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Module 9 . Business Deductions. Module Topics. Statutory Scheme for Deductions §162 Business Deductions: The Basic Requirements Prohibited Deductions Deductions Common to Most Businesses Special Deductions for Corporations Capitalization Issues. Statutory Scheme for Deductions.

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Module 9

Business Deductions

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Module Topics

  • Statutory Scheme for Deductions

  • §162 Business Deductions: The Basic Requirements

  • Prohibited Deductions

  • Deductions Common to Most Businesses

  • Special Deductions for Corporations

  • Capitalization Issues

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Statutory Scheme for Deductions

Key Learning Objective

  • Apply the three-tier expense deduction classification scheme

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Tax Concept

  • No expenditure is deductible unless allowed by a provision in the tax law

    • Specifically authorized by the Code, or

    • Satisfies general criteria

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General Criteria for Deductibility

  • Expense must be:

    • Ordinary, necessary, and reasonable in amount

    • Incurred in connection with a trade or business or in the production of income

  • Expense is not:

    • A capital expenditure

    • A personal expenditure

    • Related to tax-exempt income

    • Contrary to public policy

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Deduction Classification Scheme

  • Trade or business deductions--§162

  • Production of income deductions--§212

  • Statutory personal deductions

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Trade or Business Deductions(§162)

  • Must be ordinary and necessary and reasonable in amount

  • Profit must be primary motive of the activity

    • Net loss from “hobby” not deductible

  • Activity must be ongoing and entrepreneurial in nature

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Production of Income Deductions (§212)

  • Must be ordinary and necessary and reasonable in amount

  • Must be for the:

    • Production or collection of income

    • Management, conservation, or maintenance of property held for the production of income

    • Determination, collection, or refund of any tax

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Statutory Personal Deductions

  • §262 disallows the deduction of personal, living, or family expenses

  • Other Code sections allow deductions for specific items

    • e.g., medical expenses, charitable contributions, mortgage interest, state and local income taxes, property taxes (Module 27)

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§162 Business Deductions: The Basic Requirements

Key Learning Objective

  • Apply the ordinary, necessary, and reasonableness requirements for business deductions

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Basic Requirements

  • Ordinary

    • Acceptable, given the circumstances

  • Necessary

    • Appropriate when incurred

  • Reasonable

    • Not lavish

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Research Query: Political Office-A Trade or Business?

  • A senator's administrative assistant incurred expenses of more than $100,000 over a four- year period despite the fact his salary had been only $1,200 a year

  • Should he be allowed to deduct these as ordinary and necessary business expenses?

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Solution--Research Query: Political Office-ATrade/BusinessFrank, Gerald v. U.S., (1978, CA9) 42 AFTR 2d 78-5309

  • Performing functions of public office is a trade or business

  • No requirement that a public employee intends to earn a livelihood from his government job in order to deduct his expenses

  • Deductions were allowed

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Paid or Incurred Requirement

  • Cash-basis taxpayers

    • Expenses deductible when paid

    • Prepayments extending beyond one year generally must be accrued

  • Accrual-basis taxpayers

    • Expenses deductible when incurred

    • All-events test

    • Economic performance test

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Prohibited Deductions

Key Learning Objective

  • Distinguish between allowable deductions and those which are prohibited

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Prohibited Deductions

  • Expenditures in violation of public policy

    • Are fines, penalties, illegal bribes, etc.

  • Lobbying expenses

    • Influence legislation, public opinion, or political elections at the state or national level

  • Expenditures associated with tax-exempt income

    • Prevents arbitrage

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Compliance Query: Which Illegal Business is Best?

  • T operates an illegal smuggling operation

  • T incurred the following expenses:

    Salaries $ 50,000

    Illegal kickbacks 20,000

    Bribes to U. S. border guards 25,000

    Cost of goods sold 150,000

  • How much is deductible if T smuggles

    • Guns

    • Drugs

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Gun smuggler--treated like any other business.

Cost of goods

sold $150,000

Salaries 50,000


Other items against public policy

Drug smuggler--limited to cost of goods sold.

