Ch6 Book

Example 12

Blackbird Airlines is required by Federal law to test its engines after 3,000 flying hours. Aircraft cannot return to flight until the tests have been conducted. An unrelated aircraft maintenance company does all of the company's tests for $1,500 per engine. For financial reporting purposes, the company accrues an expense based upon $.50 per hour of flight and credits an allowance account. The actual amounts paid for maintenance are offset against the allowance account. For tax purposes, the economic performance test is not satisfied until the work has been done. Therefore, the reserve method cannot be used for tax purposes.

Hobby Losses

Business or investment expenses are deductible only if the taxpayer can show that the activity was entered into for the purpose of making a profit. Certain activities can have attributes that make it difficult to determine if the primary motivation for the activity is to make a profit or is for personal pleasure. Examples include raising horses and operating a farm used as a weekend residence. While personal losses are not deductible, losses attributable to profit-seeking activities may be deducted and used to offset a taxpayer's other income. Activities that have both personal and profit-seeking motives are classified as hobbies, and the tax law limits the deductibility of hobby losses. The income and deductions from a hobby are reported separately on the tax return. Whether deductions related to a hobby generate a tax benefit, the revenue for the hobby is always reported as other income on page 1 of Form 1040. The reporting of deductions is discussed below. General Rules: If an individual can show that an activity has been conducted with the intent to earn a profit, losses from the activity are fully deductible. The hobby loss rules apply only if the activity is not engaged in for profit. Hobby expenses are deductible only to the extent of hobby income. The Regulations stipulate that the following nine factors should be considered in determining whether an activity is profit-seeking or is a hobby: •Whether the activity is conducted in a businesslike manner. •The expertise of the taxpayers or their advisers. •The time and effort expended. •The expectation that the assets of the activity will appreciate in value. •The taxpayer's previous success in conducting similar activities. •The history of income or losses from the activity. •The relationship of profits earned to losses incurred. •The financial status of the taxpayer (e.g., if the taxpayer does not have substantial amounts of other income, this may indicate that the activity is engaged in for profit). •Elements of personal pleasure or recreation in the activity. The presence or absence of a factor is not by itself determinative of whether the activity is profit-seeking or is a hobby. Rather, the decision is a subjective one that is based on an analysis of the facts and circumstances. Presumptive Rule of § 183: The Code provides a rebuttable presumption that an activity is profit-seeking if the activity shows a profit in at least three of the previous five tax years. If the activity involves horses, a profit in at least two of the previous seven tax years meets the presumptive rule. If these profitability tests are met, the activity is presumed to be a trade or business rather than a personal hobby. In this situation, the IRS bears the burden of proving that the activity is personal rather than trade- or business-related. On the other hand, if the three-year test (two for horses) is not met, then the activity is presumed to be a hobby and the taxpayer has the burden to prove that it is profit-seeking. Determining the Amount of the Deduction: If an activity is deemed to be a hobby, the expenses are deductible only to the extent of the gross income from the hobby. These expenses must be deducted in the following order: •Amounts deductible under other Code sections without regard to the nature of the activity, such as property taxes and home mortgage interest. •Amounts deductible under other Code sections if the activity had been engaged in for profit, but only if those amounts do not affect adjusted basis. Examples include maintenance, utilities, and supplies. •Amounts for depreciation, amortization, and depletion. The last two categories of deductions are deductible from AGI as itemized deductions to the extent they exceed 2 percent of AGI. If the taxpayer uses the standard deduction rather than itemizing, the hobby loss deductions generate no tax benefit. Even if this is the case, the revenue from a hobby still must be reported on page 1 of Form 1040.

Deductions and Losses—Timing of Expense Recognition: Importance of Taxpayer's Method of Accounting

A taxpayer's accounting method is a major factor in determining taxable income. The method used determines when an item is includible in income and when an item is deductible on the tax return. Usually, the taxpayer's regular method of record keeping is used for income tax purposes. The taxing authorities do not require uniformity among all taxpayers. They do require that the method used clearly reflect income and that items be handled consistently. The most common methods of accounting are the cash method and the accrual method. If a taxpayer owns multiple businesses, it may be possible to use the cash method for some and the accrual method for others. Throughout the portions of the Code dealing with deductions, the phrase paid or incurred is used. Paid refers to the cash basis taxpayer who gets a deduction only in the year of payment. Incurred concerns the accrual basis taxpayer who obtains the deduction in the year in which the liability for the expense becomes certain.

Example 4

Albert engaged in a mail-order business. The post office judged that his advertisements were false and misleading. Under a fraud order, the post office stamped "fraudulent" on all letters addressed to Albert's business and returned them to the senders. Albert spent $30,000 on legal fees in an unsuccessful attempt to force the post office to stop. The legal fees (although not recurring) were ordinary business expenses because they were normal, usual, or customary in the circumstances.

Reporting Procedures

All deductions for AGI are ultimately reported on page 1 of Form 1040. Most of the deductions for AGI originate on supporting schedules. Examples include business expenses (Schedule C); rent, royalty, partnership, and fiduciary deductions (Schedule E); and farming expenses (Schedule F). Other deductions for AGI, such as traditional IRAs, Keogh retirement plans, and alimony, are entered directly on page 1 of Form 1040. Adjusted gross income appears on the last line of page 1 and, again, on the first line of page 2. The total of all itemized deductions, which is carried over from Schedule A, is then subtracted from AGI. After that, personal and dependency exemptions are deducted to arrive at taxable income. As indicated in Exhibit 6.2, some Schedule A deductions originate on other forms. Form 1040 incorporates the deductible amounts for many expenses that are computed on other schedules and forms.

Concept Summary 6.1 Costs of Investigating a Business

Are the investigation expenses for a business that the taxpayer either acquires or commences? >Yes Is the taxpayer already in the same or a similar business? >>>Yes: Deduct >>>No: Deduct up to $5,000 (portion not deducted, amortize over a 180-month period) Are the investigation expenses for a business that the taxpayer either acquires or commences? >No Is the taxpayer already in the same or a similar business? >>>Yes: Deduct >>>No: Not deductible

Tax Planning Vacation Homes

As previously discussed, homes that are used for both personal and rental use can fall into one of three categories, all of which have different tax consequences. Therefore, careful tax planning often ensures that the home is classified into the category that provides the optimal tax result. For example, if a taxpayer is planning to rent a home for 15 or more days, this will subject the net income from the rental activity to taxation. If the homeowner could rent the home for 14 days or less (possibly just one less day), then all of the rental income received would escape taxation. This strategy is particularly attractive to individuals who live in areas where major sporting or entertainment events are held if there is a lack of hotel accommodations in the area. In addition, assume that a taxpayer intends to use a home for 150 rental days and 16 personal days. Because the personal days exceed 15 (the greater of 14 days or 10% × the number of rental days), the property will be classified as rental/personal and a rental loss will not be allowed. However, if the owner can reduce the personal use days by only one day to 15, then the property will be classified as rental, and a rental loss can be allowed (subject to the passive loss rules).

Example 39

Ashley had the following gains and losses in an artistic endeavor: 2011- ($50,000) 2012- (65,000) 2013- 400 2014- 200 2015- 125 Under these circumstances, the IRS might try to overcome the presumption that this is a business because it has profits in three of the last five years. To do this, the IRS would focus on the nine factors from the Regulations discussed in Section 6-3e. On the other hand, if Ashley could show conformity with the factors enumerated in the Regulations or could show evidence of business hardships (e.g., injury, death, or illness), the government might have difficulty overriding the presumption.

