Part 2 - Businesses - Unit 2 - Content Flashcards
1
Q
Business Income
A
- Although most income that a business receives is taxable, there are certain exceptions where income is deferred, or not subject to tax at all.
- For example, a corporation or partnership may choose to invest in tax-exempt muni bonds, just like an individual taxpayer. The interest income received from the muni bonds would retain its character as tax-exempt income to the business. Businesses may also engage in “tax deferred” transactions, where the taxation of income is deferred to a later date.
- An example is a section 1031 exchange, which allows for the deferral of income on the exchange of business or investment real estate.
2
Q
Advance Payments for Services
A
- Advance payments for services are generally taxable in the year it is received, even by an accrual-basis taxpayer.
- However, an accrual-basis taxpayer can elect to accrue income for advance payments for the year of receipt of the advanced payment using the same figure used for financial accounting purposes, with the remainder of the advanced payment reported as taxable income in the following year - regardless of the number of years of services that are to be provided.
- The taxpayer cannot postpone the recognition of income beyond the year following the year of the advanced payment.
- This election to defer some income into the year following the receipt of the advance payment does not apply to advanced payments received for prepaid rent, interest and insurance premiums. In these situations, the prepaid payments must be fully reported in taxable income in the year received.
3
Q
Warranties & Service Agreements
A
- Guarantee or Warranty: Many companies provide or sell additional warranties on their products. Cash basis taxpayers would recognize income at the time of the sale. Generally, an accrual-basis taxpayer normally cannot postpone reporting income received under a guarantee or warranty contract. However, IRC Section 451(c) provides a rule for a taxpayer using an accrual method of accounting to elect to defer certain advance payments in gross income, recognizing income in the year of receipt only to the extent income is effectively earned in that first year (i.e., a properly accrued amount in the year of the advance payment) and recognize all the remaining gross income in the next tax year.
- Service Agreements: If a business receives an advance payment for a service agreement on property it sells, leases, builds, installs, or constructs, the business can postpone reporting income, but only if it offers the property without a service agreement in the normal course of business.
- Example: Albatross Copiers, Inc. is an accrual-based, calendar-year corporation that sells commercial copiers to large businesses. Albatross Copiers offers copier service agreements to customers that purchase a commercial copier, but the service agreements are optional. On July 1, 2023, Albatross Copiers receives a $12,000 payment for a one-year service contract ($1,000 per month) that specifies the company will service and repair any copier components that break. Since the $12,000 payment is for a service contract, Albatross Copiers may choose to include each payment evenly in gross income over the current and the following tax years as it is earned, rather than recognizing all the income for the contract at once when payment is received. Albatross Copiers cannot delay recognition of the income beyond the next tax year (2024).
4
Q
Types of Income
A
- The three main categories of income to remember for the EA exam are: (1) active income, (2) passive activity income, and (3) portfolio income. Portfolio income includes interest, dividends, etc.
- Do not confuse the widely-used term “passive income” with “passive-activity income.” They are not the same thing.
- Although some of these items seem “passive” in nature, they are, by definition, excluded from treatment as passive activities. This categorization of income is important because passive activity losses generally cannot be offset against active income or portfolio income (with a few exceptions).
5
Q
Passive Activities - In General
A
- Certain types of business activities are considered passive activities and are subject to passive activity limits on the deductibility of losses. These “passive activity loss rules” are designed to prevent investors from using losses incurred from income-producing activities in which they do not materially participate.
- The passive activity rules apply to individuals, estates, trusts (other than grantor trusts), personal service corporations, and closely held corporations. The rules also apply to owners of grantor trusts, partners in a partnership, and shareholders of an S corporation (but not to the entities themselves).
- There are two kinds of passive activities:
- 1.Passive business activities: These are trade or business activities in which the taxpayer does not materially participate during the year.
- 2.Rental real estate activities: Rental of real estate is generally passive, even if the taxpayer participates in the activity, except for bona fide real estate professionals.
- Note: “Active” participation isn’t the same as “material” participation. Active participation is a less stringent standard than material participation.
