your contributions to an employee's SEP-IRAare excluded from the employee's income.Unless there are contributions under a salaryreduction arrangement, do not include thesecontributions in your employee's wages onForm W–2 for income, social security, or

Medicare tax purposes. Your SEP contribu-tions under a salary reduction arrangementare included in your employee's wages forsocial security and Medicare tax purposesonly.

Example. Jim's salary reduction ar-rangement calls for 10% of his salary to becontributed by his employer as an electivedeferral to Jim's SEP-IRA. Jim's salary for theyear is $30,000 (before reduction for thedeferral). The employer did not choose totreat deferrals as compensation under thearrangement. To figure the deferral, the em-ployer multiplies Jim's salary of $30,000 by9.0909%, the reduced rate equivalent of 10%,to get the deferral of $2,727.27. (This methodis the same one you, as a self-employedperson, use to figure the contributions youmake on your own behalf. See Rate Work-sheet for Self-Employed under QualifiedPlan.)

On Jim's Form W–2, his employer showstotal wages of $27,272.73 ($30,000 −$2,727.27), social security wages of $30,000,and Medicare wages of $30,000. Jim reports$27,272.73 as wages on his individual incometax return.

If his employer chooses to treat deferralsas compensation under the salary reductionarrangement, Jim's deferral would be $3,000($30,000 x 10%). In this case, the employeruses the rate called for under the arrange-ment (not the reduced rate) to figure thedeferral and the ADP test. On Jim's FormW–2, the employer shows total wages of$27,000 ($30,000 − $3,000), social securitywages of $30,000, and Medicare wages of$30,000. Jim reports $27,000 as wages onhis return.

In either case, the maximum deductiblecontribution would be $3,913.05 ($30,000 x13.0435%).

More information. For more information onemployer withholding requirements, seePublication 15.

For more information on SEPs, see Pub-lication 560.

SIMPLERetirement PlansA Savings Incentive Match Plan for Employ-ees (SIMPLE plan) is a written arrangementthat provides you and your employees with asimplified way to make contributions to pro-vide retirement income. Under a SIMPLEplan, employees can choose to make salaryreduction contributions to the plan rather thanreceiving these amounts as part of their reg-ular pay. In addition, you will contributematching or nonelective contributions.

SIMPLE plans can only be maintained ona calendar-year basis.

A SIMPLE plan can be set up in either ofthe following ways.

• Using SIMPLE IRAs (SIMPLE IRA plan).

• As part of a 401(k) plan (SIMPLE 401(k)plan).

See Publication 560 for information onSIMPLE 401(k) plans.

TIPMany financial institutions will helpyou set up a SIMPLE plan.

SIMPLE IRA PlanA SIMPLE IRA plan is a retirement plan thatuses SIMPLE IRAs for each eligible em-ployee. Under a SIMPLE IRA plan, a SIMPLEIRA must be set up for each eligible em-ployee. For the definition of an eligible em-ployee, see Who Can Participate in a SIMPLEIRA Plan?, next.

Who Can Set Upa SIMPLE IRA Plan?You can set up a SIMPLE IRA plan if youmeet both the following requirements.

• You meet the employee limit.

• You do not maintain another qualifiedplan unless the other plan is for collectivebargaining employees.

Employee limit. You can set up a SIMPLEIRA plan only if you had 100 or fewer em-ployees who earned $5,000 or more in com-pensation during the preceding year. Underthis rule, you must take into account all em-ployees employed at any time during the cal-endar year regardless of whether they areeligible to participate. Employees includeself-employed individuals who receivedearned income, and leased employees.

Once you set up a SIMPLE IRA plan, youmust continue to meet the 100-employee limiteach year you maintain the plan.

Grace period for employers who ceaseto meet the 100-employee limit. If youmaintain the SIMPLE IRA plan for at least 1year and you cease to meet the100-employee limit in a later year, you will betreated as meeting it for the 2 calendar yearsimmediately following the calendar year forwhich you last met it.

A different rule applies if you do not meetthe 100-employee limit because of an acqui-sition, disposition, or similar transaction. Un-der this rule, the SIMPLE IRA plan will betreated as meeting the 100-employee limit forthe year of the transaction and the 2 followingyears if both the following conditions are sat-isfied.

• Coverage under the plan has not signif-icantly changed during the grace period.

• The SIMPLE IRA plan would have cont-inued to qualify after the transaction if youhad remained a separate employer.

CAUTION!

The grace period for acquisitions,dispositions, and similar transactionsalso applies if, because of these types

of transactions, you do not meet the rulesexplained under Other qualified plan or WhoCan Participate in a SIMPLE IRA Plan?, be-low.

Other qualified plan. The SIMPLE IRA plangenerally must be the only retirement plan towhich you make contributions, or benefitsaccrue, for service in any year beginning withthe year the SIMPLE IRA plan becomes ef-fective.

Exception. If you maintain a qualifiedplan for collective bargaining employees, youare permitted to maintain a SIMPLE IRA planfor other employees.


Who Can Participatein a SIMPLE IRA Plan?

Eligible employee. Any employee who re-ceived at least $5,000 in compensation duringany 2 years preceding the current calendaryear and is reasonably expected to earn atleast $5,000 during the current calendar yearis eligible to participate. The term“employee” includes a self-employed individ-ual who received earned income.

You can use less restrictive eligibility re-quirements (but not more restrictive ones) byeliminating or reducing the prior year com-pensation requirements, the current yearcompensation requirements, or both. For ex-ample, you can allow participation for em-ployees who received at least $3,000 incompensation during any preceding calendaryear. However, you cannot impose any otherconditions on participating in a SIMPLE IRAplan.

Excludable employees. The following em-ployees do not need to be covered under aSIMPLE IRA plan.

• Employees who are covered by a unionagreement and whose retirement benefitswere bargained for in good faith by theemployees' union and you.

• Nonresident alien employees who havereceived no U.S. source wages, salaries,or other personal services compensationfrom you.

Compensation. Compensation for employ-ees is the total wages required to be reportedon Form W–2. Compensation also includesthe salary reduction contributions made underthis plan, compensation deferred under asection 457 plan, and the employees' electivedeferrals under a section 401(k) plan, aSARSEP, or a section 403(b) annuity con-tract. If you are self-employed, compensationis your net earnings from self-employment(line 4 of Short Schedule SE (Form 1040))before subtracting any contributions made tothe SIMPLE IRA plan for yourself.

How To Set Up a SIMPLE IRA PlanYou can use Form 5304–SIMPLE or Form5305–SIMPLE to set up a SIMPLE IRA plan.Each form is a model savings incentive matchplan for employees (SIMPLE) plan document.Which form you use depends on whether youselect a financial institution or your employeesselect the institution that will receive the con-tributions.

Use Form 5304–SIMPLE if you allow eachplan participant to select the financial institu-tion for receiving his or her SIMPLE IRA plancontributions. Use Form 5305–SIMPLE if yourequire that all contributions under theSIMPLE IRA plan be deposited initially at adesignated financial institution.

The SIMPLE IRA plan is adopted whenyou (and the designated financial institution,if any) have completed all appropriate boxesand blanks on the form and you have signedit. Keep the original form. Do not file it with theIRS.

Other uses of the forms. If you set up aSIMPLE IRA plan using Form 5304–SIMPLEor Form 5305–SIMPLE, you can use the formto satisfy other requirements, including thefollowing.

• Meeting employer notification require-ments for the SIMPLE IRA plan. Page 3of Form 5304–SIMPLE and Page 3 ofForm 5305–SIMPLE contain a ModelNotification to Eligible Employees thatprovides the necessary information to theemployee.

• Maintaining the SIMPLE IRA plan recordsand proving you set up a SIMPLE IRAplan for employees.

Deadline for setting up a SIMPLE IRA plan.You can set up a SIMPLE IRA plan effectiveon any date between January 1 and October1 of a year, provided you did not previouslymaintain a SIMPLE IRA plan. If you previ-ously maintained a SIMPLE IRA plan, youcan set up a SIMPLE IRA plan effective onlyon January 1 of a year. This requirement doesnot apply if you are a new employer thatcomes into existence after October 1 of theyear the SIMPLE IRA plan is set up and youset up a SIMPLE IRA plan as soon as ad-ministratively feasible after you come intoexistence. A SIMPLE IRA plan cannot havean effective date that is before the date youactually adopt the plan.

Setting up a SIMPLE IRA. SIMPLE IRAsare the individual retirement accounts or an-nuities into which the contributions are de-posited. A SIMPLE IRA must be set up foreach eligible employee. Forms 5305–S,SIMPLE Individual Retirement Trust Account,and 5305–SA, SIMPLE Individual RetirementCustodial Account, are model trust and cus-todial account documents the participant andthe trustee (or custodian) can use for thispurpose.

A SIMPLE IRA cannot be designated asa Roth IRA. Contributions to a SIMPLE IRAwill not affect the amount an individual cancontribute to a Roth IRA.

Deadline for setting up a SIMPLE IRA.A SIMPLE IRA must be set up for an em-ployee before the first date by which a con-tribution is required to be deposited into theemployee's IRA. See Time limits for contrib-uting funds later under Contribution Limits.

Notification RequirementIf you adopt a SIMPLE IRA plan, you mustnotify each employee of the following infor-mation before the beginning of the electionperiod.

1) The employee's opportunity to make orchange a salary reduction choice undera SIMPLE IRA plan.

2) Your choice to make either reducedmatching contributions or nonelectivecontributions (discussed later).

3) A summary description and the locationof the plan. The financial institutionshould provide you with this information.

4) Written notice that his or her balance canbe transferred without cost or penalty ifyou use a designated financial institu-tion.

Election period. The election period is gen-erally the 60-day period immediately preced-ing January 1 of a calendar year (November2 to December 31 of the preceding calendaryear). However, the dates of this period aremodified if you set up a SIMPLE IRA plan inmid-year (for example, on July 1) or if the

60-day period falls before the first day anemployee becomes eligible to participate inthe SIMPLE IRA plan.

A SIMPLE IRA plan can provide longerperiods for permitting employees to enter intosalary reduction agreements or to modify prioragreements. For example, a SIMPLE IRAplan can provide a 90-day election period in-stead of the 60-day period. Similarly, in addi-tion to the 60-day period, a SIMPLE IRA plancan provide quarterly election periods duringthe 30 days before each calendar quarter,other than the first quarter of each year.

Contribution LimitsContributions are made up of salary reductioncontributions and employer contributions.You, as the employer, must make eithermatching contributions or nonelective contri-butions, defined later. No other contributionscan be made to the SIMPLE IRA plan. Thesecontributions, which you can deduct, must bemade timely. See Time limits for contributingfunds, later.

Salary reduction contributions. Theamount the employee chooses to have youcontribute to a SIMPLE IRA on his or herbehalf cannot be more than $6,000 for 2000.These contributions must be expressed as apercentage of the employee's compensationunless you permit the employee to expressthem as a specific dollar amount. You cannotplace restrictions on the contribution amount(such as limiting the contribution percentage),except to comply with the $6,000 limit.

If an employee is a participant in any otheremployer plan during the year and has elec-tive salary reductions or deferred compen-sation under those plans, the salary reductioncontributions under a SIMPLE IRA plan alsoare elective deferrals that count toward theoverall $10,500 annual limit on exclusion ofsalary reductions and other elective deferrals.

If the other plan is a deferred compen-sation plan of a state or local government ora tax-exempt organization, the limit on elec-tive deferrals is $8,000.

Employer matching contributions. You aregenerally required to match each employee'ssalary reduction contributions on a dollar-for-dollar basis up to 3% of the employee'scompensation. This requirement does notapply if you make nonelective contributionsas discussed later.

Example. In 2000, your employee, JohnRose, earned $25,000 and chose to defer 5%of his salary. You make a 3% matching con-tribution. The total contribution you can makefor John is $2,000, figured as follows.

Lower percentage. If you choose amatching contribution less than 3%, the per-centage must be at least 1%. You must notifythe employees of the lower match within areasonable period of time before the 60-dayelection period (discussed earlier) for thecalendar year. You cannot choose a per-centage less than 3% for more than 2 yearsduring the 5-year period that ends with (andincludes) the year for which the choice is ef-fective.

Salary reduction contributions($25,000 × .05) ............................................ $1,250Employer matching contribution($25,000 × .03) ............................................ 750Total contributions .................................... $2,000


Nonelective contributions. Instead ofmatching contributions, you can choose tomake nonelective contributions of 2% ofcompensation on behalf of each eligible em-ployee who has at least $5,000 of compen-sation (or some lower amount of compen-sation that you select) from you for the year.If you make this choice, you must make non-elective contributions whether or not the em-ployee chooses to make salary reductioncontributions. Only $170,000 of the employ-ee's compensation can be taken into accountto figure the contribution limit.

If you choose this 2% contribution formula,you must notify the employees within a rea-sonable period of time before the 60-dayelection period (discussed earlier) for thecalendar year.

Example 1. In 2000, your employee,Jane Wood, earned $36,000 and chose tohave you contribute 10% of her salary. Youmake a 2% nonelective contribution. The totalcontributions you can make for her are$4,320, figured as follows.

Example 2. Using the same facts as inExample 1, above, the maximum contributionyou can make for Jane if she earned $75,000is $7,500, figured as follows.

Time limits for contributing funds. Youmust make the salary reduction contributionsto the SIMPLE IRA within 30 days after theend of the month in which the amounts wouldotherwise have been payable to the employeein cash. You must make matching contribu-tions or nonelective contributions by the duedate (including extensions) for filing your fed-eral income tax return for the year.

When To Deduct ContributionsYou can deduct SIMPLE IRA contributions inthe tax year with or within which the calendaryear for which contributions were made ends.You can deduct contributions for a particulartax year if they are made for that tax year andare made by the due date (including exten-sions) of your federal income tax return forthat year.

Example 1. Your tax year is the fiscalyear ending June 30. Contributions under aSIMPLE IRA plan for the calendar year 2000(including contributions made in 2000 beforeJuly 1, 2000) are deductible in the tax yearending June 30, 2001.

Example 2. You are a sole proprietorwhose tax year is the calendar year. Contri-butions under a SIMPLE IRA plan for thecalendar year 2000 (including contributionsmade in 2001 by April 16, 2001) are deduct-ible in the 2000 tax year.

Where To Deduct ContributionsDeduct contributions you make for your com-mon-law employees on your tax return. Forexample, sole proprietors deduct them onSchedule C (Form 1040) or Schedule F (Form

1040), partnerships deduct them on Form1065, and corporations deduct them on Form1120, Form 1120–A, or Form 1120S.

Sole proprietors and partners deduct con-tributions for themselves on line 29 of Form1040. (If you are a partner, contributions foryourself are shown on the Schedule K–1(Form 1065) you receive from the partner-ship).

Tax Treatment of ContributionsYou can deduct your contributions and youremployees can exclude these contributionsfrom their gross income. SIMPLE IRA contri-butions are not subject to federal income taxwithholding. However, salary reduction con-tributions are subject to social security, Med-icare, and federal unemployment (FUTA)taxes. Matching and nonelective contributionsare not subject to these taxes.

Reporting on Form W–2. Do not includeSIMPLE IRA contributions in the “Wages, tips,other compensation” box of Form W–2.However, salary reduction contributions mustbe included in the boxes for social securityand Medicare wages. Also include the propercode in Box 13. For more information, see theinstructions for Forms W–2 and W–3.

Distributions (Withdrawals)Distributions from a SIMPLE IRA are subjectto IRA rules and generally are includible inincome for the year received. Tax-freerollovers can be made from one SIMPLE IRAinto another SIMPLE IRA. A rollover from aSIMPLE IRA to another IRA can be made taxfree only after a 2-year participation in theSIMPLE IRA plan.

Early withdrawals generally are subject toa 10% additional tax. However, the additionaltax is increased to 25% if funds are withdrawnwithin 2 years of beginning participation.

More information. See Publication 590 forinformation about IRA rules, including thoseon the tax treatment of distributions, rollovers,required distributions, and income tax with-holding.

More Informationon SIMPLE IRA PlansIf you need more help to set up and maintaina SIMPLE IRA plan, see the following IRSnotice and revenue procedure.

Notice 98–4. This notice contains questionsand answers about the implementation andoperation of SIMPLE IRA plans, including theelection and notice requirements for theseplans. Notice 98–4 is in Cumulative Bulletin1998–1.

Revenue Procedure 97–29. This revenueprocedure provides guidance to drafters ofprototype SIMPLE IRAs on obtaining opinionletters. Revenue Procedure 97–29 is in Cu-mulative Bulletin 1997–1.

Qualified PlanA qualified retirement plan is a written planyou can set up for the exclusive benefit ofyour employees and their beneficiaries. It issometimes called a Keogh or H.R.10 plan.

You, or you and your employees, canmake contributions to the plan. If your plan

meets the qualification requirements, you cangenerally deduct your contributions to theplan. For more information, see Publication560.

Your employees generally are not taxedon your contributions or increases in theplan's assets until they are distributed. How-ever, certain loans made from qualified plansare treated as taxable distributions. For moreinformation, see Publication 575.

Qualification requirements. To be a qual-ified plan, the plan must meet many require-ments. They include requirements that de-termine the following.

• Who must be covered by the plan.

• How contributions to the plan are to beinvested.

• How contributions to the plan and bene-fits under the plan are to be determined.

• How much of an employee's interest inthe plan must be guaranteed (vested).

For more information, see Publication 560.

More than one job. If you are self-employedand also work for someone else, you canparticipate in retirement plans for both jobs.Generally, your participation in a retirementplan for one job does not affect your partici-pation in a plan for the other job. However,if you have an IRA, you may not be allowedto deduct part or all of your IRA contributions.See Publication 590.

Kinds of Qualified PlansThere are two basic kinds of qualified retire-ment plans: defined contribution plans anddefined benefit plans.

Defined Contribution PlanThis plan provides for a separate account foreach person covered by the plan. Benefits arebased only on amounts contributed to or al-located to each account.

There are two types of defined contribu-tion plans: profit-sharing and money purchasepension.

Profit-sharing plan. This plan lets your em-ployees or their beneficiaries share in theprofits of your business. The plan must havea definite formula for allocating the contribu-tion among the participating employees andfor distributing the accumulated funds in theplan.

Money purchase pension plan. Under thisplan, contributions fixed and are not basedon your business profits. For example, if theplan requires contributions be 10% of eachparticipating employee's compensation re-gardless of whether you have a profit, theplan is a money purchase pension plan.

Defined Benefit PlanThis is any plan that is not a defined contri-bution plan. In general, contributions to aqualified defined benefit plan are based onwhat is needed to provide definitely determi-nable benefits to plan participants. Your con-tributions to the plan are based on actuarialassumptions. Generally, you will need con-tinuing professional help to administer a de-fined benefit plan.

Salary reduction contributions($36,000 × .10) ............................................ $3,6002% nonelective contributions($36,000 × .02) ............................................ 720Total contributions .................................... $4,320

Salary reduction contributions(maximum amount) ...................................... $6,0002% nonelective contributions($75,000 × .02) ............................................ 1,500Total contributions .................................... $7,500


Setting Up a PlanYou must adopt a written plan. The plan canbe an IRS-approved master or prototype planoffered by a sponsoring organization. Or itcan be an individually designed plan.

Master or prototype plans. The followingsponsoring organizations generally can pro-vide IRS-approved master or prototype plans.

• Trade or professional organizations.

• Banks (including savings and loan asso-ciations and federally insured credit un-ions).

• Insurance companies.

• Mutual funds.

Adoption of a master or prototype plan doesnot mean your plan is automatically qualified.It must still meet all the qualification require-ments stated in the law.

Individually designed plan. If you prefer,you can set up an individually designed planto meet specific needs. Although advanceIRS approval is not required, you can applyfor approval by paying a fee and requestinga determination letter. You may need profes-sional help with this. Revenue Procedure2000–6 in Internal Revenue Bulletin 2000–1can help you decide whether to apply for ap-proval.

Deduction LimitThe deduction limit for contributions to aqualified plan depends on the kind of plan youhave.

CAUTION!

In figuring the deduction for contribu-tions to these plans, you cannot takeinto account any contributions or

benefits that are more than the limits dis-cussed under Limits on Contributions andBenefits in Publication 560.

Defined contribution plans. The deductionlimit for a defined contribution plan dependson whether it is a profit-sharing plan or amoney purchase pension plan.

Profit-sharing plan. Your deduction forcontributions to a profit-sharing plan cannotbe more than 15% of the compensation paid(or accrued) during the year to the eligibleemployees participating in the plan. You mustreduce this limit in figuring the deduction forcontributions you make for your own account.See Deduction of contributions for yourself,later.

Money purchase pension plan. Yourdeduction for contributions to a money pur-chase pension plan is generally limited to25% of the compensation paid during the yearto a participating eligible employee. You mustreduce this limit in figuring the deduction forcontributions you make for yourself, as dis-cussed later.

Defined benefit plans. An actuary must fig-ure the deduction for contributions to a de-fined benefit plan since it is based on actuarialassumptions and computations.

Deduction of contributions for yourself.To take a deduction for contributions youmake to a plan for yourself, you must havenet earnings from the trade or business forwhich the plan was set up.

Limit on deduction. If the qualified planis a profit-sharing plan, your deduction foryourself is limited to the lesser of $30,000 or13.0435% (15% reduced as discussed below)of your net earnings from the trade or busi-ness that has the plan. If the plan is a moneypurchase plan, the deduction is limited to thelesser of $30,000 or 20% (25% reduced asdiscussed later) of your net earnings.

Net earnings. Your net earnings mustbe from self-employment in a trade or busi-ness in which your personal services are amaterial income-producing factor. Your netearnings do not include items excluded fromincome (or deductions related to that income),other than foreign earned income and foreignhousing cost amounts.

Your net earnings are your business grossincome minus the allowable business de-ductions from that business. Allowable busi-ness deductions include contributions to SEPand qualified plans for common-law employ-ees and the deduction for one-half your self-employment tax.

Net earnings include a partner's distribu-tive share of partnership income or loss (otherthan separately stated items such as capitalgains and losses) and any guaranteed pay-ments. If you are a limited partner, netearnings include only guaranteed paymentsfor services rendered to or for the partnership.For more information, see Partners underWho Must Pay Self-Employment Tax in Pub-lication 533.

Net earnings do not include incomepassed through to shareholders of S corpo-rations.

Adjustments. You must reduce your netearnings by the deduction for one-half yourself-employment tax. Also, net earnings mustbe reduced by the deduction for contributionsyou make for yourself. This reduction is madeindirectly, as explained next.

Net earnings reduced by adjustingcontribution rate. You must reduce netearnings by your deduction for contributionsfor yourself. The deduction and the netearnings depend on each other. You makethe adjustment indirectly by reducing thecontribution rate called for in the plan andusing the reduced rate to figure your maxi-mum deduction for contributions for yourself.

Annual compensation limit. You gen-erally cannot take into account more than$170,000 of your compensation in figuringyour contribution to a defined contributionplan.

Figuring Your DeductionUse the following worksheet to find the re-duced contribution rate for yourself. Make noreduction to the contribution rate for anycommon-law employees.

Now that you have figured your self-employed rate, you can figure your maximumdeduction for contributions for yourself bycompleting the following steps.

Example. You are a self-employedfarmer and you have employees. The termsof your plan provide that you contribute 81/2%(.085) of your compensation (defined earlier)and 81 / 2% of your participants' compensation.Your net earnings from line 36, Schedule F(Form 1040) are $200,000. In figuring this,you deducted your participants' pay of$100,000 and contributions for them of$8,500 (81 / 2% x $100,000). You figure yourself-employed rate and maximum deductionfor contributions on behalf of yourself as fol-lows.

When to make contributions. To take adeduction for contributions for a particularyear, you must make the contributions notlater than the due date (generally, April 15 forcalendar year taxpayers), plus extensions, ofyour tax return for that year.

More information. See Publication 560 formore information on retirement plans for smallbusiness owners, including the self-employed. Publication 560 also discusses

Step 2Enter your net earnings (net profit) fromline 31, Schedule C (Form 1040); line3, Schedule C–EZ (Form 1040); line36, Schedule F (Form 1040); or line15a, Schedule K–1 (Form 1065) .........

Step 3Enter your deduction for self-employ-ment tax from line 27, Form 1040 .......

Step 4Subtract step 3 from step 2 and enterthe result ..............................................

Step 5Multiply step 4 by step 1 and enter theresult ....................................................

Step 6Multiply $170,000 by your plan contri-bution rate. Enter the result, but notmore than $30,000 ..............................

Step 7Enter the lesser of step 5 or step 6.This is your maximum deductiblecontribution. Enter your deduction online 29, Form 1040 ..............................

Rate Worksheet for Self-Employed1) Plan contribution rate as a decimal (for

example, 101 / 2% = .105) ...................... 0.0852) Rate in line 1 plus 1

(for example, .105 + 1 = 1.105) .......... 1.0853) Self-employed rate as a decimal

rounded to at least 3 decimal places(line 1 ÷ line 2) .................................... 0.078

Deduction Worksheet for Self-EmployedStep 1

Enter the rate shown on line 3 above . 0.078Step 2

Enter your net earnings (net profit) fromline 31, Schedule C (Form 1040); line3, Schedule C–EZ (Form 1040); line36, Schedule F (Form 1040); or line15a, Schedule K–1 (Form 1065) ......... $200,000

Step 3Enter your deduction for self-employ-ment tax from line 27, Form 1040 ....... 7,403

Step 4Subtract step 3 from step 2 and enterthe result .............................................. 192,597

Step 5Multiply step 4 by step 1 and enter theresult .................................................... 15,023

Step 6Multiply $170,000 by your plan contri-bution rate. Enter the result but notmore than $30,000 .............................. 14,450

Step 7Rate Worksheet for Self-Employed Enter the lesser of step 5 or step 6.This is your maximum deductiblecontribution. Enter your deduction online 29, Form 1040 .............................. $ 14,450

1) Plan contribution rate as a decimal (forexample, 101 / 2% = .105) ......................

2) Rate in line 1 plus 1(for example, .105 + 1 = 1.105) ..........

3) Self-employed rate as a decimalrounded to at least 3 decimal places(line 1 ÷ line 2) ....................................

Deduction Worksheet for Self-EmployedStep 1

Enter the rate shown on line 3 above .


the reporting forms that must be filed for theseplans.

Individual RetirementArrangement (IRA)An individual retirement arrangement (IRA) isa personal savings plan that allows you to setaside money for your retirement or for certaineducation expenses. You do not have to setup IRAs for your employees or make contri-butions for them. You may be able to deductyour contributions, depending on the type ofIRA and your circumstances. Generally,amounts in an IRA, including earnings andgains, are not taxed until they are distributed.In certain cases, your earnings and gains maynot be taxed at all if they are distributed ac-cording to the rules. For more information onIRAs, see Publication 590.

4.Rent Expense

IntroductionThis chapter discusses the tax treatment ofrent or lease payments you make for propertyyou use in your business but do not own. Italso discusses how to treat other kinds ofpayments you make that are related to youruse of this property. These include paymentsyou make for taxes on the property, im-provements to the property, and getting alease. There is a discussion about capitaliz-ing (including in the cost of property) certainrent expenses at the end of the chapter.


• The definition of rent

• Taxes on leased property

• The cost of getting a lease

• Improvements by the lessee

• Capitalizing rent expenses


Publication



RentRent is any amount you pay for the use ofproperty you do not own. In general, you candeduct rent as an expense only if the rent isfor property you use in your trade or business.If you have or will receive equity in or title tothe property, the rent is not deductible.

Unreasonable rent. You cannot take a rentaldeduction for unreasonable rents. Ordinarily,the issue of reasonableness arises only if youand the lessor are related. Rent paid to a re-lated person is reasonable if it is the sameamount you would pay to a stranger for useof the same property. Rent is not unreason-able just because it is figured as a percentageof gross receipts. For examples of relatedpersons, see Related Persons in chapter 12.

Rent on your home. If you rent your homeand use part of it as your place of business,you may be able to deduct the rent you payfor that part. You must meet the requirementsfor business use of your home. For more in-formation, see Business use of your home inchapter 1.

Rent paid in advance. Generally, rent paidin your trade or business is deductible in theyear paid or accrued. If you pay rent in ad-vance, you can deduct only the amount thatapplies to your use of the rented propertyduring the tax year. You can deduct the restof your payment only over the period to whichit applies.

Example 1. You leased a building for 5years beginning July 1. Your rent is $12,000per year. You paid the first year's rent($12,000) on June 30. You can deduct only$6,000 (6 / 12 × $12,000) for the rent that appliesto the first year.

Example 2. Last January you leasedproperty for 3 years for $6,000 a year. Youpaid the full $18,000 (3 × $6,000) during thefirst year of the lease. Each year you candeduct only $6,000, the part of the rent thatapplies to that year.

Canceling a lease. You generally can de-duct as rent an amount you pay to cancel abusiness lease.

Lease or purchase. There may be instancesin which you must determine whether yourpayments are for rent or for the purchase ofthe property. You must first determinewhether your agreement is a lease or a con-ditional sales contract. Payments made undera conditional sales contract are not deductibleas rent expense.

Conditional sales contract. Whether anagreement is a conditional sales contract de-pends on the intent of the parties. Determineintent based on the provisions of the agree-ment and the facts and circumstances thatexist when you make the agreement. No sin-gle test, or special combination of tests, al-ways applies. However, in general, anagreement may be considered a conditionalsales contract rather than a lease if any of thefollowing is true.

• The agreement applies part of each pay-ment toward an equity interest you willreceive.

• You get title to the property after youmake a stated amount of required pay-ments.

• The amount you must pay to use theproperty for a short time is a large partof the amount you would pay to get titleto the property.

• You pay much more than the current fairrental value of the property.

• You have an option to buy the propertyat a nominal price compared to the value

of the property when you may exercisethe option. Determine this value whenyou make the agreement.

• You have an option to buy the propertyat a nominal price compared to the totalamount you have to pay under theagreement.

• The agreement designates part of thepayments as interest, or that part is easyto recognize as interest.

Leveraged leases. Leveraged leasetransactions may not be considered leases.Leveraged leases generally involve threeparties: a lessor, a lessee, and a lender to thelessor. Usually the lease term covers a largepart of the useful life of the leased property,and the lessee's payments to the lessor areenough to cover the lessor's payments to thelender.

If you plan to take part in what appears tobe a leveraged lease, you may want to getan advance ruling. The following revenueprocedures contain the guidelines the IRS willuse to determine if a leveraged lease is alease for federal income tax purposes.

• Revenue Procedure 75–21, in Cumula-tive Bulletin 1975–1.




In general, the revenue procedures pro-vide that, for advance ruling purposes only,the IRS will consider the lessor in a leveragedlease transaction to be the owner of theproperty and the transaction to be a validlease if all the factors in the revenue proce-dures are met, including the following.

• The lessor must maintain a minimumunconditional “at risk” equity investmentin the property (at least 20% of the costof the property) during the entire leaseterm.

• The lessee may not have a contractualright to buy the property from the lessorat less than fair market value when theright is exercised.

• The lessee may not invest in the property,except as provided by Revenue Proce-dure 79–48.

• The lessee may not lend any money tothe lessor to buy the property or guaran-tee the loan used by the lessor to buy theproperty.

• The lessor must show that it expects toreceive a profit apart from the tax de-ductions, allowances, credits, and othertax attributes.

The IRS may charge you a user fee forissuing a tax ruling. For more information,see Revenue Procedure 2001–1, in InternalRevenue Bulletin No. 2001–1, or Publication1375, Procedures for Issuing Rulings, Deter-mination Letters, and Information Letters,etc., which is a reprint of Revenue Procedure2001–1.

Leveraged leases of limited-use prop-erty. The IRS will not issue advance rulingson leveraged leases of so-called limited-use

Chapter 4 Rent Expense

property. Limited-use property is property notexpected to be either useful to or usable bya lessor at the end of the lease term exceptfor continued leasing or transfer to a lessee.See Revenue Procedure 76–30 for examplesof limited-use property and property that isnot limited-use property.

Leases over $250,000. Special rules areprovided for certain leases of tangible prop-erty. The rules apply if the lease calls for totalpayments of more than $250,000 and any ofthe following apply.

• Rents increase during the lease.

• Rents decrease during the lease.

• Rents are deferred (rent is payable afterthe close of the calendar year followingthe calendar year in which the use occursand the rent is allocated).

• Rents are prepaid (rent is payable beforethe close of the calendar year precedingthe calendar year in which the use occursand the rent is allocated).

Thus, these rules do not apply if your leasespecifies equal amounts of rent for eachmonth in the lease term and all rent paymentsare due in the calendar year to which the rentrelates (or in the preceding or following cal-endar year).

Generally, if the special rules do apply,you must use an accrual method of account-ing (and time value of money principles) foryour rental expenses, regardless of youroverall method of accounting. In addition, incertain cases in which the IRS has deter-mined that a lease was designed to achievetax avoidance, you must take rent and statedor imputed interest into account under a con-stant rental accrual method in which the rentis treated as accruing ratably over the entirelease term. For details, see the regulationsunder section 467 of the Internal RevenueCode.

Taxes onLeased Property If you lease business property, you can de-duct as additional rent any taxes you have topay to or for the lessor. When you can deductthese taxes as additional rent depends onyour accounting method.

Cash method. If you use the cash methodof accounting, you can deduct the taxes asadditional rent only for the tax year in whichyou pay them.

Accrual method. If you use an accrualmethod of accounting, you can deduct taxesas additional rent for the tax year in which youcan determine all the following.

• That you have a liability for taxes on theleased property.

• How much the liability is.

• That economic performance occurred.

The liability and amount of taxes are de-termined by state or local law and the leaseagreement. Economic performance occurs asyou use the property.

Example 1. Oak Corporation is a calen-dar year taxpayer that uses an accrualmethod of accounting. Oak leases land foruse in its business. Under state law, ownersof real property become liable (incur a lien onthe property) for real estate taxes for the yearon January 1 of that year. However, they donot have to pay these taxes until July 1 of thenext year (18 months later) when tax bills areissued. Under the terms of the lease, Oakbecomes liable for the real estate taxes in thelater year when the tax bills are issued. If thelease ends before the tax bill for a year isissued, Oak is not liable for the taxes for thatyear.

Oak cannot deduct the real estate taxesas rent until the tax bill is issued. This is whenOak's liability under the lease becomes fixed.

Example 2. The facts are the same as inExample 1 except that, according to the termsof the lease, Oak becomes liable for the realestate taxes when the owner of the propertybecomes liable for them. As a result, Oak willdeduct the real estate taxes as rent on its taxreturn for the earlier year. This is the year inwhich Oak's liability under the lease becomesfixed.

Cost ofGetting a Lease You may either enter into a new lease withthe lessor of the property or get an existinglease from another lessee. Very often whenyou get an existing lease from another lessee,you must pay the previous lessee money toget the lease, besides having to pay the renton the lease.

If you get an existing lease on propertyor equipment for your business, you generallymust amortize any amount you pay to get thatlease over the remaining term of the lease.For example, if you pay $10,000 to get alease and there are 10 years remaining on thelease with no option to renew, you can deduct$1,000 each year.

The cost of getting an existing lease oftangible property is not subject to the amorti-zation rules for section 197 intangibles dis-cussed in chapter 9.

Option to renew. The term of the lease foramortization includes all renewal options plusany other period for which you and the lessorreasonably expect the lease to be renewed.However, this applies only if less than 75%of the cost of getting the lease is for the termremaining on the purchase date (not includingany period for which you may choose to re-new, extend, or continue the lease). Allocatethe lease cost to the original term and anyoption term based on the facts and circum-stances. In some cases, it may be appropriateto make the allocation using a present valuecomputation. For more information, see sec-tion 1.178–1(b)(5) of the regulations.

Example 1. You paid $10,000 to get alease with 20 years remaining on it and twooptions to renew for 5 years each. Of thiscost, you paid $7,000 for the original leaseand $3,000 for the renewal options. Because$7,000 is less than 75% of the total $10,000cost of the lease (or $7,500), you mustamortize the $10,000 over 30 years. That isthe remaining life of your present lease plusthe periods for renewal.

