exam 2
Example 67 Kathryn and Michael are married and both participate in their employers' qualified pension plans. Their adjusted gross income is $80,000, and each contributes $3,500 to a deductible IRA. What is the maximum amount they each may contribute to a Roth IRA?
Discussion: The maximum amount they each can contribute to a Roth IRA is $2,000. Each must reduce her or his maximum Roth IRA contribution amount of $5,500 by the $3,500 contribution made to the deductible IRA account.
Example 34 Assume that the loan in example 33 was a bona fide nonbusiness bad debt. How much of the bad debt can Maria deduct for 2017 and 2018?
Discussion: A deduction is not allowed for the partial worthlessness of a nonbusiness bad debt. Maria must wait until 2018 when she knows the amount of the bad debt to take a deduction. At that time, Maria has a short-term capital loss of $3,500 ($5,000 - $1,500). If Maria has no other capital gains or losses in 2018, she may deduct only $3,000 of the short-term capital loss for 2018, with the remainder carried forward to 2019.
Example 12 Frank sells the property in example 10 at a $10,000 loss during the current year. How much of the loss can Frank deduct?
Discussion: Because Frank's rental activity is a production-of-income activity, the $10,000 is a capital loss. The $10,000 loss would be included in the capital gain-and-loss netting. If Frank had no other capital gains and losses during the year, he could deduct only $3,000 of the loss, with the remaining $7,000 of loss carried forward to next year.
Example 69 Howard is single, and his adjusted gross income for the year is $98,000. He has two sons, Jason and Brian, ages 16 and 13, respectively. What amount can Howard contribute to Coverdell Education Savings Accounts for Jason and Brian?
Discussion: Because Howard's adjusted gross income exceeds $95,000, the amount he can contribute to each son's CESA must be reduced to $1,600: 20% = ($98,000 - $95,000) / $15,000 $1,600 = $2,000 x (1 - 20%)
Example 14 Aaron purchases a computer in 2016 at a cost of $8,000. He uses the computer in his dry-cleaning business and for personal purposes after work and on weekends. During 2016, Aaron's records indicate that 75% of the computer's use is for business purposes and 25% for personal purposes. How should Aaron treat the computer for tax purposes?
Discussion: Aaron must treat the computer as two separate assets for tax purposes. For purposes of computing depreciation on the computer, only $6,000 ($8,000 * 75%) of the cost can be depreciated for tax purposes. The remaining $2,000 of cost is considered a personal use asset. Depreciation is not allowed on personal use asset
Example 15 Aaron sells the computer in 2018 for $4,000. His business use remains at 75% for 2017 and 2018. Aaron properly deducts $2,400 in depreciation on the computer for 2016 through 2018. What is Aaron's taxable gain or loss on the sale of the computer?
Discussion: Aaron must treat the sale of the computer as the sale of two assets— one a business asset and one a personal asset. The $4,000 sales price and the $8,000 purchase price must be allocated between business and personal use: Business Personal Selling Price 4,000 x 75% 3,000 4,000 x 25% 1,000 Less adj. Basis: Original Cost 8,000 x 75% 6,000 8,000 x 25% (2,000) Less Depr. (2,400) (3,600) Loss on sale ($600) ($1,000) The $600 loss on the business portion of the computer is deductible as a business loss. However, the $1,000 loss on the personal use portion is a nondeductible personal use loss.
Example 13 Theresa, a CPA, travels to Houston for 10 days. The business purpose for making the trip is to audit a client's accounting records. The airplane ticket cost $195, the hotel cost $85 a night, and she spends $40 a day on meals and $15 a day for incidentals. She did not spend any time sightseeing or visiting friends. What is Theresa's deductible travel expense?
Discussion: All of Theresa's travel expenses are allowed as a deduction because they are related to business. However, she is still subject to the 50% limit on meals and entertainment costs. She can deduct: Transportation 195 Lodging (10 days x $85) 850 Meals [(10 days x $40) x 50%] 200 Incidentals (10 days x $15) 150 Total deductible travel expense $1395
Example 32 Wenona lends her uncle $15,000 to pay hospital and medical bills. She does not intend to charge any interest nor require him to sign a note. Her uncle promises to pay her back as soon as possible. Wenona's uncle dies without repaying her. Can she deduct the loan to her uncle as a nonbusiness bad debt?
Discussion: Although her uncle defaulted on his debt, Wenona is likely to be denied a nonbusiness bad debt deduction. There is no evidence that a bona fide arm's-length loan was made to the uncle. None of the elements found in a bona fide loan is present in this situation: no note as evidence of the debt, no collateral for the loan, no provision for interest on the loan, no payment or due date, and no collection efforts on Wenona's part. She would have to prove that her intent was not to make a gift to her uncle to get a nonbusiness bad debt deduction.
Example 65 Assume the same facts as in example 64, except that Chong and Ling's adjusted gross income is $93,000. What is the amount of their IRA deduction?
Discussion: Although they both participate in an employer-sponsored plan, their adjusted gross income is below the level at which the IRA deduction is reduced. Therefore, they are allowed to deduct their entire $11,000 contribution.
Example 26 Do-Rite, Inc., owes Kelly $10,000 for goods it purchased from Kelly on account. Because of financial difficulty, Do-Rite cannot repay the debt when it comes due in 2017. Kelly wants to deduct the $10,000 as a loss. How should she report the bad debt on her tax return?
Discussion: An account receivable from the sale of merchandise to Do-Rite is related to Kelly's trade or business. Therefore, Kelly can deduct the $10,000 bad debt as a business expense in 2017.
Example 31 Assume that in 2018, Raquel in example 30 collects $1,000 of the accounts receivable it wrote off as a bad debt expense for 2017. What is the effect on Raquel's 2018 income from the collection of the bad debt?
Discussion: Based on the tax benefit rule, the recovery of the $1,000 in bad debts deducted in 2017 must be reported as income when the accounts receivable are collected in 2018.
Example 14 Using the facts in example 13, assume that Theresa spends 6 days visiting family in Houston and 4 days auditing her client's records. What is Theresa's deductible travel expense?
Discussion: Because 60% (6 of 10 total days) of Theresa's time on the trip is related to personal activities, none of the transportation expense is deductible. She can deduct the other expenses to the extent related to business activities: Transportation 0 Lodging (4 days x $85) 340 Meals [(4 days x $40) x 50%] 80 Incidentals (4 days x $15) 60 Total deductible travel expense $480
Example 62 Assume the same facts as in example 60, except that Chong is 52 years old. What is the maximum amount Chong and Ling can contribute to their individual retirement accounts?
Discussion: Because Chong is at least 50 years old, his maximum contribution is $6,500. Ling's maximum contribution does not change, and their total contribution limit is $12,000.
Example 73 Assume the same facts as in example 72, except that Conchita's adjusted gross income is $68,000 and the interest paid is $2,200. What amount can she deduct as student loan interest?
Discussion: Because Conchita's adjusted gross income exceeds $65,000, the $2,200 maximum deduction must be reduced proportionately for each dollar of adjusted gross income that exceeds $65,000. Based on the reduction formula, Conchita must reduce her student loan interest deduction to $1,760: 20% = ($68,000 - $65,000) / $15,000 $1,760 = $2,200 x (1 - 20%)
Example 10 Frank agrees to lease land in downtown Chicago to Sleepytime Motels for 99 years. Under the lease, Sleepytime has the right to construct a motel on the land. Sleepytime is responsible for all expenses, claims, and liabilities related to the property. In the event of default on the lease, Frank has the right to assume ownership of the building and possession of the property. Is Frank's rental activity a trade or business or a production-of-income activity?
