Chapter 7 Overview of Deductions and Losses

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Chapter 7Overview of Deductions and Losses
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Deductions Authorized by General Sections of the
IRC

• Positive Criteria (general allowance of ded.)
• Sec. 162 Expenses of carrying on a T/B
• Sec. 212 Expenses for production of income
• Sec. 165 Losses
• Sec. 172 NOL
• Negative Criteria (general disallowance of ded.)
• Sec. 262 Personal, living and family expenses,
  page 25
• Sec. 263 Capital expenditures
• Sec. 265 Expenses interest relating to tax
  exempt income - Example 40
• Sec. 162 expenses contrary to public policy
  Examples 35, 36, 37, 38, 39

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Trade or Business Expenses vs. Expenses for the
Production of Income

• Sec. 162 Requirements
• T/B Related
• Intention to make a profit
• Entrepreneurial/personal effort required
• No hobbies
• Ordinary and Necessary
• Reasonable in amount
• Paid/incurred during the year

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Trade or Business Expenses vs. Expenses for the
Production of Income

• Sec. 212 Requirements
• For production of income or
• for management of property held for production of
  income or
• in connection with the determination, collection
  or refund of any tax
• Ordinary and necessary
• reasonable is implied
• Entrepreneurial/personal effort not required
• Paid/incurred during the year
• Why bother with the distinction?
• Deductibility for/from AGI
• Limitations

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Deductible FOR or FROM AGI

• History of IR Code Sec. 62
• Significance of classification FOR or FROM AGI
• Deductions FOR AGI are deductible even if TP
  doesnt itemize
• Itemized deductions are deducted FROM AGI only if
  they exceed the standard deduction
• If itemized deductions lt standard deduction, does
  the TP lose the deduction?
• Pages 17 - 20

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Deductible FOR or FROM AGI

• AGI is used as a base to limit several FROM AGI
  deductions

EXAMPLES Casualties Medical Expenses
Many states use AGI as a starting point to
determine state income taxes
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Deductible FOR AGI

• Business Expenses (Sec. 162)
• Rental Expenses (Sec. 212)
• Alimony Paid
• Gains and losses on property dispositions
• Deductible contributions to tax deferred plans -
  IRAs, Keogh Plans, etc.
• Reimbursed employee business expenses (if
  included in income)
• Expenses incurred by a qualified performing
  artist
• Moving expenses
• Interest paid on student loans beginning in 1998
• Others

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Deductible FROM AGI

• Personal Itemized Deductions
• Medical and dental
• Some taxes
• Some interest
• Charitable contributions
• Casualties and thefts
• Miscellaneous deductions not subject to 2 floor
• Gambling losses to extent of gambling winnings
  (Sec. 165(d))
• Job expenses of handicapped
• Amortizable bond premiums
• Miscellaneous deductions subject to 2 floor

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Miscellaneous Itemized Deductions Subject to 2
of AGI Limitation

• Employee Business Expenses
• Dues to professional societies
• Employment-related educational expenses
• Job hunting expenses, including agency fees,
  resumes, etc.
• Home office expenses
• Outside salesperson expenses
• Travel expenses
• Transportation expenses
• Subscriptions to professional journals and
  magazines
• Work clothes and uniforms
• Union dues and fees
• 50 of unreimbursed business entertainment
  expenses

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Miscellaneous Itemized Deductions Subject to 2
of AGI Limitation

• Expenses for the Production of Income
• Legal and accounting fees
• Custodial fees related to income-producing
  property
• IRA fees
• Fees paid to collect interest or dividends
• Hobby expenses (limited to hobby income)
• Investment counsel fees
• Rental cost of safe deposit boxes used to store
  non-tax-exempt securities

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Miscellaneous Itemized Deductions Subject to 2
of AGI Limitation

• Other Miscellaneous Itemized Deductions
• Fees paid for investment counsel
• Tax counsel and assistance
• Cost of tax services, periodicals, return
  preparation manuals
• Appraisal fees establishing a casualty loss or
  charitable contribution

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Example of the 2 Limitation

• AGI 25,000
• Potential Miscellaneous Itemized Deduction 800
• 25,000 X 2 500 (2 floor)
• 800 - 500 limit 300 misc. itemized deduction

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Deductions for Losses

• Losses on personal use assets are deductible only
  if attributable to a casualty or theft
• Individuals may deduct losses incurred in a
• trade or business or
• transaction entered into for profit
• Events which trigger realization of gain or loss
• sale
• abandonment
• exchange
• casualty or theft
• involuntary conversion

