Chapter 6: Deductions And Losses Flashcards
1
Q
Three general categories of deductions
A
1) expenses incurred in connection with a trade or business
2) expenses incurred by an individual in connection with the production of income
3) other types of expenses as specifically provided for
2
Q
Deductions for AGI
A
Deductions subtracted from gross income in order to calculate adjusted gross income
3
Q
Deductions from AGI
A
Deductions subtracted from AGI to calculate taxable income
Generally standard or itemized deductions, though also qualified business income deduction and charitable deduction for non itemizing taxpaters
4
Q
Common deductions to arrive at AGI
A
- expenses incurred in trade or business
- losses from sale/exchange of business/trade/investment property
- expenses attributable to production of rent or royalty income
- contributions to certain retirement, pensions or profit sharing plans
- penalties paid for early withdrawal from an CD or time savings account
- cash payments made to a qualified HSA or Archer Medical Savings Account
- up to $2500 of interested paid on student loans
- educational expenses for elementary and highschool teachers up to $250 (indexed for inflating)
- half of self employment tax
- 100% of health insurance costs paid by self employed taxpayers
- reimbursed employee business expenses
- certain business expenses incurred by performing artists, state or political employees
5
Q
Alimony paid as a deduction to arrive at AGI
A
Only for divorce agreements finalized before 2018
6
Q
Moving expenses as a deduction to arrive at AGI
A
From 2017 to at least 2025 limited to active duty armed forces members
7
Q
Medical expense deduction limitation
A
Taxpayers may only deduct medical expenses EXCEEDING 7.5% of years AGI
8
Q
Casualty losses on personal use property limitations
A
1st: reduce allowable casualty losses on personal use property by $100/ casualty event
2) after this can only deduct casualty losses if exceeds 10% of AGI
9
Q
Where do deductions to arrive at AGI appear on the tax return
A
Schedule 1 part 1
And
Separate schedules:
C (profit or loss from business)
E (supplemental income or loss)
D (profit or loss from farming)
All carry over to front of form 1040
10
Q
Requirements for business expense deductions
A
Must be:
- related to a profit-motivated activity
- ordinary
- necessary
- reasonable in amount
- properly documented
- an expense of the taxpayer (not someone else)
11
Q
Expenditures that cannot be deducted
A
- capital expenditures
- expenses related to tax exempt income
- expenditures that are illegal or in violation of public policy
- anything specifically disallowed by tax law
12
Q
Tests of profit motivated activities
A
1) determination if expenditure originates from activity engaged in for profit
2) distinction between trade/business vs investment activity
13
Q
determination if expenditure originates from activity engaged in for profit
A
No single objective test rather a series of considerations to determine the motive of the activity
14
Q
Distinguishing between trade or business activity and investment activity
A
(only pertinent to individual taxes. Corporations always assumed to be doing business)
Determines if loss is an ordinary loss (business transaction) or capital loss (investment transaction). Former will generally be a deduction to arrive at AGI. Latter has limited deductibility (can deduct expenses to produce rents and royalties)
15
Q
Are expenses incurred for investment activity deductable?
A
Generally no, except for those incurred to produce rents and royalties
16
Q
Judicial definition of trade or business
A
“holding one’s self out to others as engaged in selling goods or services”
17
Q
Deductions of legal and accounting fees
A
- if incurred in regular conduct of trade or business (or for production of rent or royalties) may be deducted TO ARRIVE AT AGI
- otherwise not deductible
18
Q
Tax preparation that may be deducted to arrive at AGI
A
Preparation of business schedules: C, E, and F
19
Q
Legal fees are incurred in connection with purchase of personal property
A
NOT deducted
Rather capitalized: added to the total basis of the property
20
Q
Requirements for an ordinary expense
A
- must be reasonable in amount and must bear a reasonable and close connection to the income-producing activity or property
- must be customary or usual in the context of the industry or business community
(So may be ordinary in one place, but not another. Also one time expenses do count if ordinary to type of business)
21
Q
Tax treatment of extraordinary expenditures for business
A
Must be capitalized
22
Q
Ordinary expenditure
A
Vs capital
Ordinary expenditure (for business) is deductable rather than capitalized
23
Q
Necessary business expenses
A
Expenses that are appropriate and helpful in the taxpayer’s business (helpful is not necessarily indispensable)
Test - If other reasonable and prudent businessperson would incur same expense in similar circumstances
24
Q
What issue does the Reasonable expense requirement address?
