Accy 405 - Tax (Chapter 5 - 8)

Drug dealers are required to report their income and are also allowed to deduct...

COGS

Form W-2

Line 1 - 6 on 1040.

Production of Income Expense

"Non-business" or "Investment" expenses. Do not apply to corporations. These go to Schedule A as itemized deductions, more specifically, *miscellaneous* itemized deductions (under "Job Expenses & Certain Miscellaneous Deductions" & "Other Miscellaneous Deductions")

Schedule A

*Note* All itemized deductions or standard deductions

Schedule K-1 (Form 1065)

*Note* - Line 1 Part III: usually we don't report the full number here for NI but we have to use multiple line items to specify

Schedule 1

*Note* - Adjustments to Income = Deductions for Adjusted Gross Income - Additional Income = line number 12 and 17 are in the AGI calculations <net of numbers>

Emily and Erin are equal partners in E&E Partnership. During 2018, the partnership reported the following: - Sales revenue = $294,000 - Long-term capital gain = $13,000 - Business expenses = $121,000 - Charitable contributions = $8,000 What is the amount that Emily will see reported on Line 1 of her Schedule K-1 from the partnership for 2018?

$86,500 (294-121)

X is a single taxpayer whose only capital asset transaction for 2018 is a $70,000 capital loss on the sale of qualifying small business stock. How much of the $70,000 loss can X deduct in 2018?

- $50,000 under special exception on small business stock - $3000 under regular annual limitation Total loss deduction: $53,000 - $17,000 carried forward to 2019 & deducted under the regular capital G/L netting procedures.

Under PAL Rules, all income is classified as: - Portfolio Income - Active Income - Passive Income Elaborate each.

- *Portfolio Income*: unearned income (dividends, interests, royalties, etc.) - *Active Income*: income from a trade/business in which taxpayer materially participates - *Passive Income*: income from a trade or business in which taxpayer does not materially participates

A works weekdays as a nurse at a local hospital (14 miles from home). A also works as a waiter at a restaurant 2 nights during the week and on weekends. The weeknights he works at the restaurant, A leaves directly from the hospital. The restaurant is 6 miles from the hospital and 8 miles from home. What portion of A's travel is considered business-related?

- 14 miles (home - hospital): N/D - 6 miles (hospital - restaurant): Deductible - On weekends A leaves to work at the restaurant: commuting, N/D

Deductions for Self-Employed Taxpayers

- Allow health insurance premium deduction - Allow SE taxes Double FICA tax = 6.2% x 2 + 1.45% x 2 = *15.3%* Only *92.35%* [100% − (50% × 15.3%)] of net earnings from SE is subject to the SE tax

Did the at-risk rules end tax shelter abuse? No...the abuse exploded. - 1986: Congress added the *Passive Activity Loss (PAL)* Rules. - Purpose: Disallow deductions of losses from passive activity against other forms of income. - VERY COMPLEX... but we'll focus on the basis. So, what's a "passive activity"?

- Conduct of a trade or business in which the taxpayer does NOT "materially participate" - What does it mean to "materially participate"? TP must be involved in operations of activity on a "regular, continuous, substantial basis" - IRS gave us 7 tests... but the first 2 are most important. 2 basic tests for material participation: 1. Individual (including spouse) participates in an activity > 500 hours/year *OR* 2. Individual (including spouse) spends > 100 hours/year in the activity & that amount is greater than any other participant If yes to either, it is material participation. If not, passive activity.

Education Expenses (Business Expenses)

- If employee --> Miscellaneous itemized deductions (no longer deductible) - If self-employed --> Deductions for AGI MUST be required for continued employment. MUST maintain/improve skills required by Trade or Business No deductions if: - Education to meet minimum requirement for job - Education qualifies taxpayers for a new trade/business

X has TI = $100,000 in 2018 from portfolio and active income sources. X owns 2 passive activities: - Passive activity 1 (PA1): NI = $(20,000) - Passive activity 2 (PA2): NI = $2,000 What's the effect of the 2 PAs on X's 2018 income?

- The $2,000 of income from PA2 is included in gross income. Under PAL rules, only $2,000 of the loss from PA1 is deductible in 2018. - The net $18,000 ($20,000 − $2,000) passive loss in 2018 is not deductible against Harriet's $100,000 of taxable income from portfolio and active income sources. In essence, passive losses are deductible only up to the amount of passive income.

Treatment of Employee Business Expense

- What if sole proprietor has auto expenses? They report them on Schedule C, deduct for AGI. - What about partner/partnerships in S-Corp? Generally conduit entity reimburses partner/shareholders, conduit entity uses standard mileage rate method to deduct expenses (which reduces line 1 of schedule K-1).

3 Areas Congress is Especially Concerned about Abuse

1. *Hobby Expenses*: deductible to extent of hobby income. Hobby losses are NEVER allowed. Only allowed if expenses are deducted as business expense OR itemized deductions. ALL hobby expenses are deducted on Schedule A. If a taxpayer does not itemize, no hobby expense are allowed. 2. *Vacation Home Expenses*: house, condo, ... used for personal & rental purposes. - If Rent period > personal use: report income, deduct expense BUT cannot deduct expense for personal use - If rent period = personal use: report rental income, allocate expenses, no losses allowed. 3. *Home Office Expenses*: deduct allowed for taxpayers operating a trade or business from home. Strict rules. - Specific part of home used EXCLUSIVELY for business - Area must be used regularly. - If employee, working @ home must be "for convenience of employer" & "required as a condition of employment" - Use square footage to allocate expenses between trade or business & personal

Specially-Treated Investment Losses (Investment-Related Loss in Transaction Loss)

1. Losses on Small Business Stock: individual TP can deduct up to $50,000 loss/year. 2. Losses on Related Party Sales: cannot deduct losses on transactions NOT made at arm's length. 3. Wash Sales: security sold @ a loss & during 30-day period before/after sale date, seller buys substantially identical security. Cannot deduct losses

Tests for Deductibility - To deduct an expense, it MUST be?

1. Ordinary: - Commonly incurred in line of business - Assignable to current accounting period (capitalized & depreciated) 2. Necessary: - "Appropriate & helpful" in taxpayer's income activity - Question - Would a reasonable person spend $ on the same item? 3. Reasonable in Amount - Amounts deemed unreasonable are disallowed - Most commonly an issue with related parties

Tests for Deductibility - To deduct an expense, it MUST NOT be?

