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Chapter 7 Overview of Deductions and Losses Deductions Authorized by General Sections of the IRC Positive Criteria (general allowance of ded.): Sec. 162: Expenses of carrying on a T/B Sec. 212: Expenses for production of income Sec. 165: Losses Sec. 172: NOL

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deductions authorized by general sections of the irc
Deductions Authorized by General Sections of the IRC
  • Positive Criteria (general allowance of ded.):
    • Sec. 162: Expenses of carrying on a T/B
    • Sec. 212: Expenses for production of income
    • Sec. 165: Losses
    • Sec. 172: NOL
  • Negative Criteria (general disallowance of ded.):
    • Sec. 262: Personal, living and family expenses, page 25
    • Sec. 263: Capital expenditures
    • Sec. 265: Expenses & interest relating to tax exempt income - Example 40
    • Sec. 162: expenses contrary to public policy Examples 35, 36, 37, 38, 39
trade or business expenses vs expenses for the production of income
Trade or Business Expenses vs. Expenses for the Production of Income
  • Sec. 162 Requirements:
    • T/B Related:
      • Intention to make a profit
      • Entrepreneurial/personal effort required
      • No hobbies
    • Ordinary and Necessary
    • Reasonable in amount
    • Paid/incurred during the year
trade or business expenses vs expenses for the production of income4
Trade or Business Expenses vs. Expenses for the Production of Income
  • Sec. 212 Requirements:
    • For production of income or
      • for management of property held for production of income or
      • in connection with the determination, collection or refund of any tax
    • Ordinary and necessary
      • “reasonable” is implied
    • Entrepreneurial/personal effort not required
    • Paid/incurred during the year
  • Why bother with the distinction?
    • Deductibility for/from AGI
    • Limitations
deductible for or from agi
Deductible FOR or FROM AGI
  • History of IR Code Sec. 62
  • Significance of classification FOR or FROM AGI
    • Deductions FOR AGI are deductible even if TP doesn’t itemize
    • Itemized deductions are deducted FROM AGI only if they exceed the standard deduction
      • If itemized deductions < standard deduction, does the TP “lose” the deduction?
      • Pages 17 - 20
deductible for or from agi6
Deductible FOR or FROM AGI
  • AGI is used as a base to limit several FROM AGI deductions

EXAMPLES

Casualties

Medical Expenses

  • Many states use AGI as a starting point to determine state income taxes
deductible for agi
Deductible FOR AGI
  • Business Expenses (Sec. 162)
  • Rental Expenses (Sec. 212)
  • Alimony Paid
  • Gains and losses on property dispositions
  • Deductible contributions to tax deferred plans - IRAs, Keogh Plans, etc.
  • Reimbursed employee business expenses (if included in income)
  • Expenses incurred by a qualified performing artist
  • Moving expenses
  • Interest paid on student loans beginning in 1998
  • Others
deductible from agi
Deductible FROM AGI
  • Personal Itemized Deductions
    • Medical and dental
    • Some taxes
    • Some interest
    • Charitable contributions
    • Casualties and thefts
    • Miscellaneous deductions not subject to 2% floor
      • Gambling losses to extent of gambling winnings (Sec. 165(d))
      • Job expenses of handicapped
      • Amortizable bond premiums
    • Miscellaneous deductions subject to 2% floor
miscellaneous itemized deductions subject to 2 of agi limitation
Miscellaneous Itemized Deductions Subject to 2% of AGI Limitation
  • Employee Business Expenses
    • Dues to professional societies
    • Employment-related educational expenses
    • Job hunting expenses, including agency fees, resumes, etc.
    • Home office expenses
    • Outside salesperson expenses
    • Travel expenses
    • Transportation expenses
    • Subscriptions to professional journals and magazines
    • Work clothes and uniforms
    • Union dues and fees
    • 50% of unreimbursed business entertainment expenses
miscellaneous itemized deductions subject to 2 of agi limitation10
Miscellaneous Itemized Deductions Subject to 2% of AGI Limitation
  • Expenses for the Production of Income
    • Legal and accounting fees
    • Custodial fees related to income-producing property
    • IRA fees
    • Fees paid to collect interest or dividends
    • Hobby expenses (limited to hobby income)
    • Investment counsel fees
    • Rental cost of safe deposit boxes used to store non-tax-exempt securities
miscellaneous itemized deductions subject to 2 of agi limitation11
Miscellaneous Itemized Deductions Subject to 2% of AGI Limitation
  • Other Miscellaneous Itemized Deductions
    • Fees paid for investment counsel
    • Tax counsel and assistance
    • Cost of tax services, periodicals, return preparation manuals
    • Appraisal fees establishing a casualty loss or charitable contribution
example of the 2 limitation
Example of the 2% Limitation
  • AGI = $25,000
  • Potential Miscellaneous Itemized Deduction = $800
  • 25,000 X 2% = 500 (“2% floor”)
  • 800 - 500 limit = 300 misc. itemized deduction
deductions for losses
Deductions for Losses
  • Losses on personal use assets are deductible only if attributable to a casualty or theft
  • Individuals may deduct losses incurred in a
    • trade or business or
    • transaction entered into for profit
  • Events which trigger realization of gain or loss:
    • sale
    • abandonment
    • exchange
    • casualty or theft
    • involuntary conversion
tax accounting methods for expenditures
Tax Accounting Methods for Expenditures
  • Cash Basis:
    • Generally, recognize income when payments are received, recognize expenses when paid.
  • Modification to Cash Basis Reporting for Expenditures:
    • Generally, cash basis TPs may deduct currently prepayments made for assets if:
      • Business purpose for prepayment
      • Asset will be consumed before end of next year
      • Income will not be materially distorted
    • Accrual method must be used for sales and COGS when inventories are income producing
more modifications to cash basis reporting for expenditures
More Modifications to Cash Basis Reporting for Expenditures
  • Prepayments for Rent & Services: deduct only when:
    • Prepayments are for 1 year or less and
    • TP is obligated legally to prepay
  • Prepaid Insurance: always accrue
  • Prepaid Interest: accrue only

