Ch6 - 2015

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2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible ebsite, in hole or in part.

Comprehensive Volume

1

Chapter !

"eductions and Losses#$n %eneral

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&he 'ig (icture )slide 1 o* 2+

"r. Cli** (ayne deter-ines that his deductible epenses associated ith his

dental practice are as *ollos#/alaries including $CA )unpaid at yearend o* 5,000+ 120,000

'uilding rent 23,000

"epreciation o* dental e4uip-ent and o**ice

*urnishings and e4uip-ent 52,000$nsurance )-alpractice and o* dental e4uip-ent

and o**ice *urnishings and e4uip-ent+ 22,000

"ental supplies 1!,000

**ice supplies 6,000

$nvestigation epenses !,000

Contribution to 7./. /enate ca-paign *und o* &o- /-ith 1,000

Contribution to 7./. /enate ca-paign *und o* 8irginia 9hite 1,000

Legal epenses associated ith patient lasuit ):ury decision *or

de*endant+ 3,000

ine i-posed by city *or i-proper disposal o* -edical aste 6,000

"ra by "r. (ayne *or living epenses )5,000 -onthly+ !0,000

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&he 'ig (icture )slide 2 o* 2+

;as "r. (ayne correctly calculated the business

epenses *or his dental practicepenses *or the use o* business property

=nehal* o* sel*e-ploy-ent taes paid

/uch epenses are deductedforA%$

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&rade or 'usiness "eductions)slide 2 o* 2+

$n order *or epenses to be deductible, they

-ust be#

=rdinary# nor-al, usual, or custo-ary *or others in

si-ilar business, and not capital in nature

=Hecessary# prudent businessperson ould incur

sa-e epense

=Reasonable# 4uestion o* *act=$ncurred in conduct o* business

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/ection 212 >penses )slide 1 o* 2+

/ection 212 allos deductions *or ordinary

and necessary epenses paid or incurred *or

the *olloing#

=&he production or collection o* inco-e

=&he -anage-ent, conservation, or -aintenance o*

property held *or the production o* inco-e

=>penses paid in connection ith thedeter-ination, collection, or re*und o* any ta

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/ection 212 >penses )slide 2 o* 2+

G 212 epenses that are deductionsforA%$ include#

= >penses related to rent and royalty inco-e

= >penses paid in connection ith the deter-ination,

collection, or re*und o* taes related to the inco-e o* soleproprietorships, rents and royalties, or *ar-ing operations

All other G 212 epenses are ite-i?ed deductions

)deductionsfromA%$+

= or ea-ple, invest-entrelated epenses )e.g., sa*edeposit bo rentals+ are deductible as ite-i?ed deductions

attributable to the production o* invest-ent inco-e

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'usiness And

Honbusiness Losses "eductible losses o* individual tapayers are

li-ited to those#

=$ncurred in a trade or business,

=$ncurred in a transaction entered into *or pro*it

$ndividuals -ay also deduct casualty losses

*ro- *ire, stor-, shiprecI, and the*t

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Methods o* Accounting

&he -ethod o* accounting a**ects hen

deductions are taIen

=Cash# epenses are deductible only hen paid

=Accrual# epenses are deductible hen incurred

Apply the all events testand the economic performance

test

= >ception to the econo-ic per*or-ance test *or recurring

items

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"isalloance (ossibilities

&he ta la disallos the deduction o* certain types

o* epenses *or a variety o* reasons

= e.g., May restrict tapayer atte-pts to deduct certain ite-s

that, in reality, are personal ependitures Certain disalloance provisions are a codi*ication or

etension o* prior court decisions

= e.g., A*ter courts denied deductions *or pay-ents in

violation o* public policy, ta la as changed to providespeci*ic authority *or the disalloance

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>penditures Contrary

&o (ublic (olicy

"eductions are disalloed *or certain speci*ic

types o* ependitures that are considered

contrary to public policy

=>a-ples# penalties, *ines, illegal bribes or

IicIbacIs, tothirds o* treble da-age pay-ents

*or violation o* antitrust la

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&he 'ig (icture >a-ple 16

Hondeductible ines

Return to the *acts o* &he 'ig (icture on p. !1.

"r. (ayne had not instituted proper procedures *or

disposing o* -edical aste *ro- his laboratory.

="uring the current ta year, he as *ined 6,000 bythe city.