1. Personal Expenses 2. Capital Expenditure - Purchase of long-lived assets (life > year of acquisition): capitalize & depreciate - Repairs & maintenance: deductible IF no change in value or useful life. If expenditures increase value or useful life, capitalize & depreciate. 3. Frustration of Public Policy - Bribes, kickbacks, final, penalties: N/D - Contributions to political campaigns: N/D - Expenses to influence federal & state legislation: N/D (old law was deductible). Monitoring legislation expenses ARE deductible - CAN deduct legal ordinary & necessary expenses of an ILLEGAL trade or business (Drug dealers ONLY allowed COGS deduction) 4. Related to Tax-Exempt Income - N/D for expenses to generate tax-exempt income 5. Not another Person's Expenses

2 Activities Are Already Settled For Passive Activity

1. Working Interests In Oil & Gas Deposits: ALWAYS ACTIVE & NOT subject to PAL Rules 2. Limited Partner Interests in Limited Partnership: ALWAYS PASSIVE Through 1994 - rental activity was passive. Now... rental activity is passive unless an individual qualify for an exception: - Rental activity also provides significant services (hotels, car/clothing/tool rentals, ...) - Rental & for a real estate professional (losses are trade/business losses).

An single taxpayer with 2018 itemized deductions of $8,290 will report total deductions from AGI of

12,000

Jared, a sole proprietor, takes a 10-day trip to Las Vegas and spends 7 days on business activities. During the trip, he accumulated the following expenses: - Airfare = $650 - Lodging = $1,000 ($100 per night) - Meals = $380 ($38 / day) - Incidentals = $120 ($12 per day) The total amount that Jared will be allowed to deduct on his 2018 Schedule C related specifically to the Las Vegas trip is

650 + 100 x 7 + 38 x 0.5 x 7 + 12 x 7 = 1,567

A TP qualifies under the real estate professional exception for PAL if?

>50% of TP's total personal services (work) are in real property trades/businesses in which the taxpayer materially participates. The TP performs > 750 hours a year of service in real property trades or businesses in which the taxpayer materially participates. The taxpayer materially participates in the rental activity

In the 2018 tax year, determining whether an individual qualifies as a taxpayer's dependent is important when considering all but which of the following? A. dependency exemptions B. filing status C. eligibility for the Child Tax Credit D. eligibility for the Dependent Care Credit

A

Negan, a cash basis sole proprietor, provided $12,000 worth of services in 2016 to his customer Michonne. Michonne did not pay for the services in 2016 or 2017 and Negan is certain in 2018 that he'll never receive the payment. On his 2018 Schedule C, Negan can take a deduction for bad debts in the amount of A. $0 B. $6,000 C. $12,000 plus the market rate of interest D. $12,000

A

The at-risk and passive activity loss rules were created to address A. abusive tax shelters. B. the taxation of illegal residents. C. increasing tax rates for low income individuals. D. loopholes causing many high-income taxpayers to pay extremely high tax rates.

A

Which of the following insurance-related expenses a business may incur is not deductible? A. key man life insurance B. health insurance for employees C. group term life insurance for employees D. unemployment insurance

A

Brandi, a single taxpayer, has adjusted gross income of $200,000 in the 2018 tax year. She decides she only needs a small fraction of the money she earned for her living expenses and makes a cash donation to her church of $130,000. On her 2018 tax return, how much will Brandi be allowed to deduct as a charitable contribution? A. $120,000 B. $130,000 C. $100,000 D. $130,000, plus any other amounts contributed to other organizations up to a total of $200,000

A (60% x 200,000)

Specific Charge Off Method

A business bad debt can written off in the accounting period in which facts known to taxpayers indicate that account is fully/partially uncollectible. If an account is fully/partially written off & the amount is later recovered, under *tax benefit rule*, the recovered amount reported as income

A purchases a new car this year and drives it 10,000 miles for business purposes and 3,000 miles for personal use. What is A's deduction for the business use of the car if he elects to use the standard mileage rate method?

A can deduct $5,450 (10,000 × 54.5 cents) in auto expense based on business mileage under the standard mileage rate method.

A rents office building. According to his 15-year lease, A is required to pay $12,000 rent in advance on 8/1 for 9/1-8/31. A has complied with the lease terms for the last 3 years. Can he deduct the $12,000 in the year it is paid?

A can deduct the $12,000 annual rent when paid. Because the terms of the lease require the prepayment, the deduction will not distort income, and because it is used up before the end of the tax year following the year of prepayment, A will not need to amortize the expense. Note that a prepayment that extends beyond 1 year (e.g., a 2-year rent prepayment) is allocated to the periods benefited by the expense.

A provides the food, beverages, and entertainment for a 7/4 picnic for its employees and their families. This is an annual event that A believes benefits its employees and the company. This year, the picnic costs $5,000. How much of the $5,000 in meals and entertainment cost can A deduct?

A can deduct the full $5000.

12/31/2018, A, a cash basis taxpayer, mails a $500 check to her attorney to pay for legal fees. The attorney receives the check on 1/2 and deposits it in her account. When can A deduct the legal fees?

A can deduct when she mailed it—in 2018—although the check was not cashed until 2019

Cash Method (Deductions)

A cash basis taxpayer may claim a deduction in the year expense is paid. WHEN does payment occur? - When check is honored & given to creditor - When service is rendered or property given to creditor - When payment is charged on credit card - May deduct prepaid expenses in the year paid if the prepayment does not create an asset that extends substantially beyond the year of payment (1-year rule for prepaid expense)

A purchases 50 shares of C/S for $5,000 in 2017. A sells the 50 shares for $4,400 in 2018. What are the tax effects for A?

A has a loss of $600 on the sale of the stock in 2018. Transaction Loss.

A owns a restaurant. GI = $74,000 and allowable deductions related to the business of $90,000. What is A's income from the restaurant?

A has suffered a business loss of $16,000 ($74,000 − $90,000). This loss is an annual loss.

A operates a shoe store in a building she rents for $1,000/month. Comparable store space is readily available for rent at $400 per month. Is the rental payment reasonable?