Discussion: Because Frank is not actively involved in the management of the property, the income earned is similar to the income that is earned by an investor in stocks or bonds. Thus, the lease described does not constitute a trade or business. Frank's rental activity is considered a production-of-income activity.
Example 66 Ling and Chong are married, and each has earned income. Ling participates in an employer-sponsored pension plan while Chong's company does not have a pension plan. Ling and Chong make the maximum contribution to their IRAs and have adjusted gross income for the year of $130,000. What is their allowable deduction for the $11,000 they contribute to their IRAs?
Discussion: Because Ling is an active participant in a pension plan and their adjusted gross income exceeds $119,000, Ling is not allowed a deduction for the $5,500 contribution to her IRA. However, Chong is allowed a deduction for his contribution because he is not an active participant in a pension plan and their adjusted gross income is less than $186,000.
Example 75 Assume the same facts as in example 74 and that Millie is reimbursed $4,343 for her move. If Millie is in the 33% tax bracket, what is the effect of the reimbursement on her taxable income and tax liability?
Discussion: Because Millie must include the $4,343 in her income and is only allowed a deduction for $3,438 of her moving expenses, the moving reimbursement will increase her taxable income by $905 ($4,343 - $3,438) and increase her total tax liability by $299 ($905 x 33%). NOTE: If the corporation has a policy to gross-up the additional tax expense Millie will have to pay, she will receive a payment of $446 [$299 / (1 - 33%)]. This will ensure that the net amount Millie receives is $299 [$446 - ($446 x 33%) = $299].
Example 25 Pamela is the chief executive officer of the Vanger Corporation. Her salary for the year is $1,250,000. What amount can the corporation deduct as salary expense?
Discussion: Because Pamela is the chief executive officer of Vanger, the corporation can deduct as salary expense only $1,000,000 of the $1,250,000 paid to her.
Example 41 Radon Corporation pays a $5,000 premium on a whole life insurance policy on the life of Luke, a key employee in the company. If the corporation is the beneficiary of the policy, how much of the premium can Radon deduct?
Discussion: Because Radon benefits directly or indirectly from the policy proceeds when Luke dies, the premium is not deductible. But recall from Chapter 4 that life insurance proceeds received upon the death of the insured are excluded from gross income.
Example 42 Assume that Luke, in example 41, is unrelated to Radon Corporation and its owners. Also, Luke's wife is the beneficiary of the life insurance policy. How much of the insurance premium can Radon deduct?
Discussion: Because Radon is not a direct or indirect beneficiary of the policy, the $5,000 premium is allowed as a deduction for additional compensation paid to Luke. Luke will have to report the $5,000 premium paid by the corporation as income. His wife can exclude the proceeds of the policy from her income when Luke dies.
Example 57 Rory is the sole proprietor of Rory's Western Wear. During 2017, he pays $1,800 for his own health insurance. How should Rory deduct the $1,800 health insurance cost?
Discussion: Because Rory is self-employed, he can deduct the $1,800 of health insurance premiums as a deduction for adjusted gross income. If Rory's wife, Eleanor, is covered by medical insurance provided by her employer, the entire $1,800 can be deducted only as an itemized medical expense (discussed in Chapter 8).
Example 6 Tom gives a party for his clients. Tom, 6 clients, and 3 social guests are present. The party costs Tom $1,000 for food, beverages, and entertainment. How much of the $1,000 can Tom deduct as a business expense?
Discussion: Because Tom is present when the food and beverages are served, the business portion of the cost is a qualified expense. The expense for Tom and his 6 clients may be deducted because the expenditure has a business purpose. The expense related to the social guests is personal and not deductible. Tom's allowable entertainment costs are $700 [(7 / 10) x $1,000]. Tom's deduction is limited to $350 ($700 x 50%).
Example 11 Yolanda owns two rental properties. She obtains tenants for the proper- ties, makes repairs, provides maintenance, pays expenses related to the properties, and is subject to claims and liabilities arising from the rental properties. Is Yolanda's rental activity a trade or business or a production-of-income activity?
Discussion: Because Yolanda actively manages the two properties, pays expenses related to them, and is liable for claims on the properties, she is deemed to be engaged in a trade or business
Example 13 Assume that Yolanda sells one of her rental properties in example 11 at a $10,000 loss during the current year. How much of the loss can Yolanda deduct?
Discussion: Because Yolanda's rental activities constitute a trade or business, the $10,000 loss on the sale of the rental property is deducted in full as a trade or business loss.
Example 3 Zoltan is a physician who has not seen his sister for more than 10 years because she lives in Kenya. He would like to visit her and write a book about his experiences. He has never written a book. Because his trip has a business purpose—to write a book—Zoltan intends to deduct the full cost of his trip as a business expense. Has Zoltan met the dominant motive requirement for deducting the cost of the trip?
Discussion: Because Zoltan has several motives for making the trip, he will have to prove that the dominant motive is a business purpose. Based on the facts, it would appear that Zoltan is not entitled to a deduction because the primary purpose of his trip is personal (to visit his sister). Because Zoltan has no experience in writing travel books, he would have a hard time proving that writing the book is his dominant motive.
Example 60 Chong and Ling are married, and each has earned income. Chong makes $19,500 per year, and Ling earns $26,500 per year. What is the maximum amount they can contribute to their individual retirement accounts?
Discussion: Because both Chong and Ling have earned income, each may contribute the $5,500 maximum to his or her own account, a total of $11,000.
Example 15 Using the facts in example 13, assume that Theresa spends 3 days visiting family in Houston and 7 days auditing her client's records. What is Theresa's deductible travel expense?
Discussion: Because more than 50% of Theresa's time on the trip is related to business activities, she can deduct all the transportation expense. She can also deduct the other expenses to the extent they relate to business activities: Transportation 195 Lodging (7 days x $85) 595 Meals [(7 days x $40) x 50%] 140 Incidentals (7 days x $15) 105 Total deductible travel expense $1,035
Example 63 Assume the same facts as in example 60, except that neither Chong nor Ling is covered by an employer-sponsored pension plan. If they each contribute the maximum allowable amount to their IRAs, what is their deduction for adjusted gross income?
Discussion: Because neither Chong nor Ling is covered by an employer-sponsored pension plan, they may each contribute $5,500 to their plans and deduct $5,500 for adjusted gross income. This gives them a total deduction of $11,000 for adjusted gross income. The effect of the deduction is to reduce their individual earned incomes by the $5,500 contribution. Chong is taxed on only $14,000 ($19,500 - $5,500) of his earned income, and Ling is taxed on only $21,000 ($26,500 - $5,500) of her earned income.
Example 20 Assume that Sam also sends each of his 5 best customers custom-made desk clocks that cost $85 each. How much of the cost of the clocks is deductible as a business gift?
Discussion: Because the annual limit of $25 per donee applies to both direct and indirect gifts, none of the cost of the clocks may be deducted as a business gift. The $25 limitation was exceeded on the gift to the spouse. Therefore, Sam is over the limit on his 5 best customers.
Example 33 Karen owes Maria $5,000. The loan is related to Maria's business. In 2017, Karen files for bankruptcy. Maria talks to Karen's lawyers and determines that only 40% of the debt is collectible. In 2018, Maria receives $1,500 from the bankruptcy proceeding in full payment of the debt. How much of the bad debt can Maria deduct for 2017 and 2018?