Example 26

Assume instead that Catherine in Example 24 rented the property for 30 days and lived in it for 30 days. The threshold for personal use is 14 days—the greater of (1) 14 days or (2) 3 days (10% × 30 rental days). The residence is classified as personal/rental use property because she used it more than 14 days and rented it for 15 days or more. The expenses must be allocated between rental use and personal use, and the rental expenses are allowed only to the extent of rent income.

Example 25

Assume instead that Catherine in Example 24 used the cottage for 12 days and rented it for 48 days for $4,800. The threshold for personal use is 14 days—the greater of (1) 14 days or (2) 4.8 days (10% × 48 rental days). Because she rented the cottage for 15 days or more but did not use it for more than 14 days, the cottage is treated as rental property. The expenses must be allocated between personal and rental days. Percentage of Use Rental 80% || Personal 20% Income: $4,800 || $ -0- Expenses: Mortgage interest ($6,000): $(4,800) || $(1,200) Property taxes ($500): $(400) || $(100) Utilities and maintenance ($1,500): $(1,200) || $(300) Depreciation ($2,400): $(1,920) || $(480) Total expenses: $(8,320) || $(2.080) Rental loss: $(3,520) || $ -0- Catherine deducts the $3,520 rental loss for AGI on Schedule E (assuming that she satisfies the at-risk and passive activity loss rules). She also has an itemized deduction for property taxes of $100 associated with the personal use. The mortgage interest of $1,200 associated with the personal use is not deductible as an itemized deduction because the cottage is not a qualified residence (qualified residence interest) for this purpose. The portion of utilities and maintenance and depreciation attributable to personal use is not deductible.

Example 34

Assume the same facts as in Example 33, except that Bill sells the stock for $9,000. Bill's gain of $1,000 ($9,000 selling price − $8,000 basis) is not recognized because of the right of offset of $2,000 from Freida's sale. Note that the offset may result in only partial tax benefit upon the subsequent sale (as in this case). If Freida had sold the stock to an unrelated party rather than to Bill, she could have recognized a $2,000 loss. However, as a family unit, Freida and Bill recognized only $1,000 of loss.

Example 8

Assume the same facts as in Example 7, except that John is required to pay only 12 months' rent in 2015. He pays $12,000 on July 1, 2015. The entire $12,000 is deductible in 2015 as the benefit does not extend beyond the end of 2016.

Example 22

Camille and Walter are married taxpayers who enjoy a busy lifestyle. Camille, who is an executive for a large corporation, is paid a salary of $800,000. Walter is a collector of antiques. Several years ago he opened an antique shop in a local shopping center and spends most of his time buying and selling antiques. He occasionally earns a small profit from this activity but more frequently incurs substantial losses. If Walter's losses are business-related, they are fully deductible against Camille's salary income on a joint return. In resolving this issue, consider the following: •Initially determine whether Walter's antique activity has met the three-out-of-five years profit test. •If the presumption is not met, the activity may nevertheless qualify as a business if Walter can show that the intent is to engage in a profit-seeking activity. It is not necessary to show actual profits. •Attempt to fit the operation within the nine criteria prescribed in the Regulations listed previously.

Tax Planning Time Value of Tax Deductions

Cash basis taxpayers often have the ability to make early payments for their expenses at the end of the tax year. This may permit the payments to be deducted currently instead of in the following tax year. In view of the time value of money, a tax deduction this year may be worth more than the same deduction next year. Before employing this strategy, the taxpayer must consider what next year's expected income and tax rates will be and whether a cash-flow problem may develop from early payments. Thus, the time value of money as well as tax rate changes must be considered when an expense can be paid and deducted in either of two years.

Example 24

Catherine owns a vacation cottage on the lake. During the current year, she rented it for $1,600 for two weeks, lived in it two months, and left it vacant the remainder of the year. The year's expenses amounted to $6,000 mortgage interest expense, $500 property taxes, $1,500 utilities and maintenance, and $2,400 depreciation. Because the property was not rented for at least 15 days, the income is excluded, the mortgage interest and property tax expenses are itemized deductions, and the remaining expenses are nondeductible personal expenses.

Public Policy Limitation

Certain disallowance provisions are a codification or extension of prior court decisions. For example, after the courts denied deductions for payments considered to be in violation of public policy, the tax law was changed to provide specific authority for the disallowance of these deductions. Justification for Denying Deductions: The courts developed the principle that a payment in violation of public policy is not a necessary expense and is not deductible. Although a bribe or fine may be helpful and may even contribute to the profitability of an activity, the courts held that to allow such expenses would be contrary to public policy. A deduction would, in effect, be indirectly subsidizing a taxpayer's wrongdoing. Because tax law did not explain which actions violated public policy, the IRS and taxpayers had no clear guidance as to whether an expense was contrary to public policy. To solve these problems, Congress enacted legislation that attempts to better define the use of the public policy doctrine. Under the legislation, the following deductions are disallowed for certain specific types of expenditures that are considered contrary to public policy: •Bribes and kickbacks, including those associated with Medicare or Medicaid. In the case of foreign bribes and kickbacks, only if the payments violate the U.S. Foreign Corrupt Practices Act of 1977. •Fines and penalties paid to a government for violation of law. •Two-thirds of the treble damage payments made to claimants resulting from violation of the antitrust law. To be disallowed, the bribe or kickback must be illegal under either Federal or state law and must also subject the payor to a criminal penalty or the loss of a license or privilege to engage in a trade or business. For a bribe or kickback that is illegal under state law, a deduction is denied if the state law is generally enforced. Legal Expenses Incurred in Defense of Civil or Criminal Penalties: To deduct legal expenses, the taxpayer must be able to show that the origin and character of the claim are directly related to a trade or business; an income-producing activity; or the determination, collection, or refund of a tax. Personal legal expenses are not deductible. Thus, legal fees incurred in connection with a criminal defense are deductible only if the crime is associated with the taxpayer's trade or business or income-producing activity. Deductible legal expenses associated with the following are deductible for AGI: •Ordinary and necessary expenses incurred in connection with a trade or business. •Ordinary and necessary expenses incurred in conjunction with rental or royalty property held for the production of income. All other deductible legal expenses are deductible from AGI. For example, legal expenses generally are deductible from AGI if they are for fees for tax advice relative to the preparation of an individual's income tax return. Contrast this with the for AGI classification of legal fees for tax advice relative to the preparation of the portion of the tax return for a sole proprietor's trade or business (Schedule C) or an individual's rental or royalty income (Schedule E). Expenses Relating to an Illegal Business: The usual expenses of operating an illegal business (e.g., a gambling operation) are deductible. While allowing deductions for illegal activity may seem inappropriate, recall that the law taxes net income from a business operation, not gross revenue. However, § 162 disallows a deduction for fines, bribes to public officials, illegal kickbacks, and other illegal payments whether these payments are part of a legal or illegal business. An exception applies to expenses incurred in illegal trafficking in drugs. Drug dealers are not allowed a deduction for ordinary and necessary business expenses incurred in their business. In arriving at gross income from the business, however, dealers may reduce total sales by the cost of goods sold.

Expenses and Interest Relating to Tax-Exempt Income

Certain income, such as interest on municipal bonds, is tax-exempt. The law also allows the taxpayer to deduct expenses incurred for the production of income. However, the law does not permit a taxpayer to profit at the expense of the government by excluding interest income and deducting interest expense. The Code specifically disallows as a deduction the expenses of producing tax-exempt income. Interest on any indebtedness used to purchase or hold tax-exempt obligations also is disallowed. To eliminate the possibility illustrated in Example 36, the Code specifically disallows as a deduction the expenses of producing tax-exempt income. Interest on any indebtedness incurred or continued to purchase or carry tax-exempt obligations also is disallowed. The classification of various expenses in terms of their deductibility and nondeductibility is reflected in Concept Summary 6.3.