Example 2. The facts are the same as inExample 1, except that you paid $8,000 forthe original lease and $2,000 for the renewaloptions. You can amortize the entire $10,000over the 20-year remaining life of the originallease. The $8,000 cost of getting the originallease was not less than 75% of the total costof the lease (or $7,500).

Cost of a modification agreement. Youmay have to pay an additional “rent” amountover part of the lease period to change certainprovisions in your lease. You must capitalizethese payments and amortize them over theremaining period of the lease. You cannotdeduct the payments as additional rent, evenif they are described as rent in the agreement.

Example. You are a calendar year tax-payer and sign a 20-year lease to rent partof a building starting on January 1. However,before you occupy it, you decide that you re-ally need less space. The lessor agrees toreduce your rent from $7,000 to $6,000 peryear and to release the excess space fromthe original lease. In exchange, you agree topay an additional rent amount of $3,000,payable in 60 monthly installments of $50each.

You must capitalize the $3,000 andamortize it over the 20-year term of the lease.Your amortization deduction each year willbe $150 ($3,000 ÷ 20). You cannot deduct the$600 (12 × $50) that you will pay during eachof the first 5 years as rent.

Commissions, bonuses, and fees. Com-missions, bonuses, fees, and other amountsthat you pay to get a lease on property youuse in your business are capital costs. Youmust amortize these costs over the term ofthe lease.

Loss on merchandise and fixtures. If yousell at a loss merchandise and fixtures thatyou bought solely to get a lease, the loss isa cost of getting the lease. You must capital-ize the loss and amortize it over the remainingterm of the lease.

Improvementsby Lessee If you add buildings or make other permanentimprovements to leased property, depreciatethe cost of the improvements using the mod-ified accelerated cost recovery system(MACRS). Depreciate the property over itsappropriate recovery period. You cannotamortize the cost over the remaining term ofthe lease.

If you do not keep the improvements whenyou end the lease, figure your gain or lossbased on your adjusted basis in the im-provements at that time.

For more information, see the discussionof MACRS in Publication 946.

Assignment of a lease. If a long-term lesseewho makes permanent improvements to landlater assigns all lease rights to you for moneyand you pay the rent required by the lease,the amount you pay for the assignment is acapital investment. If the rental value of theleased land increased since the lease began,part of your capital investment is for that in-crease in the rental value. The rest is for yourinvestment in the permanent improvements.

Chapter 4 Rent Expense

The part that is for the increased rentalvalue of the land is a cost of getting a lease,and you amortize it over the remaining termof the lease. You can depreciate the part thatis for your investment in the improvementsover the recovery period of the property asdiscussed earlier, without regard to the leaseterm.

CapitalizingRent Expenses Under the uniform capitalization rules, youhave to capitalize the direct costs and part ofthe indirect costs for production or resale ac-tivities.

Generally, you are subject to the uniformcapitalization rules if you do any of the fol-lowing in the course of a trade or businessor an activity carried on for profit.

• Produce real or tangible personal prop-erty for use in the business or activity.

• Produce real or tangible personal prop-erty for sale to customers.

• Acquire property for resale. However, thisrule does not apply to personal propertyif your average annual gross receipts forthe 3 previous tax years were not morethan $10 million.

Indirect costs include amounts incurred forrenting or leasing equipment, facilities, orland.

Example 1. You rent construction equip-ment to build a storage facility. You mustcapitalize as part of the cost of the buildingthe rent you paid for the equipment. You re-cover your cost by claiming a deduction fordepreciation on the building.

Example 2. You rent space in a facilityto conduct your business of manufacturingtools. You must include the rent you paid tooccupy the facility in the cost of the tools youproduce.

More information. For more information,see the regulations under section 263A of theInternal Revenue Code.

5.Interest

IntroductionThis chapter discusses the tax treatment ofbusiness interest expense. Business interestexpense is an amount charged for the use ofmoney you borrowed for business activities.


• Allocation of interest

• Interest you can deduct

• Interest you cannot deduct

• Capitalization of interest

• When to deduct interest

• A below-market loan


Publication

� 537 Installment Sales


� 550 Investment Income and Expenses

� 936 Home Mortgage InterestDeduction


� Sch A (Form 1040) ItemizedDeductions

� Sch E (Form 1040) Supplemental In-come and Loss

� Sch K–1 (Form 1065) Partner's Shareof Income, Credits, Deductions,etc.

� Sch K–1 (Form 1120S) Shareholder'sShare of Income, Credits, De-ductions, etc.

� 1098 Mortgage Interest Statement

� 3115 Application for Change in Ac-counting Method

� 4952 Investment Interest ExpenseDeduction

� 8582 Passive Activity Loss Limitations


Allocation of InterestThe rules for deducting interest vary, de-pending on whether the loan proceeds areused for business, personal, investment, orpassive activities. If you use the proceeds ofa loan for more than one type of expense, youmust make an allocation to determine the in-terest for each use of the loan's proceeds.

Allocate your interest expense to the fol-lowing categories.

• Trade or business interest

• Passive activity interest

• Investment interest

• Portfolio interest

• Personal interest

In general, you allocate interest on a loan thesame way you allocate the loan proceeds.You allocate loan proceeds by tracing dis-bursements to specific uses.

TIPThe easiest way to trace disburse-ments to specific uses is to keep theproceeds of a particular loan separate

from any other funds.

Secured loan. The allocation of loan pro-ceeds and the related interest is not generallyaffected by the use of property that securesthe loan.

Example. You secure a loan with prop-erty used in your business. You use the loanproceeds to buy an automobile for personaluse. You must allocate interest expense onthe loan to personal use (purchase of theautomobile) even though the loan is securedby business property.

TIPIf the property that secures the loanis your home, you generally do notallocate the loan proceeds or the re-

lated interest. The interest is usually deduct-ible as qualified home mortgage interest, re-gardless of how the loan proceeds are used.For more information, see Publication 936.

Allocation period. The period for which aloan is allocated to a particular use begins onthe date the proceeds are used and ends onthe earlier of the following dates.

• The date the loan is repaid.

• The date the loan is reallocated to an-other use.

Proceeds not disbursed to borrower. Evenif the lender disburses the loan proceeds toa third party, the allocation of the loan is stillbased on your use of the funds. This applieswhether you pay for property, services, oranything else by incurring a loan, or you takeproperty subject to a debt.

Proceeds deposited in borrower's ac-count. Treat loan proceeds deposited in anaccount as property held for investment. Itdoes not matter whether the account paysinterest. Any interest you pay on the loan isinvestment interest expense. If you withdrawthe proceeds of the loan, you must reallocatethe loan based on the use of the funds.

Example. Connie, a calendar-year tax-payer, borrows $100,000 on January 4 andimmediately uses the proceeds to open achecking account. No other amounts aredeposited in the account during the year andno part of the loan principal is repaid duringthe year. On April 1, Connie uses $20,000from the checking account for a passive ac-tivity expenditure. On September 1, Connieuses an additional $40,000 from the accountfor personal purposes.

Under the interest allocation rules, theentire $100,000 loan is treated as propertyheld for investment for the period from Janu-ary 4 through March 31. From April 1 throughAugust 31, Connie must treat $20,000 of theloan as used in the passive activity and$80,000 of the loan as property held for in-vestment. From September 1 through De-cember 31, she must treat $40,000 of the loanas used for personal purposes, $20,000 asused in the passive activity, and $40,000 asproperty held for investment.

Order of funds spent. Generally, youtreat loan proceeds deposited in an accountas used (spent) before either of the following.

• Any unborrowed amounts held in thesame account.

• Any amounts deposited after these loanproceeds.

Example. On January 9, Edith opened achecking account, depositing $500 of theproceeds of Loan A and $1,000 of unbor-rowed funds. The following table shows thetransactions in her account during the taxyear.

Chapter 5 Interest

Edith treats the $800 used for personalpurposes as made from the $500 proceedsof Loan A and $300 of the proceeds of LoanB. She treats the $700 used for a passiveactivity as made from the remaining $200proceeds of Loan B and $500 of unborrowedfunds. She treats the $800 used for an in-vestment as made entirely from the proceedsof Loan C.

Edith treats the $600 used for personalpurposes as made from the remaining $200proceeds of Loan C and $400 of unborrowedfunds. Note that for the periods during whichloan proceeds are held in the account, theyare treated as property held for investment.

Payments from checking accounts.Generally, you treat a payment from achecking or similar account as made at thetime the check is written if you mail or deliverit to the payee within a reasonable period af-ter you write it. You can treat checks writtenon the same day as written in any order.

Amounts paid within 30 days. If youreceive loan proceeds in cash or if the loanproceeds are deposited in an account, youcan treat any payment (up to the amount ofthe proceeds) made from any account youown, or from cash, as made from those pro-ceeds. This applies to any payment madewithin 30 days before or after the proceedsare received in cash or deposited in your ac-count.

If the loan proceeds are deposited in anaccount, you can apply this rule even if therules stated earlier under Order of fundsspent would otherwise require you to treat theproceeds as used for other purposes. If youapply this rule to any payments, disregardthose payments (and the proceeds fromwhich they are made) when applying the rulesstated under Order of funds spent.

If you received the loan proceeds in cash,you can treat the payment as made on thedate you received the cash instead of the dateyou actually made the payment.

Example. Frank gets a loan of $1,000 onAugust 4 and receives the proceeds in cash.Frank deposits $1,500 in an account on Au-gust 18 and on August 28 writes a check onthe account for a passive activity expense.Also, Frank deposits his paycheck, depositsother loan proceeds, and pays his bills duringthe same period. Regardless of these othertransactions, Frank can treat $1,000 of thedeposit he made on August 18 as being paidon August 4 from the loan proceeds. In addi-tion, Frank can treat the passive activity ex-pense he paid on August 28 as made fromthe $1,000 loan proceeds treated as depos-ited in the account.

Optional method for determining dateof reallocation. You can use the followingmethod to determine the date loan proceeds

Date Transaction are reallocated to another use. You can treatall payments from loan proceeds in the ac-count during any month as taking place on thelater of the following dates.

• The first day of that month.

• The date the loan proceeds are depositedin the account.

However, you can use this optional methodonly if you treat all payments from the accountduring the same calendar month in the sameway.

Interest on a separate account. If youhave an account that contains only loan pro-ceeds and interest earned on the account,you can treat any payment from that accountas being made first from the interest. Whenthe interest earned is used up, any remainingpayments are from loan proceeds.

Example. You borrowed $20,000 andused the proceeds of this loan to open a newsavings account. When the account hadearned interest of $867, you withdrew$20,000 for personal purposes. You can treatthe withdrawal as coming first from the inter-est earned on the account, $867, and thenfrom the loan proceeds, $19,133 ($20,000 −$867). All of the interest charged on the partof the loan from the time it was deposited inthe account until the time of the withdrawal isinvestment interest expense. The interestcharged on the part of the proceeds used forpersonal purposes ($19,133) from the timeyou withdrew it until you either repay it or re-allocate it to another use is personal interestexpense. The interest charged on the loanproceeds you left in the account ($867) con-tinues to be investment interest expense untilyou either repay it or reallocate it to anotheruse.

Loan repayment. When you repay any partof a loan allocated to more than one use, treatit as being repaid in the following order.

1) Personal use.

2) Investments and passive activities (otherthan those included in (3)).

3) Passive activities in connection with arental real estate activity in which youactively participate.

4) Former passive activities.

5) Trade or business use and to expensesfor certain low-income housing projects.

Line of credit (continuous borrowings).The following rules apply if you have a lineof credit or similar arrangement.

1) Treat all borrowed funds on which inter-est accrues at the same fixed or variablerate as a single loan.

2) Treat borrowed funds or parts of bor-rowed funds on which interest accruesat different fixed or variable rates as dif-ferent loans. Treat these loans as repaidin the order shown on the loan agree-ment.

Loan refinancing. Allocate the replacementloan to the same items to which the repaidloan was allocated. Make the allocation onlyto the extent you use the proceeds of the newloan to repay any part of the original loan.

Partnershipsand S CorporationsThe following rules apply to the allocation ofinterest expense in connection with debt-financed acquisitions of interests in partner-ships and S corporations. These rules alsoapply to the allocation of interest expense inconnection with debt-financed distributionsfrom partnerships and S corporations.

CAUTION!

These rules do not apply if the part-nership or S corporation is formed orused for the principal purpose of

avoiding the interest allocation rules.

Debt-financed acquisition. A debt-financedacquisition is the use of loan proceeds to buyan interest in a partnership or S corporationor to make a contribution to the capital of one.

You must allocate the loan proceeds andthe related interest expense among all theassets of the entity. You can use any rea-sonable method. If you buy an interest in apartnership or S corporation (other than byway of a contribution to capital), reasonablemethods include a pro rata allocation basedon the fair market value, book value, or ad-justed basis of the assets, reduced by anydebts allocated to the assets.

If you contribute to the capital of a part-nership or S corporation, reasonable methodsordinarily include allocating the debt amongall the assets or tracing the loan proceeds tothe entity's expenditures.

Treat the purchase of an interest in apartnership or S corporation as a contributionto capital to the extent the entity receives anyproceeds of the purchase.

Example. You buy an interest in a part-nership for $20,000 using borrowed funds.The partnership's only assets include ma-chinery used in its business valued at$60,000 and stocks valued at $15,000. Youallocate the loan proceeds based on the valueof the assets. Therefore, you allocate $16,000of the loan proceeds ($60,000/$75,000 ×$20,000) and the interest expense on thatpart to trade or business use. You allocate theremaining $4,000 ($15,000/$75,000 ×$20,000) and the interest on that part to in-vestment use.

Reallocation. If you allocate the loanproceeds among the assets, you must makea reallocation if the assets or the use of theassets change.

How to report. Individuals should reporttheir deductible interest expense on eitherSchedule A or Schedule E of Form 1040,depending on the type of asset (or expendi-ture if the allocation is based on the tracingof loan proceeds) to which the interest ex-pense is allocated.

For interest allocated to trade or businessassets (or expenditures), report the interestin Part II, Schedule E (Form 1040). On aseparate line, put “business interest” and thename of the partnership or S corporation incolumn (a) and the amount in column (i).

For interest allocated to passive activityuse, enter the interest on Form 8582 as adeduction from the passive activity of thepartnership or S corporation. Show anydeductible amount in Part II, Schedule E(Form 1040). On a separate line, put “passiveinterest” and the name of the entity in column(a) and the amount in column (g).

For interest allocated to investment use,enter the interest on Form 4952. Carry anydeductible amount allocated to royalties to

January 9 $500 proceeds of Loan A and$1,000 unborrowed fundsdeposited

January 13 $500 proceeds of Loan Bdeposited

February 18 $800 used for personal purposes

February 27 $700 used for passive activity

June 19 $1,000 proceeds of Loan Cdeposited

November 20 $800 used for an investment

December 18 $600 used for personal purposes

Chapter 5 Interest

Part II, Schedule E (Form 1040). On a sepa-rate line enter “investment interest” and thename of the partnership or S corporation incolumn (a) and the amount in column (i).Carry the balance of the deductible amountto line 13, Schedule A (Form 1040).

Any interest allocated to proceeds usedfor personal purposes is generally notdeductible.

Debt-financed distribution. A debt-financeddistribution occurs when a partnership or Scorporation borrows funds and allocatesthose funds to distributions made to partnersor shareholders. The distributed loan pro-ceeds and related interest expense must bereported to the partners and shareholdersseparately. This is because the loan proceedsand the interest expense must be allocateddepending on how the partner or shareholderuses the proceeds.

This treatment of debt-financed distribu-tions follows the general allocation rules dis-cussed earlier. For example, if a shareholderuses distributed loan proceeds to invest in apassive activity, that shareholder's portion ofthe entity's interest expense on the loan pro-ceeds is allocated to a passive activity use.

Optional allocation method. The part-nership or S corporation can choose to allo-cate the distributed loan proceeds to otherexpenditures it makes during the tax year ofthe distribution. This allocation is limited to thedifference between the other expendituresand any loan proceeds already allocated tothem. For any distributed loan proceeds thatare more than the amount allocated to theother expenditures, the rules in the previousparagraph apply.

How to report. If the entity does not usethe optional allocation method, it reports theinterest expense on the loan proceeds on theline on Schedule K–1 (Form 1065 or Form1120S) for “Other deductions.” The expenseis identified on an attached schedule as “In-terest expense allocated to debt-financeddistributions.” The partner or shareholderclaims the interest expense depending onhow the distribution was used.

If the entity uses the optional allocationmethod, it reports the interest expense on theloan proceeds allocated to other expenditureson the appropriate line or lines of ScheduleK–1. For example, if the entity chooses toallocate the loan proceeds and related inter-est to a rental activity expenditure, the entitywill take the interest into account in figuringthe net rental income or loss reported onSchedule K–1.

More information. For more information onallocating and reporting these interest ex-penses, see Notice 88–37 in CumulativeBulletin 1988–1. Also see Notice 89–35 inCumulative Bulletin 1989–1.

Interest YouCan DeductYou can generally deduct all interest you payor accrue during the tax year on debts relatedto your trade or business. Interest relates toyour trade or business if you use the pro-ceeds of the loan for a trade or business ex-pense. It does not matter what type of prop-erty secures the loan. You can deductinterest on a debt only if you meet all the fol-lowing requirements.

• You are legally liable for that debt.

• Both you and the lender intend that thedebt be repaid.

• You and the lender have a true debtor-creditor relationship.

Partial liability. If you are liable for part ofa business debt, you can deduct only yourshare of the total interest paid or accrued.

Example. You and your brother borrowmoney. You are liable for 50% of the note.You use your half of the loan in your busi-ness, and you make one-half of the loanpayments. You can deduct your half of thetotal interest payments as a business de-duction.

Mortgage. Generally, mortgage interest paidor accrued on real estate you own legally orequitably is deductible. However, rather thandeducting the interest currently, you mayhave to add it to the cost basis of the propertyas explained later under Capitalization of In-terest.

Statement. If you paid $600 or more ofmortgage interest (including certain points)during the year on any one mortgage, yougenerally will receive a Form 1098 or a simi-lar statement. You will receive the statementif you pay interest to a person (including afinancial institution or a cooperative housingcorporation) in the course of that person'strade or business. A governmental unit is aperson for purposes of furnishing the state-ment.

If you receive a refund of interest youoverpaid in an earlier year, this amount willbe reported in box 3 of Form 1098. You can-not deduct this amount. For information onhow to report this refund, see Refunds of in-terest later in this chapter.

Expenses paid to obtain a mortgage.Certain expenses you pay to obtain a mort-gage cannot be deducted as interest. Theseexpenses, which include mortgage commis-sions, abstract fees, and recording fees, arecapital expenses. If the property mortgagedis business or income-producing property,you can amortize the costs over the life of themortgage.

Prepayment penalty. If you pay off yourmortgage early and pay the lender a penaltyfor doing this, you can deduct the penalty asinterest.

Interest on employment tax deficiency.Interest charged on employment taxes as-sessed on your business is deductible.

Original issue discount (OID). Original is-sue discount is a form of interest. A loan(mortgage or other debt) generally has OIDwhen its proceeds are less than its principalamount. The OID is the difference betweenthe stated redemption price at maturity andthe issue price of the loan.

A loan's stated redemption price atmaturity is the sum of all amounts (principaland interest) payable on it other than qualifiedstated interest.

Stated interest, in general, is qualifiedstated interest if it is unconditionally payablein cash or property (other than another loanof the issuer) at least annually over the termof the loan at a single fixed rate.

You generally deduct OID over the termof the loan. Figure the amount to deduct eachyear using the constant-yield method, un-less the OID on the loan is de minimis.

De minimis OID. The OID is de minimisif it is less than one-fourth of 1% (.0025) of thestated redemption price of the loan at maturitymultiplied by the number of full years from thedate of original issue to maturity (the term ofthe loan).

If the OID is de minimis, you can chooseone of the following ways to figure the amountyou can deduct each year.

• On a constant-yield basis over the termof the loan.

• On a straight-line basis over the term ofthe loan.

• In proportion to stated interest payments.

• In its entirety at maturity of the loan.

You make this choice by deducting the OIDin a manner consistent with the method cho-sen on your timely filed tax return for the taxyear in which the loan is issued.

Example. On January 1, 2000, you tookout a $100,000 discounted loan and received$98,500 in proceeds. The loan will mature onJanuary 1, 2010 (a 10-year term), and the$100,000 principal is payable on that date.Interest of $10,000 is payable on January 1of each year, beginning January 1, 2001. The$1,500 OID on the loan is de minimis becauseit is less than $2,500 ($100,000 × .0025 × 10).You choose to deduct the OID on a straight-line basis over the term of the loan. Beginningin 2000, you can deduct $150 each year for10 years.

Constant-yield method. If the OID is notde minimis, you must use the constant-yieldmethod to figure how much you can deducteach year. You figure your deduction for thefirst year using the following steps.

1) Determine the issue price of the loan.Generally, this equals the proceeds ofthe loan. If you paid points on the loan(as discussed later), the issue pricegenerally is the difference between theproceeds and the points.

2) Multiply the result in (1) by the yield tomaturity.

3) Subtract any qualified stated interestpayments from the result in (2). This isthe OID you can deduct in the first year.

To figure your deduction in any subse-quent year, use the adjusted issue price instep (1) above. To get the adjusted issueprice, add to the issue price any OID previ-ously deducted. Then follow steps (2) and (3)above.

The yield to maturity (YTM) is generallyshown in the literature you receive from yourlender. If you do not have this information,consult your lender or tax advisor. In general,the YTM is the discount rate that, when usedin computing the present value of all principaland interest payments, produces an amountequal to the principal amount of the loan.

Qualified stated interest (QSI) generallyis stated interest that is unconditionally pay-able in cash or property (other than debt in-struments of the issuer) at least annually ata single fixed rate.

Example. The facts are the same as inthe previous example, except that you deductthe OID on a constant yield basis over theterm of the loan. The yield to maturity on yourloan is 10.2467%, compounded annually. For2000, you can deduct $93 [($98,500 ×

Chapter 5 Interest

.102467) − $10,000]. For 2001, you can de-duct $103 [($98,593 × .102467) − $10,000].

Loan or mortgage ends. If your loan ormortgage ends, you may be able to deductany remaining OID in the tax year in which theloan or mortgage ends. A loan or mortgagemay end due to a refinancing, prepayment,foreclosure, or similar event.

CAUTION!

If you refinance with the same lender,you generally cannot deduct the re-maining OID in the year in which the

refinancing occurs, but you may be able todeduct it over the term of the new mortgageor loan. See Interest paid with funds borrowedfrom same lender under Interest You CannotDeduct, later.

Points. The term “points” is often used todescribe some of the charges paid by a bor-rower when the borrower takes out a loan ora mortgage. These charges are also calledloan origination fees, maximum loancharges, or premium charges. If any of thesecharges (points) are solely for the use ofmoney, they are interest.

Because points are prepaid interest, youcannot deduct the full amount in the yearpaid. (For an exception for points paid on yourhome mortgage, see Publication 936.) In-stead, the points reduce the issue price of theloan and result in original issue discount,deductible as explained in the preceding dis-cussion.

Partial payments on a nontax debt. If youmake partial payments on a debt (other thana debt owed the IRS), the payments are ap-plied, in general, first to interest and any re-mainder to principal. You can deduct only theinterest. This rule does not apply when it canbe inferred the borrower and lender under-stood that a different allocation of the pay-ments would be made.

Installment purchase. If you make an in-stallment purchase of business property, thecontract between you and the seller generallyprovides for the payment of interest. If no in-terest or a low rate of interest is charged un-der the contract, a portion of the stated prin-cipal amount payable under the contract maybe recharacterized as interest (unstated in-terest). The amount recharacterized as inter-est reduces your basis in the property andincreases your interest expense. For moreinformation on installment sales and unstatedinterest, see Publication 537.

Interest YouCannot DeductCertain interest payments cannot be de-ducted. In addition, certain other expensesthat may seem to be interest are not, and youcannot deduct them as interest.

You cannot currently deduct interest thatmust be capitalized and (except for corpo-rations) you generally cannot deduct personalinterest.

Interest paid with funds borrowed fromsame lender. If you use the cash methodof accounting, you cannot deduct interest youpay with funds borrowed from the originallender through a second loan, an advance,or any other arrangement similar to a loan.

You can deduct the interest expense onceyou start making payments on the new loan.

When you make a payment on the newloan, you first apply the payment to interestand then to the principal. All amounts youapply to the interest on the first loan aredeductible, along with any interest you payon the second loan, subject to any limits thatapply.

Capitalized interest. You cannot deduct in-terest you are required to capitalize under theuniform capitalization rules. See Capitaliza-tion of Interest, later. In addition, if you buyproperty and pay interest owed by the seller(for example, by assuming the debt and anyinterest accrued on the property), you cannotdeduct the interest. Add this interest to thebasis of the property.

Commitment fees or standby charges.Fees you incur to have business funds avail-able on a standby basis, but not for the actualuse of the funds, are not deductible as inter-est payments. You may be able to deductthem as business expenses.

If the funds are for inventory or certainproperty used in your business, the fees areindirect costs and you must capitalize themunder the uniform capitalization rules. Formore information on uniform capitalizationrules, see section 1.263A–8 through1.263A–15 of the regulations.

Interest on income tax. Interest charged onincome tax assessed on your individual in-come tax return is not a business deductioneven though the tax due is related to incomefrom your trade or business. Treat this inter-est as a business deduction only in figuringa net operating loss deduction.

Penalties. Penalties on underpaid defi-ciencies and underpaid estimated tax are notinterest. You cannot deduct them. Generally,you cannot deduct any fines or penalties.

Interest on loans with respect to life in-surance policies. For contracts issued be-fore June 9, 1997, you generally cannot de-duct interest paid or accrued on a debtincurred with respect to any life insurance,annuity, or endowment contract coveringsomeone who is or was an employee, officer,or someone financially interested in yourbusiness unless that person is a key person.

For contracts issued or considered issuedafter June 8, 1997, you generally cannot de-duct interest with respect to any life insur-ance, annuity, or endowment contract thatcovers any individual unless that individual isa key person.

If the policy or contract covers a key per-son, you can deduct the interest on up to$50,000 of debt for that person. However, thededuction for any month cannot be more thanthe interest figured using Moody's CorporateBond Yield Average-Monthly Average Corpo-rates (Moody's rate) for that month.

Who is a key person? A key person isan officer or 20% owner. However, the num-ber of individuals you can treat as key per-sons is limited to the greater of the following.

• Five individuals.

• The lesser of 5% of the total officers andemployees of the company or 20 individ-uals.

Pre-June 21, 1986 contracts. With a fewexceptions, otherwise allowable interest (notin excess of the maximum rates set by law)

paid or accrued on debt with respect to con-tracts purchased before June 21, 1986, canbe deducted no matter when the debt wasincurred.

Interest allocated to unborrowed policycash value. Corporations and partnershipsgenerally cannot deduct any interest expenseallocable to unborrowed cash values of lifeinsurance, annuity, or endowment contracts.This rule applies to contracts issued afterJune 8, 1997, that cover someone other thanan officer, director, employee, or 20% owner.For more information, see section 264(f) ofthe Internal Revenue Code.

Capitalizationof InterestUnder the uniform capitalization rules, yougenerally must capitalize interest on debtequal to your expenditures to produce realproperty or certain tangible personal property.The property must be produced by you foruse in your trade or business or for sale tocustomers. You cannot capitalize interest re-lated to property that you acquire in any othermanner.

Interest you paid or incurred during theproduction period must be capitalized if theproperty produced is designated property.Designated property is any of the following.

• Real property.

• Tangible personal property with a classlife of 20 years or more.

• Tangible personal property with an esti-mated production period of more than 2years.

• Tangible personal property with an esti-mated production period of more than 1year if the estimated cost of productionis more than $1 million.

Property you produce. You produce prop-erty if you construct, build, install, manufac-ture, develop, improve, create, raise, or growit. Treat property produced for you under acontract as produced by you up to the amountyou pay or incur for the property.

Capitalized interest. Treat capitalized inter-est as a cost of the property produced. Yourecover your interest when you sell or use theproperty. If the property is inventory, recovercapitalized interest through cost of goodssold. If the property is used in your trade orbusiness, recover capitalized interest throughan adjustment to basis, depreciation, amorti-zation, or other method.

Partnerships and S corporations. The in-terest capitalization rules are applied first atthe partnership or S corporation level. Therules are then applied at the partners' orshareholders' level to the extent the partner-ship or S corporation has insufficient debt tosupport the production or construction costs.

If you are a partner in a partnership or ashareholder in an S corporation, you mayhave to capitalize interest you incur during thetax year for the production costs of the part-nership or S corporation. You may also haveto capitalize interest incurred by the partner-ship or S corporation for your own productioncosts. You must provide the required infor-mation in an attachment to the Schedule K–1to properly capitalize interest for this purpose.

Chapter 5 Interest

Additional information. The procedures forapplying the uniform capitalization rules arebeyond the scope of this publication. Formore information, see section 1.263A–8through 1.263A–15 of the regulations andNotice 88–99 (as amended by Announcement89–72). Notice 88–99 is in Cumulative Bul-letin 1988–2. Announcement 89–72 is in Cu-mulative Bulletin 1989–1.

When ToDeduct InterestIf the uniform capitalization rules, discussedearlier, do not apply to you, deduct interestas follows.

Cash method. In general, you can deductonly the interest you actually paid during thetax year. You cannot deduct a promissorynote you gave as payment because it is apromise to pay and not an actual payment.

Prepaid interest. Under the cashmethod, you generally cannot deduct any in-terest paid before the year it is due. Interestpaid in advance can be deducted only in thetax year in which it is due.

Discounted loan. If interest or a discountis subtracted from your loan proceeds, it isnot a payment of interest and you cannotdeduct it when you get the loan.

For more information, see Original issuediscount (OID) under Interest You Can De-duct, earlier.

Refunds of interest. If you pay interestand then receive a refund in the same taxyear of any part of the interest, reduce yourinterest deduction by the refund. If you re-ceive the refund in a later tax year, include therefund in income if the deduction for the in-terest reduced your tax. You should includein income only the interest deduction that re-duced your tax.

Accrual method. You can deduct only in-terest that has accrued during the tax year.

Prepaid interest. Under the accrualmethod, you generally cannot deduct any in-terest paid before it is due. Instead, deduct itin the year in which it is due.

Discounted loan. If interest or a discountis subtracted from your loan proceeds, it isnot a payment of interest and you cannotdeduct it when you get the loan. For moreinformation, see Original issue discount (OID)under Interest You Can Deduct, earlier.

Tax deficiency. If you contest a federalincome tax deficiency, interest does not ac-crue until the tax year the final determinationof liability is made. If you do not contest thedeficiency, then the interest accrues in theyear the tax was asserted and agreed to byyou.

However, if you contest but pay the pro-posed tax deficiency and interest, and you donot designate the payment as a cash bond,then the interest is deductible in the year paid.

Related person. If you use the accrualmethod, you cannot deduct interest owed toa related person who uses the cash methoduntil payment is made and the interest isincludible in the gross income of that person.The relationship is determined as of the endof the tax year for which the interest wouldotherwise be deductible. If a deduction is de-nied under this rule, the rule will continue toapply even if your relationship with the person

ceases to exist before the interest is includiblein the gross income of that person. See Re-lated Persons in Publication 538.

Below-Market LoanIf you receive a below-market gift or demandloan and use the proceeds in your trade orbusiness, you may be able to deduct the for-gone interest. See Treatment of gift and de-mand loans later in this discussion.

A below-market loan is a loan on whichno interest is charged or on which interest ischarged at a rate below the applicable federalrate. A gift or demand loan that is a below-market loan generally is considered anarm's-length transaction in which you, theborrower, are considered as having receivedboth the following.

• A loan in exchange for a note that re-quires the payment of interest at the ap-plicable federal rate.

• An additional payment.

The additional payment is treated as a gift,dividend, contribution to capital, payment ofcompensation, or other payment, dependingon the substance of the transaction.

For any period, forgone interest is:

1) The interest that would be payable forthat period if interest accrued on the loanat the applicable federal rate and waspayable annually on December 31,minus

2) Any interest actually payable on the loanfor the period.

TIPApplicable federal rates are publishedby the IRS each month in the InternalRevenue Bulletin. Internal Revenue

Bulletins are available on the IRS web site atwww.irs.gov .You can also contact an Inter-nal Revenue Service office to get these rates.

Loans subject to the rules. The rules forbelow-market loans apply to the following.

1) Gift loans (below-market loans where theforgone interest is in the nature of a gift).

2) Compensation-related loans (below-market loans between an employer andan employee or between an independentcontractor and a person for whom thecontractor provides services).

3) Corporation-shareholder loans.

4) Tax avoidance loans (below-marketloans where the avoidance of federal taxis one of the main purposes of the inter-est arrangement).

5) Loans to qualified continuing care facili-ties under a continuing care contract(made after October 11, 1985).

Except as noted in (5) above, these rulesapply to demand loans (loans payable in fullat any time upon the lender's demand) out-standing after June 6, 1984, and to termloans (loans that are not demand loans)made after that date.

Treatment of gift and demand loans. If youreceive a below-market gift loan or demandloan, you are treated as receiving an addi-tional payment (as a gift, dividend, etc.) equalto the forgone interest on the loan. You are

then treated as transferring this amount backto the lender as interest. These transfers areconsidered to occur annually, generally onDecember 31. If you use the loan proceedsin your trade or business, you can deduct theforgone interest each year as a business in-terest expense. The lender must report it asinterest income.

Limit on forgone interest for gift loansof $100,000 or less. For gift loans betweenindividuals, forgone interest treated as trans-ferred back to the lender is limited to theborrower's net investment income for theyear. This limit applies if the outstandingloans between the lender and borrower total$100,000 or less. If the borrower's net in-vestment income is $1,000 or less, it istreated as zero. This limit does not apply toa loan if the avoidance of any federal tax isone of the main purposes of the interest ar-rangement.

Treatment of term loans. If you receive abelow-market term loan other than a gift loan,you are treated as receiving an additionalcash payment (as a dividend, etc.) on thedate the loan is made. This payment is equalto the loan amount minus the present value,at the applicable federal rate, of all paymentsdue under the loan. The same amount istreated as original issue discount on the loan.See Original issue discount (OID) under In-terest You Can Deduct, earlier.

Exceptions for loans of $10,000 or less.The rules for below-market loans do not applyto certain loans on days on which the totaloutstanding loans between the borrower andlender is $10,000 or less. This exception ap-plies only to the following.

1) Gift loans between individuals if the giftloan is not directly used to buy or carryincome-producing assets.

2) Compensation-related loans orcorporation-shareholder loans if theavoidance of any federal tax is not aprincipal purpose of the interest ar-rangement.

This exception does not apply to a term loandescribed in (2) above that was previouslysubject to the below-market loan rules. Thoserules will continue to apply even if the out-standing balance is reduced to $10,000 orless.

Exceptions for loans without significanttax effect. The following loans are specif-ically exempted from the rules for below-market loans because their interest arrange-ments do not have a significant effect on thefederal tax liability of the borrower or thelender.

1) Loans made available by lenders to thegeneral public on the same terms andconditions that are consistent with thelender's customary business practices.

2) Loans subsidized by a federal, state, ormunicipal government that are madeavailable under a program of generalapplication to the public.

3) Certain employee-relocation loans.

4) Certain loans to or from a foreign person,unless the interest income would be ef-fectively connected with the conduct ofa U.S. trade or business and not exemptfrom U.S. tax under an income tax treaty.

Chapter 5 Interest

5) Any other loan if the taxpayer can showthat the interest arrangement has nosignificant effect on the federal tax li-ability of the lender or the borrower.Whether an interest arrangement has asignificant effect on the federal tax li-ability of the lender or the borrower willbe determined by all the facts and cir-cumstances. Consider all the followingfactors.

a) Whether items of income and de-duction generated by the loan offseteach other.

b) The amount of the items.

c) The cost of complying with thebelow-market loan provisions if theywere to apply.

d) Any reasons, other than taxes, forstructuring the transaction as abelow-market loan.