Discussion: Because the debt is a business bad debt, a deduction is allowed for partial worthlessness. Maria can deduct $3,000 ($5,000 x 60%), the amount estimated as uncollectible, for 2017. When the debt is finally settled in 2018, Maria can deduct the remaining $500 ($2,000 - $1,500) of the debt that she will not collect. Note that if Maria had received $2,800 from the bankruptcy proceeding, she would have had gross income of $800 ($2,800 - $2,000) under the tax benefit rule.
Example 70 Victoria is single and her adjusted gross income for the year is $58,000. During 2016, she works as an engineer and during the year she enrolls in two engineering courses at Kane University. Even though the courses improve her job skills, her company does not reimburse her for the $2,200 in tuition. How should Victoria account for the education expense on her tax return?
Discussion: Because the expenses are qualified higher education expenses and her adjusted gross income is less than $65,000, she can deduct the $2,200 in tuition as a deduction for adjusted gross income. NOTE: If Victoria's adjusted gross income is greater than $65,000 but less $80,000, she could deduct $2,000. If her adjusted gross income exceeds $80,000, she would not be entitled to a deduction for adjusted gross income. However, she could deduct the education expenses as a miscellaneous itemized deduction because the expenses were incurred to maintain or improve the skills required in her job.
Example 27 Assume in example 26 that Do-Rite owes Kelly the $10,000 because the owner of Do-Rite is a friend of Kelly's and Kelly made the company a temporary loan to help it through a cash-flow shortage. Kelly does not do any business with Do-Rite. How should Kelly report the bad debt on her tax return?
Discussion: Because the loan is not related to Kelly's trade or business, the debt is a nonbusiness debt. Assuming Kelly does not have other capital gains or losses to report, she is permitted a $3,000 capital loss deduction in 2017, 2018, and 2019. The remaining $1,000 is deductible in 2020. If Kelly forgives the $10,000 due from Do-Rite because the company is owned by her uncle and she wants to do him a favor, the forgiveness is considered to be a gift to her uncle and not allowed as a bad debt deduction.
Example 44 Leslie Corporation purchases a new computer for use in its office. The computer costs $8,000 and is subject to a 10% sales tax. What is Leslie's deduction for the $800 in sales tax paid on the computer?
Discussion: Because the sales tax is for the purchase of a depreciable asset, the $800 in tax is not currently deductible. The sales tax is added to the computer's basis as part of the cost of acquiring the asset. A deduction is allowed for depreciation of the computer's $8,800 tax basis.
Example 17 Assume that in example 16, Raul is a tax attorney who represents clients who invest in real estate partnerships. Can he deduct the cost of attending the seminar?
Discussion: Because the seminar is related to his trade or business as a tax attorney, Raul may deduct the allowable costs of attending the seminar as an expense incurred in his trade or business.
Example 68 Assume the same facts as in example 67, except that Kathryn and Michael's adjusted gross income is $192,000. What is the maximum amount they may contribute to their Roth IRAs?
Discussion: Because their adjusted gross income is greater than $119,000, they cannot make a deductible IRA contribution. They must reduce their $11,000 Roth IRA contribution proportionately for each dollar of adjusted gross income that exceeds $186,000. The entire contribution amount is reduced to zero when adjusted gross income exceeds $196,000. Kathryn and Michael must reduce the amount of their Roth IRA contribution to $4,400 (i.e., $2,200 each): 60% = ( $192,000 - $186,000) / $10,000 $4,400 = $11,000 x (1 - 60%)
Example 53 Santamaria Company requires its employees to adequately account for all reimbursed business expenses. Sarah, an account executive, submits for reimbursement the following valid business expenses: Transportation costs 600 Meals 400 Lodging costs 800 Entertainment 200 Total costs $2000 What are the tax consequences if Santamaria reimburses Sarah the $2,000?
Discussion: Because there has been an adequate accounting, Sarah has no tax effects. None of the reimbursement is included in her gross income, and she is allowed no deductions for the expenses. 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 and entertainment. The actual deduction for the employer is only $1,700 [$600 + $200 ($400 x 50%) + 800 + $100 ($200 x 50%)].
Example 24 Atman and Sarita are good friends. Atman also supplies Sarita with artwork that she sells to customers in her interior decorating business. Atman takes Sarita to dinner at the Greyhouse. During the meal, they discuss business, and Sarita agrees to buy several pieces of art. Atman pays for the meal. Is the cost of the meal a business expense or a personal expense?
Discussion: If Atman takes Sarita to dinner just to spend time with a friend, the fact that the conversation drifts to business does not result in a business deduction for the meal. Because the dominant motive for the expense is personal, the expense is not deductible. If Atman takes Sarita to dinner so he can discuss his artwork and to solicit an order for paintings and the event centered on a business discussion, Atman can deduct the cost of the meal as a business expense because the dominant motive is business
Example 64 Assume the same facts as in example 60, except that both Chong and Ling participate in an employer-sponsored pension plan. Chong and Ling continue to make the maximum contribution to their IRAs, and they have an adjusted gross income of $111,000. What is their allowable deduction for the $11,000 they contribute to their IRAs?
Discussion: Because they both participate in an employer-sponsored pension plan, Chong and Ling must reduce their $11,000 IRA deduction proportionately for each dollar of adjusted gross income that exceeds $99,000. The entire deduction is reduced to zero when adjusted gross income reaches $119,000. Based on the reduction formula below, Chong and Ling must reduce the amount of their IRA deduction to $4,400 (i.e., $2,200 each): 60% = ($111,000 - $99,000) / $20,000 $4,400 = $11,000 x (1 - 60%) Chong and Ling may still contribute the $11,000 maximum to their IRA accounts. It is only the amount of the allowable deduction that must be reduced when both taxpayers are covered by a separate pension plan, not the allowable contribution amount. The tax benefit of making nondeductible contributions is that the earnings on the contributions are allowed to accumulate tax-free until they are with- drawn. Chong and Ling do not have to make the maximum contribution to get the $4,400 deduction. They may choose to contribute only the deductible amount, or they may contribute another amount less than the $11,000 maximum.
Example 2 Randy and Cindy are both practicing CPAs, specializing in tax. Randy enrolls in law school so he can take tax courses. He intends to get a law degree. Cindy enrolls in a master's program in tax to improve her skills as a tax accountant. Eventually, Cindy hopes to earn a master's degree.
Discussion: Both Randy and Cindy have incurred expenses to improve or maintain their skills as practicing tax accountants. However, Randy cannot deduct his expenses. Educational expenses that qualify a person for a new profession (the practice of law) are not deductible. Cindy's expenses are deductible because they relate to her job and do not qualify her for a new profession.1 Although treating Randy differently from Cindy seems unfair, Randy did not satisfy all the requirements of the tax law to claim an educational expense deduction.
Example 9 On a typical day, Carla drives 10 miles round-trip between home and her office. In addition, she drives 75 miles to meet customers and take care of other business needs. How many of the 85 miles she drives each day count as business-related miles?
Discussion: Carla can deduct the cost of driving the 75 business miles. The cost of transportation to work and back home is personal and not deductible.
Example 72 Upon graduating from Deekman University, Conchita begins working as a financial analyst for Cobblestone Securities. To finance her college education, she had borrowed $34,000 from a local bank. During the current year, she paid $2,600 in interest on her student loans. What amount can Conchita deduct as student loan interest if her adjusted gross income is $38,000?
Discussion: Conchita is allowed a deduction for adjusted gross income of $2,500. The remaining $100 is considered personal interest and is not deductible.
Example 61 Assume that in example 60, only Ling works and Chong stays home with the children. What is the maximum amount they can contribute to their individual retirement accounts?