Example 9

Chris's entertainment business sponsored a jazz festival in a rented auditorium at a local college. His business is responsible for cleaning up after the festival, which took place on December 22, 2015, and reinstalling the auditorium seats. Because the college is closed over the Christmas holidays, the company hired by Chris to perform the work did not begin these activities until January 3, 2016. Chris's business cannot deduct its $1,200 labor cost until 2016, when the services are performed.

Example 5

Debby is a retired pilot who owns a small portfolio of investments, including 10 shares of Robin, Inc., a publicly traded company, worth $1,000. She incurred $350 in travel expenses to attend the annual shareholders' meeting where she voted her 10 shares against the current management group. No deduction is permitted because a 10-share investment is insignificant in value in relation to the travel expenses incurred.

Example 15

Debra, a financial officer of Blue Corporation, incurs legal expenses in connection with her defense in a criminal indictment for evasion of Blue's income taxes. Debra may deduct her legal expenses because she is deemed to be in the trade or business of being an executive. The legal action impairs her ability to conduct this business activity.

Example 29

During the current year, Fred pays the property taxes on his son Jayden's home. Neither Fred nor Jayden can take a deduction for the amount paid for Jayden's property taxes. Fred is not entitled to a deduction because the property taxes are not his obligation. Jayden cannot claim a deduction because he did not pay the property taxes. The tax result would have been more favorable had Fred made a cash gift to Jayden and let him pay the property taxes. Then Jayden could have deducted the property taxes.

Example 14

During the year, Keith, an insurance salesperson, paid $5,000 to Karen, a real estate broker. The payment represented 20% of the commissions Keith earned from customers referred by Karen. Under state law, the splitting of commissions by an insurance salesperson is an act of misconduct that could warrant a revocation of the salesperson's license. Keith's $5,000 payments to Karen are not deductible if the state law is generally enforced.

Exhibit 6.2 Format of Form 1040

FORM 1040, PAGE 1 Income from All Sources Less: Deductions for AGI (partial list): -Traditional IRAs -Keogh Retirement Plans -Alimony -Moving Expenses -Student Loan Interest -Penalty on Early Withdrawal of Savings Equals: Adjust Gross Income >>>>> Schedule B: Interest and Dividends Schedule C: Business Income Schedule D/Form 8949: Capital Gains and Losses Schedule E: Rents, Royalties, etc. Schedule F: Farm Income FORM 1040, PAGE 2 Adjusted Gross Income Less: Standard Deduction or Itemized Deductions -Exemptions Equals: Taxable Income >>>>> Schedule A: Medical Expenses Taxes Intererst (Form 4952: Investment Interest) Charitable Contributions (Form 8283: Noncash Charitable Contributions) Casualty Losses (Form 4684: Casualties and Thefts) Miscellaneous Itemized Deductions (Form 2106 or Form 2106 EZ: Employee Business Expenses) Equals: Total Itemized Deductions

Concept Summary 6.3 Classification of Expenses

For AGI | From AGI | Not deductible Investment expenses --Rent and royalty: √ | o | o --All other investments: o | √ | o Employee expenses --Commuting expenses: o | o | √ --Travel and transportation: o | √ | o --Reimbursed expenses: √ | o | o --Moving expenses: √ | o | o --Entertainment: o | √ | o --Teacher supplies (if extended to 2015 by Congress): √ | √ | o --All other employee expenses: o | √ | o Certain expenses of performing artists: √ | o | o Trade or business expenses: √ | o | o Casualty losses --Business: √ | o | o --Personal: o | √ | o Tax determination --Collection or refund expenses: √ | √ | o Bad debts: √ | o | o Medical expenses: o | √ | o Charitable contributions: o | √ | o Taxes --Trade or business: √ | o | o --Personal taxes -----Real property: o | √ | o -----Personal property: o | √ | o -----State and local income or sales (sales tax if extended to 2015 by Congress): o | √ | o Investigation of a business: √ | o | o Interest --Business: √ | o | o --Personal: √ | √ | √ Qualified tuition and related expenses (if extended to 2015 by Congress): √ | o | o All other personal expenses: o | o | √

Example 33 Use of Right of Offset

Freida sells common stock with a basis of $10,000 to her son, Bill, for its fair market value of $8,000. The $2,000 realized loss is not recognized, which creates a $2,000 right of offset. Bill sells the stock several years later for $11,000. Freida's previously disallowed loss is used by Bill, and only $1,000 of gain ($11,000 selling price − $8,000 basis − $2,000 right of offset) is taxable to him upon the subsequent sale.

Political Contributions and Lobbying Activities

Generally, no business deduction is permitted for direct or indirect payments for political purposes. Historically, the government has been reluctant to accord favorable tax treatment to business expenditures for political purposes. Allowing deductions might encourage abuses and enable businesses to have undue influence on the political process. Lobbying expenses incurred in attempting to influence state or Federal legislation or the actions of certain high-ranking public officials are not deductible. The disallowance also applies to a pro rata portion of the membership dues of trade associations and other groups that are involved in lobbying activities. There are three exceptions to the disallowance of lobbying expenses. First, an exception is provided for influencing local legislation (e.g., city and county governments). Second, the disallowance provision does not apply to activities devoted solely to monitoring legislation. Third, a de minimis exception is provided for annual in-house expenditures (lobbying expenses other than those paid to professional lobbyists or any portion of dues used by associations for lobbying) if such expenditures do not exceed $2,000. If the in-house expenditures exceed $2,000, none of the in-house expenditures can be deducted.

Example 37

In January of the current year, Alan borrowed $100,000 at 8% interest. He used the loan proceeds to purchase 5,000 shares of stock in White Corporation. In July, he sold the stock for $120,000 and reinvested the proceeds in City of Denver bonds, the income from which is tax-exempt. Assuming that the $100,000 loan remained outstanding throughout the entire year, Alan cannot deduct the interest attributable to the period in which he held the bonds.

Investigation of a Business

Investigation expenses are expenses paid or incurred to determine the feasibility of entering a new business or expanding an existing business. They include such costs as travel, engineering and architectural surveys, marketing reports, and various legal and accounting services. How such expenses are treated for tax purposes depends on a number of variables, including the following: •The current business, if any, of the taxpayer. •The nature of the business being investigated. •The extent to which the investigation has proceeded. •Whether the acquisition actually takes place. If the taxpayer is in a business that is the same as or similar to that being investigated, all investigation expenses are deductible in the year paid or incurred. The tax result is the same whether or not the taxpayer acquires the business being investigated. When the taxpayer is not in a business that is the same as or similar to the one being investigated, the tax result depends on whether the new business is acquired. If the business is not acquired, all investigation expenses generally are nondeductible. If the taxpayer is not in a business that is the same as or similar to the one being investigated and actually acquires the new business, the expenses must be capitalized as startup expenditures. Startup costs are not deductible under § 162 because they are incurred before a business begins rather than in the course of operating a trade or business. The first $5,000 of the expenses is immediately deducted. Any excess of expenses is amortized over a period of 180 months (15 years). In arriving at the $5,000 immediate deduction allowed, a dollar-for-dollar reduction must be made for those expenses in excess of $50,000. An election can be made by the taxpayer not to deduct or amortize any portion of the startup costs. In that case, this intangible asset will remain on the balance sheet until the business is sold. Concept Summary 6.1 sets forth the tax rules applicable to the costs involved in investigating a business.