A is allowed a $400 rent expense deduction unless A can establish that the location or other unique features of her father's building justify a higher rent than other, comparable store space.

Nonrecourse Debt

A liability in which the borrower is not personally liable for the debt.

A operates a successful consulting practice. 1/2018, she performs $5,000 in services for clients who still owe her as of 12/30/2019. A determines that $3,000 in receivables is un-collectible. How much of a deduction is A allowed if she uses the accrual basis of accounting? What if A uses cash basis?

A would report $5000 A/R and sales in 2018. Business bad debt. A can take $3000 bad debt deduction. A would report $2000 when received. No deduction at any point.

MUST conduits separately report items of income/deductions that require specific tax treatment? Examples?

ABSOLUTELY! Examples of items requiring separate reporting: - Charitable contributions - Investment interest expenses - Investment expenses - Section 179 expenses - Nondeductible expenses

Which entities are subject to PAL rules?

ALL noncorporate taxable entities (individuals, estates, trusts, ...) What about corporations? - Publicly traded --> can offset passive losses against active/portfolio income - Non-publicly traded --> can offset passive losses against active income ONLY What about individuals? - Passive losses may be deducted ONLY to the extent of passive income. - Losses not deductible are "suspended" and carried forward to future years

Elaborate Trade/Business Loss in Transaction Loss

Always deductible (for AGI for individuals) - Generally ordinary loss: not limited - Loss occurs from disposition: stem from sales, casualty/theft (capital recovery concept) With a casualty (flood, fire, ...), 2 possibilities: *a. Business Property, Fully Destroyed* - Taxpayer recovers un-recovered capital: business casualty loss = property's basis - Insurance proceeds > basis = casualty gain *b. Business Property, Partially Destroyed* - Taxpayer deducts "decrease in market value" of property - FMV before casualty - FMV after casualty = decrease in market value: loss cannot > basis - Same rules for insurance - Valuation before & after loss is rare. Decrease in MV = cost of repairs

C owes A $10,000 for goods it purchased from A on account. Because of financial difficulty, C cannot repay the debt when it comes due in 2018. A wants to deduct the $10,000 as a loss. How should she report the bad debt on her tax return?

An A/R from the sale of merchandise to C is related to A's trade or business. Therefore, A can deduct the $10,000 bad debt as a business expense in 2018.

Donald & Hillary are 50/50 partners in Presidential Partnership. When the partnership was formed, Donald contributed: - $20,000 cash - Property purchased for $10,000 (depreciated $5,000) - $15,000 borrowed funds (personally liable) During 2018, Presidential Partnership had a net loss of $50,000 & Donald withdrew $5,000 cash. What's Donald's allowable 2018 loss?

At-risk amount (12/31/2018 before considering any loss) = $20,000 + $5,000 (recourse debt) + $15,000 (recourse debt) - $5,000 = $35,000 The $25,000 ($50,000 x 50%) is Donald's share of the loss, fully deductible because we have enough at-risk amount. At-risk amount (1/1/19) = $35,000 - $25,000 = $10,000 *What if in 2019, partnership has a loss of $80,000 & Donald withdraws $5,000 cash?* - At-risk amount 12/31/19 before loss = $10,000 - $5,000 = $5,000 - Donald's share of loss = $40,000 ($80,000 x 50%) - Donald deduct $5000 & carries $35,000 loss forward to 2020. At-risk amount (1/1/20) = $5,000 - $40,000 = ($35,000).

An individual that has one capital asset transaction in a tax year, a $15,000 short-term loss, will be allowed A. a $15,000 deduction from AGI. B. a $3,000 deduction for AGI. C. a $15,000 deduction for AGI. D. a $3,000 deduction from AGI.

B

For tax years beginning after December 31, 2017, net operating losses (NOLs) may be A. carried forward to future tax years of taxpayers that do not materially participate in the business that generated the loss. B. carried forward indefinitely, but deductions are subject to an 80% of taxable income limitation. C. carried forward indefinitely, without restriction. D. carried back 2 years and/or forward 20 years.

B

Which of the following is not an allowable itemized deduction in the 2018 tax year? A. deduction for home mortgage interest paid B. unreimbursed employee business expenses C. gambling losses D. deduction for medical and dental expenses

B

The most likely maximum deductible amount of compensation paid to a CEO of a closely-held corporation is A. $1,000,000. B. $4,000,000, the average salary for CEOs in similar industries and a similar geographical area. C. $1,100,000. D. $400,000, the average salary for CEOs across the country.

B. $4,000,000, the average salary for CEOs in similar industries and a similar geographical area.

A is the CEO. Salary = $1,250,000. What amount can the corporation deduct as salary expense?

Because A is the CEO, the corporation can deduct as salary expense only $1,000,000 of the $1,250,000 paid to her.

A a CPA, travels to Houston for 10 days (7 days to work, 3 to visit family). The business purpose for making the trip is to audit a client's accounting records. - Airplane ticket = $195 - Hotel = $85/night - Meals = $40/day - Incidentals = $15/day What is A's deductible travel expense? What if A spends 6 days to play and 4 days to work?

Because more than 50% of A's time on the trip is for business activities, she can deduct all the transportation expense. She can also deduct the other expenses to the extent they relate to business activities If 6 days to play & 4 days to work (<50% business time): no transportation is deductible so A's total deductible expense *$480*

X is a mechanic who owns an apartment building that has a net rental loss of $22,000 during the current year. AGI = $120,000. If X owns no other passive activities, how much of the rental loss can he deduct? What if AGI = $90,000 & loss = 20,000 next year?

Because property is rental real estate, it's always considered a passive activity unless there are exceptions. X owns 100% of the property, and it is assumed that X is involved in the rental in some significant way. So... The special deduction for rental real estate is $25,000. However, because X's AGI exceeds $100,000, X must reduce the allowable deduction by $10,000 [($120,000 − $100,000) × $0.50] to $15,000. X can deduct $15,000 of the rental loss against the $120,000 of AGI. The remaining $7,000 is suspended and treated like any other passive loss. What if AGI = $90,000 & loss = 20,000? X's current loss of $20,000 & suspended loss of $7,000 exceed the $25,000 rental real estate limitation. Therefore, X can only deduct $25,000 under the special annual deduction, and the remaining $2,000 of suspended loss is carried forward.

