Deductions and Losses: In General

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Deductions and Losses In General

• Chapter 6

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Deductions

• Exclusive definition of deductions
• Deductions allowed based on legislative grace and
  defined narrowly
• Substantiation requirements
• Taxpayer has burden of proof for substantiating
  all expenses deducted on return
• Thus, adequate records of expenses must be
  maintained

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Deductions FOR and FROM AGI (slide 1 of 3)

• Deductions FOR AGI
• Those listed in 62
• Can be claimed even if taxpayer does not itemize
• Called above the line deductions
• AGI is important in determining the amount of
  certain itemized deductions
• Certain itemized deductions are limited to
  amounts in excess of specified percentages of AGI
• e.g., Medial expenses (7.5 of AGI), misc.
  itemized deductions ( 2 of AGI)

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Deductions FOR and FROM AGI (slide 2 of 3)

• Deductions FROM AGI
• Those not listed in 62
• In total must exceed standard deduction to
  provide any tax benefit
• Called below the line or itemized deductions

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Deductions FOR and FROM AGI (slide 3 of 3)

• Comparison of deductions FOR and FROM AGI (2007
  tax year)
• Single taxpayer has gross income of 45,000 and a
  6,000 deduction
• For AGI From AGI
• Gross income 45,000 45,000
• Less for AGI ded. 6,000
  0
• AGI 39,000 45,000
• Less from AGI ded. 5,350
  6,000
• Less personal exempt. 3,400 3,400
• Taxable income 30,250 35,600

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Types of Deductions

• Trade or Business
• Usually for AGI, except employee expenses
• Nonbusiness
• Related to the production of nonbusiness income
  (Investments)
• Tax determination
• Usually from AGI, except rent or royalty income
• Personal
• Mostly from AGI

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Deductions FOR AGI (slide 1 of 3)

• Partial list includes
• Trade or business expenses
• Reimbursed employee business expenses
• Deductions from losses on sale or exchange of
  property
• Deductions from rental and royalty property
• Alimony
• One-half of self-employment tax paid

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Deductions FOR AGI (slide 2 of 3)

• Partial list includes
• 100 of health insurance premiums paid by a
  self-employed individual
• Contributions to pension, profit sharing, annuity
  plans, IRAs, etc.
• Penalty on premature withdrawals from time
  savings accounts or deposits
• Moving expenses

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Deductions FOR AGI (slide 3 of 3)

• Partial list includes
• Interest on student loans
• Qualified tuition and related expenses under
  222
• Up to 250 for teachers supplies for elementary
  and secondary school teachers

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Deductions FROM AGI

• Itemized deductions include
• Medical expenses (in excess of 7.5 of AGI)
• Certain state and local taxes
• Contributions to qualified charitable
  organizations
• Personal casualty losses (in excess of 10 of
  AGI and a 100 floor per casualty for
  individuals)
• Certain personal interest expense (e.g., mortgage
  interest on a personal residence)
• Miscellaneous itemized deductions (in excess of
  2 of AGI)

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Business and Nonbusiness Lossesof Individuals

• Deductible losses of individual taxpayers are
  limited to those
• Incurred in a trade or business,
• Incurred in a transaction entered into for profit
• Individuals may also deduct casualty losses from
  fire, storm, shipwreck, and theft

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Trade or Business Deductions

• 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

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Trade or Business Deductions

• In order for expenses to be deductible, they must
  be
• 1. Ordinary normal, usual, or customary for
  others in similar business, and not capital in
  nature
• 2. Necessary prudent businessperson would incur
  same expense
• 3. Reasonable question of fact
• 4. Activity is deemed to be a trade or business

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Trade or Business Deductions

• 5. Not a capital expenditure
• 6. Not related to the production of tax-exempt
  income
• 7. Not contrary to public policy
• 8. For a business purpose rather than a personal
  expenditure

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Reasonable in amountExample Excessive Executive
Compensation

• For publicly held corporations
• Deduction of salaries for chief executive officer
  and four highest compensated executives is
  limited to 1 million each
• Does not include
• Performance-based compensation and commissions
• Payments to qualified retirement plans
• Payments excludible from gross income

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4. Incurred in conduct of business

• Activities are either
• Business
• Intent to make a profit
• Involves entrepreneurial effort
• Investment
• Intent to make a profit
• No entrepreneurial effort
• Hobby
• No intent to make a profit
• Involves entrepreneurial effort

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Hobby Losses

• Hobby defined
• Activity not entered into for profit
• Personal pleasure associated with activity
• Examples raising horses, fishing boat charter
• Often it is difficult to determine if an activity
  is profit motivated or a hobby
• Regulations provide nine factors to consider in
  making this determination

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Hobby Losses

• Profit activity
• If activity is entered into for profit, taxpayer
  can deduct expenses FOR AGI even in excess of
  income from the activity
• (At-risk and passive loss rules may apply)
• If an activity is not engaged in for profit, the
  hobby loss rules apply
• Hobby expenses are deductible only to the extent
  of hobby income

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Hobby Losses

• Presumptive rule of 183
• If activity shows profit 3 out of 5 years (2 out
  of 7 years for horses), the activity is presumed
  to be a trade or business rather than a personal
  hobby
• Rebuttable presumption, shifts burden of proof to
  IRS
• Otherwise, taxpayer has burden to prove profit
  motive
• (If the activity generates a loss, it is
  generally better for it not to be considered a
  hobby.)

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Hobby Losses
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Hobby Losses

• Hobby activity
• Can only deduct expenses to extent of income from
  activity (i.e., cannot deduct hobby losses)

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Hobby Losses

• If an activity is a hobby
• Expenses are deductible FROM AGI
• Treated as miscellaneous itemized deductions
  subject to the 2 of AGI limitation
• Exception expenses that are deductible without
  regard to profit motive, such as
• Mortgage interest
• Property taxes

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Hobby Losses

• Order in which hobby expenses are deductible
• First Those otherwise deductible e.g., home
  mortgage interest and property taxes
• Then Expenses that do not affect adjusted basis
  e.g., maintenance, utilities
• Then Expenses that affect adjusted basis e.g.,
  Depreciation (or cost recovery)

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Hobby Losses

• Example of hobby expenses Taxpayer sells horses
  raised as a hobby for 15,500

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5. Not a capital expenditure

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

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6. Is not related to the production of 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

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7. 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
• See Tank Truck Rental, Inc. v. CIR

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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 officers legal fees in defending
  against price-fixing charges
• e.g., Landlords legal fees associated with
  eviction of tenant

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Investigation of a Business

• 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

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Investigation of a Business

• 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

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Investigation of a Business

• 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

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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

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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

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Expenditures Incurred for Taxpayers Benefit or
Obligation

• No deductions is allowed for payment of another
  taxpayers expenses
• Must be incurred for taxpayers benefit or arise
  from taxpayers obligation
• Exception Payment of medical expenses for a
  dependent

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Transactions Between Related Parties

• 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

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Transactions Between Related Parties

• 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

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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