Classification of Deductible Expenses

It is important to classify deductible expenses as deductions for adjusted gross income (AGI) or deductions from adjusted gross income. Deductions for AGI can be claimed whether or not the taxpayer itemizes. Deductions from AGI result in a tax benefit only if they exceed the taxpayer's standard deduction. If itemized deductions (from AGI) are less than the standard deduction, they provide no tax benefit. As Example 1 illustrates, whether a deduction is classified as for AGI or from AGI can affect the benefit the taxpayer receives from the deduction. It is important to understand that deductions for AGI may directly affect the amount of itemized deductions. The impact arises because many itemized deductions are limited to amounts in excess of specified percentages of AGI. Examples of such itemized deductions are medical expenses; personal casualty losses; and, as shown in Example 1, unreimbursed employee expenses.

Classifying Deductions

It is important to understand that two key issues must be resolved for any potential deduction. First, it must be determined whether the item is deductible, as discussed in Section 6-1b. If the item is deductible, then the second issue is to determine if the deduction is classified as for AGI or from AGI. To understand how deductions of individual taxpayers are classified, it is necessary to examine the role of § 62. The purpose of § 62 is to classify various deductions as deductions for AGI. It does not provide the statutory authority for taking the deduction. If a deduction is not listed in § 62, it is an itemized deduction, not a deduction for AGI. Exhibit 6.1 provides a partial list of the items classified as deductions for AGI by § 62.

Example 27 Personal/Rental: IRS vs. Courts

Jason rents his vacation home for 60 days and lives in the home for 30 days. The property is classified as personal/rental because it is rented for 15 days or more, and personal use (30 days) is greater than 14 [greater of 14 days or 6 days (10% × 60 rental days)]. Jason's gross rent income is $10,000. For the entire year, the real estate taxes are $2,190, his mortgage interest expense is $10,220, utilities and maintenance expense equals $2,400, and depreciation is $9,000. Using the IRS approach, these amounts are deductible in this specific order: Gross income -- $10,000 Deduct: Taxes and interest (60/90 x 12,410) - $(8,273) Remainder to apply to rental operating expenses and depreciation -- $1,727 Deduct: Utilities and maintenance (60/90 x 2,400) - $(1,600) Balance -- $127 Deduct: Depreciation (60/90 x 9,000= 6,000 but limited to above balance) - $(127) NET RENT INCOME ----- $ -0- The nonrental use portion of real estate taxes and mortgage interest ($4,137 in this case) is deductible if the taxpayer elects to itemize. The personal use portion of utilities, maintenance, and depreciation is not deductible in any case. Jason has a carryover of $5,873 ($6,000 − $127) of the unused depreciation, which he may be able to deduct in future years. Also note that the basis of the property is only reduced by the $127 depreciation allowed because of the above limitation.

Example 38

Jena pledged $50,000 to her church's special building fund. She can make the contribution in December 2015 or January 2016. Jena is in the 35% tax bracket in 2015 and in the 28% bracket in 2016. She itemizes in both years. Assume that Jena's discount rate is 8%. If she takes the deduction in 2015, she saves $4,536 ($17,500 − $12,964) due to the decrease in the tax rates and the time value of money. 2015 || 2016 Contribution: $50,000 || $50,000 Tax bracket: x.35 || x.28 Tax savings: $17,500 || $14,000 Discounted @ 8%: x1.0 || x.926 Present value of tax savings: $17,500 || $12,964

Example 23

Jim, the vice president of an oil company, has AGI of $80,000. He decides to pursue painting in his spare time. He uses a home studio comprising 10% of the home's square footage. During the current year, Jim incurs the following expenses: Frames- $1,800 Art supplies- $900 Fees paid to models- $4,000 Home studio expenses: Total home property taxes- $2,000 Total home mortgage interest- $10,000 Total home maintenance and utilities- $4,600 Calculated depreciation on 10% of home- $500 During the year, Jim sold paintings for a total of $8,660. If the activity is held to be a hobby, Jim is allowed deductions as follows: Gross Income -- $8,660 Deduct: Taxes and interest (10% or 12,000) - $(1,200) Remainder -- $7,460 Deduct: Frames - $1,800 >Art supplies - $900 >Models' fees - $4,000 >Maintenance and utilities (10%) - $460 --- $(7,160) Remainder -- $300 Deduct: Depreciation ($500, but limited to $300) - $(300) NET INCOME ----- $ -0- Jim includes the $8,660 of income in AGI, making his AGI $88,660. The taxes and interest are itemized deductions, deductible in full. The remaining $7,460 of expenses are reduced by 2% of his AGI ( 2% x $88,660 = $1,773 ), so the net deduction is $5,687. All of these deductions are reported as itemized deductions on Schedule A. Because the property taxes and home mortgage interest are deductible even without the hobby, the net effect is a $2,973 ($8,660 less $5,687) increase in taxable income.

Example 7

John, a calendar year and cash basis taxpayer, rents property from Carl. On July 1, 2015, John pays $24,000 rent for the 24 months ending June 30, 2017. The prepaid rent extends 18 months after the close of the tax year—substantially beyond the year of payment. Therefore, John must capitalize the prepaid rent and amortize the expense on a monthly basis. His deduction for 2015 is $6,000.

Example 20

Lynn, a retired merchant, incurs expenses in traveling from Rochester, New York, to California to investigate the feasibility of acquiring several auto care centers. If no acquisition takes place, none of the expenses are deductible.

Example 3

Pat purchased a business that had just been adjudged bankrupt. Because the business had a poor financial rating, Pat wanted to restore its financial reputation. Consequently, he paid off some of the debts owed by the former owners that had been cancelled by the bankruptcy court. Because Pat had no legal obligation to make these payments, the U.S. Supreme Court found he was trying to generate goodwill. Although the payments were necessary (i.e., appropriate and helpful), they were not ordinary and their deduction was not allowed.

Personal Expenses

Personal Expenses Expenditures that are incurred in one's personal life are not deductible unless a specific Code section authorizes the deduction. These expenses, which generally are not related to the production of income, are usually deductions from AGI and, in some cases, must be less than (or greater than) a certain percentage of the AGI. Some of the more frequently encountered deductions in this category include the following: •Contributions to qualified charitable organizations. •Medical expenses. •Certain state and local taxes. •Personal casualty losses. •Certain personal interest. •Legal fees, but only if they relate to the determination of a tax liability.

Example 35

Pete sells common stock with a basis of $10,000 to an unrelated third party for its fair market value of $8,000. Pete's son repurchased the same stock in the market on the same day for $8,000. The $2,000 loss is not allowed because the transaction is an indirect sale between related parties.

Example 19 The Big Picture

Refer to the facts of The Big Picture. Dr. Payne believes that his administrative and business skills can be used to turn around dental practices whose revenues have been declining. He investigates Teeth Restoration LLC, a local dental practice that is for sale. Expenses paid to consultants and accountants as part of this investigation totaled $6,000. He determined that Teeth Restoration would not be a good investment, so he did not buy it. The $6,000 spent to investigate this business is deductible as a business expense because Dr. Payne is already in the dental business. Investigating new business opportunities in one's current trade or business is an ordinary and necessary business expense.

Example 18 The Big Picture

Refer to the facts of The Big Picture. Dr. Payne had made contributions to The Dental Society, a trade association for dentists. The trade association estimates that 70% of its dues are allocated to lobbying activities. Thus, his deduction on Schedule C is limited to $3,000 ($10,000 × 30%).

Example 17 The Big Picture

Refer to the facts of The Big Picture. Dr. Payne had made political contributions to the State Senate campaigns of Tom Smith and Virginia White. Dr. Payne made these contributions to encourage these senators to support a new bill that is beneficial to the state's dental profession. Therefore, he assumed that these would be deductible business expenses. However, political contributions are not deductible, so he will receive no tax benefit from them.

