Chapter 5: Business Deductions

Question 1

Section 162?

Answer 1

Common Business deductions

Question 2

What is generally deductible?

Answer 2

Ordinary and necessary business expenses

Question 3

Current deductions for capital expenditures?

Answer 3

The regulations require capitalization of any expenditure that creates an asset having a useful life that extends substantially beyond the end of the tax year.

Can only take a current deduction for capital expenditures through AMORTIZATION, DEPLETION, OR DEPRECIATION over the tax life of the asset.

Question 4

All events Test

Answer 4

A deduction cannot be claimed until;

1. All of the events have occurred to create the taxpayer’s liability
2. The amount of the liability can be determined with reasonable accuracy

Question 5

Economic performance test

Answer 5

Following the all events test, the deduction is only permitted if economic performance has occurred.

Economic performance is met when the service, property, or use of the property giving rise to the liability is actually performed for, provided to, or used by the taxpayer.

Question 6

Expenditures that are not deductible because they are contrary to public policy?

Answer 6

1. Bribes and Kickbacks illegal under fed/state law (Including those associated with medicare and medicaid)
2. Two thirds of the treble damage payments made to claimants resulting from violation of antitrust law.
3. Fines and penalties paid to a government for violation of law.

Question 7

Justification for denying deductions?

Answer 7

Violation of public policy is not a necessary expense and is not deductible. A deduction would, in effect, represent an indirect governmental subsidy for taxpayer wrongdoing.

Question 8

Legal expenses incurred in defense of civil or criminal penalties?

Answer 8

To deduct legal expenses, taxpayer must be able to show that the origin and character of the claim are directly related to a trade or business.

Personal legal expenses are not deductible.

Legal fees are only deductible if the crime is associated with the taxpayer’s trade or business.

Question 9

Expenses related to an illegal Business?

Answer 9

Deductible

Law taxes net income from a business operation, not gross revenue.

Disallowed deduction for fines, brides to public officials, illegal kickbacks, and other illegal payments without regard to whether these payments are part of a legal or illegal business.

Exception: expenses incurred in trafficking drugs; drug dealers are not allowed a deduction for ordinary and necessary business expenses incurred in their business.

Question 10

Political contributions?

Answer 10

Generally, no business deduction is permitted for direct or indirect payments for political purposes.

Allowing deductions might encourage abuses and enable business to have undue influence on the political process.

Question 11

lobbying Expenditures?

Answer 11

Deny deductions for expenditures incurred in connection with attempting to influence;

1. State or federal legislation
2. The actions of certain high ranking public officials

Exceptions;

1. Influencing local legislation
2. Activities devoted solely to monitoring legislation
3. De Minimis exceptions: allow deductions of up to 2,000 of annual in house expenditures incurred by the taxpayer if the expenditures are not otherwise disallowed under the provisions discussed above

In house lobbying expenditures: dont include expenses paid to professional lobbyist or any portion of dues used by associations for lobbying. If > $2,000, none of the in house expenditures can be deducted.

Question 12

Excessive Executive Compensation?

Answer 12

Millionaires’ provision: applies to compensation paid by publicly held corporations. Does not limit the amount of compensation that can be paid to an employee, it limits the amount the employer can deduct for the taxable compensation of a covered executive to 1 Million annually.

This disallowance does not apply to commissions based on individual performance and performance based compensation tied to overall company performance

Question 13

Dissallowance of deductions for capital expenditures?

Answer 13

The code specifically disallows a deduction for “any amount paid out for a new building or for permanent improvements or betterments made to increase the value of any property or estate”

Incidental repairs and maintenance of property are not capital expenditures and can be deducted as ordinary and necessary business expenses.

Question 14

Capitalization versus expenses?

Answer 14

When an expenditure is capitalized rather than expensed, the deduction is deferred or lost forever. Immediate tax benefit is lost, but the cost may be deductible in increments over a longer period of time as the asset provides utility to the taxpayer.

Example: tangible asset that has ascertainable life, it is capitalized and may be deducted as depreciation over the life of the asset.

Land is not subject to depreciation; doesn’t have ascertainable life.

Question 15

Investigation of a business

Answer 15

Investigation expenses are incurred to determine the feasibility of starting a new business or expanding an existing business.

How they are treated for tax depends on:

1. The current business, if any, of the taxpayer
2. The nature of the business being investigated
3. whether the acquisition actually takes place.

If the taxpayer is in a business that is the same or similar to that being investigated. all investigation expenses are deductible in the year paid or incurred. (Tax result is the same whether the business is acquired or not)

When the taxpayer is not in the business that is the same or similar to the one being investigated, tax result depends on whether the new business is acquired. Not acquired=all expenses generally not deductible.

Taxpayer not in business that is the same or similar to the one being investigated, and actually acquires the new business, the expenditures must be capitalized as STARTUP EXPENDITURES. Startup expenditures are not deductible under section 162 because they are incurred before a business begins rather than in operation of a trade or business. First $5,000 of the expenses is immediately deducted. any excess of expense is amortized over a period of 180 months (15 years)

Can elect not to deduct or amortize any portion of the start up costs and the asset will remain on the business sheet until the business is sold.