Exception for certain loans to a qualifiedcontinuing care facility. The below-marketinterest rules do not apply to a loan made toa qualified continuing care facility under acontinuing care contract if the lender (orlender's spouse) is age 65 or older by the endof the calendar year. For 2000, this exceptionapplies only to the part of the total outstandingloans from the lender (or lender's spouse) thatdoes not exceed $139,700.

A qualified continuing care facility isone or more facilities that are designed toprovide services under continuing care con-tracts and where substantially all of the resi-dents have entered into continuing care con-tracts. In addition, substantially all of thefacilities used to provide services requiredunder the continuing care contract must beowned or operated by the loan borrower.

A continuing care contract is a writtencontract between an individual and a qualifiedcontinuing care facility that meets all the fol-lowing conditions.

1) The individual and/or the individual'sspouse must be entitled to use the facil-ity for the rest of their life or lives.

2) The residential use must begin in aseparate, independent living unit pro-vided by the continuing care facility andcontinue until the individual (or individ-ual's spouse) is incapable of living inde-pendently. The facility must provide var-ious “personal care” services to theresident such as maintenance of theresidential unit, meals, and daily aid andsupervision relating to routine medicalneeds.

3) The facility must be obligated to providelong-term nursing care if the resident isno longer capable of living independ-ently.

4) The contract must require the facility toprovide the “personal services” and“long-term nursing care” without sub-stantial additional cost to the individual.

Sale or exchange of property. Differentrules generally apply to a loan connected withthe sale or exchange of property. If the loandoes not provide adequate stated interest,part of the principal payment may be consid-ered interest. However, there are exceptionsthat may require you to apply the below-market interest rate rules to these loans. See

Unstated Interest and Original Issue Discountin Publication 537.

More information. For more information onbelow-market loans, see section 7872 of theInternal Revenue Code and section1.7872–5T of the regulations.

6.Taxes

IntroductionYou can deduct various federal, state, local,and foreign taxes directly attributable to yourtrade or business as business expenses.

CAUTION!

You cannot deduct federal incometaxes, estate and gift taxes, or stateinheritance, legacy, and succession

taxes.


• When to deduct taxes

• Real estate taxes

• Income taxes

• Employment taxes

• Other taxes


Publication

� 15 Circular E, Employer's Tax Guide

� 378 Fuel Tax Credits and Refunds

� 533 Self-Employment Tax


� 551 Basis of Assets


� Sch A (1040) Itemized Deductions

� Sch SE (Form 1040) Self-EmploymentTax

� 3115 Application for Change in Ac-counting Method


When ToDeduct TaxesGenerally, you can only deduct taxes in theyear you pay them. This applies whether youuse the cash method or an accrual methodof accounting.

Under an accrual method, you can deducta tax before you pay it if you meet the ex-

ception for recurring items discussed underEconomic Performance in Publication 538.You can also choose to ratably accrue realestate taxes as discussed later under RealEstate Taxes.

Limit on accrual of taxes. A taxing juris-diction can require the use of a date for ac-cruing taxes that is earlier than the date itoriginally required. However, if you use anaccrual method and can deduct the tax beforeyou pay it, the accrual date for federal incometax purposes is the original accrual date. Usethe original accrual date for all future yearsas well.

Example. Your state imposes a tax onintangible and tangible personal propertyused in a trade or business conducted in thestate. This tax is assessed and becomes alien as of July 1. In 2000, the state, by legis-lative action, changes the assessment andlien dates from July 1, 2001, to December 31,2000, for property tax year 2001. BecauseDecember 31 is earlier than the original ac-crual date, the tax for federal income taxpurposes accrues on July 1, 2001.

Uniform capitalization rules. Uniform cap-italization rules apply to certain taxpayers whoproduce real or tangible personal property foruse in a trade or business or for sale to cus-tomers. They also apply to taxpayers whoacquire property for resale. Under these rules,you may have to either include in inventorycosts or capitalize certain expenses relatedto the property, such as taxes. For more in-formation, see Publication 551.

Carrying charges. Carrying charges includetaxes you pay to carry or develop real estateor to carry, transport, or install personalproperty. You can choose to capitalize carry-ing charges not subject to the uniform cap-italization rules if they are otherwise deduct-ible. For more information, see chapter 8.

Refunds of taxes. If you receive a refund forany taxes you deducted in an earlier year,include the refund in income only to the extentthe deduction reduced your tax in the earlieryear. For more information, see Recovery ofamount deducted in chapter 1.

TIPYou must include in income any in-terest you receive on state or local taxrefunds.

Real Estate TaxesDeductible real estate taxes are any state,local, or foreign taxes on real estate levied forthe general public welfare. The taxing au-thority must base the taxes on the assessedvalue of the real estate and charge themuniformly against all property under its juris-diction. Deductible real estate taxes generallydo not include taxes charged for local benefitsand improvements that increase the value ofthe property. See Taxes for local benefits,later.

If you use an accrual method, you gener-ally cannot accrue real estate taxes until youpay them to the government authority. Youcan, however, choose to ratably accrue thetaxes during the year. See Election to ratablyaccrue, later.

Chapter 6 Taxes

Taxes for local benefits. Generally, youcannot deduct taxes charged for local benefitsand improvements that tend to increase thevalue of your property. These include as-sessments for streets, sidewalks, watermains, sewer lines, and public parking facili-ties. You should increase the basis of yourproperty by the amount of the assessment.

You can deduct taxes for these localbenefits only if the taxes are for maintenance,repairs, or interest charges related to thosebenefits. If part of the tax is for maintenance,repairs, or interest, you must be able to showhow much of the tax is for these expenses toclaim a deduction for that part of the tax.

Example. City X, to improve downtowncommercial business, converted a downtownbusiness area street into an enclosed pedes-trian mall. The city assessed the full cost ofconstruction, financed with 10-year bonds,against the affected properties. The city ispaying the principal and interest with the an-nual payments made by the property owners.

The assessments for construction costsare not deductible as taxes or as businessexpenses, but are depreciable capital ex-penses. The part of the payments used to paythe interest charges on the bonds is deduct-ible as taxes.

Charges for services. Water bills, sewer-age, and other service charges assessedagainst your business property are not realestate taxes, but are deductible as businessexpenses.

Purchase or sale of real estate. If real es-tate is sold during the year, the real estatetaxes must be divided between the buyer andthe seller.

The buyer and seller must divide the realestate taxes according to the number of daysin the real property tax year (the period towhich the tax imposed relates) that eachowned the property. Treat the seller as pay-ing the taxes up to but not including the dateof sale. Treat the buyer as paying the taxesbeginning with the date of sale. For this pur-pose, disregard the accrual or lien dates un-der local law. You can usually find this infor-mation on the settlement statement youreceived at closing.

If you (the seller) cannot deduct taxes untilthey are paid because you use the cashmethod and the buyer of your property ispersonally liable for the tax, you are consid-ered to have paid your part of the tax at thetime of the sale. This lets you deduct the partof the tax up to the date of sale even thoughyou did not pay it. You must also include theamount of that tax in the selling price of theproperty.

If you (the seller) use an accrual methodand have not chosen to ratably accrue realestate taxes, you are considered to have ac-crued your part of the tax on the date you sellthe property.

Example. Al Green, a calendar year ac-crual method taxpayer, owns real estate in XCounty. He has not chosen to ratably accrueproperty taxes. November 30 of each year isthe assessment and lien date. He sold theproperty on June 30, 2000. Under his ac-counting method he would not be able toclaim a deduction for the taxes because thesale occurred before November 30. He istreated as having accrued his part of the tax,181 / 366 (January 1–June 29), on June 30 andhe can deduct it for 2000.

Election to ratably accrue. If you use anaccrual method, you can choose to accruereal estate tax related to a definite periodratably over that period.

Example. John Smith is a calendar yeartaxpayer who uses an accrual method. Hisreal estate taxes for the real property tax year,July 1, 2000, to June 30, 2001, amount to$1,200. July 1 is the assessment and liendate.

If John chooses to ratably accrue thetaxes, $600 will accrue in 2000 ($1,200 ×6 / 12, July 1–December 31) and the balancewill accrue in 2001.

Separate elections. You can make anelection for each separate trade or businessand for nonbusiness activities if you accountfor them separately. Once you elect to ratablyaccrue real estate taxes, you must use thatmethod unless you get permission from theIRS to revoke the election. See Revoking theelection, later.

Making the election. If you make yourelection for the first year in which you incurreal estate taxes, attach a statement to yourincome tax return for that year. The statementshould show all the following items.

• The trades or businesses to which theelection applies and the accountingmethod or methods used.

• The period to which the taxes relate.

• The computation of the real estate taxdeduction for the first year of the election.

Generally, you must file your return by thedue date (including extensions). However, ifyou timely filed your return for the year with-out making the election, you can still make theelection by filing an amended return within 6months of the due date of the return (exclud-ing extensions). Attach the election to theamended return and write “FILED PURSU-ANT TO SECTION 301.9100–2” on theelection statement. File the amended returnat the same address you filed the original re-turn.

If you make the election for a year afterthe first year in which you incur real estatetaxes, file Form 3115. Generally, you mustfile this form during the tax year for which theelection is to be effective. For more informa-tion, see the instructions for Form 3115.

Revoking the election. To revoke anelection to ratably accrue real estate taxes,file Form 3115 during the tax year for whichthe change is requested.

Income TaxesThis section discusses federal, state, local,and foreign income taxes.

Federal income taxes. You cannot deductfederal income taxes.

State and local income taxes. A corpo-ration or partnership can deduct state incometaxes imposed on the corporation or partner-ship as business expenses. An individual candeduct state income taxes only as an item-ized deduction on Schedule A (Form 1040).

However, an individual can deduct a statetax on gross income (as distinguished fromnet income) directly attributable to a trade orbusiness as a business expense.

Accrual of contested income taxes. Ifyou use an accrual method, can deduct taxesbefore you pay them, and contest a state orlocal income tax liability, a special rule ap-plies. Under this special rule, you must accrueand deduct any contested amount in the taxyear in which the liability is finally determined.

Filing a tax return is not considered con-testing a liability. If you do not make an ob-jective act of protest or show some affirmativeevidence of denial of the liability, you candeduct any additional state or local incometaxes found to be due for a prior year in theyear for which they were originally imposed.You cannot deduct them in the year in whichthe liability is finally determined.

Foreign income taxes. Generally, you cantake either a deduction or a credit for incometaxes imposed on you by a foreign countryor a U.S. possession. However, an individualcannot take a deduction or credit for foreignincome taxes paid on income that is exemptfrom U.S. tax under the foreign earned in-come exclusion or the foreign housing exclu-sion. For information on these exclusions, seePublication 54, Tax Guide for U.S. Citizensand Resident Aliens Abroad. For informationon the foreign tax credit, see Publication 514,Foreign Tax Credit for Individuals.

Employment TaxesIf you have employees, you must withholdvarious taxes from your employees' pay. Mostemployers must withhold their employees'share of social security and Medicare taxesalong with state and federal income taxes.You may also need to pay certain employ-ment taxes from your own funds. These in-clude your share of social security and Medi-care taxes as an employer, along withunemployment taxes.

You should treat the taxes you withholdfrom your employees' pay as wages on yourtax return. You can deduct the employmenttaxes you must pay from your own funds astaxes.

Example. You pay your employee$18,000 a year. However, after you withholdvarious taxes, your employee receives$14,500. You also pay an additional $1,500in employment taxes. You should deduct thefull $18,000 as wages. You can deduct the$1,500 you pay from your own funds as taxes.

For more information on employmenttaxes, see Publication 15.

Unemployment fund taxes. As an em-ployer, you may have to make payments toa state unemployment compensation fund orto a state disability benefit fund. Deduct thesepayments as taxes.

Other TaxesThe following are other taxes you can deductif you incur them in the ordinary course ofyour trade or business.

Excise taxes. You can deduct as a businessexpense all excise taxes that are ordinary andnecessary expenses of carrying on your tradeor business.

Chapter 6 Taxes

Franchise taxes. You can deduct corporatefranchise taxes as a business expense.

Fuel taxes. Taxes on gasoline, diesel fuel,and other motor fuels that you use in yourbusiness are usually included as part of thecost of the fuel. Do not deduct these taxesas a separate item.

You may be entitled to a credit or refundfor federal excise tax you paid on fuels usedfor certain purposes. For more information,see Publication 378.

Occupational taxes. You can deduct as abusiness expense an occupational taxcharged at a flat rate by a locality for theprivilege of working or conducting a businessin the locality.

Personal property tax. You can deduct anytax imposed by a state or local governmenton personal property used in your trade orbusiness.

Sales tax. Treat any sales tax you pay on aservice or on the purchase or use of propertyas part of the cost of the service or property.If the service or the cost or use of the propertyis a deductible business expense, you candeduct the tax as part of that service or cost.If the property is merchandise bought for re-sale, the sales tax is part of the cost of themerchandise. If the property is depreciable,add the sales tax to the basis for depreciation.For more information on basis, see Publica-tion 551.

CAUTION!

Do not deduct state and local salestaxes imposed on the buyer that youmust collect and pay over to the state

or local government. Do not include thesetaxes in gross receipts or sales.

Self-employment tax. You can deduct one-half of your self-employment tax as a busi-ness expense in figuring your adjusted grossincome. This deduction only affects your in-come tax. It does not affect your net earningsfrom self-employment or your self-employ-ment tax.

To deduct the tax, enter on Form 1040,line 27, the amount shown on the “Deductionfor one-half of self-employment tax” line ofSchedule SE (Form 1040).

For more information on self-employmenttax, see Publication 533.

7.Insurance

Important ReminderHealth insurance deduction for the self-employed. For 2000 and 2001, this de-duction remains 60% of the amount you paidfor health insurance for yourself and yourfamily. After 2001, the deduction will in-crease. See Health Insurance Deduction forthe Self-Employed, later.

IntroductionYou generally can deduct the ordinary andnecessary cost of insurance as a businessexpense if it is for your trade, business, orprofession. However, you may have to capi-talize certain insurance costs under the uni-form capitalization rules. For more informa-tion, see Capitalizing Premiums, later.


• Deductible premiums

• Nondeductible premiums

• Capitalizing premiums

• When to deduct premiums


Publication



� 547 Casualties, Disasters, and Thefts(Business and Nonbusiness)


� 1040 U.S. Individual Income Tax Return


Deductible PremiumsYou can generally deduct premiums you payfor the following kinds of insurance related toyour trade or business.

1) Fire, theft, flood, or similar insurance.

2) Credit insurance on losses from unpaiddebts.

3) Group hospitalization and medical insur-ance for employees, including long-termcare insurance.

a) If a partnership pays accident andhealth insurance premiums for itspartners, it generally can deductthem as guaranteed paymentsmade to the partners.

b) If an S corporation pays accidentand health insurance premiums forits 2% shareholder-employees, itgenerally can deduct them.

For more details, see Accident andHealth Benefits in chapter 2 of Publica-tion 15–B, Employer's Tax Guide toFringe Benefits.

4) Liability insurance.

5) Malpractice insurance that covers yourpersonal liability for professionalnegligence resulting in injury or damageto patients or clients.

6) Workers' compensation insurance set bystate law that covers any claims forbodily injuries or job-related diseasessuffered by employees in your business,regardless of fault.

a) If a partnership pays workers' com-pensation premiums for its partners,it generally can deduct theseamounts as guaranteed paymentsto the partners.

b) If an S corporation pays the work-ers' compensation premiums for its2% shareholder-employees, it gen-erally can deduct these amounts.

7) Contributions to a state unemploymentinsurance fund are deductible as taxesif they are considered taxes under statelaw.

8) Overhead insurance that pays you forbusiness overhead expenses you haveduring long periods of disability causedby your injury or sickness.

9) Car and other vehicle insurance thatcovers vehicles used in your business forliability, damages, and other losses. Ifyou operate a vehicle partly for personaluse, you can deduct only the part of yourinsurance premiums that applies to thebusiness use of the vehicle. If you usethe standard mileage rate to figure yourcar expenses, you cannot deduct anycar insurance premiums.

10) Life insurance covering your officers andemployees if you are not directly or indi-rectly a beneficiary under the contract.

11) Use and occupancy and business inter-ruption insurance that pays you for lostprofits if your business is shut down dueto a fire or other cause.

Health InsuranceDeduction for theSelf-Employed You can deduct 60% of the amount paidduring 2000 for medical insurance and qual-ified long-term care insurance for yourself andyour family if you are one of the following.

• A self-employed individual.

• A general partner (or a limited partnerreceiving guaranteed payments) in apartnership.

• A shareholder owning more than 2% ofthe outstanding stock of an S corporation.

You are allowed this deduction whether youpaid the premiums yourself or your partner-ship or S corporation paid them and you in-cluded the premium amounts in your grossincome. Take this deduction on line 28 ofForm 1040.

Deductible percentage increases after2001. For tax years beginning after 2001, thedeductible percentage of your health insur-ance premiums gradually increases. The in-creases are shown in the following table.

Long-term care insurance. If you pay thepremiums on a qualified long-term care in-surance contract for yourself, your spouse,or your dependents, you can include thosepremiums when figuring your deduction. But,

For Tax Years Beginning in:Deductible

Percentage

2000 and 2001 ................................... 60%2002 .................................................... 70%After 2002 ........................................... 100%

Chapter 7 Insurance

for each person covered, you can include onlythe smaller of the following amounts.

1) The amount you pay for that person.

2) The amount shown below. (Use theperson's age at the end of the tax year.)

a) Age 40 or younger — $220

b) Age 41 to 50 — $410

c) Age 51 to 60 — $820

d) Age 61 to 70 — $2,200

e) Age 71 and older — $2,750

Long-term care insurance contract. Along-term care insurance contract is any in-surance contract that only provides coverageof qualified long-term care services. Thecontract must meet all the following require-ments.

• It must be guaranteed renewable.

• It must provide that refunds, other thanrefunds on the death of the insured orcomplete surrender or cancellation of thecontract, and dividends under the con-tract may be used only to reduce futurepremiums or increase future benefits.

• It must not provide for a cash surrendervalue or other money that can be paid,assigned, pledged as collateral for a loan,or borrowed.

• It generally must not pay or reimburseexpenses incurred for services or itemsthat would be reimbursed under Medi-care, except where Medicare is a sec-ondary payer or the contract makes perdiem or other periodic payments withoutregard to expenses.

Qualified long-term care services.Qualified long-term care services are:

• Necessary diagnostic, preventive,therapeutic, curing, treating, mitigating,and rehabilitative services, and

• Maintenance or personal care services.

The services must be required by a chron-ically ill individual and prescribed by a li-censed health care practitioner.

Chronically ill individual. A chronicallyill individual is a person who has been certi-fied as one of the following.

• An individual who, for at least 90 days, isunable to perform at least two activitiesof daily living without substantial assist-ance due to loss of functional capacity.Activities of daily living are eating,toileting, transferring, bathing, dressing,and continence.

• An individual who requires substantialsupervision to be protected from threatsto health and safety due to severe cog-nitive impairment.

The certification must have been made by alicensed health care practitioner within theprevious 12 months.

Benefits received. For information onexcluding from gross income benefits you re-ceive from a long-term care contract, seePublication 525.

Limits. You cannot deduct more than yournet earnings from the trade or business inwhich the medical insurance plan or long-termcare insurance plan is established. If the

Table 7-1. Self-Employed Health Insurance DeductionWorksheet (Keep for your records.)

1)

2)

3)

4)

5)

6)

7)

8)

9)

10)

11)

12)

13)

14)

Enter total payments made during the tax year for health insuranceestablished under your business for yourself, your spouse, and yourdependents. (Do not include payments for any month you wereeligible to participate in a health plan subsidized by your or yourspouse’s employer. Also, do not include payments for qualifiedlong-term care insurance.)

Percentage used to figure deduction for 2000 .60

Multiply the amount on line 3 by the percentage on line 4

Enter your net profit and any other earned income* from the tradeor business under which the insurance plan is established. (If thebusiness is an S corporation, skip to line 13.)

Enter the total of all net profits from: line 31, Schedule C (Form1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F(Form 1040); or line 15a, Schedule K-1 (Form 1065); plus anyother income allocable to the profitable businesses. See theinstructions for Schedule SE (Form 1040). (Do not include anynet losses shown on these schedules.)

Divide line 6 by line 7

Multiply Form 1040, line 27, by the percentage on line 8

Subtract line 9 from line 6

Enter the amount, if any, from Form 1040, line 29, attributable tothe same trade or business in which the health insurance plan isestablished

Subtract line 11 from line 10

Enter your wages from an S corporation in which you are amore-than-2% shareholder and in which the health insurance planis established

Enter the amount from Form 2555, line 43, attributable to theamount entered on line 6 or 13 above, or the amount from Form2555-EZ, line 18, attributable to the amount entered on line 13above

Subtract line 14 from line 12 or 13, whichever applies

Compare the amounts on lines 5 and 15 above. Enter the smallerof the two amounts here and on Form 1040, line 28. (Do not includethis amount when figuring a medical expense deduction onSchedule A (Form 1040).)

*Earned income includes net earnings and gains from the sale, transfer, or licensing of property youcreated. It does not include capital gain income.

For coverage under a qualified long-term care insurance contract,enter for each person covered the lesser of:a)b)

Total payments made for that person during the year, or$220—if that person is age 40 or younger$410—if age 41 to 50$820—if age 51 to 60

$2,200—if age 61 to 70$2,750—if age 71 or older

(Do not include payments for any month you were eligible toparticipate in a long-term care insurance plan subsidized by youror your spouse’s employer.) If more than one person is covered,figure separately the amount to enter for each person. Then enterthe total of those amounts

Add the total of lines 1 and 2

15)

16)

1)

2)

3)

4)

5)

6)

7)

8)

9)

10)

11)

12)

13)

14)

15)

16)

business in which the insurance plan is es-tablished is an S corporation, you cannot de-duct more than your wages from the S cor-poration.

Other coverage. You cannot take thededuction for any month you were eligible toparticipate in any employer (including yourspouse's) subsidized health plan at any timeduring that month. This rule is applied sepa-rately to plans that provide long-term care in-surance and plans that do not provide long-term care insurance. However, any medicalinsurance payments not deductible on line 28of Form 1040 can be included as part of yourmedical expenses on Schedule A (Form1040) if you itemize your deductions.

Effect on self-employment tax. Do notsubtract the health insurance deduction whenfiguring net earnings for your self-employmenttax.

Effect on itemized deductions. Subtractthe health insurance deduction from yourmedical insurance when figuring your medicalexpenses on Schedule A (Form 1040) if youitemize your deductions.

How to figure the deduction. Generally,you can use the worksheet in the Form 1040instructions to figure your deduction. How-ever, if any of the following apply, you mustuse the worksheet in this chapter.

Chapter 7 Insurance

• You have more than one source of in-come subject to self-employment tax.

• You file Form 2555 or Form 2555–EZ(relating to foreign earned income).

• You are using amounts paid for long-termcare insurance to figure the deduction.

More than one health plan and busi-ness. If you have more than one health planduring the year and each plan is establishedunder a different business, you must useseparate worksheets (Table 7–1) to figureeach plan's net earnings limit. Include thepremium you paid under each plan on line 1of that separate worksheet and your net profit(or wages) from that business on line 6 (orline 13). For a plan that provides long-termcare insurance, enter the premiums paid online 2 instead, but the total of the amountsentered for each person on line 2 of allworksheets cannot be more than the appro-priate limit shown on line 2 for that person.

NondeductiblePremiumsYou cannot deduct premiums on the followingkinds of insurance.

1) Self-insurance reserve funds. Youcannot deduct amounts credited to a re-serve you set up for self-insurance. Thisapplies even if you cannot get businessinsurance coverage for certain businessrisks. However, your actual losses maybe deductible. See Publication 547.

2) Loss of earnings. You cannot deductpremiums for a policy that pays for yourlost earnings due to sickness or disabil-ity. However, see the discussion onoverhead insurance, item (8), underDeductible Premiums, earlier.

3) Certain life insurance and annuities.For contracts issued before June 9,1997, you cannot deduct the premiumson a life insurance policy covering your-self, an employee, or any person with afinancial interest in your business if youare directly or indirectly a beneficiary ofthe policy. You are included amongpossible beneficiaries of the policy if thepolicy owner is obligated to repay a loanfrom you using the proceeds of the pol-icy. A person has a financial interest inyour business if the person is an owneror part owner of the business or has lentmoney to the business.

For contracts issued after June 8,1997, you generally cannot deduct thepremiums on any life insurance policy,endowment contract, or annuity contractif you are directly or indirectly a benefi-ciary. The disallowance applies withoutregard to whom the policy covers.

Partners. If, as a partner in a part-nership, you take out an insurance policyon your own life and name your partnersas beneficiaries to induce them to retaintheir investments in the partnership, youare considered a beneficiary. You cannotdeduct the insurance premiums.

4) Insurance to secure a loan. If you takeout a policy on your life or on the life ofanother person with a financial interestin your business to get or protect a

business loan, you cannot deduct thepremiums as a business expense. Norcan you deduct the premiums as intereston business loans or as an expense offinancing loans. In the event of death,the proceeds of the policy are not taxedas income even if they are used to liqui-date the debt.

Capitalizing PremiumsUnder the uniform capitalization rules, youmust capitalize the direct costs and part of theindirect costs for production or resale activ-ities. Include these costs in the basis ofproperty you produce or acquire for resalerather than claiming them as a current de-duction. You recover the costs through de-preciation, amortization, or cost of goods soldwhen you use, sell, or otherwise dispose ofthe property.

Indirect costs include premiums for insur-ance on your plant or facility, machinery,equipment, materials, property produced, orproperty acquired for resale.

When the uniform capitalization rules ap-ply. You must use the uniform capitalizationrules if, in your trade or business or activitycarried on for profit, you do any of the fol-lowing.

• Produce real property or tangible per-sonal property for use in the business oractivity.

• Produce real property or tangible per-sonal property for sale to customers.

• Acquire property for resale. However, yougenerally do not have to use the uniformcapitalization rules for personal propertyacquired for resale if your average annualgross receipts are not more than$10,000,000 for the 3 prior tax years.

More information. For more information onthe uniform capitalization rules, see UniformCapitalization Rules in Publication 538 andthe regulations under Internal Revenue Codesection 263A.

When ToDeduct PremiumsYou can usually deduct insurance premiumsin the tax year to which they apply.

Cash method. If you use the cash methodof accounting, you must generally deduct in-surance premiums in the tax year in whichyou actually pay them, even if you incurredthem in an earlier year.

Accrual method. If you use an accrualmethod of accounting, you cannot deduct in-surance premiums before the tax year inwhich you incur a liability for them, even if youpaid them in an earlier year. In addition, youcannot deduct insurance premiums before thetax year in which you actually pay them (un-less the exception for recurring items applies).For more information about accrual methodsof accounting, see chapter 1. For informationabout the exception for recurring items, seePublication 538.

Cash or accrual method prepayments.You cannot deduct in one year the entirepremium for an insurance policy that coversmore than one year. You can deduct only thepart of the premium that applies to that year.For each later tax year, you can deduct thepart that applies to that tax year. This applieswhether you use the cash or accrual method.

Example. You operate a business andfile your returns on a calendar-year basis.You bought a fire insurance policy on yourbuilding effective October 1, 2000, and paida premium of $1,200 for 2 years of coverage.On your 2000 return, you can deduct only thepart of the total premium that applies to the3 months of coverage in 2000. For 2001 and2002, you can deduct the part of the premiumthat applies to each of those years. Since thetotal policy premium is $1,200 for 2 years, theyearly rate is $600 and the monthly rate is$50. For the 3-month period in 2000, you candeduct $150; for 2001, you can deduct $600;and for the 9-month period in 2002, you candeduct $450.

If you use the cash method of accountingand you pay the $1,200 premium in January2001, you cannot deduct any amount on your2000 return. However, you can deduct $750(the $150 that applies to 2000 plus the $600that applies to 2001) on your return for 2001.

Dividends received. If you receive dividendsfrom business insurance and you deductedthe premiums in prior years, at least part ofthe dividends generally are income. For moreinformation, see Recoveries in Publication525.

8.Costs YouCan Deductor Capitalize

IntroductionThis chapter discusses two ways of treatingcertain costs—deduction or capitalization.

You generally deduct a cost as a currentbusiness expense by subtracting it from yourincome in either the year you incur it or theyear you pay it.

If you capitalize a cost, you may be ableto recover it over a period of years throughperiodic deductions for amortization, de-pletion, or depreciation. When you capitalizea cost, you add it to the basis of property towhich it relates.

Except for exploration costs for mineraldeposits, a partnership, corporation, estate,or trust makes the choice to deduct or capi-talize the costs discussed in this chapter.Each individual partner, shareholder, or ben-eficiary chooses whether to deduct or capi-talize exploration costs.

CAUTION!

You may be subject to the alternativeminimum tax (AMT) if you deduct anyof the expenses discussed in this

Chapter 8 Costs You Can Deduct or Capitalize

chapter, other than carrying charges and thecosts of removing architectural barriers.

For more information on alternative mini-mum tax, see the instructions for one of thefollowing.

• Form 6251, Alternative MinimumTax—Individuals

• Form 4626, Alternative MinimumTax—Corporations


• Carrying charges

• Research and experimental costs

• Intangible drilling costs

• Exploration costs

• Development costs

• Circulation costs

• Costs of removing a retired asset

• Costs of removing barriers to the disabledand the elderly


Publication

� 544 Sales and Other Dispositions ofAssets


� 3468 Investment Credit

� 8826 Disabled Access Credit


Carrying ChargesCarrying charges include the taxes and inter-est you pay to carry or develop real propertyor to carry, transport, or install personalproperty. Certain carrying charges must becapitalized under the uniform capitalizationrules. (For information on capitalization of in-terest, see chapter 5.) You can choose tocapitalize carrying charges not subject to theuniform capitalization rules, but only if theyare otherwise deductible.

You can choose to capitalize carryingcharges separately for each project you haveand for each type of carrying charge. For un-improved and unproductive real property,your choice is good for only 1 year. You mustdecide whether to capitalize carrying chargeseach year the property remains unimprovedand unproductive. For other property, yourchoice to capitalize carrying charges remainsin effect until construction, development, orinstallation is completed (or, for personalproperty, the date you first use it, if later).

How to make the choice. To make thechoice to capitalize a carrying charge, writea statement saying which charges youchoose to capitalize. Attach it to your originaltax return for the year the choice is to be ef-fective. However, if you timely filed your re-turn for the year without making the choice,you can still make the choice by filing anamended return within 6 months of the due

IF you . . . THEN . . .

Deduct research and experimental costs asa current business expense,

Do not deduct research and experimentalcosts as a current business expense,

Deduct all research and experimental costsfor the year of choice and all later years.

Amortize them over at least 60 months,starting with the month you first receive aneconomic benefit from the research.

date of the return (excluding extensions). At-tach the statement to the amended return andwrite “FILED PURSUANT TO SECTION301.9100–2” on the statement. File theamended return at the same address you filedthe original return.

Research andExperimental CostsThe costs of research and experimentationare generally capital expenses. However, youcan choose to deduct these costs as a currentbusiness expense.

For information on amortizing these costs,see Research and Experimental Costs inchapter 9.

Research and experimental costs defined.Research and experimental costs are rea-sonable costs you incur in your trade orbusiness for activities intended to provide in-formation to help eliminate uncertainty aboutthe development or improvement of a prod-uct. Uncertainty exists if the informationavailable to you does not establish how todevelop or improve a product or the appro-priate design of a product. Whether costsqualify as research and experimental costsdepends on the nature of the activity to whichthe costs relate. Neither the nature of theproduct or improvement being developed northe level of technological advancement mat-ters when making this determination.

The costs of obtaining a patent, includingattorneys' fees in making and perfecting apatent application, are research and exper-imental costs.

Product. The term “product” includes anyof the following.

• Formula.

• Invention.

• Patent.

• Pilot model.

• Process.

• Technique.

• Similar property.

It also includes products used by you in yourtrade or business or held for sale, lease, orlicense.

Costs not included. Research and ex-perimental costs do not include expenses forany of the following.

• Advertising or promotions.

• Consumer surveys.

• Efficiency surveys.

• Management studies.

• Quality control testing.

• Research in connection with literary, his-torical, or similar projects.

• The acquisition of another's patent,model, production, or process.

When and how to choose. Generally, youcan make the choice to deduct these costsonly in the first year you incur research andexperimental costs.

You choose to deduct research and ex-perimental costs, rather than capitalize them,by deducting them on your tax return for theyear in which you first have research andexperimental costs.

IntangibleDrilling CostsThe costs of developing oil, gas, orgeothermal wells are ordinarily capital ex-penses. You can usually recover themthrough depreciation or depletion. However,you can choose to deduct intangible drillingcosts as a current business expense. Theseare certain drilling and development costs forwells in the United States in which you holdan operating or working interest. You candeduct only costs for drilling or preparing awell for the production of oil, gas, geothermalsteam, or geothermal hot water.

You can choose to deduct only the costsof items with no salvage value. These includewages, fuel, repairs, hauling, and suppliesrelated to drilling wells and preparing them forproduction. Your cost for any drilling or de-velopment work done by contractors underany form of contract is also an intangibledrilling and development cost. However, seeAmounts paid to a contractor that must becapitalized, next.

You can also choose to deduct the costof drilling bore holes to determine the locationand delineation of offshore hydrocarbon de-posits if the shaft is capable of conductinghydrocarbons to the surface on completion.It does not matter whether there is any intentto produce hydrocarbons.

If you do not choose to deduct your in-tangible drilling and development costs cur-rently, you can choose to deduct them overthe 60-month period beginning with the monththey were paid or incurred.

Amounts paid to a contractor that mustbe capitalized. Amounts paid to a contractormust be capitalized if they are either of thefollowing.

• Amounts properly allocable to the costof depreciable property.

• Amounts paid only out of production orproceeds from production if the amountis depletable income to the recipient.

How to make the choice. You choose todeduct intangible drilling and developmentcosts currently by taking the deduction onyour income tax return for the first tax yearyou have eligible costs. No formal statement


is required. If you file Form Schedule C (Form1040), enter these costs under “Other ex-penses.”

Energy credit for costs of geothermalwells. If you capitalize the drilling and de-velopment costs of geothermal wells that youplace in service during the tax year, you maybe able to claim a business energy credit.See Form 3468 for more information.

Nonproductive well. If you capitalize yourintangible drilling and development costs, youhave another option if the well is nonproduc-tive. You can deduct the intangible drillingand development costs of the nonproductivewell as an ordinary loss. You must indicateand clearly state your choice on your tax re-turn for the year the well is completed. Oncemade, the choice for oil and gas wells isbinding for all later years. You can revokeyour choice for a geothermal well by filing anamended return that does not claim the loss.

Costs incurred outside the United States.You cannot deduct in one year all the intan-gible drilling and development costs paid orincurred for an oil, gas, or geothermal welllocated outside the United States. However,you can choose to include the costs in theadjusted basis of the well to figure depletion.If you do not make this choice, you can de-duct the costs over the 10-year period begin-ning with the tax year in which you paid orincurred them. These rules do not apply to anonproductive well.

Exploration CostsThe costs of determining the existence, lo-cation, extent, or quality of any mineral de-posit are ordinarily capital expenses if thecosts lead to the development of a mine. Yourecover these costs through depletion as themineral is removed from the ground. How-ever, you can choose to deduct domestic ex-ploration costs paid or incurred before thedevelopment stage began (except those foroil, gas, and geothermal wells).

How to make the choice. You choose todeduct exploration costs by taking the de-duction on your income tax return or anamended income tax return for the tax yearyou paid or incurred the costs. Your returnmust adequately describe and identify eachproperty or mine, and clearly state how muchis being deducted for each one. The choiceapplies to the tax year you make this choiceand all later tax years.

Partnerships. Each partner, not thepartnership, chooses whether to capitalize orto deduct that partner's share of explorationcosts.

Reduced corporate deductions for explo-ration costs. A corporation (other than anS corporation) can deduct only 70% of itsdomestic exploration costs. It must capitalizethe remaining 30% and amortize them overthe 60-month period starting with the monththe exploration costs are paid or incurred. The30% the corporation capitalizes cannot beadded to its basis in the property for purposesof figuring cost depletion. However, theamount amortized is treated as additionaldepreciation and is subject to recapture asordinary income on a disposition of the prop-erty. See Section 1250 Property under De-

preciation Recapture in chapter 3 of Publica-tion 544.

