Chapter 8 Flashcards
what has
Congress chosen to place limitations on
the ability of taxpayers to take certain deductions and losses
what are
some of the most common limitations
- Public policy limitations
- Political contributions
- Excessive compensation
- Hobby losses
- Rental of vacation homes
- Personal expenditures
what do
public policy concerns do
impose some limitations on taxpayers’ ability to take deductions
are they permitted or not permitted?
in terms of income tax purposes, deductions for activities that violate public policy
they are NOT permitted for income tax purposes
what are
4 items that are NOT DEDUCTIBLE due to public policy limitations?
penalties, fines, illegal bribes & kickbacks
their purpose
Penalties & Fines
intended to be a form of punishment for legal violations
purpose/define it
Bribes & kickbacks
are illegal acts themselves, and are never deductible for income tax purposes
- This rule applies even when it is customary to provide bribes to facilitate the conduct of business
- Individuals engaged in international business transactions in some parts of the world may be faced with such a situation.
how is it treated
giving or receiving a bribe
- It’s an illegal act in the United States and may also be a violation of the Foreign Corrupt Practices Act)
- These payments may never be deducted on a taxpayer’s income tax return, even if they are considered reasonable, ordinary, and necessary expenses in that jurisdiction.
what can they do
some illegal activities
can generate permissible income tax deductions
what can taxpayer do
If a taxpayer is involved in the operation of an illegal trade or business
taxpayer is permitted to take all ordinary, necessary, and reasonable expenses associated with the production of that income as if the business activity was a legal business.
they cannot be what
fines, penalties, bribes & kickbacks
may not be deducted, and are not considered to be ordinary, necessary, or reasonable business expenses
define
16th Amendment
grants Congress the power to collect tax on income from whatever source derived
define
income
constitutes the gross receipts of a business enterprise reduced by all ordinary, reasonable, and necessary expenses to generate that income.
how do
smart criminals report their illegal sources of income
as “other income” on their tax return
what can’t the IRS do
b/c of the imposition of privacy rules on the IRS….
IRS cannot inform the Department of Justice, or other law enforcement agencies, that the taxpayer is conducting an illegal business activity
indicating what
by structuring the system to have public policy rules, Congress is clearly indicating that….
it wants to tax ALL income from whatever source derived, even if that income is generated by illegal activities
what do
the public policy rules provide
provides a fair degree of protection to the criminal, and encourages reporting of illegal source income
what deduction can taxpayers take if
the illegal activity generatign income involves trafficking in controlled substances (drugs)
The ony deduction the taxpayer is permitted to take is the cost of goods sold (the cost of the drugs)
may permit what
state laws
may permit ther sale and distribution of weed within the state
what does it do
The act of selling or distributing weed
violates federal law
when can
companies deduct COGS from gross income when calculating taxable income for federal income tax purposes
when a company that has received a license from a state government to distribute marijuana within the state
(All other expenses incured in the business of selling and distributing marijuana (other than COGS) may not be deducted on the business’s federal income tax return))
not permitted to do what
generally, businesses & individuals are
not permitted to deduct political contributions or lobbying expenses
can do what
businesses can
- deduct expenses associated with the monitoring of legislation
- deduct de minimis in-house expenses associated with lobbying, provided that the total expenses incurred do not exceed $2,000
If the expenses do exceed $2,000, none of the expenses are deductible
by what
many large businesses may be affected…
pending legislation, and need to know if that legislation becomes law due to the added compliance responsibilities that must be performed
These types of expenditures do not attempt to influence legislation, and are considered ordinary, necessary, and reasonable business expenses
subject to what
publicly held corporations are subject to
to a deduction limitation on executive compensation
what is the amount
maximum deduction that can be taken for compensation paid to the chief executive officer, the chief financial officer, and the three highest compensated executives (covered employees)
$1 million each
when is it
not deductible by the corporation
if the regular compensation of the chief executive officer, the chief financial officer, and the three highest compensated executives (covered employees) or (the top 5 officers) is in excess of $1 million
what happens if they no longer work for the company
covered employees
once an employee becomes a covered employee, they will remain a covered employee even when no longer working for the company
when does it not apply
$1 million compensation limitation
doesn’t apply to payments to qualified retirement plans or payments that are otherwise excludable from gross income
what expenses
are deductible against income
all ordinary, necessary & reasonable business expenses
how to be classified as a
business activity
taxpayer must have a profit motive
why do
some individuals attempt to classify their hobbies as business activities
so that they can deduct the expenses incurred in engaging in the activity
define
hobby activity (under IRS Section 183)
- any activity that the taxpayer engages in without a profit motive
- usually are activities that involve personal pleasure, such as collecting exotic cars, raising horses, gardening, racing sailboats, and collecting and/or trading stamps or coins
is it difficult
determining when an activity is a hobby or a trade or a business
yes, but the distinction between the two centers on the presence or absence of a profit motive
what does it NOT imply
profit motive
doesn’t imply that the activity must generate a profit each year
- most profit-motivated business activities generate losses in the early years of operation, turning profits as the business matures
define
profit motives (under Treas. Reg. 81.183-2 (a))
an actual and honest, even though unreasonable or unrealistic, profit objective in engaging in the activity
what are the 9 factors for determining profit motive
Treas Reg. $1.183-2 (b) provided nine factors that should be considered in determining whether or not a taxpayer has a profit motive
- The manner in which the taxpayer manages the activity
- The time and effort spent in running the activity
- The expertise of the taxpayer and the taxpayer’s advisors
- The taxpayer’s success in similar activities
- The taxpayer’s history of profit/loss associated with the activity
- The amount of occasional profits generated by the activity
- The expectation that assets used in the business will increase in value
- The financial status of the taxpayer
- The extent to which personal pleasure or recreation dictates the taxpayer’s involvement in the activity
define
IRC Section 183
(the presumptive rule)
sets forth a rebuttable presumption that an activity is engaged in for profit if the activity has generated a profit in three out of the last five years
what happens if
the activity generates a profit for the required number of years
under IRC Section 183
burden of proof shifts to the IRS to show that the taxpayer did not have a profit motive
what happens if
the activity does not generate a profit for the required number of years
under IRC Section 183
the taxpayer has the burden of proving that they have a profit motive for the activity
what happens when
When a taxpayer operating an activity has a profit motive
the activity is classified as a trade or business.