A driver for PPP is involved in an accident that totally destroys one of the company's vans. The van had been purchased for $26,000, and depreciation taken to date on the van is $8,000. What is the measure of the loss on the van?

Because the van was fully destroyed in the accident, the measure of the loss is the unrecovered investment in the van, its basis. Although the van cost $26,000, the company has recovered $8,000 of the cost through depreciation deductions. The unrecovered portion, $18,000 ($26,000 − $8,000), is the amount of the investment lost. *NOW* assume PPP receives $15,000 from the insurance company for the accident. What is PPP's casualty loss? $3,000. *NOW* what if PPP receives $20,000 for the destruction of its van. What is PPP's casualty gain (loss)? Gain of $2,000.

For the last 3 years, C has averaged annual gross receipts of $30 million. This year, C has EBITDA of $4,000,000, and it has incurred $1,500,000 in business interest expense. What can C deduct as business interest in the current year?

Because their annual gross receipts > 25 m, C is subject to business interest expense limitation. C can only deduct $4,000,000 x 30% = $1,200,000 interest expense.

A requires its employees to adequately account for all reimbursed business expenses. B, an account executive, submits for reimbursement the following valid business expenses: - Transportation costs = 600 - Meals = 600 - Lodging = 800 Total = 2000 What are tax consequences if A reimburses B $2000? What are tax consequences if A reimburses B $1500?

Because there has been an adequate accounting, B has no tax effects. None of the reimbursement is included in her GI. NOTE: In this case, the employer is the taxpayer who effectively gets the deduction for the business expenses. Therefore, the employer is subject to the 50% limitation on meals. The actual deduction for the employer is only $1,700 [$600 + $300 ($600 × 50%) + 800]. - If 1500 reimbursement: $1,500 is included in B's GI, and $1,500 of the expenses is deducted for AGI. 50% limit on meals applies. If the reimbursement occurs *prior to* 1/1/18, the remaining $500 in unreimbursed expenses is deductible from AGI as a miscellaneous itemized deduction. 75% = 1500/2000 = reimbursement ratio

Active Trader

Buy/sell securities for personal profit. Main income = capital gains. If activities are frequent & substantial, trader IS deemed to engage in trade/business. Expenses deductible for AGI.

A loss that results when a taxpayer sells property for less than its adjusted basis is known as A. an annual loss. B. a tax-exempt loss. C. a transaction loss. D. a casualty loss.

C

Business Gifts (Business Expenses)

Can deduct $25/year/donee for gifts to business customers.

A owns a large portfolio of stocks, bonds, and other securities. What is the treatment of A's securities activities in each of the following cases? - Case A: A spends all time to manage portfolio. A continually trades securities to obtain profit for short-term price increases. A has no other jobs. - Case B: A is employed. A spends some time to invest in long-term portfolio to earn dividend & interest.

Case A: Trade/business expense. Expenses deductible for AGI. G/L are treated as G/L from trade/business activities Case B: Production-of-income. G/L are capital G/L. Before the 2017 Tax Cut & Jobs Act, investment expenses are deductible as miscellaneous itemized deductions, but now, NOPE!

Ivanka, a sole proprietor, takes her client to dinner and a concert immediately after a day of meetings spent discussing the client's accounts. The total cost of the dinner was $124 and the cost of the concert was $210. How much of the amounts spent on dinner and the concert will Ivanka deduct on her 2018 Schedule C? A. $334 B. $124 C. $167 D. $62

D

The IRS has identified three areas of major concern regarding mixed-use expenses and has created strict rules for taxpayers to follow in calculating deductions. Which of the following is not one of the three areas of concern? A. home office expenses B. vacation home expenses C. hobby expenses D. investment expenses

D

The difference between a tax credit and a tax deduction A. is that deductions are never limited. B. is that deductions reduce tax on a dollar-for-dollar basis while credits do not. C. is that deductions directly reduce tax while credits reduce taxable income. D. is that deductions reduce taxable income while credits directly reduce tax.

D

The passive activity loss rules apply to all but which of the following? A. trusts B. individuals C. estates D. C corporations

D

A pays the following taxes during the current year: Federal income tax = $50,000 State and local income taxes = 15,000 State and local real estate and personal property taxes = 2,000 State and local sales taxes = 7,000 What is A's deduction for taxes paid?

Except for the federal income tax, A may deduct all the taxes listed. A's deduction for taxes paid is $24,000. The $50,000 federal income tax is never allowed as a deduction.

Investment-Related Loss in Transaction Loss

Dealing w/ capital assets: losses are often limited. For Individuals: net capital losses deductible for AGI up to $3000/year (disallow loss carried forward) For corporations: no deduction for net capital loss (can't offset ordinary income w/ capital loss). Carried backward losses for 3 years. Carries forward for 5 years.

A hurricane damages a warehouse used by X. X had paid $200,000 for the warehouse and had taken $80,000 in depreciation before the hurricane. FMV before hurricane = $300,000. FMV after hurricane = $100,000. What is the amount of loss X suffered on the warehouse because of the hurricane?

Decline in FMV = $200,000 ($300,000 − $100,000). X's basis = $120,000 ($200,000 − $80,000). Xs loss is the lesser of the decline in FMV because of the hurricane or its basis in the warehouse. So the maximum amount that X can recover through a loss deduction is the $120,000 basis.

Compensation of Employees (Business Expenses)

Deductible if paid for services actually performed by employees & reasonable in amount. "Reasonable" --> Publicly-traded corporation --> maximum deduction = $1,000,000 (per employee on a list). CEO, CFO, 3 next highest paid officers. "Reasonable" --> Non-publicly-traded corporation --> based on specific facts & circumstances --> go back to "reasonable compensation".

