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Chapter 12. Expenses Incurred in Business and Profit-Oriented Activities. Net Profits v. Gross Receipts. Tax on Net Profits Gross Receipts Less: Cost of Goods Sold Equals: Gross income Less: Business Expenses Equals: Net Profits For wage earners and salaried employees

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chapter 12

Chapter 12

Expenses Incurred in Business and Profit-Oriented Activities

net profits v gross receipts
Net Profits v. Gross Receipts
  • Tax on Net Profits

Gross Receipts

Less: Cost of Goods Sold

Equals: Gross income

Less: Business Expenses

Equals: Net Profits

  • For wage earners and salaried employees
    • Deductions allowed from Gross Receipts is limited
  • The cost of earning a living is deductible, BUT the cost of living is not deductible.
statutory provisions
Statutory Provisions

Business Expenses § 162

Expenses of Producing Income § 212

Cost of Goods Sold § 471

Depreciation §§§ 167, 168 and 197

Losses § 165

Hobbies § 183

business expenses 162
Business Expenses § 162

“all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

  • Cost must be an expense
  • Expense must be ordinary
  • Expense must be necessary
  • Expense must be paid or incurred during the taxable yr
  • Expense must be paid or incurred while carrying on a trade or business
for from agi
For / From AGI
  • Business Expenses § 162
    • For AGI – nonemployee expenses and reimbursed employee expenses
    • From AGI – Itemized Deduction subject to 2% floor – employee expenses
  • Expenses for Producing Income § 212
    • For AGI – rents and royalties
    • From AGI – Itemized Deduction subject to 2% floor - investment expenses
business personal borderline
Business-Personal Borderline

Inherently Personal – no deduction for expenses incurred whether a taxpayer works or not (even though also serves business purpose)

Excess Cost – deduction only for additional expenses incurred for business

Allocation – deduction only for business portion

Primary Purpose – full deduction for expense incurred if primarily for business purpose (personal benefit – by-product)

borderline expenses
Borderline Expenses

Food and Shelter

Clothing and Personal Grooming

Medical Expenses

Care of Dependents

Commuting Expenses

Entertainment Expenses § 274

Business Use of Personal Residences § 280A

Education

Litigation Expenses

Expenses to Protect taxpayer’s Reputation

Expenses of Public Officials

qualified deductions
Qualified Deductions

“Ordinary” – normal, usual, and customary for the particular business (not necessarily often)

“Necessary” – appropriate and helpful in developing taxpayer’s business

“Reasonable” – paid by the taxpayer to an independent party

welch v helvering
Welch v. Helvering

Facts:

Issue:

Decision:

Reasons:

qualified deductions continued
Qualified Deductions (continued)
  • Current expense or capital expenditure
    • § 263A – denies deduction for amounts paid for acquisition, improvement, or betterment of property
  • Personal expense or business expense
  • Ordinary expense or extraordinary expense
    • Unusual, idiosyncratic, or unique expenditures; could have been avoided or reflect unusual business judgments
compensation for personal services
Compensation for Personal Services
  • Disallows unreasonable amounts of compensation
    • Applied to closely held corporations – inflated salaries to controlling shareholders and related persons
      • Deductible salaries vs. nondeductible dividends
  • Disallows payments inflated to disguise a nondeductible transfer
criteria of reasonableness
Criteria of Reasonableness
  • Position held by employee
  • Hours worked and duties performed
  • General importance to success of company
  • Comparison of past duties and salary with current responsibilities and compensation
  • Comparison with other companies
  • Size of company, complexity, economic conditions
  • Existence of exploitable relationship
  • Bonus system/dividend policy of the company

“Independent investor” test – Exacto Springs Corp. v. CIR

limitations on compensation deductions by corporations
Limitations on Compensation Deductions by Corporations
  • Golden Parachute Payments § 280G
  • Compensation Exceeding $1 Million

