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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

Module 9

Business Deductions

module topics
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
Statutory Scheme for Deductions

Key Learning Objective

  • Apply the three-tier expense deduction classification scheme
tax concept
Tax Concept
  • No expenditure is deductible unless allowed by a provision in the tax law
    • Specifically authorized by the Code, or
    • Satisfies general criteria
general criteria for deductibility
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
deduction classification scheme
Deduction Classification Scheme
  • Trade or business deductions--§162
  • Production of income deductions--§212
  • Statutory personal deductions
trade or business deductions 162
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
production of income deductions 212
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
statutory personal deductions
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)
162 business deductions the basic requirements
§162 Business Deductions: The Basic Requirements

Key Learning Objective

  • Apply the ordinary, necessary, and reasonableness requirements for business deductions
basic requirements
Basic Requirements
  • Ordinary
    • Acceptable, given the circumstances
  • Necessary
    • Appropriate when incurred
  • Reasonable
    • Not lavish
research query political office a trade or business
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?
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
paid or incurred requirement
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
prohibited deductions
Prohibited Deductions

Key Learning Objective

  • Distinguish between allowable deductions and those which are prohibited
prohibited deductions16
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
compliance query which illegal business is best
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
solution compliance query which illegal business is best
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?
deductions common to most businesses
Deductions Common to Most Businesses

Key Learning Objective

  • Identify and compute common business deductions
deferred compensation potential benefits
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
deferred compensation types covered in later modules
Deferred Compensation--Types(covered in later modules)
  • Qualified pension plans
  • Nonqualified plans
    • Fewer potential benefits
  • Keogh plans
  • SEPs
  • IRAs
  • 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
  • Generally deductible if business related
  • Sales taxes capitalized as part of cost
  • Employer portion of payroll taxes deductible
  • Federal income taxes not deductible
charitable contributions
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
business gifts
Business Gifts
  • Limited to $25 per donee per year
  • Special rules for safety or length of service awards to employees
  • Generally deductible if business related
  • Includes incidental expenses
  • “Away from home” requirement for meals and lodging
    • 50% limit for meals
  • Strict substantiation requirements
research query where is a traveling man s home
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?
solution research query a traveling man s tax home
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
  • 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
special deductions for corporations
Special Deductions for Corporations

Key Learning Objective

  • Calculate deductions for corporate organizational costs and dividends received
organization costs
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
dividend received deduction
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
capitalization issues
Capitalization Issues

Key Learning Objective

  • Classify expenditures that contain both repair and capitalization attributes
  • 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
research query capital expenditure or repair
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
solution research query capital expenditure or repair
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