Example 13 The Big Picture

Refer to the facts of The Big Picture. Dr. Payne had not instituted proper procedures for disposing of medical waste from his laboratory. During the current tax year, he was fined $3,000 by the city. Dr. Payne believes the fine should be deducted as an ordinary business expense. However, because the fine was due to a violation of public policy, the $3,000 is not deductible.

Rental of Vacation Homes

Restrictions on the deductions allowed for part-year rentals of personal vacation homes were written into the law to prevent taxpayers from deducting essentially personal expenses as rental losses. Many taxpayers who own vacation homes use the property for personal use during a portion of the year and rent the property at other times. For example, a summer cabin would be rented for 2 months per year, used for vacationing for 1 month, and left vacant the rest of the year. If the taxpayer could then deduct 11 months' depreciation, utilities, maintenance, etc., as rental expenses, resulting in a rental loss, the taxpayer would have converted into rental expenses personal expenses from the time the property was vacant. Section 280A eliminates this treatment by not allowing a loss for property that is not used primarily for rental purposes. Only a break-even situation is allowed; no losses can be deducted. There are three possible tax treatments for residences used for both personal and rental purposes. The treatment depends upon the relative time the residence is used for personal purposes versus rental use. These rules are summarized in Concept Summary 6.2. Primarily Personal Use: If the residence is rented for fewer than 15 days in a year, it is treated as a personal residence. The rent income is excluded from gross income, and mortgage interest and real estate taxes are allowed as itemized deductions, as with any personal residence. No other expenses (e.g., depreciation, utilities, and maintenance) are deductible. Primarily Rental Use: If the residence is rented for 15 days or more in a year and is not used for personal purposes for more than the greater of (1) 14 days or (2) 10 percent of the total days rented, the residence is treated as rental property. The expenses must be allocated between personal and rental days if there are any personal use days during the year. The real estate taxes allocated to the personal days are deductible as an itemized deduction. However, the mortgage interest allocated to the personal days cannot be deducted because the property is not a qualified residence. The deduction of the expenses allocated to rental days can exceed rent income and result in a rental loss. The loss may be deductible, subject to the at-risk and passive activity loss rules. Personal/Rental Use: If the residence is rented for 15 days or more in a year and is used for personal purposes for more than the greater of (1) 14 days or (2) 10 percent of the total days rented, it is treated as a personal/rental use residence. The expenses must be allocated between personal days and rental days. Expenses are allowed only to the extent of rent income. If a residence is classified as personal/rental use property, the expenses that are deductible anyway (e.g., real estate taxes and mortgage interest) must be deducted first. If a positive net income results, expenses, other than depreciation, that are deductible for rental property (e.g., maintenance, utilities, and insurance) are allowed next. Finally, if any positive balance remains, depreciation is allowed. Any disallowed expenses allocable to rental use are carried forward and used in future years subject to the same limitations. Note that these ordering rules for deductions are the same as for hobby expenses. Expenses must be allocated between personal and rental days before the limits are applied. The courts have held that real estate taxes and mortgage interest, which accrue ratably over the year, are allocated on the basis of 365 days. The IRS, however, disagrees and allocates real estate taxes and mortgage interest on the basis of total days of use. Other expenses (e.g., utilities, maintenance, depreciation) are allocated on the basis of total days used.

Example 10 Exceptions to Economic Performance Rules

Rick, an accrual basis, calendar year taxpayer, entered into a monthly maintenance contract during the year. He makes a monthly accrual at the end of every month for this service and pays the fee sometime between the first and fifteenth of the following month when services are performed. The amount involved is immaterial, and all of the other tests are met. The December 2015 accrual is deductible in 2015 even though the service is performed on January 12, 2016.

Example 11

Rita, an accrual basis, calendar year taxpayer, shipped merchandise sold on December 30, 2015, via Greyhound Van Lines on January 3, 2016, and paid the freight charges at that time. Because Rita reported the sale of the merchandise in 2015, the shipping charge should also be deductible in 2015. This procedure results in a better matching of income and expenses.

Example 16

Sam owns and operates an illegal gambling establishment. In connection with this activity, he has the following expenses during the year: Rent $60,000 Payoffs to the police $40,000 Depreciation on equipment $100,000 Wages $140,000 Interest $30,000 Criminal fines $50,000 Illegal kickbacks $10,000 Total $430,000 All of the usual expenses (rent, depreciation, wages, and interest) are deductible; payoffs, fines, and kickbacks are not deductible. Of the $430,000 spent, $330,000 is deductible and $100,000 is not.

Example 36

Sandy, a taxpayer in the 35% bracket, purchased $100,000 of 6% municipal bonds. At the same time, she used the bonds as collateral on a bank loan of $100,000 at 8% interest. A positive cash flow would result from the tax benefit as follows: Cash paid out on loan - $(8,000) Cash received from bonds - $6,000 Net negative cash flow --- $(2,000) Had the deduction of $8,000 been allowed for interest expense, this would have resulted in a tax benefit of $2,800 (35% of $8,000). In that case, a positive cash flow of $800 ($6,000 + $2,800 − $8,000) would have resulted.

Business and Nonbusiness Losses

Section 165 provides for a deduction for losses not compensated for by insurance. As a general rule, deductible losses of individual taxpayers are limited to those incurred in a trade or business or in a transaction entered into for profit. Individuals also are allowed to deduct losses that are the result of a casualty. Casualty losses include, but are not limited to, those caused by fire, storm, shipwreck, and theft. A personal casualty loss is an itemized deduction.

Disallowance of Personal Expenditures

Section 262 states that "except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses." To justify a deduction, an individual must be able to identify a particular section of the Code that sanctions the deduction (e.g., charitable contributions and medical expenses). Sometimes the character of a particular expenditure is not easily determined. For example, the legal fee associated with a property settlement that results in one party retaining ownership of a family business is not deductible. The IRS has clarified the issue of the deduction of legal fees incurred in connection with a divorce. To be deductible, an expense must relate solely to tax advice in a divorce proceeding. For example, legal fees attributable to the determination of dependency exemptions of children are deductible if the fees are distinguishable from the general legal fees incurred in obtaining a divorce. Therefore, it is advisable to request an itemization of attorney's fees to substantiate a deduction for the tax-related amounts.

Example 6

Sparrow Corporation, a closely held corporation, is owned equally by Lupe, Carlos, and Ramon. The company has been highly profitable for several years and has not paid dividends. Lupe, Carlos, and Ramon are key officers of the company, and each receives a salary of $200,000. Salaries for similar positions in comparable companies average only $100,000. Amounts paid the owners in excess of $100,000 may be deemed unreasonable; if so, a total of $300,000 in salary deductions by Sparrow is disallowed. The disallowed amounts are treated as dividends rather than salary income to Lupe, Carlos, and Ramon because the payments are proportional to stock ownership. Salaries are deductible by the corporation, but dividends are not. Note that the shareholders may benefit from this reclassification. Salaries would be taxed at ordinary income rates and are subject to payroll taxes. However, dividend income would be taxed at long-term capital rates if qualified.

Example 31

Stan purchased a prime piece of land located in an apartment-zoned area. Stan paid $500,000 for the property, which had an old but usable apartment building on it. He immediately had the building demolished at a cost of $100,000. The $500,000 purchase price and the $100,000 demolition costs must be capitalized, and the basis of the land is $600,000. Because land is a nondepreciable asset, no deduction is allowed.