A
Paying shareholders dividends disguise as salary so they can be deducted instead of taxed
Judged by duties vs compensation
25
Publicly held corporation
Any corporation
- considered an issuer required to securities with the SEC
- requires to comply with the reporting requirements imposed by SEC
26
Limitation on deduction for compensation paid by public corporations
$1,000,000 for covered employees (five highest compensated officers in the company: CEO, CFO, three others)
As of 2018 includes performance based compensation
27
Exception to rule that taxpayer must directly incurred all expenses being deducted
Medical expenses paid on behalf of a dependent and those who would otherwise be a dependent but they failed to meet certain tests (gross income
28
Assets used for both business and personal uses
Deductions may be limited, either personal uses must be reported as additional compensation or business must be reimbursed for the personal use
29
Capital expenditures
Expenditures that
- provide a permanent improvement or betterment that increases the value of an asset
- restore the asset
Generally must be capitalized and deducted over time in the form of depreciation
30
What assets may not be depreciated or amortized? And how is their cost recovered?
Land, stock, partnership interests
Recover cost only through sale
31
Election to deduct currently
Allows taxpayers to choose to take a current deduction for certain capital expenditures
- cost of fertilizer and soil and water conservation for farmers
- intangible drilling cost for gas and oil wells
- tertiary injectants
- certain mining development projects
- costs incurred to remove architectural and transportation carriers to the mobility impaired
- certain qualified research and experimental expenditures
(Doesn't change book value)
32
Other elections to deduct otherwise capital expenses
- may elect to deduct a limited amount of capital expenditures for tangible property bought for use in business
- 100% bonus depreciation deduction for qualified property (phased out between 2023 - 2026)
33
Normally deductable items that taxpayers can elect to capitalize
- interest & employment taxes incurred in transporting and installing personal, movable property up to time when taxpayer puts property into use
- annual property taxes, mortgage interest, and other getting charged on unimproved, unproductive real estate
- annual property taxes, interest, employment taxes, other expense incurred for development, improvement, or construction of real property (once construction is completed expenses must be deducted as incurred)
34
Election to capitalize deductable items length of effect
- for unimproved, unproductive real estate make make or change election every year
- for development or construction once election is made the election remains in effect until the project is completed (separate election for each project)
35
Why would a taxpayer want to capitalize deductable expenses
If they have large net operating loss carryovers or if they expected to be in a higher tax bracket in the future (so the future deduction would be more beneficial)
36
Expenses related to exempt income
May not be deducted at all
Including any debt taxpayer may incur to purchase or hold tax-exempt securities
37
Expenditures contrary to public policy
Taxpayers may not deduct expenditures if payment itself is illegal or if it is a penalty or fine resulting from an illegal acr
38
Fines imposed NOT due to illegal act
Can be deducted we ordinary and necessary business expense
39
Nondeductiblity of illegal payments under state law
Only if state generally enforces it's law
40
Rebate paid from seller to purchaser
Considered an adjustment of the selling price and is an exclusion from gross income
41
Medicare and Medicaid kickback, rebate, or bribe
May not be illegal but are still not deductable
42
Fines and penalties
Cannot be deducted from income if due to the violation of a law
43
Damages resulting from a conviction in an action regarding a criminal violation of the federal antitrust laws
Only 1/3 of payment is deductable
44
Items excluded from disallowance of deduction for payment of fines or penalties
Payments
- made as restitution for damages
- made to become compliant with the law violated
- ordered by a court in a setting in which the government is not a party (which are otherwise deductable)
45
Settlement payments to avoid litigation
Deductible if business related
Non-deductible if subject to nondisclosure and based on sexual harassment or abuse
46
Expenses relating to an illegal activity
Are deductible if they are ordinary, necessary, and reasonable and the taxpayer reports the income from the illegal activity
Except if business is trafficking or dealing drugs
47
Political contributions and lobbying expense
May not be deducted if made in connection with:
- influencing legislation
- participating or interviewing in any political campaign of any candidate for public office
- attempting to influence the general public with respect to elections, legislative matters, or referendums
- communicating with POTUS, VP, and certain other federal employees or officials
48
Payments for advertising in a convention or any other program
Disallowed as deduction it any part of the proceeds will directly or indirectly benefit a specific political party or candidate
49
In house expenses incurred directly by taxpayer trying to influence legislation on a local level
If less than $2,000 and legislation is of direct interest to taxpayers business and are all in house (not paid to lobbyists) may still be deducted
(Not if business is lobbying)
50
Limitation on business interest expense deductions
Deduction cannot exceed business interest income + 50% of adjusted taxable income (which must not be negative
Interest expense deduction disallowed by limit may be carried forward indefinitely and treated as an expense in later tax years
Does not apply to small businesses
51
Adjustable taxable income
Taxable income excluding:
- business interest income & expense
- nonbusiness income, gains, deductions, and losses
- cost recovery deductions
- net operating losses
52
Small businesses by gross receipts test
Average annual gross receipts may not exceeds $26,000,000 for prior three year period
