Chapter 5A

1. Business Expenses-Part A- Criteria, Timing.Edited Aug. 12, 2007T7-05-01A-Ch5A-Exp-Criteria-Timing-2008.ppt Chapter 5A

4. Code Sections • Sec. 161 - deductions permitted only for those expenses and losses for which a deduction is authorized • Sec. 162(a) authorizes deductions for ordinary and necessary expenses, that are reasonable in amount, and incurred in actively carrying on a trade or business • Sec. 212 authorizes deductions for expenses related to production of income (investment-related expenses)

5. Rules for Deductions for AGI. Pg. 167. [1 of 7] • A taxpayer reports income and can deduct reasonable expenses (and losses) for a trade or business operation. • A taxpayer reports income and can deduct reasonable expenses (and losses) for a transaction entered into for profit, even though it does not meet the definition of a trade or business operation.

6. Rules for Deductions for AGI. 183. [2 of 7] • A trade or business operation often means providing goods or services to customers. (By comparison, an employee provides services to his or her employer.) • When you buy an asset hoping to sell it later at a profit (such as buying IBM stock) you are not in a trade or business, but this is a transaction entered into for profit.

7. Rules for Deductions for AGI. 183. [3 of 7] • There is no good definition of a trade or business. • An typical investor is not in a trade or business. • Wachovia Securities invests in stocks and sells stocks to its customers. It is a trade or business. • If you buy land and build an apartment building on it for resale, you may not be in a trade or business. If you repeat this 20 times, you are in a trade or business as a real estate developer. • When does your activity rise to the level that causes you to be in a trade or business? Who knows? • See Godfrey article in T1-4-07-12-Capital Loss vs. Ordinary Loss Journal of Accountancy

8. Rules for Deductions for AGI. 183. [4 of 7] • Expenses (and losses) are deductible “For AGI” if they are for a trade or business operation (generally providing goods or services to customers, clients, etc.). • Expenses are deductible “For AGI” is they are for a transaction entered into for profit, and they involve property that generates rental income or royalty income. • Expenses for othertransactions entered into for profit are deductible as Misc. Item. Deductions.

9. Rules for Deductions for AGI. 183. [5 of 7] • A taxpayer can deduct reasonable expenses (and losses) for a trade or business operation. (Sec. 162) • A taxpayer can deduct reasonable expenses (and losses) for a transaction entered into for profit, even though it does not meet the definition of a trade or business operation. (Se. 212)

10. Rules for Deductions for AGI. 183. [6 of 7] • Renting property to tenants (for example under one-year contract or longer) is generally not a trade or business, unless you provide substantial services. • A golf course technically rents you the land for a few hours, but it mainly provides service. • A Marriott Hotel is a trade or business.They have many customers and they provide substantial services to their customers.

11. Rules for Deductions for AGI. 183. [7 of 7] • An employee is in the trade or business of being an employee, but is subject to special limits on deductions. • Employee expenses are deductible from AGI (Misc. Deductions) except for reimbursed expenses. (If the reimbursement is included in income, there is an offsetting deduction for AGI. Usually, reimbursed expenses are not included in income, so there is no deduction.)

13. Investor Losses • An investor in the stock market deducts related expenses from AGI on Schedule A. • An investor in the stock market reports gains (and deducts losses) on the sale of stock on Schedule D, and the net gain or loss (subject to loss limits) flows from Schedule D to the front of Form 1040. • Capital losses from stock sales are deductible for AGI.

14. Expense Requirements. Pg. 184. A business expense is deductible if it is • Ordinary and necessary (considered an appropriate expense by a prudent business person) • Reasonable in amount (not excessive)

15. Disallowed Deductions. Pg. 185. Unless provided for otherwise in the Code, a deduction will be disallowed if it is • Contrary to public policy (fines, penalties) • Related to tax-exempt income • Accrued to related party (no deduction until related party recognizes income) • The obligation of another taxpayer

16. Expenses of Illegal Business Taxpayer sells drugs at local junior high school. • We know revenue from an illegal business is taxable. • May he deduct expenses such as “pay-offs” to police and school officials, etc.? • He cannot deduct certain expenses – when it would be against public policy to allow the deduction. • In many cases normal expenses such as auto expenses would be deductible. • But Congress added a code section prohibiting deduction of expenses by a dealer in illegal drugs. • Deductions are allowed for normal expenses of other types of illegal businesses.