Except for “points” paid for loan on personal residence.

more modifications to cash basis reporting for expenditures16
More Modifications to Cash Basis Reporting for Expenditures
  • Points paid on personal residence mortgages
    • Definition of “Points”
  • Prepaid points incurred to secure a loan on a principle residence are deductible currently if:
    • Paid by the buyer or seller
    • They are not withheld from loan proceeds, i.e. they are paid from a separate fund.
  • If points paid for refinancing, accrue the deductions
tax accounting methods for expenditures17
Tax Accounting Methods for Expenditures
  • Accrual Basis Reporting:
    • Generally recognize income when earned and expenses when incurred
  • Modifications to Accrual Basis:
    • To deduct an expense, 2 things must be satisfied
      • All events test must be satisfied
        • All events which legally fix liability have occurred and
        • liability can be estimated with reasonable accuracy
      • And “Economic performance” must have occurred

Example: Warranties, contingent liabilities may not be accrued unless there is reasonable basis to estimate the amount

tax accounting methods for expenditures18
Tax Accounting Methods for Expenditures
  • “Economic Performance”
  • When TP provides goods or services
    • Economic performance occurs when the TP provides the goods or services
  • When TP receives goods or services
    • Economic performance occurs when TP receives goods or services, or uses the property in the case of rentals
    • Exhibit 7-1
exception to economic performance requirement
Exception to Economic Performance Requirement
  • If “economic performance” has not occurred but will occur within 8 1/2 months of end of period and
  • Expense is of reoccurring nature and
  • TP consistently accrues the item and
  • Accruing results in a better match against revenue, then ok to accrue
  • Example 17

Example: One-time payment in November for snow removal for season, may be accrued.

common law factors that indicate control irs
Self-employed v. Employee

Instructions

Integration*

Training

Services rendered personally

Hiring, supervising, and paying assistants

Continuing relationship

Employer-defined hours of work

Full-time required

Doing work on the employer’s premises

Setting the order or sequence of work

Self-employed v. Employee

Oral or written reports required

Payment by the hour, week, month*

Payment of business or travel expense

Furnishing of tools, materials

Significant investment*

Realization of profits or loss

Working for more than one firm at a time

Making services available to the general public

Right to discharge*

Right to terminate*

Common Law Factors That Indicate “Control” (IRS)
disallowance of losses on transactions between related parties sec 267 b
Disallowance of Losses on Transactions Between Related Parties -- Sec. 267(b)
  • “Related parties under Sec. 267(b)
    • lineal antecedents and descendants
    • brothers and sisters
    • spouses
    • TP and his/her corporation or P/S if the TP owns > 50% directly or indirectly
    • Estates and their beneficiaries - Examples 44, 45, 46

RULE

Losses are disallowed between related parties. But, disallowed losses may be used to offset gains on a subsequent sale to an unrelated party.

disallowance of losses on transactions between related parties sec 267 b22

FMV = 20

Basis = 30

(10)

FMV = 35

Basis = 20

asset

Disallowance of Losses on Transactions Between Related Parties -- Sec. 267(b)

Example:

Father (F) sells Daughter (D) an antique asset

realized loss, not recognized

Later, D sells the asset to an unrelated party

15 realized gain

(10) F’s previously disallowed loss

5 gain recognized by D

limitation on deduction for executive compensation
Limitation on Deduction for Executive Compensation
  • Publicly held corporations may deduct maximum of $1,000,000 of “compensation” to certain employees.
  • “Publicly Held Corporations”
    • Listed on a national securities exchange and
    • At least $5,000,000 in assets and
    • At least 500 shareholders
  • Covered Employees
    • CEO plus
    • Any of four most highly paid officers
  • “Applicable Employee Remuneration”
    • Includes: Cash and benefits
    • Excludes: Commissions; performance related pay if approved by shareholders; payment to a qualified retirement plan
repairs vs improvements
Repairs vs. Improvements
  • Tax Treatment:
    • Deduct repair expenses currently
    • Capitalize improvements (a.k.a. betterments)
  • Distinguishing between repairs and improvements
    • Improvements: Any expenditure for a property that
      • Materially increases its value, or
      • Materially prolongs its life, or
      • Changes its use for the taxpayer
    • Repairs: expenditures that are not improvements
      • Examples
      • Pages 26, 27, 28
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