Auto Expenses (Business Expenses)

Deductible. Taxpayers choose between 2 methods for deducting expenses - choose larger amount: - *Standard Mileage Rate Method*: deduct 54.5 cents/business mile driven. No deduction for personal miles. ADD: + Parking & tolls: 100% business + Interest on auto loan, property taxes: allocate between personal & business - *Actual Cost Method*: deduct actual costs of depreciation, gas/oil, repairs, maintenance, insurance. If mixed use, allocate based on mileage (Bus.miles x Expense / Total miles). ADD: + Parking & tolls + Interest on auto loan, property taxes

Disposition of Passive Activities

Deductions of suspended losses are allowed when passive activities are sold & when they are disposed of because the taxpayer dies. - *Disposition by Sale*: any suspended loss is deductible in the year of sale against portfolio and active income. - *Disposition upon Death*: PAs become part of real estate & subject to estate tax. Unrealized gain on asset is not subject to income tax. - *Disposition by Gift*: Carryover basis (donor's basis becomes donee's basis). Unrealized gain is taxed.

Annual Loss (Realized Loss)

Did the taxpayers "materially participate" in the operation of the business? - No: Passive Activity Loss (PAL) rule applied - Yes: Trade/Business Loss - Net Operating Loss (NOLs) deduction allowed Tax = TI x Tax rate --> either 0 or positive. If TI <= 0, tax = 0 If TI > 0, tax > 0 This seems *logical & fair*...consider a 3-year time period.

To know proper treatment of deductions, we classify expenditures HOW?

Expenditures include: 1) Profit-Motivated Business Expense - Trade or Business Expense: - Production of Income Expense 2) Personal Expense - Specifically Allowed Itemized Deductions - Nondeductible Personal Expense Business expense MUST have a business *purpose* to deduct anything as a business expense (other than avoiding tax)

Mixed-Use Assets & Expenditures

Expenses/Assets to earn both income & personal purposes. Use a common-sense allocation. - Portion related to business: deductible business expense - Portion related to personal: nondeductible personal expense

Substantiation Requirements

For meals, auto, travel, gifts: - The amount of expense - Time & place of travel/meal - Business purpose of travel, meal, gift - Business relationship to person entertained/receiving gift These items are necessary to defend deductions IF audited.

Personal Use Losses

Generally disallowed (no deduction) - Possible to deduct personal casualty loss: On schedule A but there are huge limitations - Tax Cut & Jobs Act 2017: deduction allowed ONLY for federal-declared disasters

Personal Expense (Deductions)

Generally limited *Specifically Allowed Itemized Deductions (Schedule A)* Medical expense, taxes paid, interest paid, charity *Nondeductible Personal Expense* Groceries, auto/home/life insurance, utilities, Only complication...expenditures that have properties of both business & personal elements

Joe is single, sole proprietor in sporting goods. In 2018, business earns $140,000 of NI & Joe has no other income. Joe does NOT itemize, but did pay $4,200 for health insurance in 2018. QBI? TI?

Gross Income 140,000 Deductions for AGI SE HI Deduction (4,200) 1/2 SE Tax Deduction (9,845) Adjusted Gross Income 125,955 Deductions from AGI (12,000) TI before QBI Deduction 113,955 QBI Deduction (22,791) TI 91,164 *1/2 SE Tax deduction* 140,000 x 0.9235 = 129,920 128,400 x 12.4% = 15,922 129,920 x 2.9% = 3,768 Sum = 19,690 x 1/2 = 9,845 *QBI Calculation* 20% QBI = 20% TI = 113,955 x 20% = 22,791

Example of Disposition of Passive Activities

How much of the $18,000 suspended loss is attributed to PA1? PA3? $18,000 suspended loss is allocated proportionately to the 2 PAs - two activities (including the $13,000 carried forward from PA1 for 2019) combine for a total loss of $20,000 ($15,000 + $5,000). So, PA1 is responsible for $13,500 [$18,000 × ($15,000 ÷ $20,000)] of the suspended loss, and PA3 is responsible for $4,500 [$18,000 × ($5,000 ÷ $20,000)] of the suspended loss. *NOW*, if X sells PA1 for $42,000. PA1 has basis = $36,000. Gain of $6,000 in included in GI for year of sale. $13,500 suspended loss is deductible against active & portfolio income sources. So net effect on TI is $7,500 reduction ($6,000 - $13,500)

A owes $3,000 in expenses that are tax deductible. However, he does not have the cash to write a check. How can A obtain a current deduction for the expenses?

If A charges the expenses to a credit card, he is deemed to have paid the expense on the date of the charge and can take a deduction on the charge date. A can pay the credit card balance when he has the money. If A pays the expense by giving a note directly to the creditor, the expense is not deductible until the note is paid.

IRA Deduction (Business Expense - Individual Retirement Account)

Individual trust account maintained for the exclusive benefit of X or X's beneficiary 3 types of IRAs: - *Coverdell Education Savings Account*: never seen one... - *Conventional (traditional) IRA*: contribute up to $5,500/year/TP --> If >50 years old, additional $1000. FULLY DEDUCTIBLE IF not participating in a qualified pension plan. Distribution are 100% taxable if contributions were deducted. - *Roth IRA*: contribute up to $5,500/year/TP --> If >50 years old, additional $1000. Cannot deduct. Distribution are 100% tax free.

Rental activity. Is it trade or business *OR* is it production of income expense?

It depends on the level of involvement. - If it looks like a portfolio investment: Production of income expense. Ex: own a condo @ a beach, someone else co manage the condo & send checks monthly. - It it looks like more time & money involvement: Trade or business expense Ex: own a rental house, you make repairs, find tenants, collect rent, etc. DOES IT MATTER? Nope! All income & expenses go to schedule E, regardless of whether it is trade or business or production of income expenses. WHEN DOES IT MATTER? If not trade or business: - If revenues < expenses, losses maybe limited - Sale of property for loss, capital loss. ONLY Production of Income expenses deductible are expenses related to rental activities.

X dies and leaves a piece of land to his son. X had paid $12,000 for the land, which is worth $23,000 at the date of his death. Upon receiving the land, X's son immediately sells it for $23,000. What are the income tax consequences of the sale of the land?

Land = FMV of $23,000 for estate tax. X's son has neither G not L on the sale of the land. The $11,000 in unrealized gain on the land is not subject to the income tax, because the fair market value of the land was assigned for estate tax purposes.

A owns & operates a pet shop. One day, a customer is bitten by a snake. Although the accident is the customer's fault, he sues A for $25,000. After A pays her lawyer $2,500 to defend her, the customer drops the suit. Are the legal fees an ordinary expense for Kara?