17. Substantiation. Pg. 186. • All taxpayers must maintain records that substantiate their expense deductions • Stringent substantiation requirements for travel, entertainment, and gifts • Amount of expenditure • Time and place (or date & description of gift) • Business purpose of expenditure • Business relationship of person entertained or receiving a gift

18. Timing of Deductions. Pg. 187. • Accrual method – expenses deductible when • “All events” have occurred that fix liability and • “Economic performance” occurs (property or services provided or used) • Cash basis taxpayer - expenses deductible when paid • Date check is mailed • Date charged on credit card

19. Accrual Accounting-1 REG §1.446-1. ..methods of accounting …a liability is incurred, …, [when] all events have occurred that establish the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

20. HW-5. Timing of Expense Deduction Aloha Airlines is required by law to have its aircraft engines tested and recertified after 5,000 flight hours. Molokai Maintenance performs the engine tests and recertification for $2,200 per aircraft. For financial accounting purposes, Aloha establishes a reserve account and accrues a maintenance expense of 44 cents per flight hour. When the maintenance is done, the amount paid for the maintenance is deducted from the reserve account. For tax purposes, when can the maintenance expense be deducted?

21. HW-5A. Timing of Expense Deduction Businesses are not permitted to use reserves for expenses for tax purposes. Aloha can only deduct the repair expenses • in the year repairs are performed, if it is an accrual-basis taxpayer, or • when they are paid, if it is a cash- basis taxpayer.

22. Accrual Accounting-1 • Automobile manufacturer sells an auto to dealer for a wholesale price of $30,000. • Dealer sells it later that year for $40,000. • Manufacturer warrants the auto for five years and estimates that the warranty cost over five years will be $3,000 per auto. • Is the manufacturer permitted to recognize an expense in the year of sale and set up a “reserve” for future warranty costs (equal to $3,000 per auto sold this year)? See Reg earlier.

26. Cash Method. Pg. 188. • When an expense is paid by providing services, the expense can be deducted but the value of the services provided is also income • Assets with useful lives extending substantially beyond the end of the year must be capitalized with their cost recovered through depreciation, amortization, or depletion • When considering whether to make an early payment of year-end expenses, the tax rates for both years and the time value of money should be considered

27. Use of Cash Method. Pg. 188. • Businesses that sell merchandise to their customers must use the accrual method to account for purchases and sales of inventory • Cash method can be used for other than inventory and cost of goods sold • Large corporations with average annual gross receipts of more than $5 million cannot use the cash method for tax reporting • All personal service corporations can use the cash method

28. Prepaid Expenses. Pg. 189. • Prepaid expenses must be capitalized as assets and their costs prorated if their lives exceed one year and the items will not be consumed by the close of the following year • Prepaid interest must generally be prorated over the life of the loan • OID is a form of prepaid interest and must be amortized over term of loan

29. HW20. Prepaid Rent On October 1, Bender (calendar-year, cash-basis taxpayer) signs a lease with Realco to rent office space for 36 months. Bender obtains favorable monthly payments of $600 by agreeing to prepay the rent for the entire 36-month period. a. If Bender pays the entire $21,600 on October 1, how much can it deduct in the current year? b. Assume the same facts above except that the lease requires Bender to make three annual payments of $7,200 each on October 1 of each year for the next 12 months rent. On October 1 of the current year, Bender pays $7,200 for the first 12-month rental period. How much can Bender Company deduct in the current year?

30. HW19A. Prepaid Rent a. Bender can only deduct $1,800 (3 x $600) rent for the three months remaining in the current year, because the rent payment is for a period extending beyond the end of the succeeding year. b. Bender can deduct the $7,200 in each year that it is paid. The contract calls for the advance payments and each payment does not extend beyond the end of the year following the year it is paid.

31. HW21. Prepaid Expenses On December 15, Simon Corporation (a cash-basis calendar-year corporation) paid $5,000 for five months of supplies and $9,000 for an insurance policy covering its office building for the next three calendar years. How much can Simon deduct this year for these expenses?

32. HWA21. Prepaid Expenses Simon can only deduct the $5,000 paid for supplies. The insurance payment must be capitalized and written off one-third in each of the years it covers as if Simon was an accrual-basis taxpayer.

33. HW22. Interest Deduction Foster Corporation, a cash-basis taxpayer, borrowed $100,000 on January 1, year 1, and received $98,000 in proceeds. The loan matures in 10 year and the $100,000 principal is due on that date. Interest of $10,000 is payable on January 1 of each year beginning January 1, year 2. How much of the interest in deductible in year 1 and in year 2?