define
business expenses
are deductible against the income of the business (above the line) even if the expenses exceed the income from the business (generating a loss)
what happens if
The business is a passive activity
the loss may be suspended under the at-risk or passive activity loss rules
what happens
When there is no profit motive and the activity is classified as a hobby
all of the hobby income must be included in gross income, and expenses associated with the activity cannot be deducted after 2017 (TCJA 2017)
when was this
many hobby activity expenses were deductible as miscellaneous itemized deductions subject to a two percent hurdle and only up to the extent of hobby income
prior to TCJA 2017 & other hobby expenses, such as mortgage expense or property taxes, were not subject to the two percent hurdle
in terms of rental of vacation homes, what does it do
the use of rent received to reduce mortgage balances plus appreciation on the real estate over time
it assists in the wealth accumulation process
what are they
almost all rental real estate activities
passive activities and are subject to the passive activity loss rules
when and why is it used
two part test
To determine whether a rental activity will be treated as a nontaxable rental activity, primarily rental use, or as mixed-use activity
define purpose
1st part of two part test
- Addresses the question of whether the real estate was rented for less than 15 days.
- If the property is rented for 14 days or less, the activity will be a nontaxable rental activity for income tax purposes.
- None of the income received from the rental activity will be included in income, and none of the expenses associated with the rental may be deducted
This rule follows the general tax principal that states deductions are only permitted for items that
define purpose
2nd part of two part test
- If real estate is rented for 15 days or more, the 2nd test will determine the classification of the activity for federal income tax purposes
- focuses on the personal use of the property by the owner
what is it classified as if
If the owner’s personal use of the property does not exceed the greater of 14 days or 10 percent of the rental days
from determination of the 2nd test
classified as a primarily rental use activity
what is it classified as if
If the owner’s personal use of the property DOES EXCEED the greater of 14 days or 10 percent of the rental days
from determination of the 2nd test
classified as a mixed-use rental activity
how to determine
the # of days of personal use
- use by family members who do not pay fair rental value are treated as personal use days
- family members include:
- spouse, ancestors, lineal descendants & siblings of the owner
list
3 ways that a rental real estate activity can be classified for income tax purposes
- as a nontaxable rental activity
- as a primarily rental use activity
- as a mixed-use rental activity
define
Nontaxable rental activity
- income is not reported but expenses may not be claimed
- taxpayer is not required to prorate mortgage interest and taxes between personal use and nondeductible rental use when the activity is classified as a nontaxable activity.
To the extent that the taxpayer makes mortgage interest or property tax payments on the property, however, those amounts can be claimed as personal expenses as itemized deductions
define
Primarily Rental Use Activity
- taxpayer must report all of the income generated from the activity, but is permitted to deduct all ordinary, necessary, and reasonable expenses associated with the operation of the activity even if the activity produces a loss
- The profit or loss from this type of rental activity is reported on Schedule E of Form 1040, and only the net profit or loss enters the taxpayer’s gross income
While losses can be generated on a primarily rental use activity, they may not be currently deductible by the taxpayer due to the application of the at-risk rules and passive activity loss rules
what are they
expenses for primarily rental use activities
are above-the-line deductions, and directly offset the income from the activity
define
Mixed-Use Activity
- tax rules that apply are similar to the hobby loss rules prior to TCJA 2017.
- All of the income of the activity must be reported, but the taxpayer can only claim expenses in the current year to the extent of the income from the activity
- (stated differently, the activity cannot generate a loss above the line)
- All of the income of the activity must be reported, but the taxpayer can only claim expenses in the current year to the extent of the income from the activity
how are deductions handled
the order in which deductions are taken from mixed-use activities
- matches the prior rules that applied to hobby losses.
- Expenses that are otherwise deductible (“Tier 1 expenses” such as mortgage interest and taxes) are claimed first,
- followed by other non-depreciation expenses (“Tier 2 expenses”),
- and finally depreciation or cost-recovery expenses (“Tier 3 expenses”).
what happens
if only a portion of the expenses that are otherwise deductible on schedule A (such as mortgage interest and taxes) can be taken against the income from the mixed-use property
the remainder of those expenses, with some limitations, can be taken as itemized deductions, assuming the taxpayer itemizes. In such a case, total deductible expenses associated with the property may in fact exceed the income from the mixed-use property.
mixed-use property is never subject to what
While the taxpayer may not be able to claim all of the expenses associated with the activity, mixed-use property is never subject to
the passive loss limitations or the at-risk rules because it cannot generate a loss
in what 2 ways do they differ
Mixed-Use Rental Real Estate Activities vs. Old Hobby Loss Rules
- Any disallowed rental expenses can be carried forward and deducted against income in future years (to the extent that the deduction of those expenses will not cause the activity to show a loss)
- The expenses that are deductible are deducted directly against the income of the property, and are therefore above-the-line deductions.
* Other than itemized deductions such as mortgage interest or property taxes that would otherwise be deductible, hobby expenses are no longer deductible after 2017.
they must be what
Expenses incurred in the operation of both mixed-use activities and primarily rental use activities
- must be allocated between personal and rental expenses
- (only the rental expense portion is deductible)