Example 1

Steve is a self-employed CPA. Ralph is one of Steve's employees. During the year, Steve and Ralph incur the following expenses: Steve || Ralph -Dues to American Institute of CPAs and State Society of CPAs: $400 || $300 -Subscriptions to professional journals: $500 || $200 -Registration fees for tax conferences: $800 || $800 TOTALS: $1,700 || $1,300 Steve does not reimburse any of his employees for dues, subscriptions, or educational programs. Steve's expenses are classified as a deduction for AGI because they are considered business expenses since he is a sole proprietor. Therefore, he can deduct the $1,700 on his Federal income tax return. Ralph's unreimbursed employee business expenses are classified as deductions from AGI. Ralph will be able to benefit from the $1,300 of expenses on his Federal income tax return only if his itemized deductions exceed his standard deduction. If he takes the standard deduction instead, the $1,300 of expenses will have no effect on the calculation of his taxable income. Even if Ralph does itemize deductions, he still may not benefit from the deduction because of the 2-percent-of-AGI phaseout rule for certain itemized deductions.

Example 30

Terry and Jack are divorced near the end of the current tax year. They had been married for 28 years and have two dependent children, Pauline (age 17) and Neal (age 18). As part of the divorce agreement, Jack paid all of the legal fees, which amounted to $24,300. The invoice from the divorce lawyer listed the following charges: Child custody agreement and determination of amount of monthly child support- $ 3,000 Divorce decree proceedings- $10,000 County court filing costs- $1,800 Property settlement determination- $6,000 Tax consequences of property settlement- $2,000 Tax consequences of child custody and child support payments and tax filing status- $1,500 Only the $3,500 ($2,000 + $1,500) paid by Jack for the charges relating to tax advice is deductible.

Transactions between Related Parties

The Code places restrictions on the recognition of gains and losses from related-party transactions. Without these restrictions, relationships created by birth, marriage, and business would provide endless possibilities for engaging in financial transactions that produce tax savings with no real economic substance or change. For example, to create an artificial loss, a wife could sell investment property to her husband at a loss and deduct the loss on their joint return. Her husband could then hold the asset indefinitely, and the family would sustain no real economic loss. A complex set of laws has been designed to eliminate such possibilities. Relationships and Constructive Ownership: Before reviewing the tax consequences of related party sales, it is important to know the individuals and business entities that are considered to be related parties. Related parties include the following: •Brothers and sisters (whether whole, half, or adopted), spouse, ancestors (parents and grandparents), and lineal descendants (children and grandchildren) of the taxpayer. •A corporation owned more than 50 percent (directly or indirectly) by the taxpayer. •Two corporations that are members of a controlled group. •A series of other complex relationships between trusts, corporations, and individual taxpayers. Constructive ownership provisions are applied to determine whether the taxpayers are related. Under these provisions, stock owned by certain relatives or related entities is deemed to be owned by the taxpayer for purposes of applying the loss and expense deduction disallowance provisions. For example, a taxpayer is deemed to own not only his or her stock but also the stock owned by lineal descendants, ancestors, brothers and sisters or half-brothers and half-sisters, and spouse. Losses: The Code provides for the disallowance of any "losses from sales or exchanges of property ... directly or indirectly" between related parties. A right of offset is created equal to the disallowed loss. When the property is subsequently sold to a nonrelated party, any gain recognized is reduced by the right of offset. However, the right of offset cannot create or increase a loss. Any right of offset is permanently lost if it is not used by the related-party buyer to offset some or all of the recognized gain on a subsequent sale or exchange to an unrelated party. A loss can also be disallowed even if the asset is sold to an unrelated party. This occurs if a related party repurchases the asset on or near the same day and the two sales were prearranged.

Disallowance of Deductions for Capital Expenditures

The Code specifically disallows a deduction for "any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." Incidental repairs and maintenance of the property are not capital expenditures and can be deducted as ordinary and necessary business expenses. Repairing a roof is a deductible expense, but replacing a roof is a capital expenditure subject to depreciation deductions over its recovery period. The tune-up of a delivery truck is an expense; a complete overhaul probably is a capital expenditure. Adding new gravel to a gravel parking lot is a repair, but paving the parking lot is a capital expenditure because this is doing more than restoring the asset to its original condition. New Regulations took effect January 1, 2014, that apply for tax years beginning in 2014. All costs incurred in acquiring or producing a Unit of Property (UOP) are included in its cost, except for employee compensation and overhead costs. The taxpayer can elect to capitalize employee compensation and overhead costs (can elect separately or both). The cost includes all related expenditures incurred before the date the asset is placed in service, even if these expenditures would be repairs if incurred after the asset was placed in service. The cost of a UOP includes costs incurred to obtain a clean title and investigation costs. Material or supplies that cost $200 or less can generally be deducted in the first tax year they are used or consumed. A single UOP includes all components that are functionally interdependent. Thus, a building includes, for example, the walls, floors, ceilings, roof, windows, doors, electrical systems, plumbing, and heating and air systems. The major exception to this rule is that if a component is treated separately for depreciation purposes, it will not be grouped into another UOP. Taxpayers can elect under the de minimis safe harbor election to expense outlays for lower-cost items. The election is irrevocable. This safe harbor applies if the taxpayer: 1. has written procedures in place at the beginning of the tax year that provide for the expensing of amounts below a specified dollar amount or that have a useful life of 12 months or less, 2. also expenses the items for its accounting/book records, and 3. ensures that items costing more than $5,000 are capitalized [$500 if the company does not have acceptable (generally meaning audited) financial statements]. The de minimis safe harbor election cannot be made for inventory, land, and certain types of spare parts. Routine maintenance to keep UOPs operating efficiently is expensed, such as testing, cleaning, inspecting, and replacing parts. To be routine, the expectation is that the expenditure will be needed more than once during the asset's life. An expense cannot be treated as routine maintenance if it improves a UOP (treated as a betterment). A cost is treated as a betterment if it: •enlarges or increases the capacity of a UOP, or •materially increases the productivity, efficiency, or quality of the UOP. Qualifying small taxpayers (those with $10 million or less average annual gross receipts in the three preceding tax years) can deduct improvements made to an eligible building property (one with an unadjusted basis of $1 million or less). The new safe harbor election applies only if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2 percent of the building's unadjusted basis. Capitalization versus Expense: When an expenditure is capitalized rather than expensed, the deduction is at best deferred and at worst lost forever. Although an immediate tax benefit for a large cash expenditure is lost, the cost may be deductible in increments over a longer period of time as the asset is depreciated, amortized, or depleted. If the expenditure is for a tangible asset that has an ascertainable life, it is capitalized and may be deducted as depreciation (or cost recovery) over its depreciable life. Land is not subject to depreciation (or cost recovery) because it does not have an ascertainable life. If the expenditure is for an intangible asset (e.g., copyright, patent, covenant not to compete, and goodwill), the capitalized expenditure can be amortized regardless of whether the intangible asset has an ascertainable life. Intangible assets, referred to as § 197 intangibles, are amortized over a 15-year statutory period using the straight-line method.

Excessive Executive Compensation

The deduction of executive compensation normally is subject to two limitations. As discussed, the compensation of shareholder-employees of closely held corporations is subject to the reasonableness requirement. The second limitation, the so-called millionaires' provision, applies to publicly held corporations (a corporation that has at least one class of stock registered under the Securities Exchange Act of 1934). The millionaires' provision does not limit the amount of compensation that can be paid to an employee. Instead, it limits the amount the employer can deduct for the taxable compensation of a covered executive to $1 million annually. Covered employees as defined by the SEC are the principal executive officer (PEO), the principal financial officer (PFO), and the three other most highly compensated executives. This disallowance does not apply to commissions based on individual performance and performance-based compensation tied to overall company performance.