="r. (ayne believes the *ine should be deducted as

an ordinary business epense. ;oever, because the *ine as due to a

violation o*public policy, the 6,000 is notdeductible.

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Legal >penses $ncurred $n "e*ense

* Civil r Cri-inal (enalties

&o deduct legal epenses

=Must be directly related to a trade or business, an

inco-e producing activity, or the deter-ination,

collection, or re*und o* a ta e.g., Corporate o**icerJs legal *ees in de*ending against

price*iing charges

e.g., LandlordJs legal *ees associated ith eviction o*

tenant

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>penses Relating &o

An $llegal 'usiness

7sual epenses o* operating an illegal business

are deductible

=;oever, deduction *or *ines, bribes to public

o**icials, illegal IicIbacIs, and other illegal

pay-ents are disalloed

&ra**icIing in controlled substances# only cost

o* goods sold can reduce gross inco-e

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(olitical Contributions And

Lobbying Activities

%enerally, no business deduction is alloed

*or pay-ents -ade *or political purposes or

*or lobbying

=>ceptions are alloed *or lobbying#

&o in*luence local legislation,

&o -onitor legislation, and

"e -ini-is inhouse epenses )li-ited to 2,000+= $* greater than 2,000, none can be deducted

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&he 'ig (icture >a-ple 1@

(olitical Contributions


"r. (ayne -ade political contributions to the /tate /enate

ca-paigns o* &o- /-ith and 8irginia 9hite.

="r. (ayne -ade these contributions to encourage thesesenators to support a ne bill that is bene*icial to the stateJs

dental pro*ession.

= &here*ore, he assu-ed that these ould be deductible

business epenses.

;oever, political contributions are not deductible,

so he ill receive no ta bene*it *ro- the-.

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>cessive >ecutive Co-pensation)slide 1 o* 2+

or publicly held corporations#

="eduction *or co-pensation o* C> and *our

other highest co-pensated o**icers is li-ited to 1

-illion each

="oes not include#

Certain per*or-ancebased co-pensation

(ay-ents to 4uali*ied retire-ent plans (ay-ents ecludible *ro- gross inco-e

i i i

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>cessive >ecutive Co-pensation

)slide 2 o* 2+ An additional li-itation applies only to

covered eecutives o* co-panies receiving&roubled Asset Relie* (rogra- )&AR(+

assistance=&he deduction *or co-pensation paid to a covered

eecutive is li-ited to 500,000

=Covered e-ployees include the C>, the C,and the three other -ost highly co-pensatedo**icers

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$nvestigation * A 'usiness)slide 1 o* 6+

$nvestigation epenses incurred to deter-ine the*easibility o* entering a ne business or epanding aneisting business= $nclude costs such as travel, engineering, architectural

surveys, -arIeting reports, various legal and accountingservices

&a treat-ent o* these epenses depends on#= &he current business, i* any, o* the tapayer

= &he nature o* the business being investigated

= &he etent to hich the investigation has proceeded

= 9hether or not the ac4uisition actually taIes place

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$* the tapayer is in a business the same as or

similar tothat being investigated

=$nvestigation epenses are deductible in the year

paid or incurred

&he ta result is the sa-e hether or not the tapayer

ac4uires the business being investigated

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9hen the tapayer is not in a business the sa-e as orsi-ilar to that being investigated= &a result depends on hether ne business is ac4uired

$* not ac4uired= All investigation epenses generally are nondeductible

$* ac4uired= $nvestigation epenses -ust be capitali?ed

= May elect to deduct the *irst 5,000 o* epenses currently

= Any ecess epenses can be a-orti?ed over a period o* not less than

1D0 -onths )15 years+= $n arriving at the 5,000 i--ediate deduction alloed, a dollar*or

dollar reduction -ust be -ade *or those epenses in ecess o*50,000

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&he 'ig (icture >a-ple 1E

$nvestigation * A 'usiness )slide 1 o* 2+


"r. (ayne believes that his ad-inistrative and

business sIills can be used to turn around dental

practices hose revenues have been declining.= ;e investigates &eeth Restoration, LLC, a local dental

practice that is *or sale.

=>penses paid to consultants and accountants as

part o* this investigation totaled !,000.

=;e deter-ined that &eeth Restoration ould not be

a good invest-ent, so he did not buy it.