53
Start up expenditures
- business investigation expenses (incurred before making decision to enter into business)
- pre opening start up costs (after decision to go into business but before business activity has started. (
Incurred by a taxpayer not engaged in any existing business related to business being acquired/created)
- expenses incurred in connection with an investment activity that taxpayer anticipates will become trade or business
- e
54
Expenditures to establish new business incurred by taxpayer already established in a similar business
Deductible
Considered to originate in existing business
55
Current deduction for start up expenditures
$5,000 deduction of start up costs allows the year the business starts
Reduced dollar for dollar by any amount of costs over $50,000
Only deductable if business is actually started
56
Start up costs in excess of allowed deduction
Must be capitalized and amortized over 180 months starting with month in which new business begins
57
Costs incurred in connection with issuance of stock and securities
Not start up costs. Capitalized as paid in caputwl
58
Cohan rule
While expenses must generally be substantiated a deduction may be allowed if substantiation is missing but expenditure was clearly made based on facts and circumstances
In which case an estimated deduction may be allowed
59
Deductions that must be fully substantiated
Travel
Entertainment
Business gifts
Computers
Vehicles for transportation
60
Information to substantiate expense
- amount of expense
- time and place of travel or entertainment
- date and description of gift
- business purpose of expenditure
- business relationship to the taxpayer of the person entertained or person who received the gift
61
When an expense is deductable under cash method accounting
When expense is paid
Check sent in one period but not received till next still considered paid in first period
62
Cash method: deductibility of a note payable
Not deductable until actually paid
63
Prepaid expenses
Even under cash accounting generally creates an asset and cannot be deducted unless expense expires
64
Exception to prepaid expenses rule
A taxpayer may take a current deduction for the entire amount of a prepaid expenditure IF the period covered is less than a year and the rent agreement obligates the taxpayer to make the prepayment
65
Deduction of prepaid interest
Deducted over the period of the loan to which the interest is allocated
66
Interest on a discounted loan
NOT prepaid interest. Deducted when loan matured and is paid
67
An interest point
One percent of the loan amount
68
Deduction of interest points
Generally amortized over the life of the loan.
Deducted when paid if paid in connection with purchase or improvement of personal residence
69
Circumstances under which points paid on the purchase of a principal residence are automatically deductable
Deductible in the year paid if:
- closing agreement designates amounts as points
- amount is computed as a percentage of the amount borrowed
- charging of business points is an established practice in the area
- points are paid in connection with the purchase of taxpayer's principal residence which is sued to secure the loan
70
Deductibility of points paid to refinance a mortgage
Over the life of the loan
71
Who is not allowed to use cash method for taxes
Tax shelters
Most c corps and partnerships with c corp partners
Businesses with income producing inventory (unless they qualify as small by the gross receipts test)
72
Accrual method deductions
Expenses deducted in the period in which they accrue
73
Tests for telling when expenses accrue
All-events test
Economic performance test
74
All-events test
Expenses accrue when both:
- the existence of the liability is established
- the amount of the liability is determined with reasonable accuracy
75
Additions to reserves for estimated expenses
May not be deducted until liability is fixed (work is actually performed)
76
Economic performance test
Economic performance depends on type of transaction
Basically when the event that gives rise to the liability has come to pass
77
Recurring liability Exception to the economic performance test
Taxpayer may take a current deduction for recurring liabilities if:
- item meets the all events test during the year and,
- economic performance occurs with the shorter of 8.5 months or a reasonable period after the close of the tax year and,
- expense is recurring and taxpayer consistently treats the item as incurred in the tax year and,
- item is not material or accrual of the item in the tax year results in a more proper matching than accruing the item in the year of economic performance
Not available for payments made to others due to a judicial settlement or similar
78
Special rule for real property taxes
Taxpayer may elect to accrue real property taxes ratably over the period to which taxes relate
Once election is made it is irrevocable unless the taxpayer obtains permission from the IRS
79
Wash sale on stock or security
When
- a taxpayer realizes a loss on the sale of stock or securities, and
- the taxpayer acquired "substantially identical" stock or securities within a 61 day period from 30 days before the date of sale to 30 days after
Such losses not deductable
Cannot circumvent via indirect transactions
If shares acquired are fewer than shares disposed of then only proportionate amount is disallowed
80
Cases where taxpayers may recognize a loss that technically falls within the wash sale requirements
- stocks purchased and a portion sold at a loss within 30 days (where intent is to reduce taxpayers holdings)
- losses of a dealer in stock or securities realized in normal course of business
81
Substantially identical stock or security
If terms are different stock is different
82
Wash sale change on basis on stock
If wash sale loss is disallowed then the disallowed loss increases the basis of recently acquired stock (essentially defers the loss)
If more stock purchased than sold stock that caused the loss to be disallowed is accounted for chronologically
Holding period of replacement stock includes holding period of stock sold
83
Under section 267 related taxpayers may not take deductions on what types of transactions?