Question 16

Transactions between related parties?

Answer 16

The code places restrictions on the recognition of gains and losses from related parties.

Constructive ownership provisions applied to determine whether the taxpayers are related. Under these provisions, stock owned by certain relatives or related entities is deemed to be owned by the tax payer for purposes of applying the loss and expense deduction disallowance provisions.

Question 17

Related Parties

Answer 17

Related parties:

• Brothers and sisters (whole, half, or adopted), spouse, ancestors (parents and g-parents), lineal descendants (children and g-children) of the taxpayer
• A corporation owned more than 50% (directly and indirectly) by the taxpayer
• Two corporations that are members of a controlled group
• A series of other complex relationships between trusts, corporations, and individual taxpayers.

Question 18

Losses and related parties?

Answer 18

Disallowance of any losses from sales or exchanges of property directly or indirectly between related parties. A right of offset is creates equal to the disallowed loss. When property is eventually sold to an unrelated party, any gain recognized is is reduced by the right of offset.

(offset can’t create or increase a loss)

(any right of offset that is not used is permanently lost)

Question 19

Unpaid Expenses and interest?

Answer 19

The law prevents taxpayers from engaging in tax avoidance schemes where one related taxpayer uses the accrual method of accounting and the other uses the cash basis.

Question 20

Lack of adequate substantiation?

Answer 20

Taxpayer has the burden of proof for sustaining expenses deducted not he returns and must retain adequate records. Upon audit, the IRS can disallow any undocumented or unsubstantiated deductions.

Question 21

Expenses and interest related to tax exempt income?

Answer 21

The law does not permit a tax payer to profit at the expense of the government by excluding interest income and deducting any related interest expense.

The code specifically disallows a deduction for the expenses of producing tax exempt income. Interest on ay indebtedness incurred or continued to purchase or carry tax-exempt obligations is also disallowed.

Question 22

Charitable contributions?

Answer 22

Corporations and individuals are allowed to deduct contributions made to qualified domestic charitable organizations, these organizations include;

1. a state or possession of the united states or any subdivisions thereof.
2. A corporation, trust, or community chest, fund, or foundation that is situated in the United states and is organized and operates exclusively for religious, charitable, scientific, literary, or educational purposes of for the prevention of cruelty to children or animals.

Generally a deduction will be allowed only for the year in which the payment is made, but an accrual basis corporation may claim the deduction in the year preceding payment of two requirements are met;

1. contribution must be authorized by the board of directors by the end of that year.
2. It must be paid on or before the 15th day of the third month of the following year.

Question 23

Property contributions?

Answer 23

The amount that can be deducted for a non cash charitable contribution depends on the type of property contributed (must identify as capital gain property to ordinary income property)

CAPIATL GAIN PROPERTY: property that if sold would result in a long term capital gain or section 1231 gain for the taxpayer
-Generally must be a capital asset and must be held for
a long term holding period (more than one year)
- Deduction is generally measured using the Fair
market value

ORDINARY INCOME PROPERTY: property that if sold would result in ordinary income for the taxpayer
- Inventory or capital assets held short term (less than a
year)

Question 24

In what two situations it is a non cash charitable donation measured by the basis of the property, not FMV?

Answer 24

1. If a corporation contributes tangible personal property and the charitable organization puts the property to an unrelated use. (unrelated use: use that is not related to the purpose or function that qualifies the organization for exempt status)
2. As a general rule, the deduction for a contribution of ordinary income property is limited to the basis of the property. On certain contributions of inventory by corporations the amount of the deductions is equal to the lesser of
   • the same of the property’s basis plus 50% of the
     appreciation of the property
     -Twice the property’s basis.

The following contributions of inventory qualify for this increased contribution amount;

1. A contribution of property to a charitable organization for use that is related to the organization’s exempt function and such use is solely for the care of the ill, needy, or infants.
2. A contribution of tangible personal research property constructed by the corporation to a qualified educational or scientific organization that uses the property for research or experimentation or for research training (the property must be contributed within two years from the date of its construction by the donor, and its original use must begin with the done)

Question 25

Limitations imposed on charitable contribution deductions?

Answer 25

For a given tax year, a corporate taxpayer’s contribution deduction is limited to 10% of taxable income.

Any contribution in excess of 10% limitation may be carried forward to the five succeeding tax years. Any carry forward must be added to the subsequent contributions and will be subject to the 10% limitation. I applying this limitation, the current year’s contributions must be deducted first,w it carryover amounts from previous years educated in order of time.

Question 26

Research and experimental expenditures?