Discussion: Even though Chong is a nonworking spouse, because their total earned income exceeds $11,000, they can contribute a total amount of $11,000, with no more than $5,500 contributed to each account.
Example 71 Assume the same facts as in example 70, except that Victoria pays $4,400 in tuition to Kane University and that the courses are unrelated to her job. How should Victoria account for the education expense on her tax return?
Discussion: Even though the expense is not related to her job, Victoria can deduct $4,000 because the tuition is a qualified higher education expense. The remaining $400 ($4,400 - $4,000) of the tuition cannot be deducted as a miscellaneous itemized deduction because the expenses were not incurred to maintain or improve the skills required in her job.
Example 43 Leslie Corporation 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 Leslie's deduction for taxes paid?
Discussion: Except for the federal income tax, Leslie may deduct all the taxes listed. Leslie's deduction for taxes paid is $24,000. The $50,000 federal income tax is never allowed as a deduction.
Example 38 PopCo purchases raw materials and produces bottled soft drinks and soft drink syrup concentrate. PopCo sells to retailers and also owns retail stores that sell the bottled soft drinks, fountain soft drinks made from the syrup concentrate, and other food products. Which portions of PopCo's operations produce domestic production gross receipts?
Discussion: Food processing is a qualified production activity. However, the sale of food and beverages at retail establishments is not a qualified production activity. The sale of bottled soft drinks and syrup concentrate to retailers constitute DPGR. The sale of bottled soft drinks at its own retail stores also qualify as DPGR. The mixing of soft drinks from syrup at its retail outlets is not a qualifying production activity. However, PopCo may allocate part of the fountain soft drink sales to its domestic production gross receipts to the extent of the value of the syrup used in the soft drinks. The selling price of syrup sold to other retailers provides a value on which to base the allocation of its soft drink sales. The value of food sold at the retail outlets does not constitute DPGR. Note that PopCo can only claim the sales of bottled soft drinks and the allocable syrup revenue from its retail stores because it is the manufacturer of the products. Other retailers who buy from PopCo cannot claim any of their sales of PopCo's products as domestic production gross receipts.
Example 39 GasCo is a processor of natural gas. PipeCo owns a natural gas pipeline transmission system. LocalCo sells natural gas to residential customers. GasCo extracts the natural gas and transmits it via pipeline to its processing facilities. GasCo sells the processed natural gas to LocalCo, which distributes the natural gas to its customers. GasCo contracts with PipeCo to transmit the natural gas to LocalCo. Which company's activities produce domestic production gross receipts?
Discussion: GasCo's extraction and processing of the natural gas are domestic production gross receipts but the transmission of the natural gas from the field to its processing facility is not a qualified receipt. PipeCo and LocalCo are both engaged in the transmission of natural gas and their activities do not produce domestic production gross receipts.
Example 12 Nancy uses her car in her business of selling real estate. In 2017, she buys a new car and drives it 18,700 miles for business and 3,800 miles for commuting to and from the office and for other personal use. Depreciation, insurance, license, gas, repairs, and other operating expenses total $14,000. She can document that she paid $125 in tolls and parking while on business, and the interest expense on her car loan is $250. What is her deduction using the standard mileage rate method and the actual cost method?
Discussion: If Nancy chooses to use the standard rate method, her car expense deduction is equal to 54 cents for each business-related mile driven plus any tolls and parking: Standard rate deduction (18,700 miles x 53.5 cents) 10,005 Tolls and parking (100% business) 125 Interest on car loan [(18,700 / 22,500 = 83%) x $250] 208 Total deduction for business use of car $10,338 Because the tolls and parking were incurred while on business, they do not have to be allocated. The interest expense is based on the ratio of business-related miles to total miles. Discussion: If Nancy chooses to use the actual cost method, her car expense deduction is determined by allocating the costs of operating the car between business and personal use: Actual operating expenses 14,000 Business use percentage (18,700 22,500) x 83% Business portion of operating expenses 11,620 Tolls and parking (100% business) 125 Interest on car loan (83% $250) 208 Total deduction for business use of car $11,953 Tolls and parking incurred while on business do not have to be allocated. The inter- est expense is allocated according to the business use percentage. If Nancy is willing to keep the records necessary to support the actual cost method, she can obtain a larger car expense deduction than under the standard mileage rate method.
Example 7 Assume the same facts as in example 6. Ahmed is single; his adjusted gross income for the year is $25,000, and his total itemized deductions are $12,000 (before considering the information in example 6). What is the effect on Ahmed's taxable income of stating the investment expenses separately?
Discussion: If the Hackett Group did not report both investment income and expenses separately, Ahmed's ordinary taxable income from the Hackett Group would be $85,000 ($255,000/3). He would have an adjusted gross income of $110,000 ($25,000 + $85,000), itemized deductions of $12,000, and taxable income of $93,950 ($110,000 - $12,000 - $4,050). Because the capital gains and investment expenses receive special tax treatment, HG must report these items separately. Ahmed's share of the ordinary income is $80,000, and his adjusted gross income is $114,000 ($25,000 + $80,000 + $9,000). The $4,000 of investment expenses is a miscellaneous itemized deduction, which is reduced by 2% of adjusted gross income Investment expense 4,000 Limitation: 2% x $114,000 (2,280) Investment expense deduction 1,720 Ahmed's itemized deductions total $13,720 ($12,000 + $1,720), and his taxable income is $96,230 ($114,000 - $13,720 - $4,050). Because HG reports these items separately, Ahmed's taxable income increases by $2,280 ($96,230 - $93,950).
Example 9 Grady owns a large portfolio of stocks, bonds, and other securities. What is the treatment of Grady's securities activities in each of the following cases? Case A Grady spends all his time managing his portfolio. He continually trades securities to obtain a profit from short-term price increases. Grady rarely holds a security for the dividend or in- terest income it may produce or for long-term appreciation in value. He has no other job and receives the bulk of his income from his securities dealings. Case B Grady is employed as a chemist for Dough Company. He spends an average of five hours per week studying investment materials and making investment decisions. Grady primarily invests in securities for their dividend and interest income and long-term appreciation potential. Because his portfolio is quite extensive, more than half his income comes from his secu- rity investments.
Discussion: In case A, Grady's activities constitute a trade or business. His primary motive is profit, he engages in the activity on a continual and regular basis, and his securities activities are his livelihood. Grady's business expenses are deductible for adjusted gross income. In addition, gains and losses from his securities dealings are considered gains and losses from a trade or business. In case B, Grady's security dealings are a production-of-income activity. He receives a substantial portion of his income from his securities, but they are not his livelihood, nor does he engage in the activity with the continuity and regularity of a trade or business. Therefore, Grady's expenses are deductible as miscellaneous itemized deductions. In addition, gains and losses Grady incurs from selling the securities are capital gains and losses.
Example 56 Assume the same facts as in example 55, except that Sarah either does not have to make an adequate accounting or does not have to return any excess reimbursement. That is, Santamaria's plan is a nonaccountable plan.
Discussion: In examples 53 to 55, the reporting is the same if the plan is non- accountable. The reimbursement must be included in Sarah's gross income, and Sarah is allowed to deduct only actual costs as miscellaneous itemized deductions, subject to the 50% limitation on meals and entertainment. In each of these instances, Sarah is allowed a miscellaneous itemized deduction of $1,700. (The calculation follows.) This is combined with her other miscellaneous itemized deductions and subjected to the 2% adjusted gross income limitation for miscellaneous itemized deductions. Transportation costs 600 Meals ($400 50%) 200 Lodging 800 Entertainment ($200 50%) 100 Total miscellaneous deductions 1,700
Example 54 What are the tax consequences if Santamaria reimburses Sarah for $1,500 instead of $2,000?