These rules also apply to the deductionof development costs for corporations. SeeDevelopment Costs, later.

Recapture of exploration expenses. Whenyour mine reaches the producing stage, youmust recapture any exploration costs youchose to deduct. Use either of the followingmethods.

Method 1—Include the deducted costs ingross income for the tax year the minereaches the producing stage. Your choicemust be clearly indicated on the return.Increase your adjusted basis in the mineby the amount included in income. Gener-ally, you must choose this recapturemethod by the due date (including exten-sions) of your return. However, if youtimely filed your return for the year withoutmaking the choice, you can still make thechoice by filing an amended return within6 months of the due date of the return(excluding extensions). Make the choiceon your amended return and write “FILEDPURSUANT TO SECTION 301.9100–2”on the form where you are including theincome. File the amended return at thesame address you filed the original return.

Method 2—Do not claim any depletion de-duction for the tax year the mine reachesthe producing stage and any later tax yearsuntil the amount of depletion you wouldhave deducted equals the amount of de-ducted exploration costs.

You also must recapture deducted explo-ration costs if you receive a bonus or royaltyfrom mine property before it reaches theproducing stage. Do not claim any depletiondeduction for the tax year you receive thebonus or royalty and any later tax years, untilthe amount of depletion you would have de-ducted equals the amount of your deductedexploration costs.

If you dispose of the mine before yourdeducted exploration costs have been fullyrecaptured, recapture the balance by treatingall or part of your gain as ordinary income.

Foreign exploration costs. If you pay orincur exploration costs for a mine or othernatural deposit located outside the UnitedStates, you cannot deduct all the costs in thecurrent year. You can choose to include thecosts (other than for an oil, gas, or geothermalwell) in the adjusted basis of the mineralproperty to figure cost depletion. (Cost de-pletion is discussed in chapter 10.) If you donot make this choice, you must deduct thecosts over the 10-year period beginning withthe tax year in which you pay or incur them.These rules also apply to foreign develop-ment costs.

Development CostsYou can deduct costs paid or incurred duringthe tax year for developing a mine or anyother natural deposit (other than an oil or gaswell) located in the United States. Thesecosts must be paid or incurred after the dis-covery of ores or minerals in commerciallymarketable quantities. Development costs in-clude those incurred for you by a contractor.Also, development costs include depreciationon improvements used in the development

of ores or minerals. They do not include costsof depreciable property.

Instead of deducting development costs inthe year paid or incurred, you can choose totreat them as deferred expenses and deductthem ratably as the units of produced oresor minerals related to the expenses are sold.This choice applies each tax year to ex-penses paid or incurred in that year. Oncemade, the choice is binding for the year andcannot be revoked for any reason.

How to make the choice. The choice todeduct development costs ratably as the oresor minerals are sold must be made for eachmine or other natural deposit by a clear indi-cation on your return or by a statement filedwith the IRS office where you file your return.Generally, you must make the choice by thedue date of the return (including extensions).However, if you timely filed your return for theyear without making the choice, you can stillmake the choice by filing an amended returnwithin 6 months of the due date of the return(excluding extensions). Clearly indicate thechoice on your amended return and write“FILED PURSUANT TO SECTION301.9100–2.” File the amended return at thesame address you filed the original return.

Foreign development costs. The rules dis-cussed earlier for foreign exploration costsapply to foreign development costs.

Reduced corporate deductions for devel-opment costs. The rules discussed earlierfor reduced corporate deductions for explo-ration costs also apply to corporate de-ductions for development costs.

Circulation CostsA publisher can deduct as a business ex-pense the costs of establishing, maintaining,or increasing the circulation of a newspaper,magazine, or other periodical. For example,a publisher can deduct the cost of hiring extraemployees for a limited time to get new sub-scriptions through telephone calls. Circulationcosts are deductible even if they normallywould be capitalized.

This rule does not apply to the followingcosts that must be capitalized.

• The purchase of land or depreciableproperty.

• The acquisition of circulation through thepurchase of any part of the business ofanother publisher of a newspaper, mag-azine, or other periodical, including thepurchase of another publisher's circu-lation list.

Other treatment of circulation costs. If apublisher does not want to currently deductcirculation costs, the publisher can chooseone of the following ways to recover thesecosts.

• Capitalize all circulation costs that areproperly chargeable to a capital account.

• Amortize circulation costs over the 3-yearperiod beginning with the tax year theywere paid or incurred.

How to make the choice. You choose tocapitalize circulation costs by attaching astatement to your return for the first tax yearthe choice applies. Your choice is binding for


the year it is made and for all later years,unless you get IRS approval to revoke it.

Costs of Removing aRetired AssetIf you retire and remove a depreciable assetin connection with the installation or pro-duction of a replacement asset, you can de-duct the costs of removing the retired asset.However, if you replace a component (part)of a depreciable asset, capitalize the removalcosts if the replacement is an improvementand deduct the costs if the replacement is arepair.

Costs ofRemoving Barriersto the Disabledand the ElderlyThe cost of an improvement to a businessasset is normally a capital expense. However,you can choose to deduct the costs of makinga facility or public transportation vehicle moreaccessible to and usable by those who aredisabled or elderly. The facility or vehiclemust be owned or leased by you for use inconnection with your trade or business.

A facility is all or any part of buildings,structures, equipment, roads, walks, parkinglots, or similar real or personal property. Apublic transportation vehicle is a vehicle, suchas a bus or railroad car, that provides trans-portation service to the public (including ser-vice for your customers, even if you are notin the business of providing transportationservices).

You cannot deduct any costs that you paidor incurred to completely renovate or build anew facility or public transportation vehicle,or to replace depreciable property in thenormal course of business.

Deduction limit. The most you can deductas a cost of removing barriers to the disabledand the elderly for any tax year is $15,000.However, you can add any costs over thislimit to the basis of the property and depreci-ate them.

Partners and partnerships. The $15,000limit applies to a partnership and also to eachpartner in the partnership. A partner can di-vide the $15,000 limit in any manner amongthe partner's individually incurred costs andthe partner's distributive share of partnershipcosts. If the partner cannot deduct the entireshare of partnership costs, the partnershipcan add any costs not deducted back to thebasis of the improved property.

A partnership must be able to show thatany amount added back to basis was notdeducted by the partner and that it was overa partner's $15,000 limit (as determined bythe partner). If the partnership cannot showthis, it is presumed that the partner was ableto deduct the distributive shares of the part-nership's costs in full.

Example. John Duke's distributive shareof ABC partnership's deductible expenses forthe removal of architectural barriers was$14,000. John had $12,000 of similar ex-

penses in his sole proprietorship. He choseto deduct $7,000 of them. John allocated theremaining $8,000 of the $15,000 limit to hisshare of ABC's expenses. John can capital-ize the excess $5,000 of his own expenses.Also, if ABC can show that John could notdeduct $6,000 of his share of the partner-ship's expenses because of how John appliedthe limit, ABC can add $6,000 to the basis ofits property.

Qualification standards. You must meet thefollowing specific standards for improved ac-cess for the disabled or the elderly to deductyour costs as a current expense.

Grading. The ground must be graded tothe level of a normal entrance to make thefacility accessible to people with physicaldisabilities.

Walks.

1) A public walk must be at least 48 incheswide and cannot slope more than 5%.A fairly long walk of maximum or nearmaximum steepness must have levelareas at regular intervals. A walk ordriveway must have a nonslip surface.

2) A walk must have a continuing commonsurface and must not have steps orsudden changes in level.

3) Where a walk crosses another walk, adriveway, or a parking lot, they mustblend to a common level. However, thisdoes not require the removal of curbsthat are a safety feature for those withdisabilities, especially blindness.

4) A sloping walk must have a level plat-form at the top and at the bottom. If adoor swings out onto the platform at thetop or bottom of the walk, the platformmust be at least 5 feet deep and 5 feetwide. If a door does not swing onto theplatform, the platform must be at least 3feet deep and 5 feet wide. The platformmust extend at least 1 foot past theopening side of any doorway.

Parking lots.

1) At least one parking space close to afacility must be set aside and marked foruse by persons with disabilities.

2) A parking space must be open on oneside to allow room for a person in awheelchair or on braces or crutches toget in and out of a car onto a level sur-face suitable for wheeling and walking.

3) A parking space marked for use by per-sons with disabilities, when placed be-tween two regular diagonal or head-onparking spaces, must be at least 12 feetwide.

4) A parking space must be located so thata person in a wheelchair or on bracesor crutches does not have to go behindparked cars.

Ramps.

1) A ramp must not rise more than 1 inchin each foot of length.

2) A ramp must have at least one handrailthat is 32 inches high, measured fromthe surface of the ramp. The handrailmust be smooth and extend at least 1foot past the top and bottom of the ramp.However, this does mean that a handrail

extension which is itself a hazard is re-quired.

3) A ramp must have a nonslip surface.

4) A ramp must have a level platform at thetop and at the bottom. If a door swingsout onto the platform, the platform mustbe at least 5 feet deep and 5 feet wide.If a door does not swing onto the plat-form, the platform must be at least 3 feetdeep and 5 feet wide. The platform mustextend at least 1 foot past the openingside of any doorway.

5) A ramp must have level platforms nofarther than 30 feet apart and at any turn.

6) A curb ramp with a nonslip surface mustbe provided at an intersection. The curbramp must not be less than 4 feet wideand must not rise more than 1 inch ineach foot of length. The two surfacesmust blend smoothly.

Entrances. A building must have at leastone main entrance a person in a wheelchaircan use. The entrance must be on a levelaccessible to an elevator.

Doors and doorways.

1) A door must have a clear opening of atleast 32 inches and must be operableby a single effort.

2) The floor on the inside and outside of adoorway must be level for at least 5 feetfrom the door in the direction the doorswings and must extend at least 1 footpast the opening side of the doorway.

3) There must not be any sharp slopes orsudden changes in level at a doorway.The threshold must be flush with thefloor. The door closer must be selected,placed, and set so as not to impair theuse of the door by persons with disabili-ties.

Stairs.

1) Stairsteps must have round nosing ofbetween 1 and 11/2 inch radius.

2) Stairs must have a handrail 32 incheshigh, measured from the tread at theface of the riser.

3) Stairs must have at least one handrailthat extends at least 18 inches past thetop step and the bottom step. But thisdoes not mean that a handrail extensionwhich is itself a hazard is required.

4) Each step must not be more than 7inches high.

Floors.

1) Floors must have a nonslip surface.

2) Floors on each story of a building mustbe on the same level or must be con-nected by a ramp of the type discussedpreviously.

Toilet rooms.

1) A toilet room must have enough spacefor persons in wheelchairs to movearound.

2) A toilet room must have at least one toi-let stall that:

a) Is at least 36 inches wide,

b) Is at least 56 inches deep,


c) Has a door, if any, that is at least32 inches wide and swings out,

d) Has handrails on each side that are33 inches high and parallel to thefloor, 11 / 2 inches in outside diam-eter, 11 / 2 inches away from the wall,and fastened securely at the endsand center, and

e) Has a toilet with a seat 19 to 20inches from the finished floor.

3) A toilet room must have, in addition toor instead of the toilet stall described in(2), at least one toilet stall that:

a) Is at least 66 inches wide,

b) Is at least 60 inches deep,

c) Has a door, if any, that is at least32 inches wide and swings out,

d) Has a handrail on one side, 33inches high and parallel to the floor,11 / 2 inches in outside diameter, 11 / 2inches away from the wall, andfastened securely at the ends andcenter, and

e) Has a toilet with a seat 19 to 20inches from the finished floor witha centerline 18 inches from the sidewall on which the handrail is lo-cated.

4) A toilet room must have sinks with nar-row aprons. Drain pipes and hot waterpipes under a sink must be covered orinsulated.

5) A mirror and a shelf above a sink mustnot be higher than 40 inches above thefloor, measured from the top of the shelfand the bottom of the mirror.

6) A toilet room for men must have wall-mounted urinals with the opening of thebasin 15 to 19 inches from the finishedfloor or floor-mounted urinals that arelevel with the main floor.

7) Towel racks, towel dispensers, and otherdispensers and disposal units must notbe mounted higher than 40 inches fromthe floor.

Water fountains.

1) A water fountain and a cooler must haveup-front spouts and controls.

2) A water fountain and a cooler must behand-operated or hand-and-foot-operated.

3) A water fountain mounted on the sideof a floor-mounted cooler must not bemore than 30 inches above the floor.

4) A wall-mounted, hand-operated watercooler must be mounted with the basin36 inches from the floor.

5) A water fountain must not be fully re-cessed and must not be set into analcove unless the alcove is at least 36inches wide.

Public telephones.

1) A public telephone must be placed sothat the dial and the headset can bereached by a person in a wheelchair.

2) A public telephone must be equipped fora person who is hearing impaired and itmust be identified as such with in-structions for its use.

3) Coin slots of public telephones must notbe more than 48 inches from the floor.

Elevators.

1) An elevator must be accessible to, andusable by, persons with disabilities andthe elderly on the levels they use to enterthe building and all levels and areasnormally used.

2) Cab size must measure at least 54 by68 inches to allow for turning a wheel-chair.

3) Door clear opening width must be atleast 32 inches.

4) All controls needed must be within 48 to54 inches from the cab floor. Thesecontrols must be usable by a person witha visual impairment and must be iden-tifiable by touch.

Controls. Switches and controls for light,heat, ventilation, windows, draperies, firealarms, and all similar controls needed orused often must be placed within the reachof a person in a wheelchair. These switchesand controls must not be higher than 48inches from the floor.

Identification.

1) Raised letters or numbers must be usedto identify rooms and offices. Theseidentification marks must be placed onthe wall to the right or left of the door ata height of 54 to 66 inches above thefinished floor.

2) A door that might prove dangerous ifused by a visually impaired person, suchas a door leading to a loading platform,boiler room, stage, or fire escape, mustbe identifiable by touch.

Warning signals.

1) An audible warning signal must be ac-companied by a simultaneous visualsignal for the benefit of those who arehearing impaired.

2) A visual warning signal must be accom-panied by a simultaneous audible signalfor the benefit of persons who are visu-ally impaired.

Hazards. Hanging signs, ceiling lights,and similar objects and fixtures must be atleast 7 feet above the floor.

International accessibility symbol. Theinternational accessibility symbol must bedisplayed on routes to a wheelchair-accessible entrance to a facility, at the en-trance itself, and at wheelchair-accessibleentrances to public transportation vehicles.

Rail facilities.

1) A rail facility must have a fare controlarea with at least one entrance with aclear opening at least 36 inches wide.

2) A boarding platform edge bordering adrop-off or other dangerous conditionmust be marked with a strip of floor ma-terial different in color and texture fromthe rest of the floor surface. The gapbetween the boarding platform and ve-hicle doorway must be as small as pos-sible.

Buses.

1) A bus must have a mechanism such asa lift or ramp to enter the bus andenough clearance to let a wheelchairuser reach a secure location.

2) The bus must have a wheelchair-securing device. However, this does notmean that a wheelchair-securing devicethat is itself a barrier or hazard is re-quired.

3) The vertical distance from a curb or fromstreet level to the first front doorstepmust not be more than 8 inches. Eachfront doorstep after the first step up fromthe curb or street level must also not bemore than 8 inches high. The steps atthe front and rear doors must be at least12 inches deep.

4) The bus must have clear signs that indi-cate that seats in the front of the bus arepriority seats for persons who have adisability or are elderly. The signs mustencourage other passengers to makethese seats available to those who havepriority.

5) Handrails and stanchions must be pro-vided in the entrance to the bus so thatpassengers who have a disability or areelderly can grasp them from outside thebus and use them while boarding andpaying the fare. This system must in-clude a rail across the front of the businterior that passengers can lean againstwhile paying fares. Overhead handrailsmust be continuous except for a gap atthe rear doorway.

6) Floors and steps must have nonslip sur-faces. Step edges must have a band ofbright contrasting color running the fullwidth of the step.

7) A stepwell next to the driver must have,when the door is open, at least 2 foot-candles of light measured on the step


tread. Other stepwells must have, at alltimes, at least 2 foot-candles of lightmeasured on the step tread.

8) The doorways of the bus must haveoutside lighting that provides at least 1foot-candle of light on the street surfacefor a distance of 3 feet from the bottomstep edge. This lighting must be belowwindow level and must be shielded fromthe eyes of entering and exiting pas-sengers.

9) The fare box must be located as far for-ward as practical and must not blocktraffic in the vestibule.

Rapid and light rail vehicles.

1) Passenger doorways on the vehiclesides must have clear openings at least32 inches wide.

2) Audible or visual warning signals mustbe provided to alert passengers of clos-ing doors.

3) Handrails and stanchions must permitsafe boarding, moving around, sittingand standing assistance, and getting offby persons who have a disability or areelderly. On a level-entry vehicle,handrails, stanchions, and seats mustbe located to allow a wheelchair user toenter the vehicle and position thewheelchair in a location that does notblock the movement of other passen-gers. On a vehicle with steps that mustbe used in boarding, handrails andstanchions must be provided in the en-trance so that persons who have a dis-ability or are elderly can grasp them anduse them from outside the vehicle whileboarding.

4) Floors must have nonslip surfaces. Stepedges on a light rail vehicle must havea band of bright contrasting color runningthe full width of the step.

5) A stepwell next to the driver must have,when the door is open, at least 2 foot-candles of light measured on the steptread. Other stepwells must have, at alltimes, at least 2 foot-candles of lightmeasured on the step tread.

6) Doorways on a light rail vehicle musthave outside lighting that provides atleast 1 foot-candle of light on the streetsurface for a distance of 3 feet from thebottom step edge. This lighting must bebelow window level and must beshielded from the eyes of entering andexiting passengers.

Other barrier removals. To be deduct-ible, expenses of removing any barrier notcovered by the above standards must meetall three of the following tests.

1) The removed barrier must be a sub-stantial barrier to access or use of a fa-cility or public transportation vehicle bypersons who have a disability or are el-derly.

2) The removed barrier must have been abarrier for at least one major group ofpersons who have a disability or are el-derly (such as people who are blind,deaf, or wheelchair users).

3) The barrier must be removed withoutcreating any new barrier that significantlyimpairs access to or use of the facilityor vehicle by a major group of personswho have a disability or are elderly.

How to make the choice. If you choose todeduct your costs for removing barriers to thedisabled or the elderly, claim the deductionon your income tax return (partnership returnfor partnerships) for the tax year the ex-penses were paid or incurred. Identify thededuction as a separate item. The choiceapplies to all the qualifying costs you haveduring the year, up to the $15,000 limit. If youmake this choice, you must maintain ade-quate records to support your deduction.

For your choice to be valid, you generallymust file your return by its due date, includingextensions. However, if you timely filed yourreturn for the year without making the choice,you can still make the choice by filing anamended return within 6 months of the duedate of the return (excluding extensions).Clearly indicate the choice on your amendedreturn and write “FILED PURSUANT TOSECTION 301.9100–2.” File the amendedreturn at the same address you filed the ori-ginal return. Your choice is irrevocable afterthe due date, including extensions, of yourreturn.

Disabled access credit. If you make yourbusiness accessible to persons with disabili-ties and your business is an eligible smallbusiness, you may be able to take the disa-bled access credit. If you make this choice,you must reduce the amount you deduct orcapitalize by the amount of the credit.

For more information, see Form 8826.

9.Amortization

IntroductionAmortization is a method of recovering (de-ducting) certain capital costs over a fixed pe-riod of time. It is similar to the straight linemethod of depreciation.


• How to deduct amortization

• Amortizing costs of section 197 intangi-bles

• Amortizing costs of going into business

• Amortizing reforestation costs

• Amortizing costs of pollution control fa-cilities

• Amortizing costs of research and exper-imentation

• Amortizing bond premium

• Amortizing the cost of getting a lease


Publication





� 3468 Investment Credit

� 4562 Depreciation and Amortization

� 6251 Alternative MinimumTax—Individuals


How To DeductAmortizationThe purpose of this section is to explain howyou deduct amortization.

Form 4562. You deduct amortization thatbegins during the current year by completingPart VI of Form 4562 and attaching it to yourcurrent year's return.

For later years, do not report your de-duction for amortization on Form 4562 unlessyou must file the form for another reason.You must file Form 4562 in any of the fol-lowing situations.

• You deduct amortization that begins thisyear.

• You claim depreciation on propertyplaced in service this year.

• You claim a section 179 deduction.

• You claim a deduction for any vehiclereported on a form other than ScheduleC (Form 1040) or Schedule C–EZ (Form1040).

• You claim depreciation on any vehicle orother listed property (regardless of whenit was placed in service).

• You claim depreciation on a return for acorporation (other than an S corporation).

Other forms to use. If you do not have tofile Form 4562, claim amortization directly onthe “Other expenses” line of Schedule C orF (Form 1040) or the “Other deductions” lineof Form 1065, Form 1120, Form 1120-A, orForm 1120-S. However, if you are amortizingreforestation costs, see Where to report underReforestation Costs.

Bond premium amortization. Do not useForm 4562 to report bond premium amorti-zation. How you report this amortization de-pends on when you got the bond. For infor-mation on how to report bond premiumamortization, see Publication 550.

Chapter 9 Amortization

Section 197IntangiblesYou must amortize over 15 years the capital-ized costs of “section 197 intangibles” youacquired after August 10, 1993. You mustamortize these costs if you hold the section197 intangibles in connection with your tradeor business or in an activity engaged in forprofit.

CAUTION!

You may not be able to amortizesection 197 intangibles acquired in atransaction that did not result in a

significant change in ownership or use. SeeAnti-Churning Rules, later.

Your amortization deduction each year isthe applicable part of the intangible's adjustedbasis (for purposes of determining gain), fig-ured by amortizing it ratably over 15 years(180 months). The 15-year period begins withthe later of:

• The month acquired, or

• The month the trade or business or ac-tivity engaged in for profit begins.

You cannot deduct amortization for the monthyou dispose of the intangible.

If you pay or incur an amount that in-creases the basis of an amortizable section197 intangible after the 15-year period begins,amortize it over the remainder of the 15-yearperiod beginning with the month the basis in-crease occurs.

You are not allowed any other depreci-ation or amortization deduction for an amor-tizable section 197 intangible.

Cost attributable to other property. Therules for section 197 intangibles do not applyto any amount that is taken into account indetermining the cost of property that is not asection 197 intangible. For example, if thecost of computer software is not separatelystated from the cost of hardware or othertangible property and you consistently treat itas part of the cost of the hardware or othertangible property, these rules do not apply.Similarly, none of the cost of acquiring realproperty held for the production of rental in-come is considered the cost of goodwill, goingconcern value, or any other section 197 in-tangible.

Section 197Intangibles DefinedThe following assets are section 197 intangi-bles.

1) Goodwill.

2) Going concern value.

3) Workforce in place.

4) Business books and records, operatingsystems, or any other information base,including lists or other information con-cerning current or prospective custom-ers.

5) A patent, copyright, formula, process,design, pattern, know-how, format, orsimilar item.

6) A customer-based intangible.

7) A supplier-based intangible.

8) Any item similar to items (3) through (7).

9) A license, permit, or other right grantedby a governmental unit or agency (in-cluding renewals).

10) A covenant not to compete entered intoin connection with the acquisition of aninterest in a trade or business.

11) A franchise, trademark, or trade name(including renewals).

12) A contract for the use of, or a term in-terest in, any item in this list.

CAUTION!

You cannot amortize any of the in-tangibles listed in items (1) through(8) that you created unless you cre-

ated them in connection with the acquisitionof assets constituting a trade or business ora substantial part of a trade or business.

Goodwill. This is the value of a trade orbusiness based on expected continued cus-tomer patronage due to its name, reputation,or any other factor.

Going concern value. This is the additionalvalue of a trade or business that attaches toproperty because the property is an integralpart of an ongoing business activity. It in-cludes value based on the ability of a busi-ness to continue to function and generate in-come even though there is a change inownership (but does not include any othersection 197 intangible). It also includes valuebased on the immediate use or availability ofan acquired trade or business, such as theuse of earnings during any period in which thebusiness would not otherwise be available oroperational.

Workforce in place, etc. This includes thecomposition of a workforce (for example, itsexperience, education, or training). It also in-cludes the terms and conditions of employ-ment, whether contractual or otherwise, andany other value placed on employees or anyof their attributes.

For example, you must amortize the partof the purchase price that is for the existenceof a highly skilled workforce. Also, you mustamortize the cost of acquiring an existingemployment contract or relationship with em-ployees or consultants.

Business books and records, etc. This in-cludes the intangible value of technical man-uals, training manuals or programs, data files,and accounting or inventory control systems.It also includes the cost of customer lists,subscription lists, insurance expirations, pa-tient or client files, and lists of newspaper,magazine, radio, and television advertisers.

Patents, copyrights, etc. This includespackage design, computer software, and anyinterest in a film, sound recording, videotape,book, or other similar property, except asdiscussed later under Assets That Are NotSection 197 Intangibles.

Customer-based intangible. This is thecomposition of market, market share, and anyother value resulting from the future provisionof goods or services because of relationshipswith customers in the ordinary course ofbusiness. For example, you must amortize

the part of the purchase price that is for thefollowing intangibles.

• A customer base.

• A circulation base.

• An undeveloped market or marketgrowth.

• Insurance in force.

• A mortgage servicing contract.

• An investment management contract.

• Any other relationship with customers in-volving the future provision of goods orservices.

Accounts receivable or other similar rightsto income for goods or services provided tocustomers before the acquisition of a tradeor business are not section 197 intangibles.

Supplier-based intangible. This is the valueresulting from the future acquisition, becauseof business relationships with suppliers, ofgoods or services that are used or sold by thebusiness.

For example, you must amortize the partof the purchase price that is for the followingintangibles.

• A favorable relationship with distributors(such as favorable shelf or display spaceat a retail outlet).

• A favorable credit rating.

• A favorable supply contract.

Government-granted license, permit, etc.This is any right granted by a governmentalunit or an agency or instrumentality of a gov-ernmental unit. For example, you mustamortize the capitalized costs of acquiring(including issuing or renewing) a liquor li-cense, a taxicab medallion or license, or atelevision or radio broadcasting license.

Covenant not to compete. A covenant notto compete (or similar arrangement) enteredinto in connection with the acquisition of aninterest in a trade or business, or a substantialportion of a trade or business, is a section 197intangible. An interest in a trade or businessincludes an interest in a partnership or a cor-poration engaged in a trade or business.

An arrangement that requires the formerowner to perform services (or to provideproperty or the use of property) is not similarto a covenant not to compete to the extent theamount paid under the arrangement repre-sents reasonable compensation for servicesrendered or for the property or use of theproperty provided.

Franchise, trademark, or trade name. Afranchise, trademark, or trade name is asection 197 intangible. You must amortize itspurchase or renewal costs, other than certaincontingent payments that you can deductcurrently. For information on currentlydeductible contingent payments, see Fran-chise, trademark, trade name under Miscel-laneous Expenses in chapter 13.

Contract for the use of, or a term interestin, a section 197 intangible. This includesany right under a license, contract, or otherarrangement providing for the use of anysection 197 intangible. It also includes anyterm interest in any section 197 intangible,whether the interest is outright or in trust.


Assets That Are NotSection 197 IntangiblesThe following assets are not section 197 in-tangibles.

1) Any interest in a corporation, partner-ship, trust, or estate.

2) Any interest under an existing futurescontract, foreign currency contract,notional principal contract, interest rateswap, or similar financial contract.

3) Any interest in land.

4) Most computer software. (See Computersoftware, later.)

5) Any of the following assets not acquiredin connection with the acquisition of atrade or business or a substantial partof a trade or business.

a) An interest in a film, sound record-ing, videotape, book, or similarproperty.

b) A right to receive tangible propertyor services under a contract or froma governmental agency.

c) An interest in a patent or copyright.

d) Certain rights that have a fixed du-ration or amount. (See Rights offixed duration or amount, later.)

6) An interest under either of the following.

a) An existing lease or sublease oftangible property.

b) A debt that was in existence whenthe interest was acquired.

7) A professional sports franchise or anyitem acquired in connection with thefranchise.

8) A right to service residential mortgagesunless the right is acquired in the acqui-sition of a trade or business or a sub-stantial part of a trade or business.

9) Certain transaction costs under a corpo-rate organization or reorganization inwhich any part of a gain or loss is notrecognized.

Intangible property that is not amortizableunder the rules for section 197 intangiblescan be depreciated if it has a determinableuseful life. You generally must use thestraight line method over its useful life. Forcertain intangibles, the depreciation period isspecified in the law and regulations. For ex-ample, the depreciation period for computersoftware that is not a section 197 intangibleis 36 months.

For more information on depreciating in-tangible property, see What Can Be Depreci-ated in chapter 1 of Publication 946.

Computer software. Section 197 intangiblesdo not include the following computer soft-ware.

1) Software that meets all the following re-quirements.

a) It is (or has been) readily availableto the general public on similarterms.

b) It is subject to a nonexclusive li-cense.

c) It has not been substantially modi-fied. This requirement is considered

met if the cost of all modificationsis not more than the greater of 25%of the price of the publicly availableunmodified software or $2,000.

2) Software that is not acquired in the ac-quisition of a trade or business or asubstantial part of a trade or business.

Computer software defined. Computersoftware includes all programs designed tocause a computer to perform a desired func-tion. It also includes any database or similaritem that is in the public domain and is inci-dental to the operation of qualifying software.

Rights of fixed duration or amount. Sec-tion 197 intangibles do not include any rightunder a contract or from a governmentalagency if the right is acquired in the ordinarycourse of a trade or business (or in an activityengaged in for profit) and either:

1) Has a fixed life of less than 15 years, or

2) Is of a fixed amount that, except for thesection 197 intangible rules, would berecovered under a method similar to theunit-of-production method of cost recov-ery.

However, this does not apply to the followingintangibles.

• Goodwill.

• Going concern value.

• A covenant not to compete.

• A franchise, trademark, or trade name.

• A customer-related information base,customer-based intangible, or similaritem.

Anti-Churning RulesAnti-churning rules prevent you from amor-tizing most section 197 intangibles if thetransaction in which you acquired them didnot result in a significant change in ownershipor use. These rules apply to goodwill andgoing concern value, and to any other section197 intangible that is not otherwise deprecia-ble or amortizable.

Under the anti-churning rules, you cannotuse 15-year amortization for the intangible ifany of the following conditions apply.

1) You or a related person (defined later)held or used the intangible at any timefrom July 25, 1991, through August 10,1993.

2) You acquired the intangible from a per-son who held the intangible at any timefrom July 25, 1991, through August 10,1993, and, as part of the transaction, theuser did not change.

3) You granted the right to use the intangi-ble to a person (or a person related tothat person) who held or used the in-tangible at any time from July 25, 1991,through August 10, 1993. This appliesonly if the transaction in which yougranted the right and the transaction inwhich you acquired the intangible arepart of a series of related transactions.

Exceptions. The anti-churning rules do notapply in the following situations.

• You acquired the intangible from a dece-

dent and its basis was stepped up to itsfair market value.

• The intangible was amortizable as asection 197 intangible by the person youacquired it from. This exception does notapply if the transaction in which you ac-quired the intangible and the transactionin which it was acquired by the personyou acquired it from are part of a seriesof related transactions.

• The gain-recognition exception, dis-cussed later, applies.

Related person. For purposes of the anti-churning rules, the following are related per-sons.

• An individual and his or her brothers,sisters, half-brothers, half-sisters,spouse, ancestors (parents, grand-parents, etc.), and lineal descendants(children, grandchildren, etc.).

• An individual and a corporation when theindividual owns, directly or indirectly,more than 20% in value of the corpo-ration's outstanding stock.

• Two corporations that are members ofthe same controlled group as defined insection 1563(a) of the Internal RevenueCode, except that “more than 20%” issubstituted for “at least 80%” in that defi-nition and the determination is madewithout regard to subsections (a)(4) and(e)(3)(C) of section 1563. (For an excep-tion, see section 1.197–2(h)(6)(iv) of theregulations.)

• A trust fiduciary and a corporation whenthe trust or grantor of the trust owns, di-rectly or indirectly, more than 20% invalue of the corporation's outstandingstock.

• A grantor and fiduciary, and the fiduciaryand beneficiary, of any trust.

• Fiduciaries of two different trusts, and thefiduciary and beneficiary of two differenttrusts, if the same person is the grantorof both trusts.

• A tax-exempt educational or charitableorganization and a person who directlyor indirectly controls the organization (orwhose family members control it).

• A corporation and a partnership if thesame persons own more than 20% invalue of the outstanding stock of thecorporation and more than 20% of thecapital or profits interest in the partner-ship.

• Two S corporations if the same personsown more than 20% in value of the out-standing stock of each corporation.

• Two corporations, one of which is an Scorporation, if the same persons ownmore than 20% in value of the outstand-ing stock of each corporation.

• Two partnerships if the same personsown, directly or indirectly, more than 20%of the capital or the profits interests inboth partnerships.

• A person and a partnership when theperson owns, directly or indirectly, morethan 20% of the capital or profits interestsin the partnership.

• Two persons who are engaged in tradesor businesses under common control (as


described in section 41(f)(1) of the Inter-nal Revenue Code).

The relationship must have existed —

• In the case of a single transaction, im-mediately before or immediately after thetransaction in which the intangible wasacquired, and

• In the case of a series of related trans-actions (or a series of transactions thattogether comprise a qualified stock pur-chase under section 338(d)(3) of theInternal Revenue Code), immediatelybefore the earliest transaction or imme-diately after the last transaction.

Ownership of stock. In determiningwhether an individual owns, directly or indi-rectly, any of the outstanding stock of a cor-poration, the following rules apply.

Rule 1. Stock owned, directly or indi-rectly, by or for a corporation, partnership,estate, or trust is considered owned propor-tionately by or for its shareholders, partners,or beneficiaries.

Rule 2. An individual is considered asowning the stock owned, directly or indirectly,by or for his or her family. Family includesonly brothers and sisters, half-brothers andhalf-sisters, spouse, ancestors, and linealdescendants.

Rule 3. An individual owning (other thanby applying rule 2) any stock in a corporationis considered to own the stock owned, directlyor indirectly, by or for his or her partner.

Rule 4. For purposes of applying rule 1,2, or 3, treat stock constructively owned by aperson under rule 1 as actually owned by thatperson. Do not treat stock constructivelyowned by an individual under rule 2 or 3 asowned by the individual for reapplying rule 2or 3 to make another person the constructiveowner of the stock.

Gain-recognition exception. This exceptionto the anti-churning rules applies if the personyou acquired the intangible from (the trans-feror) meets both the following requirements.

1) That person would not be related to you(as described under Related person,earlier) if the 20% test for ownership ofstock and partnership interests were re-placed by a 50% test.

2) That person chose to recognize gain onthe disposition of the intangible and payincome tax on the gain at the highest taxrate. See chapter 2 in Publication 544 forinformation on making this choice.

If this exception applies, the anti-churningrules apply only to the amount of your ad-justed basis in the intangible that is more thanthe gain recognized by the transferor.

Notification. If the person you acquiredthe intangible from chooses to recognize gainunder the rules for this exception, that personmust notify you in writing by the due date ofthe return on which the choice is made.

Anti-abuse rule. You cannot amortize anysection 197 intangible acquired in a trans-action for which the principal purpose waseither of the following.

1) To avoid the requirement that the intan-gible be acquired after August 10, 1993.

2) To avoid any of the anti-churning rules.

More information. For more informationabout the anti-churning rules, including addi-tional rules for partnerships, see section1.197–2(h) of the regulations.

Incorrect Amount ofAmortization DeductedIf you did not deduct the correct amortizationfor a section 197 intangible in any year, youmay be able to make a correction for that yearby filing an amended return. See AmendedReturn, later. If you are not allowed to makethe correction on an amended return, you canchange your accounting method to claim thecorrect amortization. See Changing Your Ac-counting Method, later.