Answer 26

Three alternatives for handling research and experimental expenditures;

1. Deduct in the year paid or incurred
2. Defer or amortize
3. Capitalize

If the costs are capitalized, a deduction is not available until the research project is abandoned or is deemed worthless. Because many projects result from research projects do not have a definite and limited usefull life, a taxpayer should ordinarily opt to write off (deduct) the expenditures immediately or to defer and amortize them. It is generally preferable o elect an immediate write-off of the research expenditures because of the time value of tax savings related tot he deduction.

Question 27

Expense method of research and experimental expenditures?

Answer 27

Taxpayer can deduct all of the r and e expenditures incurred int he current year and all subsequent years. the consent of the IRS is not required if the method is adopted for the first taxable year in which expenditures were paid of incurred. once the meths is adopted, the taxpayer must continue to deduct all qualifying expenditures unless a request for a change is made to, and approved by the irs.

Question 28

Deferral and amortization method of research and experimental expenditures?

Answer 28

Can choose to deferr and amortize r and e expenditures. Amortized ratably over a period of not less than 60 months. a deduction is allowed beginning with the month in which the taxpayer first realizes benefits from the research and experimental expenditures. the election is binding and change requires permission from the IRS.

Usually employed when a company does have sufficient income to offset the research and experimental expenditures. rather than creating a NOL carryovers that might not be utilized because of the 20 year limitation, this method may be used.

Question 29

Interest expense Rule?

Answer 29

Generally corporations are not limited to the amount of interest expense they can deduct. However the deductibility of expenses, including interest, from certain activities may be limited.

Individuals generally may not deduct interest expense unloads used for personal purposes, unless it is secured by the taxpayers personal residence, then is the related interest may be deductible.

Individuals may deduct interest expense associated with investments to the extent of net investment income and interest on qualified loans.

Under these rules, interest is allocated in the same manner as the debt with respect to which the interest is paid, and debt is allocated by tracing disbursements of the debt process to specific expenditures.

Question 30

Taxes and their deductibility?

Answer 30

Tax payments in a business or investment context are generally deductible, however, most federal taxes are not deductible. Individuals may also deduct tax payments, subject to limitations.

Unique problem is real-estate taxes paid during a year when the real-estate is sold. These taxes must be apportioned between the buyer and the seller based on the number of days the property was held by each during the real property tax year. the apportionment determines who is entitled to deduct the real estate taxes in the year of sale. This prevents the shifting of the deduction for real estate taxes from buyer to seller or vice versa. (the date of sale is the day the property is owned by the buyer)

If actual real estate taxes are not prorates between he buyer and seller as part of the purchase agreement, adjustments are required.

IF buyer pays the entire amount of the tax, he pays part of the sellers tax so has essentially paid more for the property than the actual purchase price. Thus the amount of tax that is apportioned to the seller and paid by the buyer is added to the buyer’s basis. Seller must increase the amount realized on the sale by the same amount.

If opposite, seller reduces the amount realized form the sale by the amount that has been apportioned to the buyer.

Question 31

Domestic Production activities deduction? (DPAP)

Answer 31

Deduction based on the income from U.S manufacturing, contained in section 199.

Formula:
9% of the lesser of;

1. Qualified production activities income (QPAI)

or

2. Taxable (or modified adjusted gross) income or alternative minimum taxable income.

In the case of an individual, modified adjusted gross income is substantial for taxable income.

The taxable income limitation is determined after the application fi any net operating losses deduction for the tax year, thus a company with a NOL carry forward fir a tax year is ineligible for the dead if the carry forward eliminates current taxable income.

Important Limitation: amount of DPAD cannot exceed 50% of certain w-2 wages paid by the tax payer during the next year. If no w-2 wages are paid, no DPAD will be allowed. Rationale is to preserve U.S manufacturing and prevent outsourcing.

W-2 wages: sum of aggregate amount of wages and elective deferrals required to be included on the w-2 wages statements for certain employers taxable year. As a result of recent statutory change: an employer is permitted to include only those w-2 pages paid to employees engaged in qualified production activities.

Question 32

Calculation of qualified production activities income

Answer 32

QOAI is the excess of domestic production gross receipts (DPGR) over the sum of;

• The cost of goods sold allocated to such receipts
• other deductions, expenses, or losses, directly allocated to such receipts
• the ratable portion of deductions, expenses, and losses not directly allocable to such receipts or another class of income.

QPAI is determined on an item by item basis, not on a division-by-division or a transaction-by-tansaction basis. because all items must be netted in the calculation, the final QPAI amount can either be positive or negative. The effect of the netting rule is to preclude taxpayers from selecting only profitable product lines or profitable transactions when calculating QPAI.

Question 33

What five specific categories of DPGR qualify for the DPAP?

Answer 33

1. the lease, license, sale, exchange, or other disposition if qualified production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) in the Untied States
2. Qualified films (i.e. motion picture film or video tape) largely created in the united States
3. The production of electricity, natural gas, or potable water
4. Construction (but not self construction) performed in the US
5. Engineering and architectural services for domestic construction.

Question 34

5-22

Answer 34

??