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Chapter 5

Chapter 5. Business Deductions. The Big Picture (slide 1 of 4). Sid Stevens operates his business as a C corporation with a December 31 year-end, uses the accrual method of accounting, and has $485,500 of gross income.

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Chapter 5

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  1. Chapter 5 Business Deductions

  2. The Big Picture (slide 1 of 4) Sid Stevens operates his business as a C corporation with a December 31 year-end, uses the accrual method of accounting, and has $485,500 of gross income. Stevens owns 80% of the corporation’s stock, while his wife, Kathleen, and his mother, Terry, each own 10% of the stock. Sid is a full-time employee at his business. His mother helps out with the books for about two hours a week. At this time, Kathleen does not work at the business. 2

  3. The Big Picture (slide 2 of 4) Sid Stevens reports the following expense information from his small engine service and repair business. Salaries and wages (including Sid’s salary of $55,000 and Terry’s salary of $3,000) $150,000 Building rent 24,000 Depreciation of machinery, equipment, and office furnishings* 18,000 Insurance (coverage for machinery, equipment, and office furnishings) 12,000 Utilities 12,000 Taxes and licenses 6,000 Advertising 3,000 Interest expense on loan to buy new machinery 6,000 Charitable contributions 3,000 Political contributions 2,000 *$180,000 of new machinery and equipment were purchased in January 2011. The financial reporting system depreciation is based on straight-line depreciation over 10 years. The MACRS cost recovery period for tax purposes is 7 years. 3

  4. The Big Picture (slide 3 of 4) Sid would like to know the amount of his deductible expenses for tax purposes and would like your advice on another matter. Because his business has been very profitable over the years, it has built up large cash reserves, and its cash flow continues to be strong. His business has never paid any dividends to the shareholders. For next year, he is considering paying himself a salary of $110,000 and his mother a salary of $30,000. This would give them more cash to spend for planned vacations and home improvements. 4

  5. The Big Picture (slide 4 of 4) Finally, during the current year, Sid purchased another personal residence for $300,000 and converted his original residence to rental property. He also purchased a condo for $170,000 near his business, which he will rent out to tenants. Read the chapter and formulate your response. 5

  6. Trade or Business Deductions (slide 1 of 2) • Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including: • Reasonable salaries paid for services • Expenses for the use of business property • One-half of self-employment taxes paid • Such expenses are deducted for AGI

  7. Trade or Business Deductions (slide 2 of 2) • In order for expenses to be deductible, they must be: • Ordinary: normal, usual, or customary for others in similar business, and not capital in nature • Necessary: prudent businessperson would incur same expense • Reasonable: question of fact • Incurred in conduct of business

  8. The Big Picture - Example 3Ordinary and Necessary Requirement Return to the facts of The Big Picture on p. 5-2. The business, a closely held C corp, is owned by Sid Stevens, his wife, Kathleen, and his mother, Terry. The company has been highly profitable. It has never paid dividends. Sid is the key employee of the business. His mother plays a very minor role. Assume their current salaries of $55,000 and $3,000 are comparable to what they could earn at similar companies for the work they do. 8

  9. The Big Picture - Example 3Ordinary and Necessary Requirement If Mr. Stevens’s plan to double his salary and increase his mother’s salary by tenfold is implemented, the amounts in excess of their current salaries may be deemed unreasonable. If so, the excess would be disallowed as deductible salary. The disallowed amounts would then be treated as dividends rather than salary income to Sid and Terry. Salaries are deductible by the corporation, but dividends are not (see Chapter 10). 9

  10. Methods of Accounting • The method of accounting affects when deductions are taken • Cash: expenses are deductible only when paid • Accrual: expenses are deductible when incurred • Apply the all events test and the economic performance test • Exception to the economic performance test for recurring items

  11. Disallowance Possibilities • The tax law disallows the deduction of certain types of expenses for a variety of reasons • e.g., May restrict taxpayer attempts to deduct certain items that, in reality, are personal expenditures • Certain disallowance provisions are a codification or extension of prior court decisions • e.g., After courts denied deductions for payments in violation of public policy, tax law was changed to provide specific authority for the disallowance