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&he 'ig (icture >a-ple 1E

$nvestigation * A 'usiness )slide 2 o* 2+


&he !,000 spent to investigate this business is

deductible as a business epense because "r. (ayne is

already in the dental business.= $nvestigating ne business opportunities in oneJs current

trade or business is an ordinary and necessary business

epense.

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;obby Losses )slide 1 o* D+

;obby de*ined

=Activity not entered into *or pro*it

(ersonal pleasure associated ith activity

>a-ples# raising horses, *ishing boat charter

$* an activity is not engaged in *or pro*it, the

hobby loss rules apply

=;obby epenses are deductible only to the etento* hobby inco-e

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(ro*it activity

=$* activity is entered into *or pro*it, tapayer can

deduct epenses *or A%$ even in ecess o* inco-e

*ro- the activity AtrisI and passive loss rules -ay apply

*ten it is di**icult to deter-ine i* an activity

is pro*it -otivated or a hobby Regulations provide nine *actors to consider in -aIing

this deter-ination

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(resu-ptive rule o* G 1D6

=$* activity shos pro*it 6 out o* 5 years )2 out o* @

years *or horses+, the activity is presu-ed to be a

trade or business rather than a personal hobby= Rebuttable presu-ption, shi*ts burden o* proo* to $R/

=therise, tapayer has burden to prove pro*it

-otive

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Year Income (loss) Hobby?

200D 500 Kes

200E )1,500+ Kes2010 @00 Kes

2011 )1,000+ Kes

2012 E00 Ho, pro*it 6 o* 5 years

2016 )500+ Kes, pro*it only 2 o* 5 years

2013 1,200 Ho, pro*it 6 o* 5 years

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$* an activity is dee-ed to be a hobby

=Can only deduct epenses to etent o* inco-e

*ro- activity )i.e., cannot deduct hobby losses+

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;obby Losses )slide ! o* D+

$* an activity is a hobby#

=>penses are deductiblefromA%$

&reated as -iscellaneous ite-i?ed deductions sub:ect to

the 2 o* A%$ li-itation >ception# epenses that are deductible ithout regard

to pro*it -otive are deductible in *ull, such as

= ;o-e -ortgage interest

= (roperty taes

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;obby Losses )slide @ o* D+

rder in hich hobby epenses are deductible#

=irst# &hose otherise deductible# e.g., ho-e

-ortgage interest and property taes

=&hen# >penses that do not a**ect ad:usted basis#

e.g., -aintenance, utilities

=&hen# >penses that a**ect ad:usted basis# e.g.,

depreciation )or cost recovery+

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;obby Losses )slide D o* D+

>a-ple o* hobby epenses# &apayer sells

horses raised as a hobby *or15,500

Amount Order Amount$nco-e 15,500

$nterest !,000 1 !,000

&aes 6,000 1 6,000

8et 'ills 2,000 2 2,000

eed 3,000 2 3,000

"epreciation 1,000 6 Ltd. to 500

&otal 15,500

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Rental 8acation ;o-es)slide 1 o* E+

May have both personal and rental use o* avacation ho-e

"eduction o* rental epenses -ay be li-ited

to rental inco-e i* pri-arily used *or personalpurposes

"eter-ination o* vacation ho-e treat-ent is

dependent on personal use vs. rental use

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Rental days

=Less than 15 days# Ho gross inco-e recogni?ed

*ro- rentals and no deductible rental epenses

Mortgage interest and property taes treated as i* onpersonal residence )generally deductible in *ull+

=More than 13 days# &reat-ent depends on a-ount

o* personal use

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(ri-arily rental use

=$* rented *or 15 days or -ore and personal use

days H& -ore than the greater o* 13 days or 10

percent o* *air rental days=Can deduct all epenses allocated to rental use

even i* loss results

Rental loss sub:ect to atrisI and passive loss rules

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(ersonalrental use

=$* rented *or 15 days or -ore and personal use

days eceed the greater o* 13 days or 10 o* *air

rental days=&reated si-ilar to hobby

Rental epenses deducted in three step process

Ho rental loss alloed

Carry*orard o* disalloed rental epenses

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>a-ple o* personal use

Rental days# 200 )10 20+

(ersonal use Hot /igni*icant /igni*icant

@ days N 1D days N

25 days N

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Rental 8acation ;o-es)slide ! o* E+