§ 162(m) – paid to employees of publicly held corporations

illegal payments bribes fines etc
Illegal Payments, Bribes, Fines, etc.
  • Frustration of public policy doctrine – allowance of unlawful payments and bribes would encourage unlawful conduct
  • In 1969, § 162 amended to disallow deductions for:
    • Illegal bribes, kickbacks, etc. § 162(c)
    • Fines and penalties § 162 (f)
    • Treble damages (excess damages assessed due to a violation harmful to society in general) § 162(g)
  • In 1982, § 280E added to disallow deductions for illegal trafficking in controlled substances
lobbying and other legislative activities 162 e
Lobbying and Other Legislative Activities § 162(e)
  • Prohibits any deduction for most lobbying expenses
    • Influencing legislation at highest levels
    • Local level legislation excluded with respect to matters of direct interest to the taxpayer’s business (i.e., deductible)
  • § 276 prohibits the deduction of amounts spent for political advertising or for admission to political dinners and similar events
lobbying and other legislative activities 162 e continued
Lobbying and Other Legislative Activities § 162(e) (continued)
  • Disallows deduction for expenditures for participation or intervention in a political campaign
  • Disallows deduction for portion of dues paid to a tax-exempt organization allocable to organization’s lobbying expenses
trade or business
Trade or Business
  • Trade or business (Higgins v. CIR, CIR v. Groetzinger)
    • Manner in which business is carried on
    • Expertise of taxpayer or advisers
    • Time and effort expended by taxpayer
    • Expectation that assets may appreciate in value
    • Success of taxpayer in other similar or dissimilar activities
    • Taxpayer’s history of income or losses
    • Amount of occasional profits, if any
    • Financial status of the taxpayer
    • Elements of personal pleasure or recreation
carrying on requirement
“Carrying On” Requirement
  • Two stages in development of a business
    • Investigatory stage –
      • used to review different businesses to make decision
      • Investigatory and start-up costs
    • Organizational and Start-up Costs
      • Still not engaged in business, but preparing for it
      • Organizational expenditures include expenditures to form and organize a business in the form of a corporation or a partnership and are incurred prior to the starting business
      • Start-up costs are costs businesses incur to start up a business
chapter 1

Chapter 1

Personal Exemptions and

Itemized Deductions

tax formula
Tax Formula

Income (broadly conceived) $x,xxx

Less:Exclusions(x,xxx)

Gross Income $x,xxx

Less:Deductionsfor AGI (x,xxx)

Adjusted Gross Income (AGI) $x,xxx

Less:The greater of-

Total itemized deductions

or the standard deduction (x,xxx)

Personal & dependency exemptions(x,xxx)

Taxable Income $x,xxx

personal and dependency exemptions
Personal and Dependency Exemptions
  • § 151(b) – allows each individual taxpayer to deduct a personal exemption of $3,650 for 2010/2011.
  • § 151(c) – allows an individual taxpayer to deduct a dependency exemption for each dependent individual who meets all five dependency tests
wftra
WFTRA
  • One objective of the Working Families Tax Relief Act of 2004 (WFTRA of 2004)
    • Establish a uniform definition of qualifying child for purposes of the:
      • Dependency exemption
      • Head-of-household filing status
      • Earned income tax credit
      • Child tax credit
      • Credit for child and dependent care expenses
    • Beginning in 2009, a child is a qualifying child for purposes of the child tax credit only if taxpayer can and does claim an exemption for the child.
dependency exemptions
Dependency Exemptions
  • A dependency exemption is available for one who is either a qualifying childor a qualifying relative
    • A qualifying child must meet the following tests: (§ 152(c))
      • Relationship
      • Abode
      • Age
      • Support
      • Joint Return § 152(b)(2)
      • Citizenship or Residency § 152(b)(3)
relationship test 152 c 2
Relationship Test § 152(c)(2)
  • The child must be the taxpayer’s:
    • Son or daughter
    • Stepson or stepdaughter
    • Brother or sister
    • Stepbrother or stepsister
    • Half brother or half sister, or
    • A descendant of such individual (e.g., grandchildren, nephews, nieces)
  • A child who has been adopted, or whose adoption is pending, qualifies
  • A foster child may also qualify
age test 152 c 3
Age Test § 152(c)(3)
  • The child must be under age 19 or under age 24 in the case of a student
    • A student is a child who, during any part of five months of the year, is enrolled full time at a school or government-sponsored on-farm training course
    • Individuals who are disabled are not subject to the age test
    • If they fail the age test, they may qualify under QR.
    • Just added for 2009 – child must be younger than the person claiming him/her unless the child is permanently and totally disabled.
abode test 152 c 1 b
Abode Test § 152(c)(1)(B)
  • A qualifying child must live with the taxpayer for more than half of the year
    • Temporary absences from the household due to special circumstances (e.g., illness, education) are not considered
support test 152 c 1 d
Support Test § 152(c)(1)(D)
  • To be a qualifying child, the individual must not be self-supporting
    • Cannot provide more than one-half of his or her own support
    • “food, shelter, clothing, medical and dental care, education, and the like,” recreation, and transportation
    • welfare and social security benefits, although excluded from gross income
    • rental value of housing
    • does not include value of uncompensated personal services provided (i.e., cooking, cleaning, nursing)
    • does not include scholarships received by dependent
tiebreaker rules 152 c 4 b
Tiebreaker Rules § 152(c)(4)(B)
  • In situations where a child may be a qualifying child for more than one person
    • Tiebreaker rules specify which person has priority in claiming the dependency exemption
    • Beginning in 2009, no person can claim the child unless their AGI is higher than the highest AGI of any parent who could claim the child
qualifying relative 152 d
Qualifying Relative § 152(d)
  • In order to claim a dependency exemption for a qualifying relative, the following tests must be met:
    • Relationship
    • Gross income
    • Support
    • Joint Return
    • Citizenship or Residency
relationship test 152 d 2
Relationship Test § 152(d)(2)
  • The relationship test for a qualifying relative is more expansive than for a qualifying child. Also included are the following relatives:
    • Lineal ascendants (e.g., parents, grandparents)
    • Collateral ascendants (e.g., uncles, aunts)
    • Certain in-laws (e.g., son-, daughter-, father-, mother-, brother-, and sister-in-law)
  • The relationship test also includes unrelated parties who live with the taxpayer
gross income test 152 d 1 b
Gross Income Test § 152(d)(1)(B)
  • Dependent must have gross income of less than the exemption amount (<$3,650 for 2010/2011)
    • Tax-exempt income is excluded from gross income
support test 152 d 1 c
Support Test § 152(d)(1)(C)
  • Taxpayer must provide more than 50% of the qualifying relative’s support
    • Only amounts expended are considered in the support test
    • Scholarships are not considered in the support test
  • Two exceptions to the support test:
    • Multiple support agreements
    • Children of divorced parents
divorced or separated parents 152 e
Divorced or Separated Parents § 152 (e)
  • Special rules apply if the parents meet the following conditions:
    • They would have been entitled to the dependency exemption had they been married and filed a joint return
    • They have custody (either jointly or singly) of the child for more than half of the year
  • Under the general rule, the parent having custody of the child for the greater part of the year (i.e., the custodial parent) is entitled to the dependency exemption
    • General rule does not apply if
      • A multiple support agreement is in effect
      • Custodial parent issues a waiver in favor of the noncustodial parent (Form 8332)
multiple support agreements 152 d 3
Multiple Support Agreements§ 152 (d)(3)