  12. Expenditures Contrary To Public Policy • Deductions are disallowed for certain specific types of expenditures that are considered contrary to public policy • Examples: penalties, fines, illegal bribes or kickbacks, two-thirds of treble damage payments for violation of anti-trust law

  13. Legal Expenses Incurred In Defense Of Civil Or Criminal Penalties • To deduct legal expenses • Must be directly related to a trade or business, an income producing activity, or the determination, collection, or refund of a tax • e.g., Corporate officer’s legal fees in defending against price-fixing charges • e.g., Landlord’s legal fees associated with eviction of tenant

  14. Expenses Relating To An Illegal Business • Usual expenses of operating an illegal business are deductible • However, deduction for fines, bribes to public officials, illegal kickbacks, and other illegal payments are disallowed • Trafficking in controlled substances: only cost of goods sold can reduce gross income

  15. Political Contributions And Lobbying Activities • Generally, no business deduction is allowed for payments made for political purposes or for lobbying • Exceptions are allowed for lobbying: • To influence local legislation, • To monitor legislation, and • De minimis in-house expenses (limited to $2,000) • If greater than $2,000, none can be deducted

  16. Excessive Executive Compensation (slide 1 of 2) • For publicly held corporations: • Deduction for compensation of CEO and four other highest compensated officers is limited to $1 million each • Does not include: • Certain performance-based compensation • Payments to qualified retirement plans • Payments excludible from gross income

  17. Excessive Executive Compensation (slide 2 of 2) An additional limitation applies only to covered executives of companies receiving Troubled Asset Relief Program (TARP) assistance The deduction for compensation paid to a covered executive is limited to $500,000 Covered employees include the CEO, the CFO, and the three other most highly compensated officers 17

  18. Investigation Of A Business(slide 1 of 3) • Investigation expenses - incurred to determine the feasibility of entering a new business or expanding an existing business • Include costs such as travel, engineering, architectural surveys, marketing reports, various legal and accounting services • Tax treatment of these expenses depends on: • The current business, if any, of the taxpayer • The nature of the business being investigated • The extent to which the investigation has proceeded • Whether or not the acquisition actually takes place

  19. Investigation Of A Business(slide 2 of 3) • If the taxpayer is in a business the same as or similar to that being investigated • Investigation expenses are deductible in the year paid or incurred • The tax result is the same whether or not the taxpayer acquires the business being investigated

  20. Investigation Of A Business(slide 3 of 3) • When the taxpayer is not in a business the same as or similar to that being investigated • Tax result depends on whether new business is acquired • If not acquired • All investigation expenses generally are nondeductible • If acquired • Investigation expenses must be capitalized • May elect to deduct the first $5,000 of expenses currently • Any excess expenses can be amortized over a period of not less than 180 months (15 years) • In arriving at the $5,000 immediate deduction allowed, a dollar-for-dollar reduction must be made for those expenses in excess of $50,000

  21. The Big Picture - Example 14Investigation Of A Business Return to the facts of The Big Picture on p. 5-2. Mr. Steven’s mother, Terry, an accrual basis sole proprietor, owns and operates three motels in Georgia. In the current year, Terry incurs expenses of $8,500 in investigating the possibility of acquiring several additional motels located in South Carolina. The $8,500 is deductible in the current year whether or not Terry acquires the motels in South Carolina. 21

  22. Capital Expenditures • Amounts are capitalized • Asset may be subject to depreciation (or cost recovery), amortization, or depletion

  23. Transactions Between Related Parties (slide 1 of 2) • Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties • Family and entity relationships apply • Constructive ownership rules apply • Loss disallowed may reduce gain on subsequent disposition to unrelated third party

  24. Transactions Between Related Parties(slide 2 of 2) • Section 267 also requires the matching principle be applied for unpaid expenses and interest when different accounting methods used • Example: An accrual basis, closely held corporation, cannot deduct accrued, but unpaid, salary to cash basis related party employee/shareholder until it is actually paid