Lawsuits by customers = common occurrence in today's business environment. The legal fees is an ordinary expense.

Insurance Expense (Business Expense)

Life insurance (must be additional compensation to the insured person), group-term life insurance, unemployment insurance: D Key man policies: N/D

X owns 400 shares of stock purchased for $20,000 several years ago. In December of the current year, X sells them for $12,000. 1 week later, X purchases 400 shares of the same stock for $12,000. Tax consequences?

Loss is disallowed. But X can still add the $8,000 loss to the basis of replacement shares ($20,000). X should be able to recover the $8,000 disallowed loss when selling in non-wash sales transactions.

Accrual Method (Deductions)

May deduct expenses in the year in which two tests are met: - *All-event test*: all events have occurred that determine that a liability exists and the amount can be determined with reasonable accuracy - *Economic performance tests*: economic performance have occurred with regard to the liability. Economic performance occurs when services or property are provided to the taxpayer or when the taxpayer uses property.

A purchases a computer @ $8,000. A uses the computer in his business and for personal purposes. A's records indicate that 75% of the computer's use is for business purposes and 25% for personal purposes. Tax treatment?

Mixed-Use Expenses. A must treat the computer as two separate assets for tax purposes. For depreciation, only $6,000 ($8,000 × 75%) can be depreciated. The remaining $2,000 of cost is considered a personal use asset. Depreciation is not allowed on personal use assets.

A travels for 4 days for business reasons. Airfare = $800, and A incurs expenses of $200/day for lodging and incidentals. A stays 2 extra days to visit the zoo and to tour the city. How much of costs can be deducted as a business expense?

Mixed-use expenditures. Primary motive for making the trip (spending more days on business than for personal purposes) = business, A can deduct the full $800 airfare. A can also deduct $200/day for lodging & incidentals. A cannot deduct $200/day for lodging and incidentals for the 2 extra days A stayed for personal reasons.

2017 Tax Cut & Jobs Act for Production of Income Expense

No miscellaneous itemized deductions allowed under new tax law. Expenses for production of income are NOT allowed!

C owes A the $10,000 because the owner of C is a friend of A's and A made the company a temporary loan to help it through a cash-flow shortage. A does not do any business with C. How should A report the bad debt on her tax return?

Non-business debt. Assuming A does not have other capital gains or losses to report, she is permitted a $3,000 capital loss deduction in 2018, 2019, and 2020. The remaining $1,000 is deductible in 2021.

X owns a miniature golf course. X and his wife, Y, are actively involved in the management of the business. Each devotes 40 hours/week to working at the miniature golf course and performing other business functions (record keeping, bank deposits, etc.). Is the miniature golf course a passive activity for X & Y?

Nope! Because it provides significant personal services & because X&Y participate w/ > 500 hours/year, making them material participants in the activity.

X sells 500 shares of ABC stock to his sister Y for $5,000. X paid $7,500 for the stock. Can he deduct the $2,500 loss on the sale of the stock to his sister?

Nope! Under specific disapprove of "losses on related party sales". *NOW* assume Y later sells the shares to an unrelated party for $9,000. How much gain does Y have to recognize from the sale? - Gain of $4,000 reduced by X's $2,500 disallowed loss = $1,500 gain recognized on the sale. *NOW* assume Y sells the stock to an unrelated party for $3,000. How much loss does Y recognize on the sale? - Loss on sale = $2,000 but Y cannot use X's $2,500 loss to increase the loss on sale. Y can only recognize $2,000 loss.

X is the sole proprietor of A. X has only 1 employee and works full-time operating the business. During the current year, the business suffers a loss of $11,000. Is this a passive activity for X?

Nope. X is a material participant in the business. Business loss is not subject to the PAL rule. The loss from the sole proprietorship flows through to X's individual return, where it is deductible against X's other active and portfolio income.

Taxpayers can benefit when deduction > income, right? Well... maybe... What's attractive about a business loss? What about tax shelter? What about at-risk loss rule?

Offset other income (drive down total tax) :) 1960s-1980s taxpayers invested in "tax shelters" (to reduce income) *Tax shelter* = investment activity designed to minimize the effect of income tax on wealth accumulation (investments that produce significant tax losses as a result of the allowable deductions associated with the investment). History lesson: - Taxpayers invested in losing tax shelters, used losses to offset other income - Taxpayers invested $10,000 in activity, which provides $100,000 tax loss. - Top marginal tax rate taxpayers ~50% - $100,000 loss yielded $50,000 tax savings 1976: Congress made its 1st attempt to stop the abuse *At-Risk Loss Rules* = limit loss deductions on business & investment-related activities to TP's actual economic investment (skin in the game). *Taxpayers cannot deduct losses in excess of the amount they have at risk in an activity*.

A tax lawyer purchases a large red, white, and blue flag with the numerals 1040 for his yacht. While using his yacht, many people inquire about the flag, and the tax attorney obtained a few customers as a result of such contact. Can the lawyer deduct the cost of operating his yacht as a promotional expense?

Operating the yacht = not the ordinary method of promoting business. Expenses of the yacht were so personal in nature that they could not be necessary in the common sense of the word.

Qualified Business Income (QBI)

Owners of conduit entities allowed a deduction based on QBI. - NI of sole proprietorship - NI of a partnership before consideration of guaranteed - NI of a S-Corp before consideration of salary Deduction = the lesser of... (1) 20% QBI or (2) 20% TI - not including capital gains & before QBI deduction

Securities Dealer

Participates directly in securities markets, buying and selling securities to buyers & sellers for profit. DEEMED to engage in trade/business.

1/7/2018, A pays a $6,000 premium for a 3-year fire and casualty insurance policy on his business buildings and equipment. How much of the premium can A deduct for 2018?

Payment of the premium in advance results in a prepaid expense that benefits tax years 2018, 2019, 2020, and 2021. Regardless of A's accounting method, the $6,000 basis in the policy must be allocated to the periods benefited by the prepaid expense. The allocation results in a $1,000 [$6,000 × (6 ÷ 36 months)] insurance expense deduction for 2018.