No one person contributed more than 50%

More than 50% is contributed by a group of persons who would have been entitled to claim the dependency exemption (except for the support test)

A member who contributed more than 10% can claim the dependency exemption

File Form 2120 - designates the person who is to claim the dependency exemption

joint return test 152 b 2
Joint Return Test § 152(b)(2)
  • Dependent cannot file a joint return with spouse unless:
    • Filing solely for refund of tax withheld
    • No tax liability exists for either spouse
    • Neither spouse required to file return
citizenship or residency test 152 b 3
Citizenship or Residency Test §152(b)(3)
  • Dependent must be a U.S. citizen or a resident of U.S., Canada, or Mexico for some part of the calendar year in which the taxpayer’s tax year begins
    • An exception provides that an adopted child need not be a citizen or resident of the U.S. (or a contiguous country) as long as his or her principal abode is with a U.S. citizen
itemized deductions 63 d
Itemized Deductions §63(d)
  • A partial list of itemized deductions includes:
    • Medical expenses (in excess of 7.5% of AGI)
    • Certain taxes and interest
    • Charitable contributions
    • Casualty Losses (in excess of 10% of AGI)
    • Deductions for expenses related to
      • The production or collection of income, and
      • The management of property held for the production of income
    • Certain miscellaneous itemized deductions (in excess of 2% of AGI)
miscellaneous itemized deductions
Miscellaneous Itemized Deductions
  • Allowed only to the extent that their aggregate amount exceeds 2% of AGI
  • Defined as: § 67(b)
    • All deductions other than those in §62, interest, taxes, casualty and wagering losses, charitable contributions, medical expenses
    • Generally INCLUDES – unreimbursed employee business expenses (§162) and investment expense (§212)
standard deduction