  25. The Big Picture - Example 17Related Parties – Disallowed Losses Return to the facts of The Big Picture on p. 5-2. Sid Stevens, an 80% shareholder, sells a stock investment in his personal portfolio with a basis of $10,000 to his corporation for its fair market value of $8,000. Sid’s $2,000 loss from the sale of the stock is disallowed because the sale is to a related party. Sid’s business sells the stock several years later for $11,000. Only $1,000 of gain is taxable to the business upon the subsequent sale. $11,000 selling price - $8,000 basis - $2,000 previously disallowed loss. 25

  26. Expenses and Interest Relating to Tax-Exempt Income • Expenses relating to production of tax-exempt income are nondeductible • Example: interest expense on loan where funds used to acquire municipal bonds

  27. Charitable Contributions(slide 1 of 2) Individuals and corporations may deduct contributions made to qualified domestic organizations Contributor must have donative intent and expect nothing in return If contributor receives tangible benefit, the FMV of such benefit must be deducted from the amount of the contribution 27

  28. Charitable Contributions(slide 2 of 2) Contribution must be to qualified domestic nonprofit organization or state or possession of U.S. or any subdivisions thereof Many (but not all) qualified domestic charities are listed in IRS Publication #78 28

  29. Timing of Charitable Contribution Deduction Generally, deductible in year in which the payment is made Exception: An accrual basis corporation may take deduction in year preceding payment if: The contribution is authorized by the board of directors by the end of that year, and The contribution is paid on or before the fifteenth day of the third month of the following year 29

  30. Ordinary Income Property Defined: assets that would produce ordinary income or short-term capital gain if sold Contribution amount FMV of asset less ordinary income (or STCG) potential; generally the lower of adjusted basis or FMV 30

  31. Capital Gain Property Defined: assets that would produce long-term capital gain or Section 1231 gain if sold Contribution amount Generally FMV of asset 31

  32. Exceptions to FMV Deduction of Capital Gain Property (slide 1 of 2) Private nonoperating foundations Deduction for contributions to private nonoperating foundations must be reduced by the amount of capital gain potential Thus, the amount is limited to the adjusted basis 32

  33. Exceptions to FMV Deduction of Capital Gain Property (slide 2 of 2) Tangible personalty If asset contributed is not used in charity’s exempt function, the charitable deduction must be reduced by the amount of capital gain potential, thus, limiting the amount to the adjusted basis 33

  34. Example of Contributions of Tangible Personalty Taxpayer contributes painting to local charity: FMV $100,000 and adjusted basis $10,000 If charitable organization is a local museum that hangs the painting for patrons to view, taxpayer has $100,000 contribution deduction If charitable organization is a local church that sells the painting immediately to obtain funds for its operation, taxpayer has $10,000 contribution 34

  35. Exceptions Related to Contributions of Ordinary Income Property (slide 1 of 2) In general, the deduction for a contribution of ordinary income property is limited to the basis of the property On certain contributions of inventory by corps, the amount of the deduction is equal to the lesser of The property’s basis plus 50% of the appreciation on the property, or Twice the property’s basis 35

  36. Exceptions Related to Contributions of Ordinary Income Property (slide 2 of 2) This increased deduction amount is available for inventory contributions to A charitable organization for use in its exempt function Such use is solely for the care of the ill, needy, or infants A public school (K-12) for use in its educational programs A qualified educational or scientific organization that uses the property for research or experimentation, or research training A qualified educational organization or public library of computer equipment and software used for educational purposes 36

  37. Charitable ContributionLimitation A corporate taxpayer’s contribution deduction is limited to 10% of taxable income before The charitable contribution deduction Any NOL or capital loss carryback The dividends received deduction, and The domestic production activities deduction 37