Discussion: In this case, Sarah is in a net deduction situation. The amount of the reimbursement, $1,500, is included in her gross income, and $1,500 of the expenses is deducted for AGI. The remaining $500 in unreimbursed expenses is deductible from AGI as a miscellaneous itemized deduction. Because Sarah is getting an actual deduction for meals and entertainment in this case, the 50% limit applies. Therefore, the individual costs must be allocated between for- and from-AGI, using the reimbursement ratio. The reimbursement ratio is the reimbursement divided by the total costs and equals 75% ($1,500 / $2,000) in this case. The remaining 25% of each expense is unreimbursed. The allocation of deductions between for- and from-adjusted gross income is 75% for AGI 25% from AGI 100% Total Transportation costs 450 150 600 Meals 300 100 400 Lodging 600 200 800 Entertainment 150 50 200 Total cost allocated $1,500 500 2000 Of the $500 in from AGI expenses, only $50 ($100 x 50%) of the meals and $25 ($50 x 50%) of the entertainment costs are deductible, resulting in a total itemized deduction of $425 ($150 + $50 + $200 + $25). The $425 is combined with other allowable miscellaneous itemized deductions and subjected to the 2% of adjusted gross income limitation.
Example 55 Assume that Santamaria reimburses Sarah in the amount of $2,200 for the $2,000 in actual expenses. Although Santamaria's plan requires employees to return excess reimbursements, Sarah does not return the excess.
Discussion: In this case, because the plan is an accountable plan, Sarah is deemed to have made an adequate accounting of the $2,000 in actual expenses. The excess reimbursement, $200, must be included in her gross income. Note that Santamaria will deduct the same amount that was allowed in example 53. The employer may deduct the $200 excess reimbursement as wages paid to Sarah.
Example 52 Assume the same facts as in example 51, except that Teresa's allowable trade or business expenses total $101,000.
Discussion: In this case, the netting of expenses against income results in a loss of $8,000 ($93,0002 - 101,000). Because it is a loss from a trade or business, it is deductible for adjusted gross income. Thus, the net figure of $8,000 is shown as a deduction for adjusted gross income.
Example 1 Joan earns $25,000 in wages as a county property tax assessor. John owns and operates his own business selling Slippery Oil. John's Slippery Oil sales are $60,000, the cost of the oil sold is $25,000, and he has other business expenses of $10,000.
Discussion: Joan should report $25,000 in wages as gross income. Because the tax law allows a deduction for the cost of sales and business expenses, John has a gross income of $35,000 ($60,000 - $25,000) and reports $25,000 in taxable income from his business ($35,000 - $10,000). After recovering his expenses, John pays tax on his increase in wealth according to the ability-to-pay concept. Compared with Joan's tax treatment, it is inequitable to tax John on his gross income and deny him a deduction to recover the amounts he invests to earn a profit.
Example 11 Jose purchases a new car this year and drives it 10,000 miles for business purposes and 3,000 miles for personal use. What is Jose's deduction for the business use of the car if he elects to use the standard mileage rate method?
Discussion: Jose can deduct $5,350 (10,000 x 53:5 cents) in auto expense based on his business mileage under the standard mileage rate method. No deduction is allowed for the personal use of the car. If he paid any parking fees or tolls out-of- pocket while on business, these expenses are also deductible.
Example 37 The Labier Corporation has gross receipts of $2,000,000 from qualified production activities. The cost of goods sold related to these receipts is $1,400,000 and Labier has direct costs related to these receipts of $150,000. Labier estimates that 20% of its $400,000 of indirect costs are attributable to its qualified production activities. What is Labier's qualified production activities income?
Discussion: Labier Corporation's qualified production activities income is $370,000 [$2,000,000 - $1,400,000 - $150,000 - $80,000 ($400,000 x 20%)]. Labier's qualified production activities gross receipts of $2,000,000 are reduced by its $1,400,000 cost of goods sold, the $150,000 of direct costs attributable to the qualified production activities and the $80,000 ($400,000 x 20%) of indirect costs attributable to the qualified production activities income.
Example 17 Kara owns and operates a pet shop. One day, a customer is bitten by a snake. Although the accident is the customer's fault, he sues Kara for $25,000. After Kara pays her lawyer $2,500 to defend her, the customer drops the suit. Are the legal fees an ordinary expense for Kara?
Discussion: Lawsuits by customers are a common occurrence in today's business environment. The cost of defending the business against the disgruntled customer is a normal cost of doing business, although it is not a recurring expense. The legal fees satisfy the ordinary test.
Example 45 Leslie Corporation sells land and a building on October 1, 2017. The property tax for the 2017 property tax year (a calendar year) is $3,600. Leslie pays its share of the property tax on the date the sale closes. What is Leslie's 2017 deduction for real estate taxes on the land and building?
Discussion: Leslie may deduct the property taxes for the period it owned the land and building. Leslie's deduction would be $2,700—the taxes related to the period January 1 through September 30, 2017 [$3,600 x (9/12)]. The buyer should deduct the property tax for the remainder of the property tax calendar year because that entity was the owner of the property.
Example 74 Millie takes a job in New City during the year. New City is 692 miles from Old City, where Millie had been working. She expects to meet the 39-week test. Millie incurs $2,900 in costs for moving her household goods and personal effects. In addition, she incurs $400 in lodging expenses, $100 in meal expenses, and pays $20 in tolls en route to New City. Before moving to New City, she flies to New City to find an apartment. The cost of the flight is $350, and she incurs lodging costs of $200 and meal expenses of $75. How much of these costs can Millie deduct as moving expenses?
Discussion: Millie's moving expense deduction is $3,438. She is allowed to deduct the cost of transporting her household goods and personal effects ($2,900). In addition, Millie is allowed to deduct a total of $538 [lodging of $400, tolls of $20, and $118 in mileage (692 miles @ 17 cents per mile)] traveling to New City. The meal expenses and the costs associated with finding an apartment are not deductible.
Example 23 Roy pays Sally $100 per week to clean his medical office. When Sally became ill, he hired his daughter, Janice, to fill in and keep the office tidy. Roy pays Janice $300 a week. How much of the $300 payment is reasonable?
Discussion: Of the $300 per week paid Janice, he is allowed to deduct only $100, because that is the amount he pays Sally. Unless Roy can prove otherwise, Janice's $300 weekly salary is considered excessive because he normally pays $100 a week for the same services. NOTE: In each of these examples, the apparently unreasonable compensation is paid to a related party. It is unlikely that the taxpayers in these examples would pay the same amounts had the transaction been with an unrelated party
Example 20 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?
Discussion: On similar facts, the Tax Court determined that operating the yacht is not the ordinary method of promoting the taxpayer's business. Further, the court determined that the expenses of the yacht were so personal in nature that they could not be necessary in the common sense of the word.
Example 8 Harry's son Junior wants to open a motorcycle dealership. Because Junior is short of funds, Harry purchases a building for the dealership and leases it to Junior. No lease is signed, but Harry tells Junior not to worry about paying rent until the dealership begins to show a profit. In addition, Harry agrees not to sell the building without Junior's approval. Is Harry's dominant motive in acquiring the building to obtain a profit?