- Example: Rose is a wealthy retiree. She no longer works in a regular job, but she owns a partnership interest in multiple limited partnerships. She is merely an investor and has no participation in any of the businesses. Each partnership is profitable, and she receives a Schedule K-1 showing her share of partnership income, which she would report on Schedule E . Since she is a limited partner, she has the benefit of receiving passive income, which is not subject to self-employment tax.
- Example: Riddick owns two residential rental properties. He also has a full-time job as a postal worker. He “actively” participates in the rental activity by personally collecting rents from his tenants and checking on the properties on a regular basis, but he is not a real estate professional. He reports income and loss from his rentals on Schedule E, and his rental activity is still considered a passive activity. The rental income is not subject to self-employment tax.
6
Q
Passive Rental Income
A
- Rental income (and losses) and the treatment of rental income may be tested on Part 1 or Part 2, these concepts are now listed on the Prometric testing specifications on both parts of the EA exam for the current exam cycle.
- We cover Rental Income in detail in Part 1, Unit 9 (please review those webinars if you have not done so already).
- We will be covering Real Estate Professionals and grouping elections in this webinar.
7
Q
NOT Passive Activity Income
A
- By definition, “passive activity income” also does not include:
- Portfolio income: Such as interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business, or gain or loss from the disposition of property that produces these types of income or that is held for investment.
- Personal service income: This includes salaries, wages, commissions, self-employment income from a business, deferred compensation, and guaranteed payments from partnerships to partners for personal services.
- Income from intangible property: income from a patent, copyright, or literary, musical, or artistic composition, if the taxpayer’s personal efforts significantly contributed to the creation of the property.
- State, local, and foreign income tax refunds.
- Income from a covenant not to compete. A “covenant not to compete” is a type of legal agreement between two parties. Sometimes a business will pay another business or individual for agreeing not to enter into direct competition.
- Alaska Permanent Fund dividends.
- Cancellation of debt income: if at the time the debt is discharged, the debt is not allocated to passive activities; it is not considered passive activity income.
8
Q
Passive Activity Losses
A
- Losses from passive activities that exceed the income from passive activities in a given year are generally disallowed as deductions for the current year.
- IN GENERAL, passive activity losses are deductible only to the extent that the taxpayer has income from other passive activities to offset the losses, or when the taxpayer completely disposes of the activity. Suspended losses can be carried forward to the following year, subject to the same passive loss rules and limitations.
- Noncorporate taxpayers use Form 8582, Passive Activity Loss Limitations, to summarize income and losses from passive activities and compute deductible losses.
- Example: Brandon works as a regional director for a sporting goods store. He is also an investor in a limited partnership, Skadden Mining, LP. He does not participate in the businesses at all; he is merely an investor. Brandon earns $80,000 in wages from his regular full-time job, as well as $13,000 in losses from his limited partnership investment. He has no other income or loss for the year. Brandon’s $13,000 passive activity loss is disallowed in the current year. He can carry forward the losses indefinitely until he has passive income to offset, or he disposes of the activity.
- Example: Evie owns a 25% interest in a partnership that runs a Miami nightclub and a 10% interest in an S corporation that runs a farming business. She has no involvement in the day-to-day operation of either business; therefore, her interest in each business is considered a passive activity. The nightclub incurred an ordinary loss of $40,000, of which $10,000 is allocated to Evie because of her 25% ownership. The farming business has ordinary business income of $75,000, of which $7,500 is allocated to Evie because of her 10% ownership. As Evie’s losses from passive activities for the year exceed her income from passive activities by $2,500 ($10,000 of loss - $7,500 of income), deduction of the excess loss is disallowed in the current year. Evie may carry forward the $2,500 excess losses to the following year.
9
Q
Dispositions
A
- When there is a qualifying disposition of a passive activity, suspended losses from that activity may be claimed in full. The activity must be sold to an unrelated party in a fully taxable transaction. Current and suspended losses related to the activity are “released” and may be used to offset gain from the sale. In other words, upon complete disposition of the activity, all passive carryovers are allowed.
- Example: Lyle is a 5% limited partner in Luna Palace, LP a Florida golf resort. For the last three years, the resort business has incurred losses, for a total passive loss of $150,000. These passive losses were suspended and carried over on Lyle’s individual tax returns because of passive activity loss limitations. This year, Lyle decides that the resort will never be profitable. On June 30, Lyle disposes of his entire partnership interest by selling it to an unrelated person. The full $150,000 in suspended losses are deductible in the year that Lyle completely disposes of the activity.