  38. Charitable Contributions Carryover Contributions in excess of the 10% limit may be carried forward for 5 years Any carryforward is added to subsequent contributions subject to the 10% limit In carryforward year, current year contributions must be deducted first, with excess deductions from previous years deducted in order of time 38

  39. Research and Experimental Expenditures (slide 1 of 2) Definition of research and experimental (R&E) expenditures Costs for the development of an experimental model, plant process, product, formula, invention, or similar property and improvement of such existing property 39

  40. Research and Experimental Expenditures (slide 2 of 2) Three alternatives are available for R&E expenditures Expense in year paid or incurred, Defer and amortize over period of 60 months or more, or Capitalize (deductible when project abandoned or worthless) Credit of 20% of certain R&E expenditures is also available 40

  41. Domestic Production Activities Deduction (slide 1 of 5) The American Jobs Creation Act of 2004 created a new deduction based on the income from manufacturing activities The Domestic Production Activities deduction is based on the following formula: 9% × Lesser of Qualified production activities income Taxable (or modified adjusted gross) income or AMTI The deduction cannot exceed 50% of an employer’s W–2 wages paid to employees engaged in qualified production activities 41

  42. Domestic Production Activities Deduction (slide 2 of 5) Qualified production activities income is the excess of domestic production gross receipts over the sum of: Cost of goods sold that are attributable to such receipts Other deductions, expenses, or losses that are directly allocable to such receipts A share of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income 42

  43. Domestic Production Activities Deduction (slide 3 of 5) Domestic production gross receipts include the following five specific categories: The lease, license, sale, exchange, or other disposition of qualified production property manufactured, produced, grown, or extracted in the U.S. Qualified films largely created in the U.S. The production of electricity, natural gas, or potable water Construction (but not self-construction) performed in the U.S. Engineering and architectural services for domestic construction Items specifically excluded from this definition include: The sale of food and beverages prepared by a taxpayer at a retail establishment and The transmission or distribution of electricity, natural gas, or potable water 43

  44. Domestic Production Activities Deduction (slide 4 of 5) A phase-in provision increases the applicable rate for the Domestic Production Activities deduction as follows: RateYears 6% 2007-2009 9% 2010 and thereafter 44

  45. Domestic Production Activities Deduction (slide 5 of 5) Eligible taxpayers include: Individuals, partnerships, S corporations, C corporations, cooperatives, estates, and trusts For a pass-through entity (e.g., partnerships, S corporations), the deduction flows through to the individual owners For sole proprietors, a deduction for AGI results and is claimed on Form 1040, line 35 on page 1 45

  46. Cost Recovery Recovery of the cost of business or income-producing assets is through: Cost recovery or depreciation: tangible assets Amortization: intangible assets Depletion: natural resources 46

  47. Nature of Property Property includes both realty (real property) and personalty (personal property) Realty generally includes land and buildings permanently affixed to the land Personalty is defined as any asset that is not realty Personalty includes furniture, machinery, equipment, and many other types of assets Personalty (or personal property) should not be confused with personal use property Personal use property is any property (realty or personalty) that is held for personal use rather than for use in a trade or business or an income-producing activity Write-offs are not allowed for personal use assets 47

  48. General Considerations(slide 1 of 3) Basis in an asset is reduced by the amount of cost recovery that is allowed and by not less than the allowable amount Allowed cost recovery is cost recovery actually taken Allowable cost recovery is amount that could have been taken under the applicable cost recovery method If no cost recovery is claimed on property The basis of the property must still be reduced by the amount that should have been deducted i.e., The allowable cost recovery 48

  49. General Considerations(slide 2 of 3) If personal use assets are converted to business or income-producing use Basis for cost recovery and for loss is lower of Adjusted basis or Fair market value at time property was converted Losses that occurred prior to conversion can not be recognized for tax purposes through cost recovery 49

  50. General Considerations(slide 3 of 3) MACRS applies to: Assets used in a trade or business or for the production of income Assets subject to wear and tear, obsolescence, etc. Assets that have a determinable useful life or decline in value on a predictable basis Assets that are tangible personalty or realty 50

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