Active Investor

Person who manages his/her own portfolio for LT value/profit. Main income = interest income, dividend income, gains from LT securities (Investment expense only deductible under miscellaneous itemized deductions). NOT deemed to engage in trade or business expense

A agrees to lease land to B for 99 years. Under the lease, B has the right to construct a motel on the land. B is responsible for all expenses, claims, and liabilities related to the property. In the event of default on the lease, A has the right to assume ownership of the building and possession of the property. Is A's rental activity a trade or business or a production-of-income activity? A sells a property for $10,000 loss. How much of the loss can A deduct?

Production-of-income activity $10,000 capital loss --> Include in netting procedures for capital gain-loss. If after netting, A can only deduct up to $3000 net loss & the $7000 loss carries forward to next year.

Fred is a single sole proprietor with no income other than that of the proprietorship and no itemized deductions. During 2018, his business earned a net income of $136,500 and he paid $4,800 for his health insurance coverage. What are Fred's 2018 Qualified Business Income deduction and 2018 taxable income?

QBI Deduction = $22,011; Taxable Income = $88,046

Where might we see deductions?

Remember the Adjusted Gross Income --> Taxable Income formula (only apply to individuals) - Deductions for Adjusted Gross Income: generally business related - Deductions from Adjusted Gross Income: generally personal in nature Question: Why is this only necessary for individuals and not corporations? Because all expenses of a corporation are business-related (there is no personal expenses)

Qualified Business Income (QBI): Line 9 on page 2 of Form 1040. Read 6-3b except additional 0.9% surtax for Medical...

Result of change in corporation tax rates --> dropped to 21%. ONLY COVERING BASICS of deduction

Transaction Loss

Results from disposition of property. Loss must be categorized according to the activity producing the loss: 1. Trade/Business Loss (Fully deductible) 2. Investment-related Loss 3. Personal-Use Loss (Not deductible most of the time)

Taxes (Business Expense)

Schedule 1 (Form 1040) - Adjustments to Income (Deductions for AGI) 23. "Educator Expense": up to $250, teachers that spend their own money. 24. / 25. Health savings account deductions: EE contributes to health savings account 26. / 27. Deductible part of SE tax: 1/2 of SE tax 28. SE SEP, SIMPLE, and qualified plans: make contribution to account & deduct for AGI 29. SE health insurance deduction: can't be eligible for ER sponsored plan 30. / 31a. Alimony (why is it still on the form?): divorce is maybe settled before 2018. 32. IRA deduction 33. Student loan interest deduction: up to $2,500/year 34-35. Reserved:

A pays $100 for supplies on 12/28/2018. TI 2018 is the lowest it has ever been, and A does not need more deductions for the year. A uses cash method of accounting and normally expenses supplies when buys, A decides to save the $100 deduction until 2019. A reasons that his actions are proper because he has not used the supplies. When should A deduct the cost of the supplies?

Since it is cash method, A must deduct the expenses in 2018. A must apply that method on a consistent basis.

Simer Corp. - calendar-year C-corp. TI (loss): *<25,000>* (2018), *20,000* (2019), *30,000* (2020) Tax rate: 21% Tax due: *0* (2018), *4,200* (2019), *6,300* (2020) NOL carries 25,000 forward indefinitely

TI (2019) = 20,000 NOL deduction = (20,000 x 80%) TI after NOL = *4000* Tax rate = 21% Tax due = *840* NOL carries forward = 25,000 - 16,000 = 9000 for 2020. TI (2020) = 30,000 NOL deduction = (9000) b/c 9000 < 30000 x 80% TI after NOL = *21,000* Tax rate = 21% Tax due = *4,410* (NOL carries forward is used up)

Active Participation Exception

TP who actively participates in rental real estate can deduct losses up to $25,000/year against portfolio & active income. Active participant must own at least 10% interest in the activity & have significant & bona fide involvement in it. $25,000 annual deduction amount is phased out when the individual's AGI exceeds $100,000

Travel Expenses (Business Expenses)

Taxpayers can deduct travel expenses incurred pursuing a business purpose. Ex: transportation, lodging, 50% of meals, incidental expenses. Treatment of expenses depends on PRIMARY purpose of travel: - Business (>50% of time): transportation is FULLY deductible - Personal: transportation is NOT deductible (Lodging, meals, incidentals,... are only deductible for business travel days)

Meals (Business Expenses)

Taxpayers may deduct only 50% of cost of meals incurred. Expense must be ordinary, necessary, reasonable, and has a *business purpose* (taxes & tips included). There are exceptions to the 50% rule. Most common ex: recreational, social expenses primarily for the benefit of employees (holiday parties, picnic...). For employees, it is de minimis fringe-benefit rule.

A = sole shareholder of C = president ($200,000/year salary) A's son = operations officer ($60,000/year). A's son seldom visits the plant because he is a full-time student at State University. The next-highest-paid employee = the general manager ($50,000/year). During an audit, the IRS determines that based on comparable salaries in the area, a reasonable salary for A should be $90,000. The IRS decides that A's son is not an employee. The salary paid A's son is a sham (an assignment of income from A). How much of the payments to A and her son is deductible?

The $110,000 ($200,000 − $90,000) excess salary paid to A is *not* a deductible expense of the corporation, taxed as dividend payment. The salary paid to the son is disallowed as a deduction for the corporation because it lacks a business purpose. Under the assignment-of-income doctrine, the payment of the son's salary is taxed as dividend income to A. Then, A is deemed to have made a gift to her son in the amount of the salary payments. The gift to the son is excluded from his income and is not deductible by Tina.

What is a trade or business? Why does Trade or Business expense matter?

There are more than 50 references in the IRC but NO OFFICIAL DEFINITION so courts decide... There are 3 requirements for an activity to be considered a trade or a business (dominant motive) - Profit Motivation - Continuous & regular activity - Livelihood, not a hobby *Who cares?* If it is a trade or business, expenses are FULLY deductible

A is a self-employed lawyer. State law requires that A attend 40 hours of continuing education each year, at least 8 hours of which must be on ethics. A attends four seminars (8 hours each) on estate taxes and an 8-hour seminar on ethics. The tuition for the four seminars = $1,200; the ethics seminar = $250. Can A deduct the cost of the continuing education seminars?

The cost of all the continuing education seminars is deductible as a business deduction. The 32 hours on estate taxes qualify because the courses either maintain or improve his skills. The cost of the ethics seminar is deductible because it is required by state law.