Filing Status

2010 Basic/ Additional

Single

$5,700 / $1,400

MFS

5,700 / 1,100

Head of Household

8,400 / 1,400

MFJ

11,400 / 1,100

Standard Deduction

§ 63(e) allows a standard deduction to taxpayers who do not elect to itemize

Standard Deduction = Basic + Additional

Additional for blind or age > 65 (per each occurrence)

qualifications
Qualifications
  • Standard deduction is denied to:
    • MFS couples if either spouse itemizes
    • nonresident aliens
    • individual filing a short year tax return, because of a change in tax year
  • Standard deduction is limited for individuals claimed as a dependent to greater of:
    • $800, or
    • Earned income + $250
housing assistance tax act of 2008
Housing Assistance Tax Act of 2008
  • For 2008, a property tax deduction is available for non-itemizers
  • The deduction is added to the standard deduction and is limited to the lesser of:
    • The amt of real property taxes paid during the year
    • $500 ($1,000 for MFJ)
  • Extended through 2009 and 2010
first time homebuyer credit
First-time Homebuyer Credit
  • Began in 2008
    • $7,500 – required to be repaid over 15 years
  • Extended/expanded for 2009-2010
    • Through 6/30/2010 for contract signing, closing by 9/1/2010
    • Increased to $8,000
    • No requirement to repay
  • In addition, payments that reduce the balance of a home mortgage under the Home Affordable Modification Program are not taxable.
other incentives
Other Incentives
  • Making Work Pay Credit (expiring in 2010)
    • 6.2% of earned income, limited to $400 per person, phased out at $95,000 single and 150,000 MFJ
    • Administered through an adjustment to wage withholding
  • Car Purchases (expiring in 2010)
    • Above-the-line deduction for state sales and excise tax incurred in vehicle purchases
  • Unemployment Compensation (expiring in 2010)
    • Exclusion from gross income for up to $2,400 of unemployment compensation benefits
  • Net Disaster Loss (expiring in 2010)
    • Increased standard deduction for net disaster loss
chapter 13

Chapter 13

Capital Expenditures

slide45
§263
  • § 263 - disallows deductions for:
    • cost of acquisition or construction of buildings, furniture and fixtures, and similar property having a useful life > 1 year
    • amounts paid to add value or prolong useful life of property
    • amounts paid to adapt property to a new or different use
benefit extending substantially beyond the taxable year
Benefit Extending Substantially Beyond the Taxable Year

Separate and Distinct Asset - permits deduction of items of short life and small cost (tools and supplies)(CIR v. Lincoln Savings & Loan Ass’n)

Current v. Future Benefits - rejected Lincoln Savings & Loan Ass’n and concluded that a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is undeniably important(INDOPCO, Inc. v. CIR)

Matching still counts (US Freightways v. CIR)

capital expenditures
Capital Expenditures
  • Cost of Acquisition (Woodward v. CIR; US v. Hilton Hotels)
    • Assets which produce a continuing, long-term benefit
    • Basis is equal to cost
  • Cost of defending or perfecting title

(Georater v. US; Medco Products v. CIR)

    • Includes fees for a new title as well as defending a pre-existing one
  • Cost of disposal (Stegar v. CIR)
    • Deductible in the year of disposal
commissioner v idaho power
Commissioner v. Idaho Power

Facts:

Issue:

Decision:

Reasons:

slide49
§263A
  • § 263A - (Uniform Capitalization Rules) Requires capitalization of both direct and indirect costs to:
    • produce real or tangible personal property used by taxpayer in trade or business (PPE)
    • produce or hold property for sale to customers (inventory)
repairs vs improvements and replacements
Repairs vs. Improvements and Replacements
  • Repairs – deductible (Midland Empire Packing v. CIR)
    • Neither materially increase the value nor appreciably prolong life, but keep in an ordinarily efficient operating condition
    • Generally must remedy a defect
  • Improvements and Replacements – capitalized (Mt. Morris Drive-In Theatre v. CIR)
    • To the extent that they arrest deterioration and appreciably prolong life, or adapt to a new or different use
other capital expenditures
Other Capital Expenditures
  • Intangible Assets
    • Capitalize acquired and created intangibles
    • Capitalize amounts paid to facilitate acquisition of trade or business
    • Employee compensation and de minimis costs not required to be capitalized
    • Not required to capitalize rights that don’t extend beyond 12 months
other capital expenditures1
Other Capital Expenditures

Expansion Costs

  • Expenses to expand an already existing business are deductible(Briarcliff Candy Corp v. CIR)
  • Expenses to expand to an additional business are nondeductible (capitalized)
    • § 195 – allows taxpayer to elect to amortize expenses over 180 months; a current deduction is allowed for up to $5,000, but the $5,000 ceiling is reduced dollar-for-dollar as the total amount of expenses rises above $50,000
other capital expenditures2
Other Capital Expenditures
  • Advertising expenses – generally deductible
    • Generally held to be beneficial principally in the short-term, although some long-term goodwill may be generated
    • Capitalization of product launch costs not required