Discussion: On the facts presented, Harry's dominant motive in acquiring the building is to help his son get his business established. Because there is no formal rental agreement and Harry will not sell the building without Junior's approval, the purchase of the building and the payment of costs related to the building are in the nature of a gift. Harry is not attempting to profit from either rental payments or potential appreciation in the value of the business. Therefore, any expenditures Harry makes regarding the building are not classified as business expenses. As personal expenses, only those personal expenses specifically allowed by the tax law (property taxes) are deductible
Example 58 Ramona is the sole proprietor of Rangoon Foods. During 2017, Rangoon has a taxable income of $142,000. Assuming that Ramona has no other sources of self-employment income, what is Ramona's 2017 self-employment income subject to the self-employment tax?
Discussion: Only 92.35% of the earnings from self-employment is subject to the self-employment tax. Thus, Ramona's net self-employment income is $131,137 ($142,000 x 92:35%)
Example 16 Pam travels to San Diego for 4 days primarily for business reasons. Her air- fare costs $800, and she incurs expenses of $200 a day for lodging and incidentals. Because Pam has never been to San Diego, she stays 2 extra days to visit the zoo and to tour the city. How much of her costs can be deducted as a business expense?
Discussion: Pam has incurred mixed-use expenditures. The expense relates to a business trip and a personal vacation. Because the primary motive for making the trip (as evidenced by spending more days on business than for personal purposes) was to conduct business, Pam can deduct the full $800 airfare. She can also deduct $200 for each day she was in San Diego to conduct business. Pam cannot deduct any part of the $200 per day for lodging and incidentals for the 2 extra days she stayed for personal reasons.
Example 40 On July 1, 2017, Sook 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 Sook deduct for 2017?
Discussion: Payment of the premium in advance results in a prepaid expense that benefits tax years 2017, 2018, 2019, and 2020. Regardless of Sook'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 x (6 / 36 months)] insurance expense deduction for 2017.
Example 22 Phoebe has a bachelor's degree in engineering from Local University and is employed as an engineer with Koza Construction. She is enrolled in an advanced thermal dynamics course at Local University. The course costs $600. Can Phoebe deduct the cost of the course as an education expense?
Discussion: Phoebe can deduct the $600 as a miscellaneous itemized deduction. The course qualifies as a deductible education expense because it improves her engineering skills.
Example 59 In example 58, what are Ramona's 2017 self-employment tax and her deduction for self-employment taxes paid?
Discussion: Ramona's self-employment tax is $19,576. Ramona is allowed to deduct $9,249, half of the self-employment tax, as a deduction for adjusted gross income. OASDI on $127,200 of income: $127,200 x 12.4% 15,773 MHI on $131,137 of income: $131,137 x 2.9% 3,803 Self-Employment Tax $19,576 Ramona is allowed to deduct $9,788, one-half of the self-employment tax as a deduction for adjusted gross income. Discussion: If Ramona's net self-employment income was $220,000, then her self- employment tax is $22,333. OASDI on $127,200 of income: $127,200 x 12.4% 15,773 MHI on $220,000 of income: $220,000 x 2.9% 6,380 HI tax on income in excess of $200,000: ($220,000 - $200,000) x .9% 180 Self-Employment tax $22,333 Ramona is allowed to deduct $11,077, one-half of the self-employment tax ($15,773 1 $6,380) as a deduction for adjusted gross income. The additional $180 HI tax is not eligible for the deduction.
Example 16 Raul 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 Raul deduct the cost of attending the seminar?
Discussion: Raul is an investor in real estate partnerships, and the travel is related to the production of income. Because the travel is not related to his medical practice (trade or business), the travel expenses are not deductible.
Example 8 Rubin Corporation provides the food, beverages, and entertainment for a Fourth of July picnic for its employees and their families. This is an annual event that Rubin 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 Rubin deduct?
Discussion: Rubin Corporation can deduct the full $5,000, because the expense is for the recreational and social benefit of its employees. The expense is not subject to the 50% limitation. The value of the party is excluded from the employees' income under the de minimis fringe-benefit rule discussed in Chapter 4.
Example 18 Yusef is a self-employed insurance agent. He and his wife, Ruby, travel to Washington to attend an insurance conference. Ruby is an executive secretary for Rhody Corporation. She spends her time in Washington attending the sessions, taking notes, and setting up meetings for Yusef. Can Yusef deduct the cost of attending the seminar for both of them?
Discussion: Ruby's presence at the conference serves a useful business purpose, but because she is not Yusef's employee, the expenses related to Ruby's travel are not deductible. If the hotel rate is the same for single or double occupancy, no part of the lodging is disallowed. But if different rates apply, Yusef can deduct only the cost of single occupancy (his own). All allowable costs Yusef incurs for his attendance at the conference are deductible (subject to the 50% meal and entertainment limitation) because the seminar relates to his trade or business.
Example 49 Elissa, Salvadore's wife, has filed for divorce and has asked for a large property settlement. The only way Salvadore can pay Elissa the amount she is seeking is to sell his business. Salvadore pays $6,000 in legal fees related to the divorce. Can he deduct his legal fees?
Discussion: Salvadore may not deduct the personal legal fees. The legal expenses did not arise from the conduct of his business. The fact that he may have to sell his business merely reflects the results of the legal claim that arose from a personal relationship.27
Example 50 Salvadore has been having a bad year. In August, he receives a letter from the IRS stating that he owes an additional $34,000 in income taxes. Salvadore pays his attorney $12,000 to settle the case with the IRS. Can he deduct the attorney's fees?
Discussion: Salvadore will be able to deduct the attorney's fees because they were incurred in relation to the collection of a tax. The tax law allows the deduction of any costs related to the collection of a tax. To the extent the amount in dispute relates to his business, he may deduct the attorney's fees as an ordinary and necessary business expense. However, any portion that relates to other types of income or deductions is allowed only as a miscellaneous itemized deduction.
Example 36 Return to the facts of example 35. Due to advanced manufacturing technology, Shepp has only 2 employees receiving wages. Their allocable DPGR wages for 2017 is $110,000. What is Shepp's qualified production activities deduction for 2017?
Discussion: Shepp's QPAD is limited to $55,000 ($110,000 x 50%). The deduction is limited to 50% of the $110,000 in DPGR wages that Shepp paid to its employees during 2017.
Example 35 Shepp Corporation manufactures golf balls. In 2017, its taxable income before the QPAD is $2,200,000 and its qualified production activities income is $2,000,000. What is Shepp's qualified production activities deduction for 2017?
Discussion: Shepp's qualified production activities deduction for 2017 is $180,000 ($2,000,000 x 9%). The deduction is based on the lesser of Shepp's $2,200,000 taxable income before the QPAD or the $2,000,000 of qualified production activities income. Note that if Shepp's taxable income before the QPAD was only $1,600,000, then the deduction is only $144,000 ($1,600,000 x 9%).
Example 22 Tara operates a shoe store in a building she rents from her father for $1,000 per month. Comparable store space is readily available for rent at $400 per month. Is the rental payment reasonable?
Discussion: Tara is allowed a $400 rent expense deduction unless she can establish that the location or other unique features of her father's building justify a higher rent than other, comparable store space. Unless Tara can prove otherwise, the $600 excess payment is considered a nondeductible payment to her father (a gift).
Example 24 Tina is the sole shareholder of Staple Manufacturing Corporation. She is the president of the corporation and pays herself $200,000 a year. Her son, who is the operations officer, is paid $60,000 a year. Her son seldom visits the plant because he is a full-time student at State University. The next-highest-paid employee, the general manager, is unrelated to Tina and is paid $50,000 a year. During an audit, the IRS determines that based on comparable salaries in the area, a reasonable salary for Tina should be $90,000. Based on an examination of employee records, the IRS decides that Tina's son is not an employee. The salary paid Tina's son is a sham (an assignment of income from Tina). How much of the payments to Tina and her son is deductible by Staple?