Cash Method Requirements

The expenses of cash basis taxpayers are deductible only when they are actually paid with cash or other property. Promising to pay or issuing a note does not satisfy the actually paid requirement. However, the payment can be made with borrowed funds. At the time taxpayers charge expenses on their credit cards, they are allowed to claim the deduction. They are deemed to have simultaneously borrowed money from the credit card issuer and constructively paid the expenses. Although the cash basis taxpayer must have actually or constructively paid the expense, payment does not ensure a current deduction. Cash basis and accrual basis taxpayers cannot take a current deduction for capital expenditures except through amortization, depletion, or depreciation over the life (actual or statutory) of the asset. The Regulations set forth the general rule that an expenditure that creates an asset having a useful life that extends substantially beyond the end of the tax year must be capitalized. Examples 7 and 8 illustrate how this rule applies to prepaid expenses. The Tax Court and the IRS took the position that an asset that will expire or be consumed by the end of the tax year following the year of payment must be prorated. The Ninth Circuit Court of Appeals held that such expenditures are currently deductible, however, and the Supreme Court apparently concurs (the one-year rule for prepaid expenses). The payment must be required, not a voluntary prepayment, to obtain the current deduction under the one-year rule. The taxpayer must also demonstrate that allowing the current deduction will not result in a material distortion of income. Generally, the deduction will be allowed if the item is recurring or was made for a business purpose rather than to manipulate income. Not all taxpayers are allowed to use the cash method. For example, in most cases, the taxpayer is required to use the accrual method for sales and cost of goods sold if inventories are an income-producing factor of the business.

Accrual Method Requirements

The period in which an accrual basis taxpayer can deduct an expense is determined by applying the all events test and the economic performance test. That is, a deduction cannot be claimed until (1) all of the events have occurred to create the taxpayer's liability and (2) the amount of the liability can be determined with reasonable accuracy. Once these requirements are satisfied, the deduction is permitted only if economic performance has occurred. The economic performance test is met only when the service, property, or use of property giving rise to the liability is actually performed for, provided to, or used by the taxpayer. An exception to the economic performance requirements allows certain recurring items to be deducted if all of the following conditions are met: •The item is recurring in nature and is treated consistently by the taxpayer. •Either the accrued item is not material or accruing it results in better matching of income and expenses. •All of the events have occurred that determine the fact of the liability, and the amount of the liability can be determined with reasonable accuracy. •Economic performance occurs within a reasonable period (but not later than 8½ months after the close of the taxable year). Reserves for estimated expenses (frequently employed for financial accounting purposes) generally are not allowed for tax purposes because the economic performance test cannot be satisfied.

Authority for Deductions

The specific authority for deductions is provided in many different Code sections. However, two of the most important are § 212 and § 162. To determine the proper authority for claiming a deduction, first determine what type of activity the expenditure relates to. All activities can be divided into one of the following mutually exclusive categories: 1. Investment/production of income (§ 212) 2. Trade or business (§ 162) 3. Personal (various sections) For example, are legal expenses deductible? To make that determination, first determine whether the legal expense relates to an investment, trade or business, or to personal activity. Section 212 Expenses: Section 212 allows deductions for ordinary and necessary expenses paid or incurred for the following: •The production or collection of income. •The management, conservation, or maintenance of property held for the production of income. •Expenses paid in connection with the determination, collection, or refund of any tax. Section 212 expenses may be for AGI or from AGI. Common examples of deductions for AGI are expenses related to rent and royalty income (reported on Schedule E) and professional fees paid to determine tax liability for a sole proprietor (reported on Schedule C), a farmer (Schedule F), or one that has rent or royalties (Schedule E). All other § 212 expenses are itemized deductions (deductions from AGI). For example, investment-related expenses (e.g., safe deposit box rentals) are deductible as itemized deductions attributable to the production of investment income. Section 162 Trade or Business Expenses: Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business. These include reasonable salaries paid for services, expenses for the use of business property, and part of self-employment taxes paid. Such expenses are deducted for AGI. It is sometimes difficult to determine whether an expenditure is deductible as a trade or business expense. The term trade or business is not defined in the Code or Regulations, and the courts have not provided a satisfactory definition. It is usually necessary to ask one or more of the following questions to determine whether an item qualifies as a trade or business expense: •Was the use of the particular item related to a business activity? For example, if funds are borrowed for use in a business, the interest is deductible as a business expense. •Was the expenditure incurred with the intent to realize a profit or to produce income? For example, expenses in excess of the income from raising horses are not deductible if the activity is classified as a personal hobby rather than a trade or business. •Were the taxpayer's operation and management activities extensive enough to indicate the carrying on of a trade or business? Section 162 excludes the following items from classification as trade or business expenses: •Charitable contributions or gifts. •Illegal bribes and kickbacks and certain treble damage payments. •Fines and penalties.

Example 32

The stock of Sparrow Corporation is owned 20% by Ted, 30% by Ted's father, 30% by Ted's mother, and 20% by Ted's sister. On July 1 of the current year, Ted loaned $10,000 to Sparrow Corporation at 6% annual interest, principal and interest payable on demand. For tax purposes, Sparrow uses the accrual basis and Ted uses the cash basis. Both are on a calendar year. Through constructive ownership, Ted is deemed also to own the 80% held by his parents and sister. Thus, he directly and constructively owns 100% of Sparrow Corporation. If the corporation accrues the interest within the taxable year, no deduction can be taken until payment is made to Ted.

Intro

The tax law has an all-inclusive definition of income; that is, income from whatever source derived is includible in gross income. Income cannot be excluded unless there is a specific statement to that effect in the Internal Revenue Code. Similarly, deductions are disallowed unless a specific provision in the tax law permits them. The inclusive definition of income and the exclusive definition of deductions may not seem fair to taxpayers, but it is the structure of the tax law. The courts have held that whether and to what extent deductions are allowed depends on legislative grace. In other words, any exclusions from income and all deductions are gifts from Congress.

Substantiation Requirements

The tax law is built on a voluntary compliance system. Taxpayers file their tax returns, report income and take deductions to which they are entitled, and pay their taxes through withholding or estimated tax payments during the year. The taxpayer has the burden of proof for substantiating expenses deducted on the returns and must retain adequate records. Upon audit, the IRS can disallow any undocumented or unsubstantiated deductions. These requirements have resulted in numerous conflicts between taxpayers and the IRS. For example, specific and more stringent rules apply for deducting travel, entertainment, and gift expenses. Certain mixed-use (both personal and business use) and listed property are also subject to the adequate records requirement. Substantiation is also extremely important for establishing the basis of an asset. An asset's basis includes all costs incurred to place an asset in service, which includes transportation, sales tax, setup, testing, unpaid property taxes of the previous owner, and other purchase costs. Basis is used to determine gain or loss on a sale of the asset and to compute depreciation for depreciable assets. The taxpayer has the burden of substantiating all expenditures included in basis.

Disallowance Possibilities

The tax law provides for the disallowance of certain types of expenses. Without specific restrictions in the tax law, taxpayers might attempt to deduct items that, in reality, are personal expenditures. For example, specific tax rules are provided to determine whether an expenditure is for trade or business purposes or related to a personal hobby.

