Chapter 6: Deductions And Losses Flashcards
Three general categories of deductions
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
Deductions for AGI
Deductions subtracted from gross income in order to calculate adjusted gross income
Deductions from AGI
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
Common deductions to arrive at AGI
- 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
Alimony paid as a deduction to arrive at AGI
Only for divorce agreements finalized before 2018
Moving expenses as a deduction to arrive at AGI
From 2017 to at least 2025 limited to active duty armed forces members
Medical expense deduction limitation
Taxpayers may only deduct medical expenses EXCEEDING 7.5% of years AGI
Casualty losses on personal use property limitations
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
Where do deductions to arrive at AGI appear on the tax return
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
Requirements for business expense deductions
Must be:
- related to a profit-motivated activity
- ordinary
- necessary
- reasonable in amount
- properly documented
- an expense of the taxpayer (not someone else)
Expenditures that cannot be deducted
- capital expenditures
- expenses related to tax exempt income
- expenditures that are illegal or in violation of public policy
- anything specifically disallowed by tax law
Tests of profit motivated activities
1) determination if expenditure originates from activity engaged in for profit
2) distinction between trade/business vs investment activity
determination if expenditure originates from activity engaged in for profit
No single objective test rather a series of considerations to determine the motive of the activity
Distinguishing between trade or business activity and investment activity
(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)
Are expenses incurred for investment activity deductable?
Generally no, except for those incurred to produce rents and royalties
Judicial definition of trade or business
“holding one’s self out to others as engaged in selling goods or services”
Deductions of legal and accounting fees
- 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
Tax preparation that may be deducted to arrive at AGI
Preparation of business schedules: C, E, and F
Legal fees are incurred in connection with purchase of personal property
NOT deducted
Rather capitalized: added to the total basis of the property
Requirements for an ordinary expense
- 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)
Tax treatment of extraordinary expenditures for business
Must be capitalized
Ordinary expenditure
Vs capital
Ordinary expenditure (for business) is deductable rather than capitalized
Necessary business expenses
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
What issue does the Reasonable expense requirement address?
Paying shareholders dividends disguise as salary so they can be deducted instead of taxed
Judged by duties vs compensation
Publicly held corporation
Any corporation
- considered an issuer required to securities with the SEC
- requires to comply with the reporting requirements imposed by SEC
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
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
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
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
What assets may not be depreciated or amortized? And how is their cost recovered?
Land, stock, partnership interests
Recover cost only through sale
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)
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)
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)
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)
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)
Expenses related to exempt income
May not be deducted at all
Including any debt taxpayer may incur to purchase or hold tax-exempt securities
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
Fines imposed NOT due to illegal act
Can be deducted we ordinary and necessary business expense
Nondeductiblity of illegal payments under state law
Only if state generally enforces it’s law
Rebate paid from seller to purchaser
Considered an adjustment of the selling price and is an exclusion from gross income
Medicare and Medicaid kickback, rebate, or bribe
May not be illegal but are still not deductable
Fines and penalties
Cannot be deducted from income if due to the violation of a law