Discussion: The $110,000 ($200,000 - $90,000) excess salary paid to Tina is not a deductible expense of the corporation. The excess salary paid Tina is taxed as a dividend payment. The salary paid to her 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 Tina. Then, Tina 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.
Example 25 Paula buys Colleen's advertising agency. As part of the purchase price, she pays Colleen $12,000 not to open another advertising agency in the area for 3 years. Can Paula deduct the $12,000 as a current business expense?
Discussion: The $12,000 payment (known as a covenant not to compete) will benefit Paula's business for 3 years by not having Colleen as a competitor during that period. Thus, the benefit of the payment extends substantially beyond the end of the tax year and must be capitalized and amortized as an intangible asset
Example 21 Buster, Inc., is a women's clothing store in Fashion City. One day a year, the company pays $500 to publish a full-page advertisement in the town newspaper to announce its annual clothing sale. Is the cost of the advertisement deductible?
Discussion: The $500 paid for the sale advertisement is deductible. The expense satisfies both the ordinary and necessary tests. It is customary for clothing retailers to advertise their merchandise. In addition, the advertisement helps the business because it both promotes the store to the public and attracts the attention of customers, and gives them an incentive to shop at the store—to take advantage of the sale prices.
Example 10 Brendan works weekdays as a nurse at a local hospital that is 14 miles from his home. He also works as a waiter at a restaurant 2 nights during the week and on weekends. The weeknights he works at the restaurant, he leaves directly from the hospital. The restaurant is 6 miles from the hospital and 8 miles from his home. What portion of Brendan's travel is considered business-related?
Discussion: The 14 miles (28 miles round-trip) from Brendan's home to the hospital are commuting and considered personal. The 6 miles from the hospital to the restaurant are business, and the 8 miles from the restaurant to his home are personal. The mileage to and from the restaurant on the weekend is considered personal because Brendan did not work at his regular job. NOTE: If during the week, Brendan went home before going to the restaurant, his business miles would be limited to his normal travel distance (6 miles).
Example 51 Teresa is the sole proprietor of a carpet-cleaning business. During the current year, she has gross income from the business of $93,000 and allowable expenses of $36,000. How should this information be reported on her return?
Discussion: The allowable trade or business expenses are netted separately against the gross income, resulting in trade or business income of $57,000. In calculating taxable income, the $57,000 in trade or business income is reported as gross income.
Example 26 Connie purchases 100 shares of Calvinator Corporation stock for $100 per share. She also pays a commission on the purchase of $400. What is the basis of the 100 shares of stock?
Discussion: The basis of the stock is the cost of obtaining it. Because the commission is part of the cost of acquiring the stock, it is added to basis; commissions are not current period expenses. Therefore, the cost of the 100 shares of stock is $10,400 [(100 x $100) + $400].
Example 23 Horace is a full-time student in computer science at State University. He works part-time as a programmer for a software developer. His employer has promised him a full-time job after he graduates. Can Horace deduct the cost of his college courses as an education expense?
Discussion: The cost of Horace's college courses is not deductible. Although his courses are related to his job, he is not considered to be engaged in a trade or business because he is working only part-time. In essence, the college degree provides Horace with the qualifications needed to enter a new trade or business.
Example 21 Juan is a lawyer for a local law firm. State law requires that he attend 40 hours of continuing education each year, at least 8 hours of which must be on ethics. Juan attends 4 seminars (8 hours each) on estate taxes and an 8-hour seminar on ethics. The tuition for the 4 seminars came to $1,200; the ethics seminar cost $250. Can Juan deduct the cost of the continuing education seminars?
Discussion: The cost of all the continuing education seminars is deductible as a miscellaneous itemized 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.
Example 5 Marisa is a partner in an advertising firm. The firm leases an 8-seat skybox at a baseball stadium for $162,000 a season ($2,000 per game). The price includes 8 tickets to each game. After a presentation to a potential client, Marisa and 2 other partners of the firm entertain 5 representatives of the prospective client at the firm's skybox. The fair market value of the most expensive nonluxury seat at the stadium is $40. The company spends $150 on food and drinks. How much of the entertainment costs can the firm deduct?
Discussion: The cost of entertaining is deductible because it followed a business meeting. Although no portion of the skybox fee is deductible, the firm can deduct $235 as entertainment expense. The firm can deduct $75 ($150 x 50%) for food and drinks and $160 for the tickets [(8 x $40 = $320) x 50%]. NOTE: If the firm had entertained only 3 representatives from the firm (and used 6 tickets), it can still deduct the cost of all 8 tickets.
Example 3 Jane owns and operates a business that makes bridal gowns and accessories. She invites 20 of her best customers to her plant for a business meeting. The business meeting and a tour of her plant take most of the day. She has lunch for her customers catered at the plant so she can show them her new products. To conclude the day, Jane takes her husband, customers, and their spouses to dinner. Is the cost of the dinner a deductible "associated with" entertainment expense?
Discussion: The cost of the lunches for her customers qualifies as an expense directly related to doing business. The amount spent for the dinner qualifies as an expense "associated with" business because the dinner directly followed the substantial business discussion. The cost of the entertainment of the spouses also qualifies because there is a clear business purpose for their presence. If they were not there, the customers might not be either. It is appropriate for Jane's husband to attend because the customers had their spouses present. Thus, Jane can deduct 50% of the meal and entertainment expense.
Example 7 Vanessa is an audit partner in a public accounting firm. Once a month, she has dinner with two of her college roommates who are audit partners in other firms. The three alternate picking up the check. Although the conversation often begins with personal issues, inevitably most of the discussion is business. Vanessa has saved the receipts, totaling $275, from the dinners. Do the dinners qualify as valid entertainment expenses?
Discussion: The dinners fail both the directly related test (no expectation of future profits) and the associated with test (no valid business purpose). The predominant motive for the dinner is personal. Vanessa cannot deduct the $275 as entertainment expense. In essence, the three are engaging in reciprocal entertaining.
Example 1 George is a funeral director in Saline City. While attending a convention of funeral directors in Orlando, he rents a hospitality room for one evening and provides snacks and beverages. Use of the hospitality room gives him the opportunity to meet with other funeral directors and major suppliers of funeral products to discuss business. Can George deduct the cost of the hospitality room and the snacks and beverages as a business expense?
Discussion: The entertainment clearly takes place in a business setting and is for a direct business purpose. George can deduct 50% of his entertainment expense related to the hospitality room.
Example 19 Sam operates a retail store. To show his appreciation for the business of his 5 best customers, he sends candy to their spouses at their homes. The candy costs Sam $45 for each box. How much of the cost can he deduct as a business gift?
Discussion: The gift of the candy to the spouse is an indirect gift to the customer. The $20 cost per box in excess of the annual donee limit is not deductible. Sam's deduction is limited to $125 (5 gifts at $25 each).
Example 48 Salvadore is being sued by a client who fell in his store and hurt himself. Salvadore spends $5,000 in legal fees to defend his business against his customer's claims. Can Salvadore deduct the legal fees?
Discussion: The legal fees originated in Salvadore's business. Because the fees are an ordinary and necessary expense of doing business, Salvadore may deduct the $5,000 in legal expenses.
Example 4 Miranda is a public accountant and is required by state law to have a license to practice public accounting. When the state license renewal fee comes due, Miranda is short of money and cannot renew her license. Miranda's mother pays the license renewal fee for her so she can continue working as a public accountant. Can Miranda deduct the fee as a business expense?