Deduction Criteria for § 162 and § 212

The terms ordinary and necessary are found in both § 162 and § 212. To be deductible, any trade or business expense must be "ordinary and necessary." In addition, compensation for services must be "reasonable" in amount. Many expenses that are necessary may not be ordinary. Neither "ordinary" nor "necessary" is defined in the Code or Regulations. The courts have held that an expense is necessary if a prudent businessperson would incur the same expense and the expense is expected to be appropriate and helpful in the taxpayer's business. But as Example 3 shows, no deduction will be allowed unless the expense is also ordinary. An expense is ordinary if it is normal, usual, or customary in the type of business conducted by the taxpayer and is not capital in nature. However, an expense need not be recurring to be deductible as ordinary. For example, a business may be in a situation that is a very rare occurrence and incur an expense. If other businesses in a similar situation are likely to incur a similar expense, then the expense can be ordinary, even though it is not recurring. For § 212 deductions, the law requires that expenses bear a reasonable and proximate relationship to (1) the production or collection of income or to (2) the management, conservation, or maintenance of property held for the production of income. The Code refers to reasonableness solely with respect to salaries and other compensation for services. But the courts have held that for any business expense to be ordinary and necessary, it must also be reasonable in amount. What constitutes reasonableness is a question of fact. If an expense is unreasonable, the excess amount is not allowed as a deduction. The question of reasonableness generally arises with respect to closely held corporations where there is no separation of ownership and management. Transactions between the shareholders and the closely held company may result in the disallowance of deductions for excessive salaries and rent expense paid by the corporation to the shareholders. The courts will view an unusually large salary in light of all relevant circumstances and may find that the salary is reasonable despite its size. If excessive payments for salaries and rents are closely related to the percentage of stock owned by the recipients, the payments are generally treated as dividends. Because dividends are not deductible by the corporation, the disallowance results in an increase in the corporate taxable income. Deductions for reasonable salaries will not be disallowed solely because the corporation has paid insubstantial portions of its earnings as dividends to its shareholders.

Example 21

Tina owns and operates 10 restaurants located in various cities throughout the Southeast. She travels to Atlanta to discuss the acquisition of an auto dealership. In addition, she incurs legal and accounting costs associated with the potential acquisition. After incurring total investigation costs of $52,000, she acquires the auto dealership on October 1, 2015. Tina may immediately deduct $3,000 [$5,000 − ($52,000 − $50,000)] and amortize the balance of $49,000($52,000 − $3,000) over a period of 180 months. For calendar year 2015, therefore, Tina can deduct $3,817 [$3,000 + ($49,000 × 3/180)].

Example 2

Tina, age 36, earns a salary of $80,000 and has no other income. She itemizes her deductions during 2015. Unreimbursed medical expenses for the year are $12,000. Tina's medical expense deduction is $4,000, as computed below. Alternatively, assume that Tina receives a $10,000 bonus from her employer in 2015. Her AGI would then be $90,000 ($80,000 + $10,000), and her medical expense is reduced by $1,000 to $3,000. No Bonus || Bonus -Qualified medical expenses: $12,000 || $12,000 -Reduction: AGI x 10%: $(8,000) || $(9,000) -Deductible medical expenses: $4,000 || $3,000 When Tina's income increased by $10,000, this reduced her medical expense deduction; so the total effect on taxable income is an increase of $11,000.

Expenditures Incurred for Taxpayer's Benefit or Taxpayer's Obligation

To be deductible, an expense must be incurred for the taxpayer's benefit or arise from the taxpayer's obligation. An individual cannot claim a tax deduction for the payment of the expenses of another individual. One exception to this disallowance rule is the payment of medical expenses for a dependent. Such expenses are deductible by the payor subject to the normal rules that limit the deductibility of medical expenses.

Tax Planning Hobby Losses

To demonstrate that an activity has been entered into for the purpose of making a profit, a taxpayer should treat the activity as a business. The business should engage in advertising, use business letterhead stationery, and maintain a business phone. If a taxpayer's activity earns a profit in three out of five consecutive years, the presumption is that the activity is engaged in for profit. It may be possible for a cash basis taxpayer to meet these requirements by timing the payment of expenses or the receipt of revenues. The payment of certain expenses incurred before the end of the year might be made in the following year. The billing of year-end sales might be delayed so that collections are received in the following year. Keep in mind that the three-out-of-five-years rule under § 183 is not absolute. All it does is shift the burden of proof. If a profit is not made in three out of five years, the losses may still be allowed if the taxpayer can show that they are due to the nature of the business. For example, success in artistic or literary endeavors can take a long time, so losses for several years in a row could occur even for a legitimate business. Also, depending on the state of the economy, full-time farmers and ranchers may have losses for several consecutive years. Merely satisfying the three-out-of-five-years rule does not guarantee that a taxpayer is automatically home free. If the three years of profits are insignificant relative to the losses of other years or if the profits are not from the ordinary operation of the business, the taxpayer is vulnerable. The IRS may still be able to establish that the taxpayer is not engaged in an activity for profit.

Example 28

Using the court's approach in allocating real estate taxes and mortgage interest, Jason, in Example 27, would have this result: Gross income -- $10,000 Deduct: Taxes and interest (60/365 x 12,410) - $(2,040) Remainder to apply to rental operating expenses and depreciation -- $7,960 Deduct: Utilities and maintenance (60/90 x 2,400) - $(1,600) Balance -- $6,360 Deduct: Depreciation (60/90 x 9,000= 6,000 but limited to above balance) - $(6,000) NET RENT INCOME ----- $360 Jason can deduct $10,370 ($12,410 paid − $2,040 deducted as expense in computing net rent income) of personal use mortgage interest and real estate taxes as itemized deductions. -------------------- Note the contrasting results in Examples 27 and 28. The IRS's approach (Example 27) results in no rental gain or loss and an itemized deduction for real estate taxes and mortgage interest of $4,137. In Example 28, Jason has net rent income of $360 and $10,370 of itemized deductions. The court's approach decreases his taxable income by $10,010 ($10,370 itemized deductions less $360 net rent income). The IRS's approach reduces his taxable income by only $4,137.

Concept Summary 6.2 Vacation/Rental Home

Was the residence rented for 15 or more days during the year? >No : Treat as a second home. Income is excludible. Itemize taxes and interest. >Yes : ««« Were personal use days more than the greater of 14 days or 10% of the total rental days? >>No : Property is a rental activity. Allocate expenses to personal use. Taxes are itemized deductions. Remaining expenses and income are from rental activity subject to at-risk and passive activity loss rules. Report on Schedule E. >>Yes : ««« Does rental portion of taxes and interest expenses exceed rent income? >>> No : ««« >>> Yes : Deduct interest and taxes only to extent of income. Other expenses are non-deductible. Remainder of taxes and interest are itemized deductions. Does rental portion of all other expenses except depreciation exceed remaining net income? >>>> No : ««« >>>> Yes : Deduct only to extent of remaining net income. Itemize personal part of interest and taxes. Remainder is nondeductible. Does rental portion of depreciation exceed remaining net income? >>>>> No : Remaining net income is passive rental activity income subject to at-risk and passive activity loss rules. Report on Schedule E. >>>>> Yes : Deduct only to extent of remaining net income. Itemize personal part of interest and taxes. Remainder is nondeductible.

Exhibit 6.1 Common Deductions for Adjusted Gross Income

•Expenses attributable to a trade or business carried on by the taxpayer. A trade or business does not include the performance of services by the taxpayer as an employee •Expenses incurred by a taxpayer in connection with the performance of services as an employee if the expenses are reimbursed and other conditions are satisfied •Deductions that result from losses on the sale or exchange of property by the taxpayer •Deductions attributable to property held for the production of rents and royalties •The deduction for payment of alimony •The deduction for part of the self-employment tax paid by a self-employed taxpayer •The deduction for the medical insurance premiums paid by a self-employed taxpayer for coverage of the taxpayer, a spouse, and any dependents •Certain contributions to pension, profit sharing, and annuity plans of self-employed individuals •The deduction for certain retirement savings allowed by § 219 (e.g., traditional IRAs) •The penalty imposed on premature withdrawal of funds from time savings accounts or deposits. •The deduction for moving expenses •The deduction for interest paid on student loans •The deduction for qualified tuition and related expenses under § 222 if extended to 2015 by Congress •The deduction for up to $250 for teacher supplies for elementary and secondary school teachers if extended to 2015 by Congress