A operates a retail store. A sends candy to 5 customers' spouses at their homes. The candy costs A $45 for each box. How much of the cost can he deduct as a business gift?

The gift of the candy to the spouse is an indirect gift to the customer. The $20 cost/box (45-25) in excess of the annual donee limit is not deductible. Sam's deduction is limited to $125 (five gifts at $25 each).

A, a partnership, buys a $300,000 machine in the current year to use in its business. The machine has a 7-year tax life. When can the partnership deduct the cost of the machine?

The machine is to be used to earn income during several tax years. So, its cost must be capitalized and allocated to the years benefited by the use of the machine.

X's car is destroyed by a tornado. X's neighborhood is part of an area that is declared a federal disaster. X had purchased the auto for $30,000. FMV = $10,000. What is the amount of X's loss on the casualty?

The measure of the amount of loss is the lesser of the decline in value because of the casualty, $10,000, or the basis, $30,000. Thus, the amount of X's loss is $10,000. *NOW* if X receives $7,000 from her insurance company. X's casualty loss = $10,000 - $7,000 - $100 = $2,900 loss on casualty ($100 statutory floor reduction = administrative convenience for small casualty losses)

A's son - B - wants to open a dealership. B is short of funds, A buys a building for dealership and leases it to B. No lease is signed. A tells B not to worry about paying rent until business has profit. A also promises not to sell building without B's approval. Is A's dominant motive in buying the building is to get profit?

The purchase is, in nature, without legal contract and for the purpose of helping B, a gift. So any expenditure A makes regarding the building are NOT classified as business expense. As personal expenses, only those personal expenses specifically allowed by tax law

X owns property with a basis of $3,000 and a FMV of $10,000. X gives the property to his daughter Y as a gift. Y immediately sells the property for $10,000. What are the tax effects of the gift and subsequent sale?

The transfer of the gift is not a taxable event for either X or Y. Y takes X's basis in the property. Y's gain = $7,000 ($10,000 − $3,000) & is taxed.

What if Income < Deductions?

Then we have losses... 1. *Annual Loss (Activity loss)*: entity's deductions > income - Trade/Business Loss (NOLs) - Passive Activity Loss 2. *Transaction Loss*: asset disposed of at less than its basis - Trade/Business Loss - Investment-Related Loss - Personal Use Loss Losses don't typically impact until they are *realized*.

Simer Corp. - calendar-year C-corp. TI (loss): *50,000* (2016), *25,000* (2017), *<25,000>* (2018) Tax rate: 21% Tax due: *10,500* (2016), *5,250* (2017), *0* (2018) Total tax 2016-2018 = 15,750 What if we arbitrarily choose 3-years as our accounting period?

Total TI (Loss) for 2016-2018 = 50,000 Tax rate = 21% Tax due = 10,500 3 year total under ANNUAL reporting = 15,750 3 year total under 3-year reporting = 10,500 *Difference = 5,250* artificially created tax liability This seems unfair...what's the solution? *The NOL carryover system* - NOLs can be carried forward INDEFINITELY (NOLs cannot be carried back) - NOL deductions are limited to 80% current year TI

A owns 2 rental properties. A obtains tenants for the properties, makes repairs, provides maintenance, pays expenses related to the properties, and is subject to claims and liabilities arising from the rental properties. Is A's rental activity a trade or business or a production-of-income activity? A sells a property for $10,000 loss. How much of the loss can A deduct?

Trade or business activity $10,000 loss on the sale of the rental property is deducted in full as trade/business loss.

A is a physician who invests in real estate partnerships. He travels from Dallas to Tulsa to attend a seminar on tax laws affecting real estate investments. Can A deduct the cost of attending the seminar?

Travel is related to production of income, not trade/business activity so N/D

Fairly straightforward for taxable entity. It is more difficult when it comes to conduit entities. True or False? Why?

True. Because all income, deductions, and credits (all tax attributes) of conduits flow down to owners. Conduit Income - Conduit Expenses = NI of Conduit (partners to partners) Ex: J&S Partnership. J = S = 50%. Revenues = $100,000. Expenses = $50,000. - J includes $25,000 in schedule K-1 - S includes $25,000 in schedule K-1 But what if some of the partnership's expenses are charitable contributions? This item has limitations specific to each individual.

X purchases a business for $200,000 by investing $20,000 of her own funds and borrowing $180,000 from a bank. X is personally liable for repayment of the loan to the bank. What is X's at-risk amount in the business? What if A suffers a loss of $70,000. A also withdraws $40,000 from the business. What is A's at-risk amount in the business at the end of the first year of operation?

X is at risk for $200,000. If the business is not successful, X can lose $20,000 in cash she invested and would be liable for payment of the $180,000 loan. At risk = $200,000 - $70,000 - $40,000 = $90,000 at the end of first year of operation (because A has sufficient amount at-risk to deduct loss from business)

A is thinking of opening a 2nd location of her hair salon and takes her real estate agent out to lunch to discuss possible locations for the new store. Can A deduct the cost of the lunch as a business expense?

Yes. A can deduct 50% cost of meal from TI.

A is single & SE. 2018, A income = $55,000. A pays $3,100 for her medical insurance policy. a. How should the medical insurance policy payment be reflect on on A's 2018 return? b. What is A's SE tax deduction?

a. Deductions for AGI = $3,100 b. $55,000 x 92.35% x 15.3% = $7,771 Tax due Deduction = 50% x $7,771 = $3,886 *What if A's income = $150,000?* $150,000 x 92.35% = $138,525 (amount subject to SE tax) $128,400 x 6.2% x 2 = $15,922 $138,525 x 1.45% x 2 = $4,017 Total SE Tax = 19,939 x 50% = $9,969.5

Bad Debts Expense (Business Expense)

business bad debt - yes. non-business bad debt, deduct as ST capital loss ($3000 cap). - Cash basis taxpayers ARE NOT allowed BDE deductions. - Accrual basis taxpayers deduct BDE using *specific charge off method*

Interest Expense (Business Expense)

interest expense cannot exceed 30% EBITDA TP are exempt from this limitation if their average annual gross receipts for 3-year period prior to tax year < 25 m (Small businesses are exempt)