Basis adjustment. If you could have de-ducted amortization but you did not take thededuction, you must reduce the basis of thesection 197 intangible by the amortization youwere entitled to deduct. If you deducted moreamortization than you should have, you mustreduce your basis by the correct amortizationplus any of the excess for which you receiveda tax benefit.

Amended ReturnIf you did not deduct the correct amortization,you can file an amended return to make anyof the following corrections.

• Correction of a mathematical error madein any year.

• Correction of a posting error made in anyyear.

• Correction of amortization for a section197 intangible for which you have notadopted a method of accounting.

If an amended return is allowed, you mustfile it by the later of the following dates.

• 3 years from the date you filed your ori-ginal return for the year in which you didnot deduct the correct amount.

• 2 years from the time you paid your taxfor that year.

A return filed early is considered filed on thedue date.

If you did not deduct the correct amorti-zation for a section 197 intangible on two ormore consecutively filed tax returns, youhave adopted a method of accounting for theintangible. You cannot file amended returnsto correct the amount of amortization.

Changing YourAccounting MethodIf you cannot correct your amortization de-ductions for a section 197 intangible by filingamended returns, you can claim the correctamount only by changing your method of ac-counting for the intangible. You will then beable to take into account any unclaimed orexcess amortization from years before theyear of change.

Approval required. You must get IRS ap-proval to change your method of accounting.File Form 3115, Application for Change inAccounting Method, to request a change toa permissible method of accounting foramortization. Revenue Procedure 97–27,which is in Cumulative Bulletin 1997–1, givesgeneral instructions for getting approval. Cu-

mulative Bulletins are available at many li-braries and IRS offices. You do not need IRSapproval to correct any mathematical orposting error. See Amended Return, earlier.

Automatic approval. You may be able toget automatic approval from the IRS tochange your method of accounting for a sec-tion 197 intangible if you meet both the fol-lowing conditions.

• You did not deduct amortization or youdeducted the incorrect amount of amorti-zation for the intangible in at least the 2years immediately preceding the year ofchange.

• You owned the intangible at the begin-ning of the year of change.

File Form 3115 to request a change to apermissible method of accounting for amorti-zation. Revenue Procedure 99–49 and sec-tion 2.01 of its Appendix, which is in InternalRevenue Bulletin No. 1999–52, has in-structions for getting automatic approval andlists exceptions to the automatic approvalprocedures.

Exceptions. You generally cannot usethe automatic approval procedure in any ofthe following situations.

• You (your federal income tax return) areunder examination.

• You are before a federal court or an ap-peals office for any income tax issue andthe method of accounting to be changedis an issue under consideration by thefederal court or appeals office.

• You changed the same method of ac-counting (with or without obtaining IRSapproval) during the last 5 years (includ-ing the year of change).

• You filed a Form 3115 to change thesame method of accounting during thelast 5 years (including the year ofchange), but did not make the changebecause the Form 3115 was withdrawn,not perfected, denied, or not granted.

Also, see the exceptions listed in section2.01(2)(b) of the Appendix of Revenue Pro-cedure 99–49.

Disposition ofSection 197 IntangiblesA section 197 intangible is treated as depre-ciable property used in your trade or busi-ness. If you held the intangible for more than1 year, any gain on its disposition, up to theamount of allowable amortization, is ordinaryincome (section 1245 gain). Any remaininggain, or any loss, is a section 1231 gain orloss. If you held the intangible 1 year or less,any gain or loss on its disposition is an ordi-nary gain or loss. For more information onordinary or capital gain or loss on businessproperty, see chapter 3 in Publication 544.

Nondeductible loss. If you acquire morethan one section 197 intangible in a trans-action (or series of related transactions) andlater dispose of one of them or if one of thembecomes worthless, you cannot deduct anyloss on the intangible. Instead, increase theadjusted basis of each remaining amortizablesection 197 intangible by the part of the non-deductible loss. Figure the increase by multi-


plying the nondeductible loss on the disposi-tion of the intangible by the following fraction.

• The numerator is the adjusted basis ofthe remaining intangible on the date ofthe disposition.

• The denominator is the total adjustedbasis of all remaining amortizable section197 intangibles on the date of the dispo-sition.

Covenant not to compete. A covenant notto compete, or similar arrangement, is notconsidered disposed of or worthless beforeyou dispose of your entire interest in the tradeor business for which you entered into thecovenant.

Nonrecognition transfers. If you disposeof one section 197 intangible and acquireanother in a nonrecognition transfer, treat thepart of the adjusted basis of the acquired in-tangible that is not more than the adjustedbasis of the transferred intangible as if it werethe transferred section 197 intangible. Youcontinue to amortize this part of the adjustedbasis over the remaining amortization periodof the transferred section 197 intangible.Nonrecognition transfers include transfers toa corporation, partnership contributions anddistributions, like-kind exchanges, and invol-untary conversions.

Example. You own a section 197 intan-gible you have amortized for 4 full years. Ithas a remaining unamortized basis of$30,000. You exchange the asset plus$10,000 for a like-kind section 197 intangible.The nonrecognition provisions of like-kindexchanges apply. You amortize $30,000 ofthe adjusted basis of the acquired section 197intangible over the 11 years remaining in theoriginal 15-year amortization period for thetransferred asset and the other $10,000 ofadjusted basis over 15 years.

Going Into BusinessWhen you go into business, treat all costs youincur to get your business started as capitalexpenses. Capital expenses are part of yourbasis in the business. Generally, you recovercosts for particular assets through depreci-ation deductions. However, you generallycannot recover other costs until you sell thebusiness or otherwise go out of business. SeeCapital Expenses in chapter 1 for a dis-cussion of how to treat these costs if you donot go into business.

You can choose to amortize certain costsfor setting up your business over a period of60 months or more. The cost must qualify asone of the following.

• A business start-up cost.

• An organizational cost for a corporation.

• An organizational cost for a partnership.

Business Start-Up CostsStart-up costs are costs for creating an activetrade or business or investigating the creationor acquisition of an active trade or business.Start-up costs include any amounts paid orincurred in connection with any activity en-gaged in for profit and for the production of

income before the trade or business beginsin anticipation of the activity becoming anactive trade or business.

Qualifying costs. A start-up cost is amor-tizable if it meets both the following tests.

1) It is a cost you could deduct if you paidor incurred it to operate an existing ac-tive trade or business (in the same field).

2) It is a cost you pay or incur before theday your active trade or business begins.

Start-up costs include costs for the fol-lowing items.

• A survey of potential markets.

• An analysis of available facilities, labor,supplies, etc.

• Advertisements for the opening of thebusiness.

• Salaries and wages for employees whoare being trained and their instructors.

• Travel and other necessary costs for se-curing prospective distributors, suppliers,or customers.

• Salaries and fees for executives andconsultants, or for other professionalservices.

Nonqualifying costs. Start-up costs do notinclude deductible interest, taxes, or researchand experimental costs. See Research andExperimental Costs, later.

Purchasing an active trade or business.Amortizable start-up costs for purchasing anactive trade or business include only costsincurred in the course of a general search foror preliminary investigation of the business.Costs you incur in the attempt to purchase aspecific business are capital expenses thatyou cannot amortize.

Investigative costs. Investigative costsare the costs that help you decide whether topurchase a business and which business topurchase.

Example. In June, you hired an ac-counting firm to assist you in the potentialpurchase of XYZ. They researched XYZ's in-dustry and analyzed the financial projectionsof XYZ. In September, you hired a law firm toprepare and submit a letter of intent to XYZ.The letter stated that a binding commitmentwould result only after a purchase agreementwas signed. The law firm and accounting firmcontinued to provide services including a re-view of XYZ's books and records and thepreparation of a purchase agreement. In Oc-tober, you signed a purchase agreement withXYZ.

The costs to investigate the business be-fore submitting the letter of intent to XYZ areamortizable investigative costs. The costs forservices after that time relate to the attemptto purchase the business and must be capi-talized.

Disposition of business. If you completelydispose of your business before the end ofthe amortization period, you can deduct anyremaining deferred start-up costs. However,you can deduct these deferred start-up costsonly to the extent they qualify as a loss froma business.

Costs of Organizinga CorporationThe costs of organizing a corporation are thedirect costs of creating the corporation.

Qualifying costs. You can amortize an or-ganizational cost only if it meets all the fol-lowing tests.

• It is for the creation of the corporation.

• It is chargeable to a capital account.

• It could be amortized over the life of thecorporation if the corporation had a fixedlife.

• It is incurred before the end of the first taxyear in which the corporation is in busi-ness. A corporation using the cashmethod of accounting can amortize or-ganizational costs incurred within the firsttax year, even if it does not pay them inthat year.

The following are examples of organiza-tional costs.

• The cost of temporary directors.

• The cost of organizational meetings.

• State incorporation fees.

• The cost of accounting services for set-ting up the corporation.

• The cost of legal services (such as draft-ing the charter, bylaws, terms of the ori-ginal stock certificates, and minutes oforganizational meetings).

Nonqualifying costs. The following costs arenot organizational costs. They are capital ex-penses that you cannot amortize.

• Costs for issuing and selling stock or se-curities, such as commissions, profes-sional fees, and printing costs.

• Costs associated with the transfer of as-sets to the corporation.

Costs of Organizinga PartnershipThe costs of organizing a partnership are thedirect costs of creating the partnership.

Qualifying costs. You can amortize an or-ganizational cost only if it meets all the fol-lowing tests.

• It is for the creation of the partnership andnot for starting or operating the partner-ship trade or business.

• It is chargeable to a capital account.

• It could be amortized over the life of thepartnership if the partnership had a fixedlife.

• It is incurred by the due date of the part-nership return (excluding extensions) forthe first tax year in which the partnershipis in business. However, if the partnershipuses the cash method of accounting andpays the cost after the end of its first taxyear, see Cash method partnership underHow To Amortize, later.

Organizational costs include the followingfees.

• Legal fees for services incident to theorganization of the partnership, such as


negotiation and preparation of the part-nership agreement.

• Accounting fees for services incident tothe organization of the partnership.

• Filing fees.

Nonqualifying costs. The following costscannot be amortized.

• The cost of acquiring assets for the part-nership or transferring assets to thepartnership.

• The cost of admitting or removing part-ners, other than at the time the partner-ship is first organized.

• The cost of making a contract concerningthe operation of the partnership trade orbusiness (including a contract between apartner and the partnership).

• Syndication fees. These are costs for is-suing and marketing interests in thepartnership (such as commissions, pro-fessional fees, and printing costs). Theyare capital expenses that cannot be de-preciated or amortized.

How To AmortizeYou deduct start-up and organizational costsin equal amounts over a period of 60 monthsor more. You can choose a period for start-upcosts that is different from the period youchoose for organizational costs, as long asboth are 60 months or more. Once youchoose an amortization period, you cannotchange it.

To figure your deduction, divide your totalstart-up or organizational costs by the monthsin the amortization period. The result is theamount you can deduct each month.

Cash method partnership. A partnershipusing the cash method of accounting cannotdeduct an organizational cost it has not paidby the end of the tax year. However, any costthe partnership could have deducted as anorganizational cost in an earlier tax year (if ithad been paid that year) can be deducted inthe tax year of payment.

When to begin amortization. The amorti-zation period starts with the month you beginbusiness operations.

How To Make the ChoiceTo choose to amortize start-up or organiza-tional costs, you must attach Form 4562 andan accompanying statement (explained later)to your return for the first tax year you are inbusiness. If you have both start-up and or-ganizational costs, attach a separate state-ment to your return for each type of costs.

Generally, you must file the return by thedue date (including any extensions). How-ever, if you timely filed your return for the yearwithout making the choice, you can still makethe choice by filing an amended return within6 months of the due date of the return (ex-cluding extensions). For more information,see the instructions for Part VI of Form 4562.

Once you make the choice to amortizestart-up or organizational costs, you cannotrevoke it.

Corporations and partnerships. If yourbusiness is organized as a corporation orpartnership, only your corporation or partner-

ship can choose to amortize its start-up ororganizational costs. A shareholder or partnercannot make this choice. You, as shareholderor partner, cannot amortize any costs youincur in setting up your corporation or part-nership. The corporation or partnership canamortize these costs.

TIPYou, as an individual, can choose toamortize costs you incur to investigatean interest in an existing partnership.

These costs qualify as business start-up costsif you succeed in acquiring an interest in thepartnership.

Start-up costs. If you choose to amortizeyour start-up costs, complete Part VI of Form4562 and prepare a separate statement thatcontains the following information.

• A description of the business to which thestart-up costs relate.

• A description of each start-up cost in-curred.

• The month your active business began(or the month you acquired the business).

• The number of months in your amorti-zation period (not less than 60).

Filing the statement early. You canchoose to amortize your start-up costs by fil-ing the statement with a return for any taxyear before the year your active businessbegins. If you file the statement early, thechoice becomes effective in the month of thetax year your active business begins.

Revised statement. You can file a re-vised statement to include any start-up costsnot included in your original statement. How-ever, you cannot include on the revisedstatement any cost you previously treated onyour return as a cost other than a start-upcost. You can file the revised statement witha return filed after the return on which youchoose to amortize your start-up costs.

Organizational costs. If you choose toamortize your corporation's or partnership'sorganizational costs, complete Part VI ofForm 4562 and prepare a separate statementthat contains the following information.

• A description of each cost.

• The amount of each cost.

• The date each cost was incurred.

• The month your corporation or partner-ship began active business (or the monthit acquired the business).

• The number of months in your amorti-zation period (not less than 60).

Partnerships. The statement preparedfor a cash basis partnership must also indi-cate the amount paid before the end of theyear for each cost.

TIPYou do not need to separately list anypartnership organizational cost that isless than $10. Instead, you can list the

total amount of these costs with the dates thefirst and last costs were incurred.

After a partnership makes the choice toamortize organizational costs, it can file anamended return to include additional organ-izational costs.

Reforestation CostsYou can choose to amortize a limited amountof reforestation costs for qualified timberproperty over a period of 84 months. Refor-estation costs are the direct costs of plantingor seeding for forestation or reforestation.

The choice to amortize reforestation costsincurred by a partnership, S corporation, orestate must be made by the partnership,corporation, or estate. A partner, shareholder,or beneficiary cannot make that choice.

Qualifying costs. Qualifying costs includeonly those costs you must capitalize and in-clude in the adjusted basis of the property.They include costs for the following items.

• Site preparation.

• Seeds or seedlings.

• Labor.

• Tools.

• Depreciation on equipment used inplanting and seeding.

Costs you can deduct currently are not quali-fying costs.

If the government reimburses you for re-forestation costs under a cost-sharing pro-gram, you can amortize these costs only ifyou include the reimbursement in your in-come.

Qualified timber property. Qualified timberproperty is property that contains trees insignificant commercial quantities. It can be awoodlot or other site that you own or lease.The property qualifies only if it meets all thefollowing requirements.

1) It is located in the United States.

2) It is held for the growing and cutting oftimber you will either use in, or sell foruse in, the commercial production oftimber products.

3) It consists of at least one acre plantedwith tree seedlings in the mannernormally used in forestation or refor-estation.

Qualified timber property does not includeproperty on which you have planted shelterbelts or ornamental trees, such as Christmastrees.

Annual limit. Each year, you can choose toamortize up to $10,000 ($5,000 if you aremarried filing separately) of qualifying costsyou pay or incur during the tax year. Youcannot carry over or carry back qualifyingcosts over the annual limit. The annual limitapplies to qualifying costs for all your qualifiedtimber property.

If your qualifying costs are more than$10,000 for more than one piece of timberproperty, you can divide the annual limitamong any of the properties in any manneryou wish.

Example. You incurred $10,000 of quali-fying costs on each of four qualified timberproperties last year. You can allocate $2,500to each property, $5,000 to two properties,or the entire $10,000 to any one property, oryou can divide the $10,000 among some orall of the properties in any other manner.


Partnerships and S corporations. Apartnership or S corporation can choose toamortize up to $10,000 of qualifying refor-estation costs each tax year. A partner's orshareholder's share of these amortizablecosts is figured under the general rules forallocating items of income, loss, deductions,etc., of a partnership or S corporation.

The partner or shareholder is also subjectto an annual limit of $10,000 ($5,000 if mar-ried filing separately) on qualifying costs. Thislimit applies to all the partner's or sharehold-er's qualifying costs, regardless of theirsource.

Example. You are single and a partnerin two partnerships, both of which incurredqualifying reforestation costs of more than$10,000 for the year. Each partnership choseto amortize these costs up to the $10,000annual limit. Your share of that $10,000 is$6,000 for one partnership and $8,000 for theother. Although your qualifying costs total$14,000, the amount you can amortize islimited to $10,000.

Estates. Estates can choose to amortizeup to $10,000 of qualified reforestation costseach tax year. These amortizable costs aredivided between the estate and the incomebeneficiary based on the income of the estateallocable to each. The amortizable cost allo-cated to the beneficiary is subject to thebeneficiary's annual limit.

Amortization period. The 84-month amorti-zation period starts on the first day of the firstmonth of the second half of the tax year youincur the costs (July 1 for a calendar yeartaxpayer). You can claim amortization de-ductions for no more than 6 months of the firstand last (eighth) tax years of the period.

Example. Last year (a full 12-month taxyear), John Jones incurred qualifying refor-estation costs of $8,400. His monthly amorti-zation deduction ($100) is figured by dividing$8,400 by 84 months. Since it was the firstyear of the 84-month period, he can deductonly $600 ($100 × 6 months).

Maximum annual amortization deduction.The maximum annual amortization deductionfor costs incurred in any tax year is $1,428.57($10,000 ÷ 7). The maximum deduction in thefirst and last tax year of the 84-monthamortization period is one half of $1,428.57,or $714.29.

Life tenant and remainderman. If one per-son holds the property for life with the re-mainder going to another person, the lifetenant is entitled to the full amortization (upto the annual limit) for reforestation costsmade by the life tenant. Any remainder inter-est in the property is ignored for amortizationpurposes.

Recapture. If you dispose of qualified timberproperty within 10 years after the tax year youincur qualifying reforestation expenses, reportany gain as ordinary income up to theamortization you took. See chapter 3 of Pub-lication 544 for more information.

Investment credit. Amortizable reforestationcosts qualify for the investment credit,whether or not they are amortized. See theinstructions for Form 3468 for information onthe investment credit.

How to make the choice. To choose toamortize qualifying reforestation costs, enteryour deduction in Part VI of Form 4562 andattach a statement that contains the followinginformation.

• A description of the costs and the datesyou incurred them.

• A description of the type of timber beinggrown and the purpose for which it isgrown.

Attach a separate statement for each propertyfor which you amortize reforestation costs.

Generally, you must make the choice ona timely filed return (including extensions) forthe tax year in which you incurred the costs.However, if you timely filed your return for theyear without making the choice, you can stillmake the choice by filing an amended returnwithin 6 months of the due date of the return(excluding extensions). Attach Form 4562and the statement to the amended return andwrite “FILED PURSUANT TO SECTION301.9100–2” on Form 4562. File the amendedreturn at the same address you filed the ori-ginal return.

Where to report. The following chart showswhere to report your amortization deductionfor reforestation costs.

Partner or shareholder. If you are apartner in a partnership or a shareholder inan S corporation, report any allocatedamortization for reforestation costs on a sep-arate line in Part II of Schedule E (Form1040). However, if you have other reforesta-tion costs you are amortizing, this deductionmay be limited. See Annual limit and Maxi-mum annual amortization deduction, earlier.

Estate. If the estate does not file Sched-ule C or F for the activity in which the refor-estation costs were incurred, include theamortization deduction on line 15a of Form1041.

Revoking the choice. You must get IRSapproval to revoke your choice to amortizereforestation costs. Your application to revokethe choice must include your name, address,the years for which your choice was in effect,and your reason for revoking it. You, or yourduly authorized representative, must sign theapplication and file it at least 90 days beforethe due date (without extensions) for filingyour income tax return for the first tax year forwhich your choice is to end.

Send the application to:

Commissioner of Internal RevenueWashington, DC 20224

PollutionControl FacilitiesYou can choose to amortize over 60 monthsthe cost of a certified pollution control facility.

Certified pollution control facility. A certi-fied pollution control facility is a new identifi-able treatment facility used, in connection witha plant or other property in operation before1976, to reduce or control water or atmo-spheric pollution or contamination. The facilitymust do so by removing, changing, disposing,storing, or preventing the creation or emissionof pollutants, contaminants, wastes, or heat.The facility must be certified by state andfederal certifying authorities.

The facility must not significantly increasethe output or capacity, extend the useful life,or reduce the total operating costs of the plantor other property. Also, it must not signif-icantly change the nature of the manufactur-ing or production process or facility.

The federal certifying authority will notcertify your property to the extent it appearsyou will recover (over the property's usefullife) all or part of its cost from the profit basedon its operation (such as through sales of re-covered wastes). The federal certifying au-thority will describe the nature of the potentialcost recovery. You must then reduce theamortizable basis of the facility.

New identifiable treatment facility. Anew identifiable treatment facility is tangibledepreciable property that is identifiable as atreatment facility. It does not include a build-ing and its structural components unless thebuilding is exclusively a treatment facility.

Basis reduction for corporations. A cor-poration must reduce the amortizable basisof a pollution control facility by 20% beforefiguring the amortization deduction.

More information. For more information onthe amortization of pollution control facilities,see section 169 of the Internal Revenue Codeand the related regulations.

Research andExperimental CostsYou can amortize your research and exper-imental costs, deduct them as current busi-ness expenses, or write them off over a10-year period. If you choose to amortizethese costs, deduct them in equal amountsover 60 months or more. The amortizationperiod begins the month you first receive aneconomic benefit from the research. For adefinition of “research and experimentalcosts” and information on deducting them ascurrent business expenses, see chapter 8.

Optional write-off method. Rather thanamortize these costs or deduct them as acurrent expense, you have the option of de-ducting (writing off) research and exper-imental costs ratably over a 10-year periodbeginning with the tax year in which you in-curred the costs.

For more information on the optionalwrite-off method, see Internal Revenue Codesection 59(e).

If you file . . . The deduction goes on . . .

Schedule C(Form 1040) Line 27

Schedule F(Form 1040) Line 34

Form 1120 Line 26

Form 1120-A Line 22

Form 1120S Schedules K and K-1

Form 1065 Schedules K and K-1

None of the aboveLine 32 of Form 1040

(identify as “RFST”)


Costs you can amortize. You can amortizecosts chargeable to a capital account if youmeet both the following requirements.

• You paid or incurred the costs in yourtrade or business.

• You are not deducting the costs currently.

How to make the choice. To choose toamortize research and experimental costs,enter your deduction in Part VI of Form 4562and attach it to your income tax return. Gen-erally, you must file the return by the due date(including extensions). However, if you timelyfiled your return for the year without makingthe choice, you can still make the choice byfiling an amended return within 6 months ofthe due date of the return (excluding exten-sions). Attach Form 4562 to the amendedreturn and write “FILED PURSUANT TOSECTION 301.9100–2” on Form 4562. Filethe amended return at the same address youfiled the original return.

Your choice is binding for the year it ismade and for all later years unless you getIRS approval to change to a different method.

More information. For more information onamortizing research and development costs,see section 174 of the Internal Revenue Codeand the related regulations.

Bond PremiumBond premium is the amount by which yourbasis in a bond right after you get it is morethan the total of all amounts payable on thebond after you get it (other than payments ofqualified stated interest).

The term “bond,” as used in this dis-cussion, means any interest-bearing bond,debenture, note, or certificate or other evi-dence of debt. The term does not include anyobligation listed below.

• Your stock in trade.

• Property that would properly be includedin your inventory if on hand at the closeof the tax year.

• Property held by you primarily for sale tocustomers in the ordinary course of yourtrade or business.

Tax-exempt bonds. If the bond yields tax-exempt interest, you must amortize the pre-mium. You cannot deduct the amortizablepremium in figuring your taxable income.However, each year you must reduce yourbasis in the bond by the amortization for theyear.

Taxable bonds. You can choose to amortizethe premium on taxable bonds. This gener-ally means that each year, over the life of thebond, you use part of the premium to reducethe amount of interest includible in your in-come. If you make this choice, you must re-duce your basis in the bond by the amorti-zation for the year. The premium on the bondis part of your basis in the bond.

Inflation-indexed instruments. Aninflation-indexed debt instrument is generallya debt instrument on which the payments areadjusted for inflation and deflation (such asTreasury inflation-indexed securities). Deter-mine the premium on an inflation-indexeddebt instrument as of the date you acquire the

instrument by assuming that there will be noinflation or deflation over the remaining termof the instrument. Allocate the premium overthe remaining term of the instrument bymaking the same assumption. Reduce theinstrument's interest income for the tax yearby the premium allocable to the tax year. Useany excess premium allocable to the tax yearto offset the original issue discount on the in-strument for the year.

Basis adjustment. If you are required toamortize bond premium, or choose to do so,you must decrease the basis of the bond bythe amortizable bond premium. The result isthe adjusted basis you use to figure gain orloss on the sale or redemption of the bond.

More information. For more information onhow to figure and report bond premium, seePublication 550.

Cost ofGetting a LeaseIf you get a lease for business property, yourecover the cost by amortizing it over the termof the lease. The term of the lease foramortization purposes includes all renewaloptions (and any other period for which thelessee and lessor reasonably expect thelease to be renewed) if less than 75% of thecost of getting the lease is attributable to theterm of the lease remaining on the acquisitiondate. The term of the lease remaining on theacquisition date does not include any periodfor which the lease may later be renewed,extended, or continued under an optionexercisable by the lessee.

Enter your deduction in Part VI of Form4562 if you must file that form, or on the ap-propriate line of your tax return.

10.Depletion

Important ChangeMarginal production of oil and gas. Thesuspension of the taxable income limit onpercentage depletion from the marginal pro-duction of oil and natural gas has been ex-tended to tax years beginning after 1999 andbefore 2002. For more information on mar-ginal production, see section 613A(c) of theInternal Revenue Code.

Important ReminderAlternative minimum tax. Individuals, cor-porations, estates, and trusts who claim de-pletion deductions may be liable for alterna-tive minimum tax.

For more information on alternative mini-mum tax, see the following sources.

IntroductionDepletion is the using up of natural resourcesby mining, quarrying, drilling, or felling. Thedepletion deduction allows an owner or oper-ator to account for the reduction of a product'sreserves.

There are two ways of figuring depletion:cost depletion and percentage depletion. Formineral property, you generally must use themethod that gives you the larger deduction;for standing timber, you must use cost de-pletion.


• Who can claim depletion

• Mineral property

• Timber

Who CanClaim DepletionIf you have an economic interest in mineralproperty or standing timber, you can take adeduction for depletion. More than one per-son can have an economic interest in thesame mineral deposit or timber.

You have an economic interest if boththe following apply.

• You have acquired by investment a legalinterest in mineral deposits or standingtimber.

• You have the right to income from theextraction of the mineral or cutting of thetimber, to which you must look for a re-turn of your capital investment.

A contractual relationship that allows you aneconomic or monetary advantage from pro-ducts of the mineral deposit or standing tim-ber is not, in itself, an economic interest. Aproduction payment carved out of, or retainedon the sale of, mineral property is not aneconomic interest.

Mineral PropertyThe term “mineral property” means eachseparate interest you own in each mineraldeposit in each separate tract or parcel ofland. You can treat mineral properties sepa-rately or as a group. See section 614 of theInternal Revenue Code for rules on how totreat separate properties.

Mineral property includes oil and gaswells, mines, and other natural deposits (in-cluding geothermal deposits).

There are two ways of figuring depletionon mineral property.

If you are: See:

An individual The instructions for Form6251, Alternative MinimumTax—Individuals.

A corporation Form 4626, Alternative Mini-mum Tax—Corporations.

An estate or trust Form 1041, U.S. Income TaxReturn for Estates and Trusts,and its instructions.

Chapter 10 Depletion

• Cost depletion.

• Percentage depletion.

Generally, you must use the method thatgives you the larger deduction. However, un-less you are an independent producer orroyalty owner, you generally cannot use per-centage depletion for oil and gas wells. SeeOil and Gas Wells, later.

Cost DepletionTo figure cost depletion you must first deter-mine the following.

• The property's basis for depletion.

• The total recoverable units in the proper-ty's natural deposit.

• The number of units sold during the taxyear.

Basis for depletion. To figure the property'sbasis for depletion, subtract all the followingfrom the property's adjusted basis.

1) The amounts recoverable through:

a) Depreciation deductions,

b) Deferred expenses (including de-ferred exploration and developmentcosts), and

c) Deductions other than depletion.

2) The residual value of land and improve-ments at the end of operations.

3) The cost or value of land acquired forpurposes other than mineral production.

Adjusted basis. The adjusted basis ofyour property is your original cost or otherbasis, plus certain additions and improve-ments, and minus certain deductions such asdepletion allowed or allowable and casualtylosses. Your adjusted basis can never be lessthan zero. See Publication 551, Basis of As-sets, for more information on adjusted basis.

Total recoverable units. The total recover-able units is the sum of the following.

1) The number of units of mineral remainingat the end of the year (including unitsrecovered but not sold).

2) The number of units sold during the taxyear (determined under your method ofaccounting, as explained next).

You must estimate or determine recover-able units (tons, pounds, ounces, barrels,thousands of cubic feet, or other measure)of mineral products using the current industrymethod and using the most accurate and re-liable information you can obtain.

Number of units sold. The number of unitssold during the tax year is one of the follow-ing.

• The units sold for which you receivepayment during your tax year (regardlessof the year of sale), if you use the cashmethod of accounting.

• The units sold based on your inventories,if you use the accrual method of ac-counting.

The number of units sold during the taxyear does not include any on which depletion

deductions were allowed or allowable in ear-lier years.

Figuring the cost depletion deduction.Once you have figured your property's basisfor depletion, the total recoverable units, andthe number of units sold during the tax year,you can figure your cost depletion deductionby taking the following steps.

Percentage DepletionTo figure percentage depletion, you multiplya certain percentage, specified for each min-eral, by your gross income from the propertyduring the tax year.

Gross income. When figuring your percent-age depletion, subtract from your gross in-come from the property the followingamounts.

• Any rents or royalties you pay or incur forthe property.

• The part of any bonus you paid for alease on the property allocable to theproduct sold (or that otherwise gives riseto gross income) for the tax year.

A bonus payment includes a bonus for eithera mineral lease or an oil and gas lease.

Use the following fraction to figure the partof the bonus you must subtract.

Taxable income limit. The percentage de-pletion deduction cannot be more than 50%(100% for oil and gas property) of your taxa-ble income from the property figured withoutthe depletion deduction.

The following rules apply when figuringyour taxable income from the property forpurposes of the taxable income limit.

• Do not deduct any net operating lossdeduction from the gross income from theproperty.

• Corporations do not deduct charitablecontributions from the gross income fromthe property.

• If, during the year, you dispose of an itemof section 1245 property that was usedin connection with mineral property, re-duce any allowable deduction for miningexpenses by the part of any gain youmust report as ordinary income that isallocable to the mineral property. Seesection 1.613–5(b)(1) of the regulationsfor information on how to figure the ordi-nary gain allocable to the property.

CAUTION!

For tax years beginning after 1997and before 2002, percentage de-pletion on the marginal production of

oil or natural gas is not limited to taxable in-come from the property figured without thedepletion deduction.

Oil and Gas WellsGenerally, only independent producers androyalty owners can claim percentage de-pletion for any oil or gas well. However, if youare not an independent producer or royaltyowner, you may be able to claim percentagedepletion for the following items.

• Natural gas sold under a fixed contract.

• Natural gas from geopressured brine.

For information on the depletion deduction forthese items, see Natural Gas Wells, later.

Independent ProducersIf you are an independent producer, you fig-ure percentage depletion using a rate of 15%of the gross income from the property basedon your average daily production of domesticcrude oil or domestic natural gas up to yourdepletable oil or natural gas quantity. How-ever, certain refiners and retailers, as ex-plained next, cannot claim percentage de-pletion. For information on figuring thededuction, see Figuring percentage depletion,later.

Refiners who cannot claim percentagedepletion. You cannot claim percentagedepletion if you or a related person refinecrude oil and you and the related person re-fined more than 50,000 barrels on any dayduring the tax year.

Related person. You and another personare related persons if either of you holds asignificant ownership interest in the otherperson or if a third person holds a significantownership interest in both of you.

For example, a corporation, partnership,estate, or trust and anyone who holds a sig-nificant ownership interest in it are relatedpersons. A partnership and a trust are relatedpersons if one person holds a significantownership interest in each of them.

For purposes of the related person rules,significant ownership interest means director indirect ownership of 5% or more of anyone of the following interests.

• The value of the outstanding stock of acorporation.

• The interest in the profits or capital of apartnership.

• The beneficial interests in an estate ortrust.

Any interest owned by or for a corporation,partnership, trust, or estate is considered tobe owned directly both by itself and propor-tionately by its shareholders, partners, orbeneficiaries.

Retailers who cannot claim percentagedepletion. You cannot claim percentagedepletion if both the following apply.

1) You sell oil or natural gas or their by-products directly or through a relatedperson in any of the following situations.

a) Through a retail outlet operated byyou or a related person.

b) To any person who is required un-der an agreement with you or a re-lated person to use a trademark,trade name, or service mark orname owned by you or a relatedperson in marketing or distributingoil, natural gas, or their by-products.

Step Action Result

1 Divide your property'sbasis for depletion bytotal recoverable units.

Rate per unit.

2 Multiply the rate perunit by units soldduring the tax year.

Cost depletiondeduction.

Number of units sold in the tax yearRecoverable units from the property × Bonus

Payments


c) To any person given authority underan agreement with you or a relatedperson to occupy any retail outletowned, leased, or controlled by youor a related person.

2) The combined gross receipts from sales(not counting resales) of oil, natural gas,or their by-products of all retail outletstaken into account in (1) are more than$5 million for the tax year.

For the purpose of determining if this ruleapplies, do not count the following.

• Bulk sales of oil or natural gas to com-mercial or industrial users.

• Bulk sales of aviation fuels to the De-partment of Defense.

• Sales of oil or natural gas or their by-products outside the United States ifnone of your domestic production or thatof a related person is exported during thetax year or the prior tax year.

Sales through a related person. Youare considered to be selling through a relatedperson if any sale by the related personproduces gross income from which you maybenefit because of your direct or indirectownership interest in the person.

You are not considered to be sellingthrough a related person who is a retailer ifall the following apply.

• You do not have a significant ownershipinterest in the retailer.

• You sell your production to persons whoare not related to either you or theretailer.

• The retailer does not buy oil or naturalgas from your customers or persons re-lated to your customers.

• There are no arrangements for theretailer to acquire oil or natural gas youproduced for resale or made available forpurchase by the retailer.

• Neither you nor the retailer knows of orcontrols the final disposition of the oil ornatural gas you sold or the original sourceof the petroleum products the retailer ac-quired for resale.

Transfers. You cannot claim percentagedepletion if you received your interest in aproven oil or gas property by transfer after1974 and before October 12, 1990. For adefinition of the term “transfer,” see section1.613A–7(n) of the regulations.

Figuring percentage depletion. Generally,as an independent producer you figure yourpercentage depletion by computing your av-erage daily production of domestic oil or gasand comparing it to your depletable oil or gasquantity. If your average daily productiondoes not exceed your depletable oil or gasquantity, you figure your percentage depletionby multiplying the gross income from the oilor gas property by 15%. If your average dailyproduction of domestic oil or gas exceedsyour depletable oil or gas quantity, you mustmake an allocation as explained later underAverage daily production exceeds depletablequantities.

In addition, there is a limit on the per-centage depletion deduction. See Taxableincome limit, later.

Average daily production. Figure your av-erage daily production by dividing your totaldomestic production for the tax year by thenumber of days in your tax year.

Part interest. If you have a part interestin the production from a property, figure yourshare of the production by multiplying totalproduction from the property by your per-centage of interest in the revenues from theproperty.

You have a part interest in the productionfrom a property if you have a net profits in-terest in the property. To figure the share ofproduction for your net profits interest, youmust determine your percentage participation(as measured by the net profits) in the grossrevenue from the property. To figure thispercentage, you divide the income you re-ceive for your net profits interest by the grossrevenue from the property.