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Tax Accounting Methods for Expenditures

• Cash Basis
• Generally, recognize income when payments are
  received, recognize expenses when paid.
• Modification to Cash Basis Reporting for
  Expenditures
• Generally, cash basis TPs may deduct currently
  prepayments made for assets if
• Business purpose for prepayment
• Asset will be consumed before end of next year
• Income will not be materially distorted
• Accrual method must be used for sales and COGS
  when inventories are income producing

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More Modifications to Cash Basis Reporting for
Expenditures

• Prepayments for Rent Services deduct only
  when
• Prepayments are for 1 year or less and
• TP is obligated legally to prepay
• Prepaid Insurance always accrue
• Prepaid Interest accrue only

Except for points paid for loan on personal
residence.
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More Modifications to Cash Basis Reporting for
Expenditures

• Points paid on personal residence mortgages
• Definition of Points
• Prepaid points incurred to secure a loan on a
  principle residence are deductible currently if
• Paid by the buyer or seller
• They are not withheld from loan proceeds, i.e.
  they are paid from a separate fund.
• If points paid for refinancing, accrue the
  deductions

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Tax Accounting Methods for Expenditures

• Accrual Basis Reporting
• Generally recognize income when earned and
  expenses when incurred
• Modifications to Accrual Basis
• To deduct an expense, 2 things must be satisfied
• All events test must be satisfied
• All events which legally fix liability have
  occurred and
• liability can be estimated with reasonable
  accuracy
• And Economic performance must have occurred

Example Warranties, contingent liabilities may
not be accrued unless there is reasonable basis
to estimate the amount
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Tax Accounting Methods for Expenditures

• Economic Performance
• When TP provides goods or services
• Economic performance occurs when the TP provides
  the goods or services
• When TP receives goods or services
• Economic performance occurs when TP receives
  goods or services, or uses the property in the
  case of rentals
• Exhibit 7-1

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Exception to Economic Performance Requirement

• If economic performance has not occurred but
  will occur within 8 1/2 months of end of period
  and
• Expense is of reoccurring nature and
• TP consistently accrues the item and
• Accruing results in a better match against
  revenue, then ok to accrue
• Example 17

Example One-time payment in November for snow
removal for season, may be accrued.
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Common Law Factors That Indicate Control (IRS)

• Self-employed v. Employee
• Oral or written reports required
• Payment by the hour, week, month
• Payment of business or travel expense
• Furnishing of tools, materials
• Significant investment
• Realization of profits or loss
• Working for more than one firm at a time
• Making services available to the general public
• Right to discharge
• Right to terminate

• Self-employed v. Employee
• Instructions
• Integration
• Training
• Services rendered personally
• Hiring, supervising, and paying assistants
• Continuing relationship
• Employer-defined hours of work
• Full-time required
• Doing work on the employers premises
• Setting the order or sequence of work

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Disallowance of Losses on Transactions Between
Related Parties -- Sec. 267(b)

• Related parties under Sec. 267(b)
• lineal antecedents and descendants
• brothers and sisters
• spouses
• TP and his/her corporation or P/S if the TP owns
  gt 50 directly or indirectly
• Estates and their beneficiaries - Examples 44,
  45, 46

RULE Losses are disallowed between related
parties. But, disallowed losses may be used to
offset gains on a subsequent sale to an unrelated
party.
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Disallowance of Losses on Transactions Between
Related Parties -- Sec. 267(b)
Example
Father (F) sells Daughter (D) an antique asset
realized loss, not recognized
Later, D sells the asset to an unrelated party
15 realized gain (10) Fs previously
disallowed loss 5 gain recognized by D
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Limitation on Deduction for Executive Compensation

• Publicly held corporations may deduct maximum of
  1,000,000 of compensation to certain
  employees.
• Publicly Held Corporations
• Listed on a national securities exchange and
• At least 5,000,000 in assets and
• At least 500 shareholders
• Covered Employees
• CEO plus
• Any of four most highly paid officers
• Applicable Employee Remuneration
• Includes Cash and benefits
• Excludes Commissions performance related pay if
  approved by shareholders payment to a qualified
  retirement plan

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Repairs vs. Improvements

• Tax Treatment
• Deduct repair expenses currently
• Capitalize improvements (a.k.a. betterments)
• Distinguishing between repairs and improvements
• Improvements Any expenditure for a property
  that
• Materially increases its value, or
• Materially prolongs its life, or
• Changes its use for the taxpayer
• Repairs expenditures that are not improvements
• Examples
• Pages 26, 27, 28