>a-ple o* personal use

Rental days# 100 )10 10+

(ersonal 7se Hot /igni*icant /igni*icant

@ days N

13 days N

1D days N

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Rental 8acation ;o-es)slide @ o* E+

Allocation o* epenses beteen personal and

rental

=Mortgage interest and real estate taes

$R/ re4uires allocation based on total days used

Courts have alloed allocation based on days in year

=ther epenses are allocated based on total days

used

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Rental 8acation ;o-es)slide D o* E+

&a treat-ent o* inco-e and epenses o* a

pri-arily rental vacation ho-e

=Rental inco-e included in gross inco-e

=Rental epenses deductibleforA%$

=Rental inco-e and epenses reported on /ch. >

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Rental 8acation ;o-es)slide E o* E+

&reat-ent o* allocated personal portion o*

vacation ho-e epenses

=(ri-arily rental use# taes deductiblefromA%$,

-ortgage interest nondeductible )personal interest+

=(ersonalrental use# -ortgage interest and taes

deductiblefromA%$

=(ersonal portion o* other epenses )e.g., insurance,-aintenance+ nondeductible

di d *

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>penditures $ncurred *or &apayerJs

'ene*it or bligation

Ho deduction is alloed *or pay-ent o*

another tapayerJs epenses

=Must be incurred *or tapayerJs bene*it or arise

*ro- tapayerJs obligation

=>ception# (ay-ent o* -edical epenses *or a

dependent

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(ersonal >penditures

7nless otherise provided in the Code,

personal epenses are not deductible

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Capital >penditures

A-ounts are capitali?ed

Asset -ay be sub:ect to depreciation )or cost

recovery+, a-orti?ation, or depletion

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&ransactions 'eteen Related (arties)slide 1 o* 2+

/ection 2!@ disallos losses *ro- direct or

indirect sales or echanges o* property

beteen related parties

=a-ily and entity relationships apply

=Constructive onership rules apply

=Loss disalloed -ay reduce gain on subse4uent

disposition to unrelated third party

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&ransactions 'eteen Related (arties)slide 2 o* 2+

/ection 2!@ also re4uires the -atching

principle be applied *or unpaid epenses and

interest hen di**erent accounting -ethods

used=>a-ple# An accrual basis, closely held

corporation, cannot deduct accrued, but unpaid,

salary to cash basis related partye-ployeeshareholder until it is actually paid

> d $ t t R l ti t

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>penses and $nterest Relating to

&a>e-pt $nco-e

>penses relating to production o* taee-pt

inco-e are nondeductible

=>a-ple# interest epense on loan here *unds

used to ac4uire -unicipal bonds

(i

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&he 'ig (icture >a-ple 32

&a (lanning /hi*ting "eductions

Re*erring to the *acts o* &he 'ig (icture on p. !1,

Assu-e that "r. (ayneJs -arginal ta rate in 2013 is

25 but that he esti-ates his rate in 2015 to be 30.

$n this case, he should consider de*erring thecharitable contribution to 7HA College until 2015.

= ;is ta bene*it in 2015 ill be 2,000.

)30 N 5,000+

= ;is ta bene*it in 2013 ould only be 1,250.

)25 5,000+

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Re*ocus n &he 'ig (icture )slide 1 o* 2+

* the epenses incurred by "r. (ayne, several co--ents need

to be -ade.

= 'eingpersonal in nature, none o* the 5,000 -onthly dra

is deductible and the a-ount involved is not sub:ect to the

reasonableness test )see >a-ple !+. "r. (ayne is a sole proprietor and not in an e-ploy-ent

relationship.

= &he *ine paid *or violating aste control rules co-es under

the public policy li-itations )see >a-ple 16+ and isspeci*ically -ade nondeductible by Code G 1!2)*+.

= Along the sa-e line are the political contributions

)>a-ple 1@+ -ade nondeductible by G 1!2)e+.

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Re*ocus n &he 'ig (icture )slide 2 o* 2+

;oever, "r. (ayneJs investigation o* the

practice o* another dental *ir- )>a-ple 1E+

appears reasonable and the epense incurred

deductible.

Although not speci*ically discussed in the tet,

"r. (ayneJs legal *ees incurred in connection

ith a lasuit *iled by a patient appear relatedto his practice )>a-ple 15+.

=As such, they are ordinary and necessary to his

trade or business.

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