Example. John Oak owns oil property inwhich Paul Elm owns a 20% net profits inter-est. During the year, the property produced10,000 barrels of oil, which John sold for$200,000. John had expenses of $90,000 at-tributable to the property. The property gen-erated a net profit of $110,000. Paul receivedincome of $22,000 ($110,000 × .20) for hisnet profits interest.

Paul determined his percentage partici-pation to be 11% by dividing $22,000 (the in-come he received) by $200,000 (the grossrevenue from the property). Paul determinedhis share of the oil production to be 1,100barrels (10,000 barrels × 11%).

Depletable oil or natural gas quantity.Generally, your depletable oil quantity is1,000 barrels and your depletable natural gasquantity is 6,000 cubic feet multiplied by thenumber of barrels of your depletable oilquantity that you choose to apply. If you claimdepletion on both oil and natural gas, youmust reduce your depletable oil quantity bythe number of barrels you use to figure yourdepletable natural gas quantity. If you are in-volved in marginal production, see section613A(c) of the Internal Revenue Code to fig-ure your depletable oil or natural gas quantity.

You must allocate the depletable oil or gasquantity among the following in proportion toeach entity's or family member's productionof domestic oil or gas for the year.

• Corporations, trusts, and estates if 50%or more of the beneficial interest is ownedby the same or related persons (consid-ering only persons that own at least 5%of the beneficial interest).

• You and your spouse and minor children.

For purposes of this allocation, a related per-son is anyone mentioned under Related per-son in chapter 12 except that item (1) in thatdiscussion includes only an individual, his orher spouse, and minor children.

Members of the same controlled group ofcorporations are treated as one taxpayerwhen figuring the depletable oil or natural gasquantity. They share the depletable quantity,and one member's share of the group'sdepletable quantity will reduce the othermembers' share of the group's depletablequantity. Under this rule, a controlled groupof corporations is defined in section 1563(a)of the Internal Revenue Code, except that“more than 50%” is substituted for “at least80%” in that definition.

Gross income from oil and gas property.For purposes of percentage depletion, grossincome from oil and gas property is theamount you receive from the sale of the oilor gas in the immediate vicinity of the well. Ifyou do not sell the oil or gas on the property,but manufacture or convert it into a refinedproduct before sale or transport it before sale,the gross income from the property is therepresentative market or field price (RMFP)of the oil or gas, before conversion or trans-portation.

If you sold gas after you removed it fromthe premises for a price that is lower than theRMFP, determine gross income from theproperty for percentage depletion purposeswithout regard to the RMFP.

Gross income from the property does notinclude lease bonuses, advance royalties, orother amounts payable without regard toproduction from the property.

Average daily production exceedsdepletable quantities. If your average dailyproduction for the year is more than yourdepletable oil or natural gas quantity, figureyour allowance for depletion for each do-mestic oil or natural gas property as follows.

1) Figure your average daily production ofoil or natural gas for the year.

2) Figure your depletable oil or natural gasquantity for the year.

3) Figure depletion for all oil or natural gasproduced from the property using a per-centage depletion rate of 15%.

4) Multiply the result figured in (3) by afraction, the numerator of which is theresult figured in (2) and the denominatorof which is the result figured in (1). Thisis your depletion allowance for thatproperty for the year.

Taxable income limit. If you are an inde-pendent producer of oil and gas, your de-duction for percentage depletion is limited tothe smaller of the following.

• Your taxable income from the propertyfigured without the deduction for de-pletion.

• 65% of your taxable income from allsources, figured without the depletion al-lowance, any net operating losscarryback, and any capital losscarryback.

You can carry over to the following year anyamount you cannot deduct because of the65%-of-taxable-income limit. Add it to yourdepletion allowance (before applying anylimits) for the following year.

Temporary suspension of taxable in-come limit for marginal production. For taxyears beginning after 1997 and before 2002,percentage depletion on the marginal pro-duction of oil or natural gas is not limited totaxable income from the property figuredwithout the depletion deduction. For informa-tion on marginal production, see section613A(c)(6) of the Internal Revenue Code.

Partnerships and S CorporationsGenerally, each partner or shareholder, andnot the partnership or S corporation, figuresthe depletion allowance separately. (How-ever, see Electing large partnerships mustfigure depletion allowance, later.) Each part-ner or shareholder must decide whether to


use cost or percentage depletion. If a partneror shareholder uses percentage depletion, heor she must apply the 65%-of-taxable-incomelimit using his or her taxable income from allsources.

Partner's or shareholder's adjusted basis.The partnership or S corporation must allo-cate to each partner his or her share of theadjusted basis of each oil or gas property heldby the partnership or S corporation. Thepartnership or S corporation makes the allo-cation as of the date it acquires the oil or gasproperty.

The partner's share of the adjusted basisof the oil or gas property generally is figuredaccording to that partner's interest in part-nership capital. However, in some cases, it isfigured according to the partner's interest inpartnership income.

The partnership or S corporation adjuststhe partner's or shareholder's share of theadjusted basis of the oil and gas property forany capital expenditures made for the prop-erty and for any change in partnership or Scorporation interests.

RECORDS

Each partner or shareholder mustseparately keep records of his or hershare of the adjusted basis in each

oil and gas property of the partnership or Scorporation. The partner or shareholder mustreduce his or her adjusted basis by the de-pletion he or she takes on the property eachyear. The partner or shareholder must usethat reduced adjusted basis to figure costdepletion or his or her gain or loss if thepartnership or S corporation disposes of theproperty.

Reporting the deduction. Deduct oil andgas depletion for a partnership or S corpo-ration interest on Schedule E (Form 1040).The instructions for Schedule E explain whereto report your income and deductions andwhether you need to file either of the followingforms.

• Form 6198, At-Risk Limitations.

• Form 8582, Passive Activity Loss Limita-tions.

Electing large partnerships must figuredepletion allowance. For partnership taxyears beginning after 1997, an electing largepartnership, rather than each partner, gener-ally must figure the depletion allowance. Thepartnership figures the depletion allowancewithout taking into account the limits on theamount of production and taxable income.Also, the adjusted basis of a partner's interestin the partnership is not affected by the de-pletion allowance.

An electing large partnership is one thatmeets both the following requirements.

• The partnership had 100 or more part-ners in the preceding year.

• The partnership chooses to be an elect-ing large partnership.

Disqualified partners. An electing largepartnership does not figure the depletion al-lowance of its disqualified partners. The dis-qualified partners must figure it themselves,as explained earlier.

All the following are disqualified partners.

• Refiners who cannot claim percentagedepletion (discussed under IndependentProducers, earlier).

• Retailers who cannot claim percentagedepletion (discussed under IndependentProducers, earlier).

• Any partner whose average daily pro-duction of domestic crude oil and naturalgas is more than 500 barrels during thetax year in which the partnership tax yearends. Average daily production is dis-cussed earlier.

Natural Gas WellsYou can use percentage depletion for naturalgas sold under a fixed contract or producedfrom geopressured brine.

Natural gas sold under a fixed contract.Natural gas sold under a fixed contract quali-fies for a percentage depletion rate of 22%.Natural gas sold under a fixed contract isdomestic natural gas sold by the producerunder a contract provided that the price can-not be adjusted to reflect any increase in theseller's tax liability because of the repeal ofpercentage depletion for gas. The contractmust have been in effect from February 1,1975, until the date of sale of the gas. Priceincreases after February 1, 1975, are pre-sumed to take the increase in tax liability intoaccount unless demonstrated otherwise byclear and convincing evidence.

Natural gas from geopressured brine.Qualified natural gas from geopressured brineis eligible for a percentage depletion rate of10%. Qualified natural gas from geopres-sured brine is natural gas that is both the fol-lowing.

• Produced from a well you began to drillafter September 1978 and before 1984.

• Determined in accordance with section503 of the Natural Gas Policy Act of 1978to be produced from geopressured brine.

Mines andGeothermal DepositsCertain mines, wells, and other natural de-posits, including geothermal deposits, qualifyfor percentage depletion.

Mines and other natural deposits. Thepercentage of your gross income from a na-tural deposit that you can deduct as depletiondepends on the type of deposit.

The following is a list of the depletionpercentages for the more common minerals.

You can find a complete list of depositsand their percentage depletion rates in sec-tion 613(b) of the Internal Revenue Code.

Corporate deduction for iron ore andcoal. The percentage depletion deduction ofa corporation for iron ore and coal (includinglignite) is reduced by 20% of:

• The percentage depletion deduction forthe tax year (figured without regard to thisreduction), minus

• The adjusted basis of the property at theclose of the tax year (figured without thedepletion deduction for the tax year).

Gross income from mining. For propertyother than a geothermal deposit or an oil orgas well, gross income from the propertymeans the gross income from mining. Miningincludes all the following.

• Extracting ores or minerals from theground.

• Applying certain treatment processes.

• Transporting ores or minerals (generally,not more than 50 miles) from the pointof extraction to the plants or mills in whichthe treatment processes are applied.

Excise tax. Gross income from miningincludes the separately stated excise tax re-ceived by a mine operator from the sale ofcoal to compensate the operator for the ex-cise tax the mine operator must pay to financeblack lung benefits.

Extraction. Extracting ores or mineralsfrom the ground includes extraction by mineowners or operators of ores or minerals fromthe waste or residue of prior mining. Thisdoes not apply to extraction from waste orresidue of prior mining by the purchaser of thewaste or residue or the purchaser of the rightsto extract ores or minerals from the waste orresidue.

Treatment processes. The processesincluded as mining depend on the ore ormineral mined. To qualify as mining, thetreatment processes must be applied by themine owner or operator. For a listing of treat-ment processes considered as mining, seesection 613(c)(4) of the Internal RevenueCode and the related regulations.

Transportation of more than 50 miles.If the IRS finds that the ore or mineral mustbe transported more than 50 miles to plantsor mills to be treated because of physical andother requirements, the additional authorizedtransportation is included in the computationof gross income from mining.

If you wish to include transportationof more than 50 miles in the compu-tation of gross income from mining,

file an application in duplicate with the IRS.Include on the application the facts concern-ing the physical and other requirements whichprevented the construction and operation ofthe plant within 50 miles of the point of ex-traction. Send this application to:

Internal Revenue ServiceWashington, DC 20224Attention: Assistant Chief Counsel,Passthroughs and Special Industries

Disposal of coal or iron ore. You cannottake a depletion deduction on coal (includinglignite) or iron ore mined in the United Statesif both the following apply.

DEPOSITS PERCENT

Sulphur, uranium, and, if from depositsin the United States, asbestos, lead ore,zinc ore, nickel ore, and mica ............... 22

Gold, silver, copper, iron ore, and certainoil shale, if from deposits in the UnitedStates ..................................................... 15

Borax, granite, limestone, marble,mollusk shells, potash, slate, soapstone,and carbon dioxide produced from a well 14

Coal, lignite, and sodium chloride ......... 10

Clay and shale used or sold for use inmaking sewer pipe or bricks or used orsold for use as sintered or burned light-weight aggregates ................................. 71 / 2

Clay used or sold for use in makingdrainage and roofing tile, flower pots,and kindred products, and gravel, sand,and stone (other than stone used or soldfor use by a mine owner or operator asdimension or ornamental stone) ............ 5


• You disposed of it after holding it for morethan 1 year.

• You retained an economic interest in it.

Treat any gain on the disposition as a capitalgain.

Disposal to related person. This ruledoes not apply if you dispose of the coal oriron ore to one of the following persons.

• A related person (as listed in chapter 12).

• A person owned or controlled by thesame interests that own or control you.

Geothermal deposits. Geothermal depositslocated in the United States or its pos-sessions qualify for a percentage depletionrate of 15%. A geothermal deposit is ageothermal reservoir of natural heat stored inrocks or in a watery liquid or vapor. For per-centage depletion purposes, a geothermaldeposit is not considered a gas well.

Figure gross income from a geothermalsteam well in the same way as for oil and gaswells. See Gross income from oil and gasproperty, earlier, under Oil and Gas Wells.

Lessor's Gross IncomeA lessor's gross income from the property thatqualifies for percentage depletion usually isthe total of the royalties received from thelease. However, for purposes of oil, gas, orgeothermal property, gross income does notinclude lease bonuses, advanced royalties,or other amounts payable without regard toproduction from the property.

Bonuses and advanced royalties. Bonusesreceived upon the grant of rights and ad-vanced royalties are payments a lesseemakes to a lessor for the lease or for min-erals, gas, or oil to be extracted from leasedproperty. Both types of payments are madebefore production. If you are the lessor, yourincome from bonuses and advanced royaltiesis subject to an allowance for depletion.

Figuring cost or percentage depletion.To figure cost depletion on a bonus, multiplyyour adjusted basis in the property by a frac-tion, the numerator of which is the bonus andthe denominator of which is the total bonusand royalties expected to be received. Tofigure cost depletion on advanced royalties,use the computation explained earlier underCost Depletion, treating the units for whichthe advanced royalty is received as the unitssold.

To figure percentage depletion (for otherthan gas, oil, or geothermal property), anybonus or advanced royalty payments are partof your gross income from the property.

Terminating the lease. If you receive abonus on a lease that expires, terminates, oris abandoned before you derive any incomefrom the extraction of mineral or cutting oftimber, include in income the depletion de-duction you took. Also increase your adjustedbasis in the property to restore the depletiondeduction you previously subtracted.

For advanced royalties, include in incomethe depletion claimed on minerals for whichthe advanced royalties were paid if the min-erals were not produced before lease termi-nation. Increase your adjusted basis in theproperty by the amount you include in in-come.

Delay rentals. These are payments for de-ferring development of the property. Sincedelay rentals are ordinary rent, they are ordi-nary income that is not subject to depletion.These rentals can be avoided by eitherabandoning the lease, beginning develop-ment operations, or obtaining production.

TimberYou can figure timber depletion only by thecost method. Percentage depletion does notapply to timber. Base your depletion on yourcost or other basis in the timber. Your costdoes not include the cost of land.

Depletion takes place when you cutstanding timber. You can figure your depletiondeduction when the quantity of cut timber isfirst accurately measured in the process ofexploitation.

Figuring cost depletion. To figure your costdepletion allowance, you multiply the numberof timber units cut by your depletion unit.

Timber units. When you acquire timberproperty, you must make an estimate of thequantity of marketable timber that exists onthe property. You measure the timber usingboard feet, log scale, cords, or other units. Ifyou later determine that you have more orless units of timber, you must adjust the ori-ginal estimate.

The term timber property means youreconomic interest in standing timber in eachtract or block representing a separate timberaccount.

Depletion unit. You figure your depletionunit each year by taking the following steps.

1) Determine your cost or adjusted basisof the timber on hand at the beginningof the year.

2) Add to the amount determined in (1) thecost of any units acquired during theyear and any additions to capital.

3) Figure the number of units to take intoaccount by adding the number of unitsacquired during the year to the numberof units on hand in the account at thebeginning of the year and then adding(or subtracting) any correction to the es-timate of the number of units remainingin the account.

4) Divide the result of (2) by the result of(3). This is your depletion unit.

Example. You bought a timber tract for$160,000 and the land was worth as muchas the timber. Your basis for the timber is$80,000. Based on an estimated one millionboard feet (1,000 MBF) of standing timber,you figure your depletion unit to be $80 perMBF ($80,000 ÷ 1,000). If you cut 500 MBFof timber, your depletion allowance would be$40,000 (500 MBF × $80).

When to claim depletion. Claim your de-pletion allowance as a deduction in the yearof sale or other disposition of the products cutfrom the timber, unless you choose to treatthe cutting of timber as a sale or exchange.Include allowable depletion for timber pro-ducts not sold during the tax year the timberis cut as a cost item in the closing inventory

of timber products for the year. The inventoryis your basis for determining gain or loss inthe tax year you sell the timber products.

Example. Assume the same facts as inthe previous example except that you soldonly half of the timber products in the cuttingyear. You would deduct $20,000 of the$40,000 depletion that year. You would addthe remaining $20,000 depletion to yourclosing inventory of timber products.

Choosing to treat the cutting of timber asa sale or exchange. You can choose, undercertain circumstances, to treat the cutting oftimber held for more than 1 year as a sale orexchange. You must make the choice on yourincome tax return for the tax year it applies.If you make this choice, subtract the adjustedbasis for depletion from the fair market valueof the timber on the first day of the tax yearin which you cut it to figure the gain or lossto report on the cutting. You generally reportthe gain as long-term capital gain. The fairmarket value then becomes your basis forfiguring your ordinary gain or loss on the saleor other disposition of the products cut fromthe timber. For more information, see Timberin chapter 2 of Publication 544, Sales andOther Dispositions of Assets.

Form T. Attach Form T, Forest ActivitiesSchedules, to your income tax return if youare claiming a deduction for timber depletionor choosing to treat the cutting of timber asa sale or exchange.

11.BusinessBad Debts

IntroductionIf someone owes you money you cannot col-lect, you have a bad debt. There are twokinds of bad debts—business bad debts andnonbusiness bad debts.

Generally, a business bad debt is one thatcomes from operating your trade or business.You can deduct business bad debts as anexpense on your business tax return.

All other bad debts are nonbusiness baddebts and are deductible as short-term capitallosses on Schedule D (Form 1040). For moreinformation on nonbusiness bad debts, seePublication 550.


• Definition of business bad debt

• When a debt is worthless

• How to treat business bad debts

• Recovery of a business bad debt

• Where to deduct business bad debts

Chapter 11 Business Bad Debts


Publication


� 536 Net Operating Losses (NOLs) forIndividuals, Estates, and Trusts



� 556 Examination of Returns, AppealRights, and Claims for Refund


Business Bad DebtDefinedA business bad debt is a loss from theworthlessness of a debt that was either of thefollowing.

• Created or acquired in your trade orbusiness.

• Closely related to your trade or businesswhen it became partly or totallyworthless.

The bad debts of a corporation are alwaysbusiness bad debts.

A debt is closely related to your trade orbusiness if your primary motive for incurringthe debt is a business reason.

Credit sales. Business bad debts are mainlythe result of credit sales to customers. Goodsand services customers have not paid for areshown in your books as either accountsreceivable or notes receivable. If you are un-able to collect any part of these accounts ornotes receivable, the uncollectible part is abusiness bad debt. Accounts or notesreceivable valued at fair market value at thetime of the transaction are deductible only atthat value, even though the fair market valuemay be less than face value.

You can take a bad debt deduction forthese accounts and notes receivable only ifthe amount owed you was included in yourgross income for the year the deduction isclaimed or for a prior year. This applies toamounts owed you from all sources of taxableincome, such as sales, services, rents, andinterest.

If you qualify under certain rules, you canuse the nonaccrual-experience method ofaccounting discussed later. Under thismethod, you do not have to accrue incomethat, based on your experience, you expectto be uncollectible.

Accrual method. If you use an accrualmethod of accounting, you normally reportincome as you earn it. You can take a baddebt deduction for an uncollectible receivableif you have included the uncollectible amountin income.

Cash method. If you use the cashmethod of accounting, you normally reportincome when you receive payment. Youcannot take a bad debt deduction for amountsowed to you that you have not received and

cannot collect because you never includedthose amounts in income.

Debts from a former business. If you sellyour business but keep its accounts receiv-able, these debts are business debts sincethey arose in your trade or business. If anaccount becomes worthless, the loss is abusiness bad debt. These accounts wouldalso be business debts if sold to the newowner of the business.

If you sell your business to one personand sell your accounts receivable to someoneelse, the character of the debts as businessor nonbusiness is based on the activities ofthe new holder of these debts. A loss from thedebts is a business bad debt to the newholder if that person acquired the debts in hisor her trade or business or if the debts wereclosely related to the new holder's trade orbusiness when they became worthless. Oth-erwise, a loss from these debts is a nonbusi-ness bad debt.

Debt acquired from a decedent. Thecharacter of a loss from debt of a businessacquired from a decedent is determined in thesame way as a debt sold by a business. If youare in a trade or business, a loss from thedebts is a business bad debt if the debts wereclosely related to your trade or business whenthey became worthless. Otherwise, a lossfrom these debts is a nonbusiness bad debt.

Liquidation. If you liquidate your busi-ness and some of your accounts receivablebecome worthless, they are business baddebts.

Types of Business BadDebtsThe following are situations that may result ina business bad debt.

Loans to clients and suppliers. If you makea loan to a client, supplier, employee, or dis-tributor for a business reason and it becomesworthless, you have a business bad debt.

Example. John Smith, an advertisingagent, made loans to certain clients to keeptheir business. His main reason for makingthese loans was to help his business. One ofthese clients later went bankrupt and couldnot repay him. Since John's business was themain reason for making the loan, the debtwas a business debt and he can take a busi-ness bad debt deduction.

Debts of political parties. If a political party(or other organization that accepts contribu-tions or spends money to influence elections)owes you money and the debt becomesworthless, you cannot take a bad debt de-duction unless you use an accrual method ofaccounting and meet all the following tests.

1) The debt was from the sale of goods orservices in the ordinary course of yourtrade or business.

2) More than 30% of all your receivablesaccrued in the year of the sale were fromsales made to political parties.

3) You made substantial continuing effortsto collect on the debt.

Loan or capital contribution. You cannottake a bad debt deduction for a loan youmade to a corporation if, based on the facts

and circumstances, the loan is actually acontribution to capital.

Debts of an insolvent partner. If yourbusiness partnership breaks up and one ofyour former partners is insolvent and cannotpay any of the partnership's debts, you mayhave to pay more than your share of thepartnership's debts. If you pay any part of theinsolvent partner's share of the debts, you cantake a bad debt deduction.

Business loan guarantee. If you guaranteea debt that becomes worthless, the debt canqualify as a business bad debt if all the fol-lowing requirements are met.

• You made the guarantee in the courseof your trade or business.

• You have a legal duty to pay the debt.

• You made the guarantee before the debtbecame worthless. You meet this re-quirement if you reasonably expected youwould not have to pay the debt withoutfull reimbursement from the issuer.

• You receive reasonable consideration formaking the guarantee. You meet thisrequirement if you made the guaranteein accord with normal business practiceor for a good faith business purpose.

Consider any guarantee you make toprotect or improve your job as closely relatedto your trade or business as an employee.

Example. Bob Zayne owns the ZayneDress Company. He guaranteed payment ofa $20,000 note for Elegant Fashions, a dressoutlet. Elegant Fashions is one of Zayne'slargest clients. Elegant Fashions later filed forbankruptcy and defaulted on the loan. Mr.Zayne made full payment to the bank. He cantake a business bad debt deduction, since hisguarantee was made in the course of histrade or business for a good faith businesspurpose. He was motivated by the desire toretain one of his better clients and keep asales outlet.

Deductible in the year paid. You candeduct a payment you make on a loan youguaranteed in the year of payment unless youhave rights against the borrower.

Rights against a borrower. When youmake payment on a loan you guaranteed, youmay have the right to take the place of thelender. The debt is then owed to you. If youhave this right, or some other right to demandpayment from the borrower, you cannot takea bad debt deduction until these rights be-come partly or totally worthless.

Bankruptcy claim. You can deduct as a baddebt only the difference between the amountowed to you by a bankrupt entity and theamount you received from the distribution ofits assets.

Sale of mortgaged property. If mortgagedor pledged property is sold for less than thedebt, the unpaid, uncollectible balance of thedebt after the sale is a bad debt. If the debtrepresents capital or an amount you previ-ously included in income, you can deduct itas a bad debt in the year it becomes totallyworthless or in the year you charged it off aspartially worthless.


When Debt IsWorthlessYou do not have to wait until a debt is due todetermine whether it is worthless. A debt be-comes worthless when there is no longer anychance the amount owed will be paid.

It is not necessary to go to court if you canshow that a judgment from the court wouldbe uncollectible. You must only show that youhave taken reasonable steps to collect thedebt. Bankruptcy of your debtor is generallygood evidence of the worthlessness of atleast a part of an unsecured and unpreferreddebt.

Property received for debt. If you receiveproperty in partial settlement of a debt, reducethe debt by the fair market value of the prop-erty received. You can deduct the remainingdebt as a bad debt in the year you determineit is worthless.

If you later sell the property, any gain onthe sale is due to the appreciation of theproperty after it was used to partially settle thedebt. You must include any gain from the salein gross income. The gain is not a recoveryof a bad debt. For information on the sale ofan asset, see Publication 544.

How To TreatThere are two ways to treat business baddebts.

• The specific charge-off method.

• The nonaccrual-experience method.

Generally, you must use the specific charge-off method. However, you can use the non-accrual-experience method if you meet therequirements discussed later.

Specific Charge-Off MethodIf you use the specific charge-off method, youcan deduct specific business bad debts thatbecome either partly or totally worthless dur-ing the tax year.

Partly worthless debts. You can deductspecific bad debts that are partly uncollect-ible. Your deduction is limited to the amountyou charge off on your books during the taxyear. You do not have to charge off and de-duct your partly worthless debts annually. Youcan delay the charge-off until a later year. Youcannot, however, deduct any part of a debtafter the year it becomes totally worthless.

Deduction disallowed. You can gener-ally take a partial bad debt deduction only inthe year you make the charge-off on yourbooks. If the Internal Revenue Service (IRS)does not allow your deduction and the debtbecomes partly worthless in a later tax year,you can deduct the amount you charge off inthat year plus the amount charged off in theearlier year. The charge-off in the earlier year,unless reversed on your books, fulfills thecharge-off requirement for the later year.

Totally worthless debts. Deduct a totallyworthless debt only in the tax year it becomestotally worthless. Do not include any amountdeducted in an earlier tax year when the debtwas only partly worthless.

You do not have to make an actualcharge-off on your books to claim a bad debtdeduction for a totally worthless debt. How-ever, you may want to do so. If you do notand the IRS later rules the debt is only partlyworthless, you will not be allowed a deductionfor the debt in that tax year. A deduction ofa partly worthless bad debt is limited to theamount actually charged off.

Filing a claim for refund. If you did not de-duct a bad debt on your original return for theyear it became worthless, you can file a claimfor a credit or refund. If the bad debt wastotally worthless, you must file the claim bythe later of the following dates.

• 7 years from the date your original returnwas due (not including extensions).

• 2 years from the date you paid the tax.

If the claim is for a partly worthless baddebt, you must file the claim by the later of thefollowing dates.

• 3 years from the date you filed your ori-ginal return.

• 2 years from the date you paid the tax.

However, you may have longer to file theclaim if you were physically or mentally una-ble to handle your financial affairs for a time.For details, see Publication 556.

Use one of the following forms to file aclaim for a credit or refund.

For more information about filing a claim, seePublication 556.

Nonaccrual-ExperienceMethodIf you use an accrual method of accountingand qualify under the rules explained in thissection, you can use the nonaccrual-experience method of accounting for baddebts. Under this method, you do not accrueincome you expect to be uncollectible.

If you determine, based on your experi-ence, that certain amounts (accounts receiv-able) are uncollectible, do not include them inyour gross income for the tax year.

Amounts must be for performing services.You can use the nonaccrual-experiencemethod only for amounts earned by perform-ing services. You cannot use this method foramounts owed to you from activities such aslending money, selling goods, or acquiringreceivables or other rights to receive pay-ments.

Interest or penalty charged. Generally, youcannot use the nonaccrual-experiencemethod for amounts due on which you chargeinterest or a late payment penalty. However,do not treat a discount offered for early pay-ment as the charging of interest or a penaltyif both the following apply.

• You otherwise accrue the full amount dueas gross income at the time you providethe services.

• You treat the discount allowed for earlypayment as an adjustment to gross in-come in the year of payment.

How to apply this method. You can applythe nonaccrual-experience method under ei-ther of the following systems.

• Separate receivable system.

• Periodic system.

Under the separate receivable system, applythe nonaccrual-experience method separatelyto each account receivable. Under the peri-odic system, apply the nonaccrual-experiencemethod to total qualified accounts receivableat the end of your tax year.

Treat each system as a separate methodof accounting. You generally cannot changefrom one system to the other without IRSapproval.

Generally, you also need IRS approval tochange from a different accounting method toeither system under the nonaccrual-experience method.

For more information on the separatereceivable system, see section 1.448–2T ofthe regulations. For more information on theperiodic system, see Notice 88–51 in Cumu-lative Bulletin 1988–1.

Recovery of Bad DebtIf you deduct a bad debt and later recover(collect) all or part of it, you may have to in-clude all or part of the recovery in gross in-come. The amount you include is limited tothe amount you actually deducted. However,you can exclude the amount deducted thatdid not reduce your tax. Report the recoveryas “Other income” on the appropriate busi-ness form or schedule.

Example. In 1999, the Willow Corporationhad gross income of $158,000, a bad debtdeduction of $3,500, and other allowable de-ductions of $49,437. The corporation reportedon the accrual method of accounting andused the specific charge-off method for baddebts. The entire bad debt deduction reducedthe tax on the 1999 corporate return. In 2000,the corporation recovers part of the $3,500deducted in 1999. It must include the partrecovered in income for 2000 as “Other in-come” on its corporate return.

Net operating loss (NOL) carryover. Ifa bad debt deduction increases an NOL car-ryover that has not expired before the begin-ning of the tax year in which the recoverytakes place, you treat the deduction as havingreduced your tax. A bad debt deduction thatcontributes to a net operating loss helps lowertaxes in the year to which you carry the netoperating loss.

More information. See Publication 536for more information about net operatinglosses. See Recoveries in Publication 525 formore information on recovered amounts.

Sale of property received for debt. If youreceive property in partial settlement of a debtand you later sell the property, any gain onthe sale is not a recovery of a bad debt. SeeProperty received for debt, earlier.

If you are an: File:

Individual Form 1040X

Corporation Form 1120X

S Corporation Form 1120S (check box F(4))

Partnership Form 1065 (check box G(4))


Where To DeductUse the following guide to find where to de-duct your business bad debts.

12.Electric andClean-FuelVehicles

IntroductionYou are allowed a limited deduction for thecost of clean-fuel vehicle property and clean-fuel vehicle refueling property you place inservice during the tax year. Also, you are al-lowed a tax credit of 10% of the cost of anyqualified electric vehicle you place in serviceduring the tax year.

TIPYou can take the electric vehiclecredit or the deduction for clean-fuelvehicle property regardless of

whether you use the vehicle in a trade orbusiness. However, you can take a deductionfor clean-fuel vehicle refueling property onlyif you use the property in your trade or busi-ness.


• The deduction for clean-fuel vehicleproperty

• The deduction for clean-fuel vehicle re-fueling property

• Recapture of the deductions

• The electric vehicle credit

• Recapture of the credit


Publication





� 8834 Qualified Electric Vehicle Credit


DefinitionsThe following definitions apply throughout thischapter.

Clean-burning fuels. The following areclean-burning fuels.

1) Natural gas.

2) Liquefied natural gas.

3) Liquefied petroleum gas.

4) Hydrogen.

5) Electricity.

6) Any other fuel that is at least 85% alco-hol (any kind) or ether.

Motor vehicle. A motor vehicle is any vehiclethat has four or more wheels and is manu-factured primarily for use on public streets,roads, and highways. It does not include avehicle operated exclusively on a rail or rails.

Nonqualifying property. This is propertyused in the following ways.

1) Predominantly outside the United States.

2) Predominantly to furnish lodging or inconnection with the furnishing of lodging.

3) By certain tax-exempt organizations.

4) By governmental units or foreign per-sons or entities.

Deductions forClean-Fuel Vehicleand RefuelingPropertyYou are allowed a limited deduction for thecost of clean-fuel vehicle property. You arealso allowed a limited deduction for the costof clean-fuel vehicle refueling property. Thesedeductions are allowed only in the tax yearyou place the property in service.

You cannot claim these deductions for thepart of the property's cost you claim as asection 179 deduction. For information on thesection 179 deduction, see Publication 946.

Deduction for Clean-FuelVehicle PropertyThe deduction for this property may beclaimed regardless of whether the property isused in a trade or business.

Clean-fuel vehicle property. Clean-fuel ve-hicle property is either of the following kindsof property.

1) A motor vehicle (defined earlier)produced by an original equipmentmanufacturer and designed to be pro-

pelled by a clean-burning fuel. The onlypart of a vehicle's basis that qualifies forthe deduction is the part attributable to:

a) A clean-fuel engine that can use aclean-burning fuel,

b) The property used to store or de-liver the fuel to the engine, or

c) The property used to exhaust gasesfrom the combustion of the fuel.

2) Any property installed on a motor vehicle(including installation costs) to enable itto be propelled by a clean-burning fuelif:

a) The property is an engine (or mod-ification of an engine) that can usea clean-burning fuel, or

b) The property is used to store ordeliver that fuel to the engine or toexhaust gases from the combustionof that fuel.

For vehicles that may be propelled by botha clean-burning fuel and any other fuel, yourdeduction is generally the additional cost ofpermitting the use of the clean-burning fuel.

CAUTION!

Clean-fuel vehicle property does notinclude an electric vehicle that quali-fies for the electric vehicle credit, dis-

cussed later.

Qualified property. Your property mustmeet the following requirements to qualify forthe deduction.

1) It must be acquired for your own use andnot for resale.

2) Its original use must begin with you.

3) Either—

a) The motor vehicle of which it is apart must satisfy any federal orstate emissions standards that ap-ply to each fuel by which the vehicleis designed to be propelled, or

b) It must satisfy any federal and stateemissions certification, testing, andwarranty requirements that apply.

4) It cannot be nonqualifying property, de-fined earlier.

Deduction limit. The maximum deductionyou can claim for qualified clean-fuel vehicleproperty with respect to any motor vehicle isone of the following.

1) $50,000 for a truck or van with a grossvehicle weight rating over 26,000 poundsor for a bus with a seating capacity ofat least 20 adults (excluding the driver).

2) $5,000 for a truck or van with a grossvehicle weight rating over 10,000 poundsbut not more than 26,000 pounds.

3) $2,000 for a vehicle not included in (1)or (2).

Deduction for Clean-FuelVehicle Refueling PropertyYour property must meet the following re-quirements to qualify for this deduction.

1) It must be depreciable property.

2) Its original use must begin with you.

If you are a: Then deduct yourbad debt on:

Sole Proprietor Line 9 of Schedule C(Form 1040)

Farmer Line 34 of Schedule F(Form 1040)

Corporation Line 15 of Form 1120or

Line 15 of Form 1120–Aor

Line 10 of Form 1120S

Partnership Line 12 of Form 1065

Chapter 12 Electric and Clean-Fuel Vehicles

3) It cannot be nonqualifying property, de-fined earlier.

Clean-fuel vehicle refueling property.Clean-fuel vehicle refueling property is anyproperty (other than a building or its structuralcomponents) used to do either of the follow-ing.

1) Store or dispense a clean-burning fuel(defined earlier) into the fuel tank of amotor vehicle propelled by the fuel, butonly if the storage or dispensing is at thepoint where the fuel is delivered into thetank.

2) Recharge motor vehicles propelled byelectricity, but only if the property is lo-cated at the point where the vehicles arerecharged.

Recharging property. This property in-cludes any equipment used to provide elec-tricity to the battery of a motor vehicle pro-pelled by electricity. It includes low-voltagerecharging equipment, high-voltage (quick)charging equipment, and ancillary connectionequipment such as inductive charging equip-ment. It does not include property used togenerate electricity, such as solar panels orwindmills, and does not include the batteryused in the vehicle.

Deduction limit. The maximum deductionyou can claim for clean-fuel vehicle refuelingproperty placed in service at one location is$100,000. To figure your maximum deductionfor any tax year, subtract from $100,000 thetotal you (or any related person or prede-cessor) claimed for clean-fuel vehicle refuel-ing property placed in service at that locationfor all earlier years.

CAUTION!

If the deduction limit applies, you mustspecify on your tax return the property(and the portion of the property's cost)

you are using as a basis for the deduction.

Related persons. For this purpose, thefollowing are considered related persons.

1) An individual and his or her brothers andsisters, half-brothers, half-sisters,spouse, ancestors, and lineal descend-ants.

2) An individual and a corporation if the in-dividual owns, directly or indirectly, morethan 50% in value of the outstandingstock of the corporation.

3) Two corporations that are members ofthe same controlled group as defined insection 267(f) of the Internal RevenueCode.