- losses on sale of property
- accrued expenses that remain unpaid to the related cash method taxpayer at the end of the year
84
Related parties
- Individuals and families
- Corp where the individual owns more than 50% controlling stock
- trust relationships depending on ownership requirements
- corporation and partnership where same person owns more than 50% of each
- two corporations where same person owns more than 50% of each and one is an s corp
85
Constructive ownership rules
Stock owned by an individual's family is treated as owned by a individual
Stock owned by a corp is treated as own proportionately by entity's shareholders (though it does not follow that the shareholders family are considered owners)
86
Subsequent sale of a property with previous loss between related parties disallowed
Any subsequent gain on sale may be offset by the amount of the previous allowed loss (only up to total amount of gain)
If sold at a loss cannot take any deduction for unused loss
87
Disallowed deduction for accrued expenses that remain unpaid to the related cash method taxpayer at the end of the year
If related Accrual method taxpayer may not deduct expenses until cash method taxpayer receives the income
Related parties for this purpose include personal service corporation and employee-owner and any person who owns (actually or constructively) any interest in an s Corp or partnership
88
Personal service corporation
A corporation whose principal activity is the performance of personal services substantially performed by employee owners
89
Employee-owner
An employee who owns any of the outstanding stock of a personal service corporation
90
Factors considered for determining profit motive vs hobby
- if activity is conducted in a businesslike manner
- expertise of taxpayer or taxpayer's advisors
- time and effort expended by taxpayer
- if the assets used in the activity are expected to appreciate in value
- taxpayer's success in carrying on other similar activities
- taxpayer's history of profits or losses with regards to the activity
- amount of occasional profits earned
- taxpayer's financial status
- elements of personal pleasure or recreation involved
None alone are determinative
91
Tax status of activity if clear profit motive cannot be shown
Activity may be presumed to be engaged in for profit if it shows a profit for any three years of a consecutive five-year period (the year of the tax return and the four years previous)
If activity meets this test the IRS has the burden to show the activity is not profit motivated otherwise burden on taxpayer to show that it is profit motivated
92
Primarily personal residence
Home is rented for fewer than 15 days
Taxpayer may exclude rental income from gross income but may not deduct home expenses (except as allowed for itemized)
93
Mixed personal and rental
Home is rented for more than 14 days and taxpayer's personal use of the home exceeds the larger of 14 days or 10% of rental days
94
Tax treatment of Mixed personal and rental property
Taxpayer must report in gross income all of the rental income and may offset rental expenses against the income but only to the extent of the income
No rental loss allowed
Expenses not deductible in one year can be carried forward and deducted against the subsequent years income
95
Primarily rental property
Home is rented for more than 14 days and the taxpayer's use of the home did not exceed the larger of 14 days or 10% of rented days
96
Tax treatment for primarily rental property
Taxpayer must report in gross income all of rental income and may offset allocated rental expenses against that income even to the extent of a rental loss
97
What is the maximum number of days during a year that a taxpayer may use a property for personal use and not have it considered to be a residence
33 says of personal use with 332 days of rental
98
Day of personal use
Any day:
- taxpayer or their family uses the property for personal purposes (only immediate family, direct line, and ancestors) (though not if full time spent substantially on repairs)
- individuals use the property under a reciprocal use agreement
- individuals use the property and do not pay fair rental for use
99
Allocation of property expenses
Must be done if home is used both personally and for rental purpose
Rental use expense = (number of rental days / total days used) x expenses for the year
(Some courts have denominator to be total days in year for purpose of allocating interest expense and property taxes)
100
Qualified residence for purpose of deductions from AGI
Taxpayer's usage must exceed the greater of 14 days or 10% of rental days
101
Residence related deductions FROM AGI
- real estate taxes paid on personal use property
- certain interest expense paid on a qualified residence
102
Order of deductions for vacation home expenses that exceed gross rental income
1) expenses that are deductible even when not incurred in trade or business
2) expenses that would be deductible for trade or business but do not affect the property's basis
3) expenses that would be deductible for trade or business that reduce the basis of the property's
Once reach limit of what may be deducted from rental income whatever's left can be a personal deduction IF ALLOWED
103
Restrictions on expense allocation method
Must be consistent over time
104
Deduction for home office expense
Disallowed unless office is used regularly and exclusively as:
- the principal place of business for a trade or business of the taxpayer, or
- a place where the taxpayer meets or deals with clients in the normal course of business
105
Payback or hedge agreement for unreasonable compensation
Agreement where employee must return to the corporation any compensation payment deemed excessive. Employee receives a deduction TO ARRIVE AT AGI for the amount repaid in the year of repayment
Required
- agreement entered into before actually making payment
- agreement legally obligates the employee to repay the excess amount
106
Form 5213
Election to postpone determination as to whether the presumption that an activity is engaged in for profit applies
Keeps returns open until sufficient years have passed for application of the test (5 or 7 total so 2 or 4 after usual statute of limitations)