Cost of goods

sold $150,000


Solution--Compliance Query: Which Illegal Business is Best?

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Deductions Common to Most Businesses

Key Learning Objective

  • Identify and compute common business deductions

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Deferred Compensation-- Potential Benefits

  • Immediate deduction for employer

  • Nontaxable to employee until payments are received

  • Deferral of tax on earnings until funds are distributed

  • Reduced or deferred tax on lump-sum distributions

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Deferred Compensation--Types(covered in later modules)

  • Qualified pension plans

  • Nonqualified plans

    • Fewer potential benefits

  • Keogh plans

  • SEPs

  • IRAs

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  • Generally deductible if business related

  • Must capitalize construction period interest and taxes

  • Prepaid interest must be accrued

  • Related party borrowings

    • Accrual-basis payer and cash-basis payee

  • Imputed interest

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  • Generally deductible if business related

  • Sales taxes capitalized as part of cost

  • Employer portion of payroll taxes deductible

  • Federal income taxes not deductible

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Charitable Contributions

  • Deductible by corporations subject to 10% limit

    • 5-year carryover for unused deductions

  • Amount deductible (basis or FMV) depends on type of property donated

    • “Ordinary income” or “capital gain” property

    • Special rules for certain inventory, scientific equipment, and tangible personal property

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Business Gifts

  • Limited to $25 per donee per year

  • Special rules for safety or length of service awards to employees

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  • Generally deductible if business related

  • Includes incidental expenses

  • “Away from home” requirement for meals and lodging

    • 50% limit for meals

  • Strict substantiation requirements

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Research Query: Where is a Traveling Man’s Home?

  • An unmarried salesman who spends almost all of his time on the road keeps some stuff at his sister’s home.

  • Will be be treated as “away from home” and entitled to deduct travel expenses if

    • He pays his sister a fair rent for the room?

    • He has free use of the room?

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Solution--Research Query: A Traveling Man’s Tax Home

  • He is “away from home” and entitled to deduct travel expenses if he rents a room in his sister's home to use whenever he wants to and he pays his sister.

  • Sapson, Irving, (1968) 49 TC 636, acq(1973) 1973-2 CB 3 39

  • IRS doesn't allow “away from home” treatment if the salesman pays no rent

    • Rev Rul 73-529, 1973-2 CB 37

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  • Deductible if “directly related to” or “associated with” active conduct of business

  • 50% limit

  • Cost of entertainment facilities generally not deductible

  • No deduction for club membership dues

  • Strict substantiation requirements

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Special Deductions for Corporations

Key Learning Objective

  • Calculate deductions for corporate organizational costs and dividends received

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Organization Costs

  • Includes first year attorney, accountant, and filing fees, etc., related to corporate formation

  • Does not include costs of issuing stock

  • Not currently deductible

  • Can capitalize and amortize over 60 months

    • Must make election

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Dividend Received Deduction

  • Mitigates triple taxation

  • Applies generally to dividends from domestic corporations

  • Percent deductible (70%; 80%; 100%) depends on ownership percentage

  • Taxable income limitation may apply

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Capitalization Issues

Key Learning Objective

  • Classify expenditures that contain both repair and capitalization attributes

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  • Deductible repair or capital expenditure?

    • Not always clear-cut

  • The Indopco decision

    • Creation of a separate asset is not a necessary condition for capitalization

    • Future benefit key factor for capitalization

  • Environmental cleanup costs

    • Present or future benefit?

    • Generally must capitalize

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Research Query:Capital Expenditure or Repair?

  • The taxpayer’s road has several potholes. What are the tax consequences of each of the following alternatives?

  • Replacing gravel driveway with a cement driveway

  • Recrowning and resurfacing with the same materials

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Solution--Research Query: Capital Expenditure or Repair?

  • Replacing gravel driveway with a cement driveway will be treated as a capital expenditure.

    • Jones, A. Raymond, (1956) 25 TC 1100

  • Recrowning and resurfacing with the same materials should be a deductible repair.

    • Pennock Plantation Inc, (1951) PH TCM ¶51341