4) A grantor and a fiduciary of any trust.

5) Fiduciaries of two separate trusts if thesame person is a grantor of both trusts.

6) A fiduciary and a beneficiary of the sametrust.

7) A fiduciary and a beneficiary of twoseparate trusts if the same person is agrantor of both trusts.

8) A fiduciary of a trust and a corporationif the trust or a grantor of the trust owns,directly or indirectly, more than 50% invalue of the outstanding stock of thecorporation.

9) A person and a tax-exempt educationalor charitable organization that is con-trolled directly or indirectly by that personor by members of the family of that per-son.

10) A corporation and a partnership if thesame persons own more than 50% invalue of the outstanding stock of thecorporation and more than 50% of thecapital or profits interest in the partner-ship.

11) Two S corporations or an S corporationand a regular corporation if the samepersons own more than 50% in value ofthe outstanding stock of each corpo-ration.

12) A partnership and a person owning, di-rectly or indirectly, more than 50% of thecapital or profits interests in the partner-ship.

13) Two partnerships if the same personsown, directly or indirectly, more than50% of the capital or profits interest inboth partnerships.

14) An executor of an estate and a benefi-ciary of the estate.

To determine whether an individual di-rectly or indirectly owns any of the outstand-ing stock of a corporation, see Ownership ofstock under Related Persons in Publication538.

How To Claimthe DeductionsHow you claim the deductions for clean-fuelvehicle property and clean-fuel vehicle refu-eling property depends on the use of theproperty and the kind of income tax return youfile.

Deduction for nonbusiness clean-fuel ve-hicle property by individuals. Individualscan claim the deduction for clean-fuel vehicleproperty used for nonbusiness purposes byincluding the deduction in the total on line 32of Form 1040. Also, enter the amount of yourdeduction and “Clean-Fuel” on the dotted linenext to line 32. If you use the vehicle partlyfor business, see the next two discussions.

Deduction for business clean-fuel vehicleproperty by employees. Employees whouse clean-fuel vehicle property for business,or partly for business and partly for nonbusi-ness purposes, should include the entire de-duction in the total on line 32 of Form 1040.Also, enter the amount of your deduction and“Clean-Fuel” on the dotted line next to line 32.

Sole proprietors. Sole proprietors mustclaim deductions for clean-fuel vehicle prop-erty and clean-fuel vehicle refueling propertyused for business on the Other expenses lineof either Schedule C (Form 1040) or Sched-ule F (Form 1040). If clean-fuel vehicle prop-erty is used partly for nonbusiness purposes,claim the nonbusiness part of the deductionas explained earlier under Deduction fornonbusiness clean-fuel vehicle property byindividuals.

Partnerships. Partnerships claim the de-ductions for clean-fuel vehicle property andclean-fuel vehicle refueling property on line20 of Form 1065.

S corporations. S corporations claim thedeductions for clean-fuel vehicle property andclean-fuel vehicle refueling property on line19 of Form 1120S.

C corporations. C corporations claim thedeductions for clean-fuel vehicle property andclean-fuel vehicle refueling property on line26 of Form 1120 (line 22 of Form 1120–A).

Recapture ofthe DeductionsIf the property ceases to qualify, you mayhave to recapture the deduction. You recap-ture the deduction by including it, or part of it,in your income.

Clean-Fuel Vehicle PropertyYou must recapture the deduction for clean-fuel vehicle property if the property ceases toqualify within 3 years after the date youplaced it in service. The property will ceaseto qualify if it is changed in any of the follow-ing ways.

1) It is modified so that it can no longer bepropelled by a clean-burning fuel.

2) It ceases to be a qualified clean-fuel ve-hicle property (for example, by failing tomeet emissions standards).

3) It becomes nonqualifying property, de-fined earlier.

Sales or other dispositions. If you sell orotherwise dispose of the vehicle within 3years after the date you placed it in serviceand know or have reason to know that it willbe changed in any of the ways describedabove, you are subject to the recapture rules.In other dispositions (including a dispositionby reason of an accident or other casualty),the recapture rules do not apply.

If the vehicle was subject to depreciation,the deduction (minus any recapture) is con-sidered depreciation when figuring the partof any gain from the disposition that is ordi-nary income. See Publication 544 for moreinformation on dispositions of depreciableproperty.

Recapture amount. Figure your recaptureamount by multiplying the deduction by thefollowing percentage.

• 100% if the recapture date is within thefirst full year after the date the vehiclewas placed in service.

• 662 / 3% if the recapture date is within thesecond full year after the date the vehiclewas placed in service.

• 331 / 3% if the recapture date is within thethird full year after the date the vehiclewas placed in service.

Recapture date. The recapture date isgenerally the date of the event that causesthe recapture. However, the recapture datefor an event described in item (3), earlier, isthe first day of the recapture year in which theevent occurs.

How to report. How you report the recaptureamount for clean-fuel vehicle property as in-come depends on how you claimed the de-duction for that property.

Deducted by individuals asnonbusiness-use property. Include theamount on line 21 of Form 1040.


Deducted by employees as business-use property. Include the amount on line 21of Form 1040.

Deducted by sole proprietors asbusiness-use property. Include the amounton the Other income line of either ScheduleC (Form 1040) or Schedule F (Form 1040).

Partnerships and corporations (includ-ing S corporations). Include the amount onthe Other income line of the form you file.

Clean-Fuel VehicleRefueling PropertyYou must recapture the deduction for clean-fuel vehicle refueling property if the propertyceases to qualify at any time before the endof its depreciation recovery period. Theproperty will cease to qualify if it is changedin any of the following ways.

1) It ceases to be a clean-fuel vehicle refu-eling property (for example, by beingconverted to store and dispense gaso-line).

2) It is no longer used 50% or more in yourtrade or business.


Sales or other dispositions. If you sell orotherwise dispose of the property before theend of its recovery period and know or havereason to know that it will be changed in anyof the ways described above, you are subjectto the recapture rules. In other dispositions(including a disposition by reason of an acci-dent or other casualty), the recapture rulesdo not apply.

The deduction (minus any recaptureamount) is considered depreciation when fig-uring the part of any gain from the dispositionthat is ordinary income. See Publication 544for more information on dispositions ofdepreciable property.

Recapture amount. Figure your recaptureamount by multiplying the deduction youclaimed by the following fraction.

How to report. How you report the recaptureamount for clean-fuel vehicle refueling prop-erty depends on how you claimed the de-duction for that property.

Sole proprietors. Include the amount onthe Other income line of either Schedule C(Form 1040) or Schedule F (Form 1040).

Partnerships and corporations (includ-ing S corporations). Include the amount onthe Other income line of the form you file.

Basis AdjustmentsYou must reduce the basis of your clean-fuelvehicle property or clean-fuel vehicle refuelingproperty by the deduction claimed. If, in alater year, you must recapture part or all ofthe deduction, increase the basis of theproperty by the amount recaptured. If theproperty is depreciable property, you can re-cover this additional basis over the property'sremaining recovery period beginning with thetax year of recapture.

CAUTION!

If you were using the percentage ta-bles to figure your depreciation on theproperty, you will not be able to con-

tinue to do so. See Publication 946 for infor-mation on figuring your depreciation withoutthe tables.

Electric Vehicle CreditYou can choose to claim a tax credit for aqualified electric vehicle you place in serviceduring the year. You can make this choiceregardless of whether the property is used ina trade or business.

Qualified Electric VehicleA vehicle is a qualified electric vehicle if itmeets all the following requirements.

1) It is a motor vehicle (defined earlier)powered primarily by an electric motordrawing current from rechargeable bat-teries, fuel cells, or other portablesources of electrical current.

2) You were the first person to use it.

3) You acquired it for your own use and notfor resale.

4) It has never been used as a nonelectricvehicle.

5) It is not nonqualifying property, definedearlier.

Amount of the CreditThe credit is generally 10% of the cost ofeach qualified electric vehicle you place inservice during the year. If your vehicle is adepreciable business asset, you must reducethe cost of the vehicle by any section 179deduction before figuring the 10% credit. Ifyou need information on the section 179 de-duction, see Publication 946.

Credit limits. The credit is limited to $4,000for each vehicle. The total credit is limited tothe excess of your regular tax liability, re-duced by certain credits, over your tentativeminimum tax. To figure the credit limit, com-plete Form 8834 and attach it to your tax re-turn.

How ToClaim the CreditYou must complete and attach Form 8834 toyour tax return to claim the electric vehiclecredit. Enter your credit on your tax returnas discussed next.

Individuals. Individuals claim the credit byentering the amount from line 19 of Form8834 on line 49 of Form 1040. Check box“d” and specify Form 8834.

Partnerships. Partnerships enter theamount from line 19 of Form 8834 on line 13of Schedule K (Form 1065). The partnershipthen allocates the credit to the partners online 13 of Schedule K–1 (Form 1065). See theinstructions for Form 1065.

S corporations. S corporations enter theamount from line 19 of Form 8834 on line 13of Schedule K (Form 1120S). The S corpo-ration then allocates the credit to the share-

holders on line 13 of Schedule K–1 (Form1120S). See the instructions for Form 1120S.

C corporations. C corporations claim thecredit by entering the amount from line 19 ofForm 8834 in the total for line 6c of ScheduleJ (Form 1120) and checking the Form 8834box to the left of the entry. See the in-structions for Form 1120.

Recapture of the CreditThe electric vehicle credit is subject to re-capture if, within 3 years after the date youplace the vehicle in service, it ceases toqualify for the electric vehicle credit. You re-capture the credit by adding it, or part of it, toyour income tax.

The vehicle will cease to qualify if it ischanged in either of the following ways.

1) It is modified so that it is no longer pri-marily powered by electricity.


Sales or other dispositions. If you sell orotherwise dispose of the vehicle within 3years after the date you placed it in serviceand know or have reason to know that it willbe changed in either of the ways describedabove, you are subject to the recapture rules.In other dispositions (including a dispositionby reason of an accident or other casualty),the recapture rules do not apply.

If the vehicle was subject to depreciation,the credit (minus any recapture amount) isconsidered depreciation when figuring thepart of any gain from the disposition that isordinary income. See Publication 544 formore information on dispositions of deprecia-ble property.

Recapture amount. Figure your recaptureamount by multiplying the credit by the fol-lowing percentage.

• 100% if the recapture date is within thefirst full year after the date the vehiclewas placed in service.

• 662 / 3% if the recapture date is within thesecond full year after the date the vehiclewas placed in service.

• 331 / 3% if the recapture date is within thethird full year after the date the vehiclewas placed in service.

Recapture date. The recapture date isgenerally the date of the event that causesthe recapture. However, the recapture datefor an event described in item (2), earlier, isthe first day of the recapture year in which theevent occurs.

How to report. Report the recapture amountas follows.

Individuals. Include the amount on line57 of Form 1040. Write “QEVCR” on the dot-ted line next to line 57.

Partnerships. Include on line 25 ofSchedule K–1 (Form 1065) the information apartner needs to figure the recapture of thecredit.

S corporations. Include on line 23 ofSchedule K–1 (Form 1120S) the informationa shareholder needs to figure the recaptureof the credit.

C corporations. Include the amount online 10 of Schedule J (Form 1120), or line 7of Part I (Form 1120–A). Write “QEV recap-

Total recovery period for _ Recovery years beforethe property the recapture year

Total recovery period for the property


ture” on the dotted line next to that entryspace.

Basis AdjustmentsIf you claim a tax credit for a qualified electricvehicle you place in service during the year,you must reduce your basis in that vehicle bythe lesser of:

1) $4,000, or

2) 10% of the cost of the vehicle.

This basis reduction rule applies even if thecredit allowed is less than that amount.

If you must recapture part or all of thecredit, increase the basis of your vehicle bythe amount recaptured. If the qualified electricvehicle is depreciable property, you can re-cover the additional basis over the vehicle'sremaining recovery period beginning with thetax year of recapture.

CAUTION!

If you were using the percentage ta-bles to figure your depreciation on thevehicle, you will not be able to con-

tinue to do so. See Publication 946 for infor-mation on figuring your depreciation withoutthe tables.

13.Other Expenses

Important Changesfor 2000Standard mileage rate. The standard mile-age rate for the cost of operating your car,van, pickup, or panel truck in 2000 is 321/2cents a mile for all business miles. See Carallowance, later.

Meal expense deduction subject to “hoursof service” limits. You can deduct 60% ofthe reimbursed meals your employees con-sume while they are subject to the Depart-ment of Transportation's “hours of service”limits. For more information, see Meal ex-penses when subject to “hours of service”limits, later.

IntroductionThis chapter covers expenses you as a busi-ness owner may have that are not explainedin earlier chapters of this publication.


• Travel, meals, and entertainment

• Bribes and kickbacks

• Charitable contributions

• Education expenses

• Franchises, trademarks, and tradenames

• Lobbying expenses

• Penalties and fines

• Repayments (claim of right)


Publication

� 15–B Employer's Tax Guide to FringeBenefits


� 529 Miscellaneous Deductions

� 542 Corporations


� 1542 Per Diem Rates


� Sch A (Form 1040) Itemized Deductions

� 1099–MISC Miscellaneous Income

� 6069 Return of Excise Tax on ExcessContributions to Black Lung Ben-efit Trust Under Section 4953 andComputation of Section 192 De-duction

See chapter 14 for information about get-ting forms and publications.

Travel, Meals,and EntertainmentTo be deductible, expenses incurred fortravel, meals, and entertainment must be or-dinary and necessary expenses of carryingon your trade or business. Generally, you alsomust show that entertainment expenses (in-cluding meals) are directly related to, or as-sociated with, the conduct of your trade orbusiness.

The following discussion explains how youdeduct any reimbursements or allowancesyou make for these expenses incurred byyour employees. If you are self-employed andincur these expenses yourself, see Publica-tion 463 for information on how you can de-duct them.

ReimbursementsHow you deduct a reimbursement or allow-ance arrangement (including per diem allow-ances, discussed later) for travel, meals, andentertainment expenses incurred by youremployees depends on whether you have anaccountable plan or a nonaccountable plan.A reimbursement or allowance arrange-ment is a system by which you pay advances,reimbursements, and charges for your em-ployees' business expenses and they sub-stantiate their expenses to you so you cansubstantiate your deduction of the advance,reimbursement, or charge. If you make asingle payment to your employees and it in-cludes both wages and an expense re-imbursement, you must specify the amountof the reimbursement.

If you reimburse these expenses underan accountable plan, deduct them as travel,meal, and entertainment expenses. If you

reimburse these expenses under a nonac-countable plan, you must report the re-imbursements as wages on Form W–2, Wageand Tax Statement, and deduct them aswages. See Table 13–1.

Accountable PlansTo be an accountable plan, your reimburse-ment or allowance arrangement must requireyour employees to meet all the followingrules.

1) They must have paid or incurreddeductible expenses while performingservices as your employees.

2) They must adequately account to you forthese expenses within a reasonable pe-riod of time.

3) They must return any excess re-imbursement or allowance within a rea-sonable period of time.

An arrangement under which you advancemoney to employees is treated as meeting (3)above only if the following requirements arealso met.

• The advance is reasonably calculated notto exceed the amount of anticipated ex-penses.

• You make the advance within a reason-able period of time.

If any expenses reimbursed under thisarrangement are not substantiated, or are anexcess reimbursement that is not returnedwithin a reasonable period of time by an em-ployee, you cannot treat these expenses asreimbursed under an accountable plan. In-stead, treat the reimbursed expenses as paidunder a nonaccountable plan, discussedlater.

Adequate accounting. Your employeesmust adequately account to you for their ex-penses. They must give you documentaryevidence of their travel, mileage, and otheremployee business expenses. This evidenceshould include items such as receipts, alongwith either a statement of expenses, an ac-count book, a diary, or a similar record inwhich the employee entered each expenseat or near the time the expense was incurred.

Excess reimbursement or allowance. Anexcess reimbursement or allowance is anyamount you pay to an employee that is morethan the business-related expenses for whichthe employee adequately accounted. Theemployee must return any excess re-imbursement or other expense allowance toyou within a reasonable period of time.

Reasonable period of time. A reasonableperiod of time depends on the facts and cir-cumstances. Generally, actions that takeplace within the times specified in the follow-ing list will be treated as taking place withina reasonable period of time.

1) You give an advance within 30 days ofthe time the employee has the expense.

2) Your employees adequately account fortheir expenses within 60 days after theexpenses were paid or incurred.

3) Your employees return any excess re-imbursement within 120 days after theexpense was paid or incurred.

Chapter 13 Other Expenses

4) You give a periodic statement (at leastquarterly) to your employees that asksthem to either return or adequately ac-count for outstanding advances and theycomply within 120 days of the statement.

How to deduct. You can take a deductionfor travel, meals, and entertainment expensesif you reimburse your employees for theseexpenses under an accountable plan. Theamount you deduct for meals and enter-tainment, however, may be subject to a 50%limit, discussed later. If you are a sole pro-prietor, deduct the reimbursement on line 24of Schedule C (Form 1040). If you file a cor-poration income tax return, include the re-imbursement in the amount claimed on the“Other deductions” line of Form 1120, U.S.Corporation Income Tax Return, or Form1120–A, U.S. Corporation Short-Form IncomeTax Return. If you file any other income taxreturn, such as a partnership or S corporationreturn, deduct the reimbursement on the ap-propriate line of the return as provided in theinstructions for that return.

Per Diem and Car AllowancesYou may reimburse your employees underan accountable plan based on travel days,miles, or some other fixed allowance. Inthese cases, your employee is considered tohave accounted to you for the amount of theexpense that does not exceed the rates es-tablished by the federal government. Youremployee must actually substantiate to youthe other elements of the expense, such astime, place, and business purpose.

Federal rate. The federal rate can be figuredusing any one of the following methods.

1) For per diem amounts:

a) The regular federal per diem rate.

b) The standard meal allowance.

c) The high-low rate.

2) For car expenses:

a) The standard mileage rate.

b) A fixed and variable rate (FAVR).

Car allowance. Your employee is consid-ered to have accounted to you for car ex-penses that do not exceed the standardmileage rate. For 2000, the standard mileagerate is 32.5 cents per mile for each businessmile.

You can choose to reimburse your em-ployees using a fixed and variable rate(FAVR) allowance. This is an allowance thatincludes a combination of payments coveringfixed and variable costs, such as a cents-per-mile rate to cover your employees' vari-able operating costs (such as gas, oil, etc.)plus a flat amount to cover your employees'fixed costs (such as depreciation, insurance,etc.). For information on using a FAVR al-lowance, see Revenue Procedure 99–38 inCumulative Bulletin 1999–2. You can readRevenue Procedure 99–38 at many public li-braries.

Per diem allowance. If your employee ac-tually substantiates to you the other elements(discussed earlier) of the expenses reim-bursed using the per diem allowance, howyou report and deduct the allowance dependson whether the allowance is for lodging andmeal expenses or for meal expenses only and

Table 16-1. Reporting Reimbursements

If the type of reimbursement (or otherexpense allowance) arrangement isunder: Then the employer reports on Form W-2:

An accountable plan with:

Actual expense reimbursement:Adequate accounting made and excessreturned

No amount.

Actual expense reimbursement:Adequate accounting and return of excessboth required but excess not returned

The excess amount as wages in box 1.

Per diem or mileage allowance up to thefederal rate:Adequate accounting and excess returned

Per diem or mileage allowance exceeds thefederal rate:Adequate accounting up to the federal rateonly and excess not returned

The excess amount as wages in box 1. Theamount up to the federal rate is reportedonly in box 13—it is not reported in box 1.

A nonaccountable plan with:

Either adequate accounting or return ofexcess, or both, not required by plan

The entire amount as wages in box 1.

No reimbursement plan The entire amount as wages in box 1.

No amount.

Per diem or mileage allowance up to thefederal rate:Adequate accounting and return of excessboth required but excess not returned

The excess amount as wages in box 1. Theamount up to the federal rate is reportedonly in box 13—it is not reported in box 1.

whether the allowance is more than the fed-eral rate.

Regular federal per diem rate. Theregular federal per diem rate is the highestamount the federal government will pay to itsemployees for lodging, meal, and incidentalexpenses (or meal and incidental expensesonly) while they are traveling away from homein a particular area. The rates are different fordifferent locations. Publication 1542 lists therates in the continental U.S.

CAUTION!

New rates went into effect on October1, 2000. You must have chosen touse either the old rates or the new

rates for the period October 1, 2000, throughDecember 31, 2000.

Internet access. Per diem rates areavailable on the Internet. If you havea computer and a modem, you can

access domestic per diem rates at:

www.policyworks.gov/perdiem

You can access foreign per diem rates at:

www.state.gov/www/perdiems

Standard meal allowance. The federalrate for meal and incidental expense (M & IE)is the standard meal allowance. You may payan allowance for meal and incidental ex-penses only if, for example, you reimburseactual lodging expenses or do not reimburselodging expenses because there are none.

High-low method. This is a simplifiedmethod of computing the federal per diemrate for lodging and meal expenses for trav-

eling within the continental United States. Iteliminates the need to keep a current list ofthe per diem rate in effect for each city in thecontinental United States.

Under the high-low method, the per diemamount for travel during 2000 is $201 ($42 forM & IE) for certain locations. All other areashave a per diem amount of $124 ($34 for M& IE). The areas eligible for the $201 per diemamount under the high-low method are listedin Publication 1542.

CAUTION!

The areas listed in Publication 1542were changed for the period October1, 2000, through December 31, 2000.

You could use the areas listed in Publication1542 for that period only if you used themconsistently for all employees who were re-imbursed under the high-low method. Other-wise, see Revenue Procedure 2000–39 forthe list of areas eligible for the $201 per diemamount.

Reporting per diem and car allowances.The following paragraphs explain how to re-port per diem and car allowances. The man-ner in which you report them depends on howthe allowance compares to the federal rate.

Allowance LESS than or EQUAL to thefederal rate. If your allowance for the em-ployee is less than or equal to the appropriatefederal rate, that allowance is not included aspart of the employee's pay in box 1 of theemployee's Form W–2. Deduct the allowanceas travel expenses (including meals that maybe subject to the 50% limit, discussed later).See How to deduct under Accountable Plans,earlier.

Allowance MORE than the federal rate.If your employee's allowance is more than theappropriate federal rate, you must report theallowance as two separate items.


You include the allowance amount up tothe federal rate in box 13 (code L) of theemployee's Form W–2. Deduct it as travelexpenses (as explained above). This part ofthe allowance is treated as reimbursed underan accountable plan.

You include the amount that is more thanthe federal rate in box 1 (and in boxes 3 and5 if they apply) of the employee's Form W–2.Deduct it as wages subject to income taxwithholding, social security, Medicare, andfederal unemployment taxes. This part of theallowance is treated as reimbursed under anonaccountable plan as explained later underNonaccountable Plans.

Meals and EntertainmentUnder an accountable plan, you can generallydeduct only 50% of any otherwise deductiblebusiness-related meal and entertainment ex-penses you reimburse your employees. Thededuction limit applies even if you reimbursethem for 100% of the expenses.

Application of the 50% limit. The 50% de-duction limit applies to reimbursements youmake to your employees for expenses theyincur for meals while traveling away fromhome on business and for entertaining busi-ness customers at your place of business, arestaurant, or another location. It applies toexpenses incurred at a business conventionor reception, business meeting, or businessluncheon at a club. The deduction limit mayalso apply to meals you furnish on yourpremises to your employees (discussed inchapter 2).

Related expenses. Taxes and tips relat-ing to a meal or entertainment activity youreimburse to your employee under an ac-countable plan are included in the amountsubject to the 50% limit. Reimbursements youmake for expenses, such as cover chargesfor admission to a nightclub, rent paid for aroom to hold a dinner or cocktail party, or theamount you pay for parking at a sports arena,are all subject to the 50% limit. However, thecost of transportation to and from an other-wise allowable business meal or a business-related entertainment activity is not subject tothe 50% limit.

Amount subject to 50% limit. If you provideyour employees with a per diem allowance(discussed earlier) only for meal and inci-dental expenses, the amount treated as anexpense for food and beverages is the lesserof the following.

• The per diem allowance.

• The federal rate for M & IE.

If you provide your employee with a perdiem allowance that covers lodging, meals,and incidental expenses, you must treat anamount equal to the federal M & IE rate forthe area of travel as an expense for food andbeverages. If the per diem allowance youprovide is less than the federal per diem ratefor the area of travel, you can treat 40% of theper diem allowance as the amount for foodand beverages.

Drilling rigs. The 50% limit does not applyto the food or beverages an employer pro-vides on an oil or gas platform or drilling riglocated offshore or in Alaska. This exceptionalso applies to food and beverages providedby an employer at a support camp that is near

and integral to an oil or gas drilling rig locatedin Alaska.

Meal expenses when subject to “hours ofservice” limits. You can deduct 60% of thereimbursed meals your employees consumewhile away from their tax home on businessduring or incident to any period subject to theDepartment of Transportation's hours of ser-vice limits.

Individuals subject to the Department ofTransportation's hours of service limits in-clude the following.

• Certain air transportation workers (suchas pilots, crew, dispatchers, mechanics,and control tower operators) who areunder Federal Aviation Administrationregulations.

• Interstate truck operators and bus driverswho are under Department of Transpor-tation regulations.

• Certain railroad employees (such as en-gineers, conductors, train crews, dis-patchers, and control operations person-nel) who are under Federal RailroadAdministration regulations.

• Certain merchant mariners who are underCoast Guard regulations.

De minimis (minimal) fringe benefit. The50% limit does not apply to an expense forfood or beverage that is excluded from thegross income of an employee because it is ade minimis fringe benefit. See Publication15–B for additional information on de minimisfringe benefits.

Company cafeteria or executive diningroom. You can deduct the cost of food andbeverages you provide primarily to your em-ployees on your business premises. This in-cludes the cost of maintaining the facilities forproviding the food and beverages. These ex-penses are subject to the 50% limit unlessthey qualify as de minimis fringe benefits,discussed in Publication 15–B, or unless theyare compensation to your employees and youtreat them as provided under a nonaccount-able plan, as discussed later.

Employee activities. You can deduct theexpense of providing recreational, social, orsimilar activities (including the use of a facil-ity) for your employees. The benefit must beprimarily for your employees who are nothighly compensated employees.

For this purpose, a highly compensatedemployee is an employee who meets eitherof the following requirements.

1) Owned a 10% or more interest in thebusiness during the year or the preced-ing year. An employee is treated asowning any interest owned by his or herbrother, sister, spouse, ancestors, andlineal descendants.

2) Received more than $85,000 in pay forthe preceding year. You may choose toinclude only employees who were alsoin the top 20% of employees whenranked by pay for the preceding year.

These expenses are not subject to the50% limit. For example, the expenses forfood, beverages, and entertainment for acompany-wide picnic are not subject to the50% limit.

Nonaccountable PlansA nonaccountable plan is an arrangementthat does not meet the requirements for anaccountable plan. All amounts paid, or treatedas paid, under a nonaccountable plan arereported as wages on Form W–2. The pay-ments are subject to income tax withholding,social security, Medicare, and federal unem-ployment taxes. You can deduct the re-imbursement as compensation or wages onlyto the extent it meets the deductibility tests foremployees' pay in chapter 2. Deduct the al-lowable amount as compensation or wageson the appropriate line of your income taxreturn, as provided in its instructions.

Other Reimbursed ExpensesYou may provide meals and entertainment toindividuals who are not your employees.These expenses may or may not be subjectto the 50% limit, depending on the circum-stances.

Nonemployee. If you provide a person whois not your employee with meals, goods, ser-vices, or the use of a facility and the item youprovide is considered entertainment, you candeduct the expense only to the extent it isincluded in the gross income of the recipientas compensation for services or as a prizeor award. If you are required to include theseexpenses on an information return (Form1099–MISC), you cannot claim a deductionfor them unless you file the necessary infor-mation return. For more information aboutwhen to file Form 1099–MISC, see the sepa-rate Instructions for Forms 1099, 1098, 5498,and W–2G. These expenses are not subjectto the 50% limit.

Director, stockholder, or employeemeetings. You can deduct entertainmentexpenses directly related to businessmeetings of your employees, partners, stock-holders, agents, or directors. You can providesome minor social activities, but the mainpurpose of the meeting must be your com-pany's business. These expenses are subjectto the 50% limit.

Trade association meetings. You can de-duct expenses directly related to and neces-sary for attending business meetings or con-ventions of certain exempt organizations.These organizations include businessleagues, chambers of commerce, real estateboards, and trade and professional associ-ations. Meal and entertainment expenses aresubject to the 50% limit.

Sale of meals or entertainment. You candeduct the cost of providing meals, enter-tainment, goods and services, or use of facil-ities that you sell to the public. For example,if you run a nightclub, your expense for theentertainment you furnish to your customers,such as a floor show, is a business expense.These expenses are not subject to the 50%limit.

Advertising to promote goodwill. You candeduct the cost of providing meals, enter-tainment, or recreational facilities to the gen-eral public as a means of advertising or pro-moting goodwill in the community. Forexample, the expense of sponsoring a tele-vision or radio show is deductible. You canalso deduct the expense of distributing freefood and beverages to the general public.


These expenses are not subject to the 50%limit.

Charitable sports event. The 50% limitdoes not apply to the expenses covered bya package deal that includes a ticket to acharitable sports event if the event meetscertain conditions. See Entertainment ticketsin chapter 2 of Publication 463 for a list of theconditions a charitable sports event mustmeet.

MiscellaneousExpensesIn addition to travel, meal, and entertainmentexpenses, there are other expenses you candeduct. This section briefly covers some ofthese expenses (listed in alphabetical order).

Advertising expenses. You generally candeduct reasonable advertising expenses ifthey relate to your business activities. Gen-erally, you cannot deduct the cost of adver-tising to influence legislation. See Lobbyingexpenses, later.

You can usually deduct as a businessexpense the cost of institutional or “goodwill” advertising to keep your name before thepublic if it relates to business you reasonablyexpect to gain in the future. For example, thecost of advertising that encourages people tocontribute to the Red Cross, to buy U.S.Saving Bonds, or to participate in similarcauses is usually deductible.

Foreign expenses. You cannot deductthe costs of advertising on foreign radio andtelevision (including cable) where the adver-tising is primarily for a market in the UnitedStates. However, this rule only applies to ad-vertising expenses in countries that deny adeduction for advertising on a United Statesbroadcast primarily for that country's market.

Anticipated liabilities. Anticipated liabilitiesor reserves for anticipated liabilities are notdeductible. For example, assume you sold1-year TV service contracts this year totaling$50,000. From experience, you know you willhave expenses of about $15,000 in the com-ing year for these contracts. You cannot de-duct any of the $15,000 this year by chargingexpenses to a reserve or liability account. Youcan deduct your expenses only when youactually pay or accrue them, depending onyour accounting method.

Black lung benefit trust contributions. Ifyou, as a coal mine operator, make a contri-bution to a qualified black lung benefit trust,you may be able to deduct your contribution.To deduct it, you must make your contributionduring the tax year or pay it to the trust by thedue date for filing your federal income taxreturn (including extensions). You must makethe contribution in cash or in property the trustis permitted to hold.

Figure your allowable deduction for con-tributions to a black lung benefit trust onSchedule A of Form 6069.

Bribes and kickbacks. You cannot deductbribes, kickbacks, or similar payments if theyare either of the following.

1) Payments directly or indirectly to an offi-cial or employee of any government oran agency or instrumentality of any gov-

ernment in violation of the law. If thegovernment is a foreign government, thepayments are not deductible if they areunlawful under the Foreign CorruptPractices Act of 1977.

2) Payments directly or indirectly to a per-son in violation of any federal or statelaw (but only if that state law is generallyenforced) that provides for a criminalpenalty or for the loss of a license orprivilege to engage in a trade or busi-ness.

Meaning of “generally enforced.” Astate law is considered generally enforcedunless it is never enforced or enforced onlyfor infamous persons or persons whose vio-lations are extraordinarily flagrant. For exam-ple, a state law is generally enforced unlessproper reporting of a violation of the law re-sults in enforcement only under unusual cir-cumstances.

Kickbacks. A kickback includes a pay-ment for referring a client, patient, or cus-tomer. The common kickback situation occurswhen money or property is given to someoneas payment for influencing a third party topurchase from, use the services of, or other-wise deal with the person who pays thekickback. In many cases, the person whosebusiness is being sought or enjoyed by theperson who pays the kickback does not knowof the payment.

Example 1. Mr. Green, an insurancebroker, pays part of the insurance commis-sions he earns to car dealers who refer in-surance customers to him. The car dealersare not licensed to sell insurance. Mr. Greencannot deduct these payments if they are inviolation of any federal or state law as ex-plained previously in (2) under Bribes andkickbacks.

Example 2. The Yard Corporation is inthe business of repairing ships. It returns10% of the repair bills as kickbacks to thecaptains and chief officers of vessels it re-pairs. It considers kickbacks necessary to getbusiness. The owners of the ships do notknow of these payments.

In the state where the corporation oper-ates, it is unlawful to attempt to influence theactions of any employee, private agent, orfiduciary in relation to the principal's or em-ployer's affairs by giving or offering anythingof value without the knowledge and consentof the principal or employer. The state gen-erally enforces the law. The kickbacks paidby the Yard Corporation are not deductible.

Medicare or Medicaid. Kickbacks,bribes, and rebates paid in Medicare orMedicaid programs are not deductible.

Form 1099–MISC. If you pay kickbacksduring your tax year, whether or not they aredeductible on your income tax return, youmay have to report them on an informationreturn, Form 1099–MISC. For more informa-tion about when to file Form 1099–MISC, seeInstructions for Forms 1099, 1098, 5498, andW–2G.

Car and truck expenses. You can deductthe costs of operating a car, truck, or othervehicle in your business. These costs includegas, oil, repairs, license tags, insurance, anddepreciation. Only the expenses for businessuse are deductible. Traveling between yourhome and your place of business is usuallynot business use.

Under certain conditions, you can use thestandard mileage rate instead of deductingthe actual expenses for your vehicle. Thestandard mileage rate for the cost of operat-ing your car, van, pickup, or panel truck in2000 is 321/2 cents a mile for all businessmiles. For more information on how to figureyour deduction, see Publication 463.

Charitable contributions. Cash paymentsto charitable, religious, educational, scientific,or similar organizations may be deductible asbusiness expenses if the payments are notcharitable contributions or gifts. If the pay-ments are charitable contributions or gifts,you cannot deduct them as business ex-penses. However, corporations (other than Scorporations) can deduct charitable contribu-tions on their income tax returns. See Chari-table Contributions in Publication 542 formore information. Sole proprietors, partnersin a partnership, or shareholders in an S cor-poration may be able to deduct charitablecontributions made by their business onSchedule A (Form 1040).

Example. You paid $15 to a local churchfor a half-page ad in a program for a concertit is sponsoring. The purpose of the ad wasto encourage readers to buy your products.Since your payment is not a contribution, youcannot deduct it as such. However, you candeduct it as an advertising expense.

Inventory. If you contribute inventory(property you sell in the course of your busi-ness), the amount you can claim as a contri-bution deduction is the smaller of its fairmarket value on the day you contributed it orits basis. The basis of donated inventory isany cost incurred for the inventory in an ear-lier year that you would otherwise include inyour opening inventory for the year of thecontribution. You must remove the amountof your contribution deduction from youropening inventory. It is not part of the costof goods sold.

If the cost of donated property is not in-cluded in your opening inventory, the proper-ty's basis is zero and you cannot claim acharitable contribution deduction. Treat theproperty's cost as you would ordinarily treatit under your method of accounting. For ex-ample, include the purchase price of inventorybought and donated in the same year in thecost of goods sold for that year.

A corporation (other than an S corpo-ration) can deduct its basis in the propertyplus one-half of the gain that would have beenrealized if the property had been sold at itsfair market value on the date of contribution.But the deduction cannot be more than twicethe property's basis. For more information onthe charitable contribution of property by acorporation, see section 170(e)(3) of theInternal Revenue Code.