Discussion: The license renewal fee is Miranda's business expense, and only she can deduct the payment of the fee. Because Miranda does not pay the license renewal fee, she is not allowed a deduction for the business expense. Because the license renewal fee is not Miranda's mother's expense, her mother cannot deduct the payment of the expense. Based on these facts, neither Miranda nor her mother can deduct the payment of the license renewal fee. Note that the bad tax result here can be avoided if Miranda's mother either gifts or makes a valid loan to Miranda of the money necessary to pay the licensing fee and Miranda makes the payment from her own funds.
Example 19 Gustav Brothers, 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?
Discussion: The machine is to be used to earn income during several tax years. As a result, its cost must be capitalized and allocated to the years benefited by the use of the machine. The deductions allowed for depreciation are discussed in Chapter 10
Example 18 The Russo Company, which raises hogs, enters into a contract with the local feed mill to buy hog feed. Under the terms of the agreement, Russo agrees to purchase a quantity of grain and pay for it in advance. The mill agrees to deliver the feed as needed and to charge the deliveries against Russo's advance payment at the lower of the market price on delivery or the maximum price in the contract. Is the advance payment for the hog feed an ordinary expense?
Discussion: The payment for the grain qualifies as an ordinary expense. The advance purchase of the grain for feeding livestock is the normal way farmers conduct their business. By ensuring that the grain is available, Russo can better plan the scope of its farm operations for the coming month
Example 46 Assume that in example 45, the sales price of the building is $86,000. As part of the sales agreement, the buyer agrees to pay Leslie's share of the property taxes for 2017. Is Leslie allowed a deduction for property taxes on the building for 2017?
Discussion: The payment of another's expense in a business setting is considered income for the entity for which the expense is being paid. Therefore, the payment of Leslie's $2,700 share of the property taxes must be included as part of the sales price of the building. Leslie is deemed to have received $88,700 for the building and to have paid $2,700 in property taxes. Each party to a real estate transaction must always recognize its share of the property taxes, regardless of which party actually pays the tax.
Example 47 The town of Guthrie imposes a special real estate tax assessment to put in new streets. Leslie Corporation has to pay $15,000 as its share of the new streets in front of its warehouse. What is Leslie's deduction for the $15,000 special property tax assessment it pays in 2017?
Discussion: The special assessment for installing streets is deemed to increase the value of Leslie's property. As a result, the special assessment is added to Leslie's basis in the land. Thus, the $15,000 tax payment is not currently deductible. When Leslie disposes of the property, the capital recovery concept permits the capitalized tax to be deducted against the amount received on the sale of the property.
Example 2 Claudia opens a new medical clinic. To publicize the clinic, she holds a grand opening and invites community leaders and business people to attend. At the open house, she serves food and beverages. Can Claudia deduct the cost of the grand opening as a business expense?
Discussion: There is a clear business purpose for the entertainment expense. Because there was no meaningful personal or social relationship between Claudia and the people she entertained, 50% of the expense is allowed as a deduction.
Example 5 Jennifer owns a dress shop. During the current year, she incurs $43,000 in valid expenses related to the dress shop. In addition, Jennifer incurs $6,000 in expenses related to production-of-income activities. If Jennifer's adjusted gross income is $83,000 without considering either of these expenses, how much expense can she deduct?
Discussion: Trade or business expenses are deductions for adjusted gross income. The $43,000 in trade or business expenses reduces her adjusted gross income to $40,000 ($83,000 - $43,000). Production-of-income expenses are deductible as misc. itemized deductions, subject to the 2% of adjusted gross income limitation. Therefore, Jennifer is allowed to deduct only $5,200 [$6,000 - ($40,000 x 2%)] of the production-of-income expenses. Note another advantage of the deductions for adjusted gross income: By reducing adjusted gross income, the amount of any deduction from adjusted gross income that is subject to a limitation increases. In this case, the $43,000 in business expenses allows Jennifer an extra $860 ($43,000 x 2%) deduction of her production- of-income expenses. Thus, correct classification of a deduction as for adjusted gross income or from adjusted gross income is critical in the calculation of an individual's taxable income. Example 6 The Hackett Group (HG), a partnership, operates a management consulting firm; it consists of three equal partners, Mark, Nancy, and Ahmed. HG's taxable income for the year is $255,000, consisting of the following: Sales Rev 1,500,000 Short term capital gains 27,000 Trade and business expenses (1,260,000) Investment expenses (12,000) Taxable income 255,000 How must the Hackett Group report its results to Mark, Nancy, and Ahmed for tax purposes? Discussion: Because the Hackett Group must report each partner's share of short- term capital gain and investment expenses, the Hackett Group cannot divide the partnership's taxable income of $255,000 equally and report ordinary taxable income of $85,000 ($255,000 / 3) to each partner. Rather, the Hackett Group uses only the partnership's sales revenue and business expenses to calculate the ordinary taxable income for each partner. As a result, each partner's share of the ordinary taxable income is $80,000 [($1,500,000 - $1,260,000 = $240,000) / 3]. The Hackett Group must report to each partner $9,000 ($27,000 / 3) of short-term capital gain and $4,000 ($12,000 / 3) of investment expenses. Because investment expenses must be reduced by 2 percent of adjusted gross income, investment expenses are not included in calculating the conduit's ordinary taxable income or loss. Otherwise, each partner is able to deduct the full amount of the investment expenses.
Example 28 Sylvia operates a successful consulting practice. During January 2017, she performs $5,000 in services for clients who still owe her as of December 31, 2018. She reviews her client files and determines that $3,000 in receivables is uncollectible. How much of a deduction is Sylvia allowed if she uses the accrual basis of accounting?
Discussion: Using the accrual method of accounting, Sylvia would report $5,000 in income from the receivables in 2017. Because the income is reported on the accrual basis as it is earned, she has a $5,000 basis for the accounts receivable. In 2018, she can take a $3,000 bad debt deduction for the uncollectible accounts. The net result is that Sylvia's taxable income from these accounts is $2,000 for the 2-year period.
Example 29 Assume the same facts as in example 28, except that Sylvia uses the cash basis of accounting.
Discussion: Using the cash method of accounting, Sylvia has not reported income from the receivables because they have not been collected. Therefore, she has no basis in the receivables and is not allowed a deduction. She reports $2,000 in taxable income when she receives cash from the collectible accounts. Note that this treatment gives Sylvia the same $2,000 in income that is reported on the accrual basis.
Example 30 Raquel Corporation owns and operates a furniture store. Because it has inventory, Raquel uses the accrual method of accounting. At the end of 2017, its accounts receivable total $75,000. Based on a review of the individual accounts, Raquel identifies $2,500 worth of accounts as uncollectible. For financial accounting purposes, Raquel's accountant estimates that $4,500 of its 2017 sales ultimately are uncollectible. How much can Raquel Corporation deduct on its 2017 tax return for bad debts?
Discussion: Using the specific charge-off method, Raquel Corporation may deduct only the $2,500 in bad debts identified as uncollectible. The allowance method of accounting for bad debts, which is used for financial reporting, is not generally allowed for tax purposes.
Example 4 Randall wants to entertain a client after a valid business meeting by taking her to a basketball game. However, the game is sold out. He is able to locate an associate who will sell him tickets for $50 each. The face amount printed on the ticket is $15. How much of the cost can Randall deduct?
Example 4 Randall wants to entertain a client after a valid business meeting by taking her to a basketball game. However, the game is sold out. He is able to locate an associate who will sell him tickets for $50 each. The face amount printed on the ticket is $15. How much of the cost can Randall deduct?
