Chapter 5Chapter 5

Introduction to Business ExpensesIntroduction to Business Expenses

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Kevin MurphyKevin MurphyMark HigginsMark Higgins

Kevin MurphyKevin MurphyMark HigginsMark Higgins

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All tax deductions are a matter of Legislative Grace

All tax deductions are a matter of Legislative Grace

Deductions are part of Congress’ approach to implementation of

Ability-to-Pay

Concept Review Concept Review

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From Chapter 1: All deductible amounts fall into one of three categories:Business Expenses (Chapters 5 & 6)Losses (Chapter 7)Deductions (Chapter 8)

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There are two primary types of deductions allowed individuals:

Deductions for adjusted gross incomegenerally have a business purpose

Deductions from adjusted gross incomegenerally have a personal purpose

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Items subject to special tax treatment are kept separate

Items not subject to special tax treatment are netted to arrive at ordinary net income or net loss

Conduit entities are not subject to tax, but results of operations flow-through to owners’ returns.

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Classification of DeductionsClassification of Deductions

All expenditures fall into two categories:Profit-motivated

Trade or business expensesExpenses for the production of income

(Investment)

PersonalSpecifically allowed itemized deductionsNondeductible personal expenses

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Profit-Motivated Expenditures

Profit-Motivated Expenditures

Show that the expense is related to a profit-motivated transaction

Show that the business purpose is the primary or dominant motive

To be deductible, an expenditure must have a business purpose unrelated to its tax effect.

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Trade or BusinessTrade or Business

Requirements to qualify as a trade or business:Primary purpose is to earn income or a

profitInvolvement is regular and continuousActivity is not merely a hobby

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Rental ActivityRental Activity

Rental activities may be either trade or business or for the production of incomeExpenses are always deducted for AGIClassification matters when property is

sold

Classification is determined by the scope of the taxpayer’s involvement

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Mixed-Use ( & ) Business and Personal Use

Mixed-Use ( & ) Business and Personal Use

Mixed-Use Assets Used both to earn income and for personal

purposesTreat as two separate assets by allocating

amount of use

Mixed-Use ExpendituresIncurred both for profit and personal

reasonsAllocate between business and personal

use and deduct as allowed

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3 Positive Tests for Deductibility

3 Positive Tests for Deductibility

To be deductible, expenses must be profit-motivated or specifically allowed, and alsoand also

OrdinaryNormal, common, generally accepted

NecessaryAppropriate, helpful, prudent

Reasonable in amountArm’s length

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5 Negative Tests for Deductibility

5 Negative Tests for Deductibility

To be deductible, expenses must not bePersonal

Business purpose is not primary motiveNot specifically allowed

Capital ExpendituresShould be capitalized as assets if useful life

extends beyond a yearStart-up costs

After 10/23/04 may expense $5,000 in first year; remainder is amortized over 180 months

Expense is phased-out if total costs > $50,000

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5 Negative Tests for Deductibility

5 Negative Tests for Deductibility

Against Public PolicyResulting from violation of a lawResulting from an illegal business

Cost of goods sold are always deductible under the capital recovery concept

Ordinary, necessary, and reasonable business expenses are deductible for all illegal businesses except sale of drugs

For lobbying and political activities Costs to influence local legislation are deductible Costs to monitor any legislation are deductible

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5 Negative Tests for Deductibility

5 Negative Tests for Deductibility

Related to Tax-Exempt IncomeIncurred to generate tax-exempt income

Another Person’s ObligationCannot recover another’s capital

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Mixed-Use ExpensesHobby Vs. Business

Mixed-Use ExpensesHobby Vs. Business

An income-earning activity without a predominant profit motive is a hobby.

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Mixed-Use ExpensesHobby Vs. Business

Mixed-Use ExpensesHobby Vs. Business

Factors considered in determining profit-motive areManner of conducting activityExpertise or reliance on expert adviceTime and effort spent on activityHistory of income and lossAmount of occasional profitElements of personal pleasureSuccess in similar activities

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Mixed-Use ExpensesHobby

Mixed-Use ExpensesHobby

Losses from a hobby are not deductibleExpenses allowed up to amount of income

generatedDeductions taken using three tier system:

Expenses also allowed as personal itemized deductions

Other expenses that qualify as business expensesDepreciation on assets used

Allowable expenses are deducted from AGI

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Mixed-Use ExpensesVacation Home

Mixed-Use ExpensesVacation Home

A residence used for personal vacations and also rented to unrelated people is a mixed-use asset and first must be classified as either:Personal residence if rented less than 15

days in a yearVacation home if used personally

more than 14 days, ormore than 10% of the number of days rented

Rental property if used personally less than 15 days, orless than or equal to 10% of the days rented

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Vacation HomeTax TreatmentVacation HomeTax Treatment

If classification is: Personal residence

Vacation home

Rental property

Then tax treatment is:• Report no income or

expense• Report income and

allocate expenses using three tier system (no loss allowed)

• Report income and allocate all expenses; Loss allowed

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Mixed-Use ExpensesHome Office

Mixed-Use ExpensesHome Office

A taxpayer who operates a trade or business from home may be able to deduct a portion of the home’s expenses.

Expenses of the home are allocated between business and personal use

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Mixed-Use ExpensesHome Office

Mixed-Use ExpensesHome Office

A specific portion of the home must be usedExclusively and regularly,As the principal place of business or as a

place to meet clients, but If taxpayer has no other available location to do

administrative or management activities, this requirement will not disqualify the deduction

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Mixed-Use ExpensesHome Office

Mixed-Use ExpensesHome Office

Employees must also show that the use Is for the convenience of their employerRequired as a condition of employment

Allowed expenses are deducted using the three tier system

Deduction is limited to the amount of net income from the businessHome-office deduction may not create a lossExcess may be carried-forward

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Timing of DeductionsTiming of Deductions

The taxpayer’s accounting method is used to determine the timing of deductions.

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Timing of DeductionsCash Method

Timing of DeductionsCash Method

Cash Method: claim a deduction in the year an expense is paidDate of mailing for checksDate of charge for credit cardsPrepaid expenses are deductible if used

within one tax year (prepaid interest does not qualify)

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Timing of DeductionsAccrual Method

Timing of DeductionsAccrual Method

Accrual Method: claim a deduction in the year two tests are metAll-events test is met when a liability exists

and the amount can be determinedEconomic performance test is met when

services or property are provided

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Timing of DeductionsRelated Party Accrued

Expenses

Timing of DeductionsRelated Party Accrued

ExpensesDeductions for accrued expenses payable to a cash basis related party are limited.

Related parties include family members and businesses owned or controlled by the taxpayer

Unless both parties are accrual basis, both report using the cash method; until income is reported no expense may be deducted

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Financial Accounting Income Vs. Taxable Income

Financial Accounting Income Vs. Taxable Income

Matching and Conservatism are not tax concepts

Estimates of expenses are not permitted for tax purposesUse specific write-off for bad debtsDo not estimate warranty expense

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End of Chapter 5End of Chapter 5