34. HWA22. Interest Deduction $200 for year 1 and $10,200 for year 2. Foster must amortize the loan discount ($100,000 - $98,000 = $2,000 discount) over the 10-year life of the loan at a rate of $200 per year. Foster can only deduct the $200 amortized discount in year 1; it can deduct $10,200 in year 2, consisting of the $10,000 interest paid on January 1 and the $200 amortization. Note: this is di minimis. Footnote 27

35. HW23. Interest Deduction When Kelley couldn’t make payments on a business loan, her brother Mike made three monthly payments of $700 each, a total of $2,100 ($1,950 for interest expense and $150 for principal) for Kelley’s loan. Kelley makes the other nine monthly payments herself ($5,850 for interest expense and $450 for principal). a. What is Mike’s deduction for interest expense? b. What is Kelley’s deduction for interest expense? c. What could they have done to preserve the tax deductions? Explain.

36. HWA23. Interest Deduction a. Mike cannot deduct anything because it is not his loan. b. Kelly can only deduct the $5,850 interest expense for the nine monthly payments that she made. c. Mike should have given (or loaned) the money to Kelly and let Kelly make the loan payments. That way, Kelly could take a deduction for the $7,800 interest paid that year.

37. Costs of Starting a Business. Pg. 190. • Sec. 162 allows deductions for “carrying on” a business. Expenses incurred prior to the commencement of operations do not qualify as “carrying on” a business but may be deductible as one of the following: • Business investigation expenses • Start-up expenses • Organization costs

38. Business Investigation. Pg. 191. Investigation expenses incurred while preparing to enter business include travel, market surveys, and feasibility studies • If the taxpayer is in a similar existing business - deduction allowed as a current expense • If taxpayer is not in a similar existing business • If new business acquired - expenses are part of start-up expenses. See next slide • If new business not acquired - no deduction

39. Start-up Expenses. Pg. 191. • Start-up expenses are incurred after the decision to proceed with the new business, but before beginning actual operations (employee training and advertising) • If the business is related to the taxpayer’s existing business, start-up costs are considered continuing costs and are deductible currently

40. Start-up Expenses. Pg. 191. If the new business is not related to an existing business • Can deduct up to $5,000 (combined business investigation and start-up expenses) in the tax year in which the business begins • $5,000 amount is reduced by amount cumulative investigation and start-up expenses exceeds $50,000 • Remainder of investigation and start-up expenses amortized over a 15-year period

41. Organization Costs. Pg. 191. • Defined as costs related to the formation of a corporation or partnership (fees paid to the state for incorporation, legal fees, and accounting fees) and incurred before end of first year • Can deduct up to $5,000 in the year business begins • $5,000 deduction is reduced by amount organizational costs exceeds $50,000 • Remaining organizational costs amortized over 15 years (180 months)

43. HW-6. Business Investigation Expenses Diane owns and manages a successful clothing store in Dallas. Before graduation of her brother, Cameron, they investigated the possibility of opening another store in Atlanta for Cameron to manage.

44. HW-6. Business Investigation Expenses Diane and Cameron each paid $1,600 in travel costs while looking for sites for the store. Each paid $300 in legal fees for a lawyer to compile a list of zoning regulations and other relevant city ordinances. They decide that it is not feasible to open a new store at the present time. Can Diane and Cameron deduct their business investigation expenses? Explain.

45. HWA-6. Business Investigation Expenses Diane can deduct the $1,900 ($1,600 + $300) in the current year as business investigation expenses. Diane can deduct this amount because she is already in the clothing business and expenses for potential expansion are ordinary business expenses whether or not a new store is opened.

46. HWA-6. Business Investigation Expenses Her brother, however, is not permitted any deduction for the $1,900 that he expended. Cameron could only capitalize and amortize the expenses if the new store was opened.

47. HW7. Organization Costs vs. Business Exp. In its first year of operations, Bell Corporation paid its attorney $4,000 and its accountant $2,000 for services related to the organization of the corporation. In its second year of operations, Bell paid the attorney $700 to handle contract negotiations with a new customer. Which expenses are immediately deductible and which ones must Bell Corporation amortize?

48. HWA7. Organization Costs vs. Business Exp. $5,000 of the $6,000 organizational costs are deducted in the first tax year and the remaining $1,000 are capitalized and amortized over 180 months starting with the month the corporation begins business. The $700 legal fees will be immediately deductible in the second year as a business expense.

49. Investigation and Start-up Costs. A new corporation incurs total business investigation expenses and start-up costs of $54,000 in 2007. The business was started in 2007. What is its total deduction for these costs for 2007?

50. End of Part A