Example 1. You own an auto repair shopand in 2000 you donated auto parts to yourlocal school for its auto repair class. The fairmarket value of the parts at the time of thecontribution was $600 and you had included$400 for the parts in your opening inventoryfor 2000. Your charitable contribution is $400.You reduce your opening inventory by the$400 for the donated property.

Example 2. Assume the same facts asExample 1, except you purchased the autoparts in 2000 for $400 (not part of the openinginventory). The $400 is included as part of thecost of goods sold for 2000 but not in figuring


the basis of the property. Your charitablecontribution is $0.

Club dues and membership fees. Gener-ally, you cannot deduct amounts you pay orincur for membership in any club organizedfor business, pleasure, recreation, or anyother social purpose. This includes countryclubs, golf and athletic clubs, hotel clubs,sporting clubs, airline clubs, and clubs oper-ated to provide meals under circumstancesgenerally considered to be conducive tobusiness discussions.

Exception. None of the following organ-izations will be treated as a club organized forbusiness, pleasure, recreation, or other socialpurpose unless one of the main purposes isto conduct entertainment activities for mem-bers or their guests or to provide membersor their guests with access to entertainmentfacilities.

• Boards of trade.

• Business leagues.

• Chambers of commerce.

• Civic or public service organizations.

• Professional organizations such as barassociations and medical associations.

• Real estate boards.

• Trade associations.

Damages recovered. Special rules apply tocompensation you receive for damages sus-tained as a result of patent infringement,breach of contract or fiduciary duty, or anti-trust violations. You must include this com-pensation in your income. However, you maybe able to take a special deduction. Thededuction applies only to amounts recoveredfor actual injury, not any additional amount.The deduction is the smaller of the following.

• The amount you received or accrued fordamages in the tax year reduced by theamount you paid or incurred in the yearto recover that amount.

• Your losses from the injury you have notdeducted.

Demolition expenses or losses. You can-not deduct any amount paid or incurred todemolish a structure or any loss for the un-depreciated basis of a demolished structure.Add these amounts to the basis of the landwhere the demolished structure was located.

Depreciation. If property you buy to use inyour business has a useful life substantiallybeyond the year it is placed in service, yougenerally cannot deduct the entire cost as abusiness expense in the year you buy it. Youmust spread the cost over more than one taxyear and deduct part of it each year. Thismethod of deducting the cost of businessproperty is called depreciation.

However, you may be able to elect to de-duct a limited amount of the cost of certaindepreciable property in the year you place itin service in your business. This deduction isknown as the “section 179 deduction.”

For information on depreciation and thesection 179 deduction, see Publication 946.

Donations to business organizations. Youcan deduct donations to business organiza-tions as business expenses if all the followingconditions are met.

• The donation relates directly to your tradeor business.

• You reasonably expect a financial returnin line with your donation.

• The donation is not a nondeductible lob-bying expense as discussed later underLobbying expenses.

For example, a donation you make to acommittee organized by the Chamber ofCommerce to bring a national convention toyour city may be deductible.

Education expenses. You can deduct theordinary and necessary expenses you pay forthe education and training of your employees.For more information, see Education Ex-penses in chapter 2.

You can also deduct your own educationexpenses (including certain related travel)related to your trade or business. You mustbe able to show the education maintains orimproves skills required in your trade orbusiness, or it is required by law or regu-lations for keeping your pay, status, or job.

You cannot deduct education expensesyou incur to meet the minimum requirementsof your present trade or business, or thosethat qualify you for a new trade or business.This is true even if the education maintainsor improves skills presently required in yourbusiness. For more information on educationexpenses, see Publication 508.

Example 1. Dr. Carter, who is a psychi-atrist, begins a program of study at an ac-credited psychoanalytic institute to qualify asa psychoanalyst. She can deduct the cost ofthe program because the study maintains orimproves skills required in her profession anddoes not qualify her for a new one.

Example 2. Herb Jones owns a repairshop for electronic equipment. The bulk ofthe business is television repairs, but occa-sionally he fixes tape decks and disc players.To keep up with the latest technical changes,he takes a special course to learn how to re-pair disc players. Since the course maintainsand improves skills required in his trade, hecan deduct its cost.

Environmental cleanup costs. You candeduct certain costs to clean up land and totreat groundwater you contaminated withhazardous waste from your business oper-ations. You can deduct the costs you incur torestore your land and groundwater to thesame physical condition that existed prior tocontamination. You cannot deduct costs forthe construction of groundwater treatment fa-cilities. You must capitalize those costs andyou can recover them through depreciation.

Franchise, trademark, trade name. If youbuy a franchise, trademark, or trade name,you can deduct the amount you pay or incuras a business expense only if your paymentsare part of a series of payments that are:

1) Contingent on productivity, use, or dis-position of the item,

2) Payable at least annually for the entireterm of the transfer agreement, and

3) Substantially equal in amount (or pay-able under a fixed formula).

When determining the term of the transferagreement, include all renewal options and

any other period for which you and thetransferor reasonably expect the agreementto be renewed.

A franchise includes an agreement thatgives one of the parties to the agreement theright to distribute, sell, or provide goods, ser-vices, or facilities within a specified area.

Property acquired after August 10,1993 (or after July 25, 1991, if elected). Anyamounts you pay or incur that are not de-scribed in (1) through (3) must be charged toa capital account. These are “section 197 in-tangibles” and are amortized over 15 years.See chapter 9 for more information onamortization.

You can elect to apply this treatment toany franchise, trademark, or trade name ac-quired after July 25, 1991. This election isbinding and cannot be revoked without ap-proval of the IRS.

Property acquired before August 11,1993. For a transfer not treated as a sale orexchange of a capital asset, you can deducta lump-sum payment of an agreed uponprincipal amount ratably over the shorter ofthe following.

• 10 years.

• The period of the transfer agreement.

For a transfer not treated as a sale or ex-change of a capital asset, you can deduct, inthe year made, a payment that is one of aseries of approximately equal payments pay-able over either of the following.

• The period of the transfer agreement.

• A period of more than 10 years, regard-less of the period of the agreement.

CAUTION!

The above business deductions donot apply to transfers after October2, 1989, and before August 11, 1993,

if the principal sum is over $100,000.

Charge any payment not deductible be-cause of these rules to a capital account.However, you can deduct the paymentscharged to a capital account over the life ofthe asset if you can determine the useful lifeof the asset. Otherwise, you can amortize thepayment over a 25-year period beginning withthe tax year the transfer occurs.

Contracts entered into before October3, 1989. For contracts to buy a franchise,trademark, or trade name entered into beforeOctober 3, 1989, you can deduct paymentscontingent on productivity, use, or disposition.The rules discussed earlier for annual andsubstantially equal payments do not apply.

Disposition of franchise, trademark, ortrade name. If you transfer, sell, or otherwisedispose of a franchise, trademark, or tradename, you must recapture as ordinary income(up to any gain realized) the payments youdeducted as any of the following.

• A lump-sum or serial payment of a prin-cipal amount not treated as a sale or ex-change of a capital asset.

• An amortized payment deducted over 25years.

• The amortization claimed on section 197intangibles.

For more information about dispositionsof franchises, trademarks, and trade names,see chapter 2 in Publication 544.


Impairment-related expenses. If you aredisabled, you can deduct expenses neces-sary for you to be able to work (impairment-related expenses) as a business expense,rather than as a medical expense.

You are disabled if you have either of thefollowing.

• A physical or mental disability (for exam-ple, blindness or deafness) that func-tionally limits your being employed.

• A physical or mental impairment thatsubstantially limits one or more of yourmajor life activities.

You can deduct the expense as a busi-ness expense if all the following apply.

• Your work clearly requires the expensefor you to satisfactorily perform the work.

• The goods or services purchased areclearly not needed or used, other thanincidentally, in your personal activities.

• Their treatment is not specifically pro-vided for under other tax law provisions.

Example. You are blind. You must usea reader to do your work, both at and awayfrom your place of work. The reader's ser-vices are only for your work. You can deductyour expenses for the reader as a businessexpense.

Interview expense allowances. Re-imbursements you make to job candidates fortransportation or other expenses related tointerviews for possible employment are notwages. You can deduct the reimbursementsas a business expense. However, expensesfor food, beverages, and entertainment aresubject to the 50% limit discussed earlier un-der Meals and Entertainment.

Legal and professional fees. Legal andprofessional fees, such as fees charged byaccountants, that are ordinary and necessaryexpenses directly related to operating yourbusiness are deductible as business ex-penses. However, you usually cannot deductlegal fees you pay to acquire business assets.Add them to the basis of the property.

If the fees include payments for work of apersonal nature (such as making a will), youtake a business deduction only for the partof the fee related to your business. The per-sonal portion of legal fees for producing orcollecting taxable income, doing or keepingyour job, or for tax advice may be deductibleon Schedule A (Form 1040) if you itemizedeductions. See Publication 529.

Tax preparation fees. You can deductas a trade or business expense the cost ofpreparing that part of your tax return relatingto your business as a sole proprietor. Theremaining cost may be deductible on Sched-ule A (Form 1040) if you itemize deductions.

You can also take a business deductionfor the amount you pay or incur in resolvingasserted tax deficiencies for your businessas a sole proprietor.

Licenses and regulatory fees. Licensesand regulatory fees for your trade or businesspaid each year to state or local governmentsgenerally are deductible. Some licenses andfees may have to be amortized. See chapter9 for more information.

Lobbying expenses. Generally, you cannotdeduct lobbying expenses. Lobbying ex-penses include amounts paid or incurred forany of the following activities.

• Influencing legislation.

• Participating in or intervening in any poli-tical campaign for, or against, any candi-date for public office.

• Attempting to influence the general pub-lic, or segments of the public, aboutelections, legislative matters, or referen-dums.

• Communicating directly with coveredexecutive branch officials (defined later)in any attempt to influence the officialactions or positions of those officials.

• Researching, preparing, planning, or co-ordinating any of the preceding activities.

Your expenses for influencing legislationand communicating directly with a coveredexecutive branch official include a portion ofyour labor costs and general and administra-tive costs of your business. For informationon making this allocation, see section1.162–28 of the regulations.

You cannot take a charitable deductionor business expense for amounts paid to anorganization if both the following apply.

• The organization conducts lobbying ac-tivities on matters of direct financial in-terest to your business.

• A principal purpose of your contributionis to avoid the rules discussed earlier thatprohibit a business deduction for lobbyingexpenses.

If a tax-exempt organization, other than asection 501(c)(3) organization, provides youwith a notice on the part of dues that isallocable to nondeductible lobbying and poli-tical expenses, you cannot deduct that partof the dues.

Covered executive branch official. Forpurposes of this discussion, a covered exec-utive branch official includes the following.

1) The President.

2) The Vice President.

3) Any officer or employee of the WhiteHouse Office of the Executive Office ofthe President and the two most seniorlevel officers of each of the other agen-cies in the Executive Office.

4) Any individual who:

a) Is serving in a position in Level I ofthe Executive Schedule under sec-tion 5312 of title 5, United StatesCode,

b) Has been designated by the Presi-dent as having Cabinet-level status,or

c) Is an immediate deputy of an indi-vidual listed in item (a) or (b).

Exceptions to denial of deduction. Thegeneral denial of the deduction does not ap-ply to the following.

• Expenses of appearing before, or com-municating with, any local council orsimilar governing body concerning itslegislation (local legislation) if the legis-lation is of direct interest to you or to youand an organization of which you are a

member. An Indian tribal government istreated as a local council or similar gov-erning body.

• Any in-house expenses for influencinglegislation and communicating directlywith a covered executive branch officialif those expenses for the tax year do notexceed $2,000 (excluding overhead ex-penses).

• Expenses incurred by taxpayers engagedin the trade or business of lobbying (pro-fessional lobbyists) on behalf of anotherperson (but does apply to payments bythe other person to the lobbyist for lob-bying activities).

Moving machinery. Generally, the cost ofmoving your machinery from one city to an-other is a deductible expense. So is the costof moving machinery from one plant to an-other, or from one part of your plant to an-other. You can deduct the cost of installingthe machinery in the new location. However,you must capitalize the costs of installing ormoving newly purchased machinery.

Outplacement services. You can deduct thecosts of outplacement services you provideto your employees to help them find newemployment, such as career counseling,resumé assistance, skills assessment, etc.

The costs of outplacement services maycover more than one deduction category. Forexample, deduct as a utilities expense thecost of telephone calls made under this ser-vice and deduct as rental expense the costof renting machinery and equipment for thisservice.

Penalties and fines. Penalties you pay forlate performance or nonperformance of acontract are generally deductible. For in-stance, if you contracted to construct a build-ing by a certain date and had to pay anamount for each day the building was notfinished after that date, you can deduct theamounts paid or incurred.

On the other hand, you cannot deductpenalties or fines you pay to any governmentagency or instrumentality because of a vio-lation of any law. These fines or penalties in-clude the following amounts.

• Paid because of a conviction for a crimeor after a plea of guilty or no contest ina criminal proceeding.

• Paid as a penalty imposed by federal,state, or local law in a civil action, in-cluding certain additions to tax and addi-tional amounts and assessable penaltiesimposed by the Internal Revenue Code.

• Paid in settlement of actual or possibleliability for a fine or penalty, whether civilor criminal.

• Forfeited as collateral posted for a pro-ceeding that could result in a fine orpenalty.

Examples of nondeductible penalties andfines include the following.

• Fines for violating city housing codes.

• Fines paid by truckers for violating statemaximum highway weight laws and airquality laws.

• Civil penalties for violating federal lawsregarding mining safety standards anddischarges into navigable waters.


A fine or penalty does not include any ofthe following.

• Legal fees and related expenses to de-fend yourself in a prosecution or civilaction for a violation of the law imposingthe fine or civil penalty.

• Court costs or stenographic and printingcharges.

• Compensatory damages paid to a gov-ernment.

Nonconformance penalty. You can de-duct a nonconformance penalty assessed bythe Environmental Protection Agency for fail-ing to meet certain emission standards.

Political contributions. You cannot deductcontributions or gifts to political parties orcandidates as business expenses. In addi-tion, you cannot deduct expenses you pay orincur to take part in any political campaign ofa candidate for public office.

Indirect political contributions. Youcannot deduct indirect political contributionsand costs of taking part in political activitiesas business expenses. Examples of non-deductible expenses include the following.

• Advertising in a convention program of apolitical party, or in any other publicationif any of the proceeds from the publicationare for, or intended for, the use of a poli-tical party or candidate.

• Admission to a dinner or program (in-cluding, but not limited to, galas, dances,film presentations, parties, and sportingevents) if any of the proceeds from thefunction are for, or intended for, the useof a political party or candidate.

• Admission to an inaugural ball, gala, pa-rade, concert, or similar event if identifiedwith a political party or candidate.

Removal costs. You can deduct the cost ofretiring and removing a depreciable asset inconnection with the installation or productionof a replacement asset. However, you mustcapitalize the cost of removing a componentof a depreciable asset if the replacement isan improvement rather than a repair. SeeDemolition expenses and losses, earlier, forexpenses you cannot deduct.

Repairs. The cost of repairing or improvingproperty used in your trade or business is ei-ther a deductible or capital expense. You candeduct repairs that keep your property in anormal efficient operating condition, but thatdo not add to its value or usefulness orappreciably lengthen its life. If the repairs addto the value or usefulness of your propertyor significantly increase its life, you mustcapitalize them. Although you cannot deductcapital expenses as current expenses, youcan usually deduct them over a period of timeas depreciation.

The cost of repairs includes the costs oflabor, supplies, and certain other items. Youcannot deduct the value of your own labor.

Examples of repairs include the following.

• Patching and repairing floors.

• Repainting the inside and outside of abuilding.

• Repairing roofs and gutters.

• Mending leaks.

You cannot deduct the cost of repairs youadded to the cost of goods sold as a sepa-rate business expense.

Repayments. If you had to repay an amountyou included in your income in an earlier year,you may be able to deduct the amount repaidfor the year in which you repaid it.

Type of deduction. The type of de-duction you are allowed in the year of repay-ment depends on the type of income you in-cluded in the earlier year. For instance, if yourepay an amount you previously reported asa capital gain, deduct the repayment as acapital loss on Schedule D (Form 1040). Ifyou reported it as self-employment income,deduct it as a business deduction on Sched-ule C or Schedule C-EZ (Form 1040).

If you reported the amount as wages, un-employment compensation, or other non-business ordinary income, enter it on line 22of Schedule A (Form 1040). However, if therepayment is over $3,000 and Method 1(discussed later) applies, deduct it on line 27of Schedule A (Form 1040).

Repayment—$3,000 or less. If theamount you repaid was $3,000 or less, de-duct it from your income in the year you re-paid it.

Repayment—over $3,000. If the amountyou repaid was more than $3,000, you candeduct the repayment, as described earlier.However, you can choose to take a tax creditfor the year of repayment if you included theincome under a claim of right. This meansthat at the time you included the income, itappeared that you had an unrestricted rightto it. If you qualify, figure your tax under bothmethods and use the method that results inless tax.

Method 1. Figure your tax for 2000claiming a deduction for the repaid amount.

Method 2. Figure your tax for 2000claiming a credit for the prepaid amount. Fol-low these steps.

1) Figure your tax for 2000 without de-ducting the repaid amount.

2) Refigure your tax from the earlier yearwithout including in income the amountyou repaid in 2000.

3) Subtract the tax in (2) from the tax shownon your return for the earlier year. Thisis the credit.

4) Subtract the answer in (3) from the taxfor 2000 figured without the deduction(step 1).

If Method 1 results in less tax, deduct theamount repaid as discussed earlier underType of deduction.

If Method 2 results in less tax, claim thecredit on line 64 of Form 1040, and write“I.R.C. 1341” next to line 64.

Example. For 1999 you filed a return andreported your income on the cash method. In2000 you repaid $5,000 included in your 1999gross income under a claim of right. Your fil-ing status in 2000 and 1999 is single. Yourincome and tax for both years are as follows:

Your tax under Method 1 is $9,181. Your taxunder Method 2 is $9,831, figured as follows:

Because you pay less tax under Method 1,you should take a deduction for the repay-ment in 2000.

Repayment does not apply. This dis-cussion does not apply to the following.

• Deductions for bad debts.

• Deductions from sales to customers,such as returns and allowances, andsimilar items.

• Deductions for legal and other expensesof contesting the repayment.

Year payment deducted. If you use thecash method of accounting, you can take thededuction for the tax year in which you actu-ally make the repayment. If you use any otheraccounting method, you can deduct the re-payment only for the tax year in which it is aproper deduction under your accountingmethod. For example, if you use an accrualmethod, you are entitled to the deduction inthe tax year in which the obligation for therepayment accrues.

Subscriptions. You can deduct as a busi-ness expense subscriptions to professional,technical, and trade journals that deal withyour business field.

Supplies and materials. Unless you havededucted the cost in any earlier year, yougenerally can deduct the cost of materials andsupplies actually consumed and used duringthe tax year.

If you keep incidental materials and sup-plies on hand, you can deduct the cost of theincidental materials and supplies you boughtduring the tax year if all of the following re-quirements are met.

• You do not keep a record of when theyare used.

• You do not take an inventory of theamount on hand at the beginning and endof the tax year.

• This method does not distort your in-come.

You can also deduct the cost of books,professional instruments, equipment, etc., ifyou normally use them up within a year.However, if the usefulness of these itemsextends substantially beyond the year theyare placed in service, you generally must re-cover their costs through depreciation. SeeDepreciation, earlier.

1999With Income

1999Without Income

TaxableIncome $15,000 $10,000

Tax $ 2,254 $ 1,504

2000Without Deduction

2000With Deduction

TaxableIncome $49,950 $44,950

Tax $10,581 $ 9,181

Tax previously determined for 1999 ........ $ 2,254Less: Tax as refigured ............................. − 1,504Decrease in 1999 tax $ 750Regular tax liability for 2000 .................... $10,581Less: Decrease in 1999 tax ..................... − 750Refigured tax for 2000 $ 9,831


Utilities. Your business expenses for heat,lights, power, and telephone service aredeductible. However, any part due to personaluse is not deductible.

Telephone. You cannot deduct the costof basic local telephone service (including anytaxes) for the first telephone line you have inyour home, even though you have an officein your home. However, charges for businesslong-distance phone calls on that line, as wellas the cost of a second line into your homeused exclusively for business, are deductiblebusiness expenses.

14.How ToGet Tax Help

You can get help with unresolved tax is-sues, order free publications and forms, asktax questions, and get more information fromthe IRS in several ways. By selecting themethod that is best for you, you will havequick and easy access to tax help.

Contacting your Taxpayer Advocate. If youhave attempted to deal with an IRS problemunsuccessfully, you should contact your Tax-payer Advocate.

The Taxpayer Advocate represents yourinterests and concerns within the IRS byprotecting your rights and resolving problemsthat have not been fixed through normalchannels. While Taxpayer Advocates cannotchange the tax law or make a technical taxdecision, they can clear up problems that re-sulted from previous contacts and ensure thatyour case is given a complete and impartialreview.

To contact your Taxpayer Advocate:

• Call the Taxpayer Advocate at1–877–777–4778.

• Call the IRS at 1–800–829–1040.

• Call, write, or fax the Taxpayer Advocateoffice in your area.

• Call 1–800–829–4059 if you are aTTY/TDD user.

For more information, see Publication1546, The Taxpayer Advocate Service of theIRS.

Free tax services. To find out what servicesare available, get Publication 910, Guide toFree Tax Services. It contains a list of free taxpublications and an index of tax topics. It alsodescribes other free tax information services,including tax education and assistance pro-grams and a list of TeleTax topics.

Personal computer. With your per-sonal computer and modem, you canaccess the IRS on the Internet at

www.irs.gov. While visiting our web site, youcan select:

• Frequently Asked Tax Questions (locatedunder Taxpayer Help & Ed) to find an-swers to questions you may have.

• Forms & Pubs to download forms andpublications or search for forms andpublications by topic or keyword.

• Fill-in Forms (located under Forms &Pubs) to enter information while the formis displayed and then print the completedform.

• Tax Info For You to view Internal Reve-nue Bulletins published in the last fewyears.

• Tax Regs in English to search regulationsand the Internal Revenue Code (underUnited States Code (USC)).

• Digital Dispatch and IRS Local News Net(both located under Tax Info For Busi-ness) to receive our electronic newslet-ters on hot tax issues and news.

• Small Business Corner (located underTax Info For Business) to get informationon starting and operating a small busi-ness.

You can also reach us with your computerusing File Transfer Protocol at ftp.irs.gov.

TaxFax Service. Using the phoneattached to your fax machine, you canreceive forms and instructions by

calling 703–368–9694. Follow the directionsfrom the prompts. When you order forms,enter the catalog number for the form youneed. The items you request will be faxed toyou.

Phone. Many services are availableby phone.

• Ordering forms, instructions, and publi-cations. Call 1–800–829–3676 to ordercurrent and prior year forms, instructions,and publications.

• Asking tax questions. Call the IRS withyour tax questions at 1–800–829–1040.

• TTY/TDD equipment. If you have accessto TTY/TDD equipment, call 1–800–829–4059 to ask tax questions or to orderforms and publications.

• TeleTax topics. Call 1–800–829–4477 tolisten to pre-recorded messages coveringvarious tax topics.

Evaluating the quality of our telephoneservices. To ensure that IRS representativesgive accurate, courteous, and professionalanswers, we evaluate the quality of our tele-phone services in several ways.

• A second IRS representative sometimesmonitors live telephone calls. That persononly evaluates the IRS assistor and doesnot keep a record of any taxpayer's nameor tax identification number.

• We sometimes record telephone calls toevaluate IRS assistors objectively. Wehold these recordings no longer than oneweek and use them only to measure thequality of assistance.

• We value our customers' opinions.Throughout this year, we will be survey-

ing our customers for their opinions onour service.

Walk-in. You can walk in to manypost offices, libraries, and IRS officesto pick up certain forms, instructions,

and publications. Also, some libraries and IRSoffices have:

• An extensive collection of products avail-able to print from a CD-ROM or photo-copy from reproducible proofs.

• The Internal Revenue Code, regulations,Internal Revenue Bulletins, and Cumula-tive Bulletins available for research pur-poses.

Mail. You can send your order forforms, instructions, and publicationsto the Distribution Center nearest to

you and receive a response within 10 work-days after your request is received. Find theaddress that applies to your part of thecountry.

• Western part of U.S.:Western Area Distribution CenterRancho Cordova, CA 95743–0001

• Central part of U.S.:Central Area Distribution CenterP.O. Box 8903Bloomington, IL 61702–8903

• Eastern part of U.S. and foreign ad-dresses:Eastern Area Distribution CenterP.O. Box 85074Richmond, VA 23261–5074

CD-ROM. You can order IRS Publi-cation 1796, Federal Tax Products onCD-ROM, and obtain:

• Current tax forms, instructions, and pub-lications.

• Prior-year tax forms, instructions, andpublications.

• Popular tax forms which may be filled inelectronically, printed out for submission,and saved for recordkeeping.

• Internal Revenue Bulletins.

The CD-ROM can be purchased fromNational Technical Information Service (NTIS)by calling 1–877–233–6767 or on the Internetat www.irs.gov/cdorders. The first releaseis available in mid-December and the finalrelease is available in late January.

IRS Publication 3207, The Business Re-source Guide, is an interactive CD-ROM thatcontains information important to small busi-nesses. It is available in mid-February. Youcan get one free copy by calling1–800–829–3676 or visiting the IRS web siteat www.irs.gov/prod/bus_info/sm_bus/smbus-cd.html.

Chapter 14 How To Get Tax Help

Index

A Accountable plan ....................... 46 Achievement awards ................... 6 Advertising ........................... 48, 49 Amortization:

Anti-abuse rule ..................... 32 Anti-churning rules ............... 31 Bond premium ...................... 36

Corporate organization costs 33Dispositions of section 197 in-

tangibles .......................... 32 Experimental costs ............... 35

Going into business costs .... 33How to amortize ................... 34How to deduct ...................... 29Incorrect amount deducted .. 32

Partnership organizationcosts ................................ 33

Pollution control facilities ...... 35 Reforestation costs .............. 34 Related person ..................... 31 Research costs .................... 35

Section 197 intangiblesdefined ............................ 30 Start-up costs ....................... 33

Anticipated liabilities .................. 49 Assessments, local .................... 21

Assistance (See Tax help) At-risk limits ................................. 4 Attorney fees ............................. 51 Awards:

Achievement ........................... 6 Length-of-service .................... 6 Safety achievement ................ 6

BBad debts (See Business bad debts)Black lung payments ................. 49

Bond premium ........................... 36 Bonuses:

Employee ............................... 6 Royalties ............................... 40

Bribes ........................................ 49Business bad debts:

Defined ................................. 41How to treat .......................... 42

Recovery .............................. 42 Types of ............................... 41 When worthless .................... 42

Where to deduct ................... 43 Business:

Assets ..................................... 3Books and records ............... 30

Meal expenses ..................... 48Use of car ......................... 3, 49Use of home ........................... 3

C Campaign contribution .............. 52 Capital expenses ..................... 2, 3

Capitalization of interest ............ 18Car and truck expenses ........ 3, 49

Carrying charges ....................... 25 Charitable:

Contributions ........................ 49 Sports event ......................... 49

Circulation costs, newspapers andperiodicals ............................ 26 Clean-fuel property .................... 43

Cleanup costs, environmental ... 50 Club dues .................................. 50 Comments ................................... 1 Commitment fees ...................... 18 Compensation ........................... 10 Computer software .................... 31

Constant-yield method, OID ...... 17 Contested liability ........................ 4

Contribution limits, SIMPLE IRA 10 Contributions:

Charitable ............................. 49 Political ................................. 52

Copyrights ................................. 30 Cost depletion ........................... 37

Cost of getting lease ........... 14, 36Cost of goods sold ...................... 2Covenant not to compete .......... 30Credit, electric vehicle ............... 45

DDe minimis OID ......................... 17

Debt-financed: Acquisition ............................ 16 Distributions .......................... 17

Definitions: Achievement award ................ 6

Business bad debt ............... 41 Clean-burning fuel ................ 43

Clean-fuel vehicle property .. 43Clean-fuel vehicle refueling

property ........................... 44 Motor vehicle ........................ 43 Necessary expense ................ 2 Nonqualifying property ......... 43 Ordinary expense ................... 2

Qualified electric vehicle ...... 45Section 197 intangibles ........ 30 Depletion:

Mineral property ................... 36Oil and gas wells .................. 37

Percentage table .................. 39 Timber .................................. 40

Who can claim ..................... 36 Depreciation .............................. 50

Development costs, miners ....... 26Disabled, improvements for ...... 27Drilling and development costs . 25

Driveways .................................... 3 Dues, membership .................... 50

E Economic interest ...................... 36 Economic performance ............... 4 Education expenses .............. 6, 50

Elderly, improvements for ......... 27Electric vehicle credit ................ 45Employee benefit programs:

Deduction for .......................... 7 Employees' pay ........................... 5 Employment taxes ..................... 21 Entertainment tickets ................. 49

Environmental cleanup costs .... 50 Excise taxes .............................. 21 Experimentation costs ......... 25, 35 Exploration costs ....................... 26

F Fees:

Commitment ......................... 18Legal and professional ......... 51

Loan origination .................... 18 Regulatory ............................ 51

Tax return preparation ......... 51 Fines .......................................... 51 Forgone interest ........................ 19 Form 4562 ................................. 34 Form:

1098 ..................................... 17 3115 ..................................... 21 4562 ..................................... 29 4952 ..................................... 16 5213 ....................................... 5 5304–SIMPLE ...................... 10 5305–S ................................. 10 5305–SA ............................... 10 5305–SEP .............................. 8 5305–SIMPLE ...................... 10 8582 ..................................... 16 8826 ..................................... 29 8834 ..................................... 45 T ........................................... 40 W–2 ...................................... 11

Franchise ............................. 30, 50 Franchise taxes ......................... 22

Free tax services ....................... 53 Fringe benefits ............................. 7 Fuel taxes .................................. 22

G Gas wells ................................... 39 Geothermal wells ................. 25, 39

Gifts, nominal value ..................... 6Going into business ............... 2, 33

Goodwill ..................................... 30

HHealth insurance, deduction for

self-employed ....................... 22 Heating equipment ...................... 3

Help (See Tax help) Hobby losses, not for profit ......... 4Home, business use .................... 3

I Impairment-related expenses,medical expenses ................ 51 Improvements:

By lessee .............................. 14For disabled and elderly ...... 27To business assets ................ 3 Income taxes ............................. 21

Incorrect amount of amortizationdeducted ............................... 32

Individual retirement arrange-ments (IRAs) ........................ 13 Insurance:

Capitalizing premiums .......... 24 Deductible premiums ........... 22 Nondeductible premiums ..... 24 Self-employed individuals .... 22

Intangible drilling costs .............. 25 Intangibles, amortization ........... 30 Interest:

Allocation of .......................... 15 Below-market ....................... 19

Business expense for ........... 15 Capitalized ............................ 18 Carrying charge .................... 25 Deductible ............................ 17 Forgone ................................ 19

Life insurance policies .......... 18 Not deductible ...................... 18 Refunds of ............................ 19

When to deduct .................... 19 Interview expenses .................... 51 IRAs ........................................... 13

KKeogh plan (See Qualified plan)

Key person ................................ 18 Kickbacks .................................. 49

L Leases:

Canceling ............................. 13Cost of getting ................ 14, 36Improvements by lessee ...... 14

Leveraged ............................ 13 Mineral .................................. 40

Oil and gas ........................... 40 Sales distinguished .............. 13 Taxes on .............................. 14

Legal and professional fees ...... 51 Licenses .............................. 30, 51

Line of credit .............................. 16 Loans:Below-market interest rate ... 19

Discounted ........................... 19 Origination fees .................... 18 To employees ......................... 7

Lobbying expenses ................... 51Lodging and meals ...................... 7Long-term care insurance ......... 22

Losses: At-risk limits ............................ 4 Limits ...................................... 4 Net operating .......................... 4 Not-for-profit rules .................. 4 Passive activities .................... 4

M Machinery parts ........................... 3

Materials and supplies .............. 52Meals and entertainment ........... 48Meals and lodging ....................... 7Medical expenses, Impairment-

related expenses .................. 51 Mining:

Depletion .............................. 39 Development costs ............... 26 Exploration costs .................. 26

Money purchase pension plan .. 11More information (See Tax help)

Mortgage:Cost of acquiring .................. 17

Interest ................................. 17Moving expenses, machinery .... 51

N Natural gas ................................ 39 Necessary expense ..................... 2

Net operating loss ....................... 4 Nonaccountable plan ................. 48 Nonqualifying intangibles .......... 31 Not-for-profit activities ................. 4 Notification requirements ........... 10

OOffice in home ............................. 3Oil and gas wells:

Depletion .............................. 37 Drilling costs ......................... 25 Partnerships ......................... 38 S corporations ...................... 38

Ordinary expense ........................ 2 Organization costs:

Corporate ............................. 33 Partnership ........................... 33

Outplacement services .............. 51

P Passive activities ......................... 4

Payments in kind ......................... 4 Penalties:

Deductible ............................ 51 Nondeductible ...................... 51 Prepayment .......................... 17

Percentage depletion ................ 37 Personal expenses ...................... 3

Personal property tax ................ 22 Points ......................................... 18 Political contributions ................. 52

Pollution control facilities ........... 35 Prepaid expenses:

General rule ........................... 4 Insurance .............................. 24 Interest ................................. 19 Rent ...................................... 13

Prepayment penalty .................. 17 Profit-sharing plans ................... 11

Publications (See Tax help)

Q Qualified plan ............................ 11

RReal estate taxes ...................... 20

Recapture: Clean-fuel deductions .......... 44

Electric vehicle credit ........... 45 Exploration expenses ........... 26 Timber property .................... 35

Recovery of amount deducted .... 4 Reforestation costs .................... 34 Regulatory fees ......................... 51 Reimbursements:

Accountable plan .................. 46 Mileage ................................. 47

Nonaccountable plan ........... 48 Per diem ............................... 47 Qualifying requirements ....... 46

Related persons: Anti-churning rules ............... 31

Clean-fuel vehicle deduction 44Coal or iron ore .................... 40

Payments to ..................... 4, 19 Refiners ................................ 37 Unreasonable rent ................ 13

Removal costs ........................... 52Removing a retired asset .......... 27Rent expense, capitalizing ........ 15

Repairs ...................................... 52Repayments (claim of right) ...... 52

Replacements .............................. 3 Research costs .................... 25, 35 Retirement plans:

Defined benefit ..................... 11 Defined contribution ............. 11 IRAs ...................................... 13 Money purchase ................... 11 Profit-sharing ........................ 11

Qualified ............................... 11 Salary reduction ..................... 9 SEP ........................................ 8 SIMPLE .................................. 9

Roads .......................................... 3

SSalaries and wages ..................... 5

Sales taxes ................................ 22Self-employed health insurance

deduction .............................. 22 Self-employment tax .................. 22

Self-insurance, reserve for ........ 24 SEP plans .................................... 8 Sick pay ....................................... 8

SIMPLE IRA plans ................ 9, 10 SIMPLE plans .............................. 9

Standard meal allowance .......... 47Standard mileage rate ............... 47

Standby charges ....................... 18 Start-up costs ............................ 33 Subscriptions ............................. 50

Suggestions ................................. 1Supplies and materials .............. 52

T Tax help ..................................... 53

Tax preparation fees ................. 51 Taxes:

Carrying charge .................... 25 Employment ......................... 21 Excise ................................... 21 Franchise .............................. 22 Fuel ...................................... 22 Income .................................. 21 Leased property ................... 14 Personal property ................. 22 Real estate ........................... 20 Sales .................................... 22 Unemployment fund ............. 21

Taxpayer Advocate ................... 53 Telephone .................................. 53 Timber ................................. 34, 40 Tools ............................................ 3

Trademark, trade name ....... 30, 50 Travel ......................................... 46 TTY/TDD information ................ 53

UUnemployment fund taxes ........ 21Unpaid expenses, related per-

son .................................... 4, 19 Utilities ....................................... 53

V Vacation pay ................................ 8

WWages and salaries ..................... 5Welfare benefit funds .................. 7

�

important changes for 2000 business expenses

Documents