10
Q
Former Passive Activities
A
- Sometimes an activity will be passive in one year, and not passive in the next. A “former” passive activity is an activity that was a passive activity in an earlier tax year, but is not a passive activity in the current tax year.
- For example, a business investor who decides to take an active role in business operations in the current year. A prior year’s disallowed loss from the activity can be deducted up to the amount of current year income from the activity if the taxpayer is now materially participating in the business.
- This means that the suspended losses from the converted activity may be offset against the income from this activity after the taxpayer becomes a material participant.
- Example: Noriko is a 30% partner in Sandal Source, LLC, a retail shoe store. She is only an investor and has never participated in the business—her cousin, Emiko, who is a general partner, completely ran the business. As such, this activity is treated as a passive activity to Noriko. The store had a net operating loss in 2022. The distributive share of loss received by Noriko was ($20,000). Noriko did not have passive income from any other sources during the year, so her loss was not deductible and was carried forward to the following year. Effective January 1, 2023, Noriko begins working full-time at the store in order to save on employee wages and also to help her cousin with the daily management. As such, for 2023, Noriko would be considered to be materially participating in the activity, and any profits generated during the year can be offset from the prior-year loss when it was a passive activity.
11
Q
Types of Rental Income
A
- Rental income earned by a sole proprietor, and related expenses, are generally reported on the following forms:
- Schedule E, Supplemental Income and Loss, is used by taxpayers who are not professional real estate dealers or do not provide substantial services.
- Schedule C, Profit or Loss from Business: Used for professional real estate dealers, and by owners of hotels and boarding houses who provide “substantial services” for tenants or guests. Normally services such as daily maid service, towels, breakfast, daily cleaning, etc. will be considered a substantial service.
- Special rules and forms apply to farmers, which we cover in the Farming chapter.
- Partnerships and S corporations use Form 8825 to report income and deductible expenses from rental real estate activities.
12
Q
Real Estate Professionals
A
- For a taxpayer to be considered a “real estate professional,” they must meet certain criteria. If they do qualify, any losses from rental real estate activities where they materially participate are not classified as passive and can be deducted in full.
- However, if they do not meet the requirements for being classified as a real estate professional, any rental losses are typically classified as passive and can only be deducted up to $25,000 according to the previously mentioned passive activity rules.
- In addition, a “real estate professional” must materially participate in each real estate rental activity in order for that activity to be considered nonpassive.
13
Q
REP: Two Tests
A
- To be classified as a real estate professional, a taxpayer must (1) provide more than one-half of their total personal services in real property trades or businesses in which they materially participate, and (2) perform more than 750 hours of services during the tax year in real property business activities, which includes: property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage services.
- In most instances, even if a taxpayer is a real estate professional, but they only provide basic services to tenants, such as trash collection, the owner would report rental income and expenses on Schedule E, Form 1040, and the rental income would not be subject to self-employment tax.
- Note: One major benefit of being classified as a “real estate professional” is that the taxpayer is not subject to the 3.8% Net Investment Income tax (NIIT) on income from rental real estate activities in which they materially participate.
- Example: Hoshi spends 800 hours a year repairing, maintaining, and dealing with tenants at her five apartment complexes, which she owns. Every spring, she also works part-time in her father’s accounting firm, to help him through the busy season. She works 500 hours total at her father’s accounting firm. Because Hoshi (1) spends more than 750 hours materially participating in real estate, and (2) the 800 hours of real estate services is more than half of the 1,300 hours of total time she spends on both real estate and accounting services for the year, she is classified as a real estate professional. As such, if she generates a tax loss in her rentals for the year, she will be able to deduct the losses on her return without any limitations.
- Example: Sofia is a self-employed real estate agent. She also owns four residential rental properties, all of which she manages herself. She also materially participates in each of the rental activities, as she is the only one doing any work for them. Sofia works more than 2,000 hours per year (40 hours a week), working in her real estate business and managing the rental properties that she owns. She meets both hours tests for real estate professional status and can deduct any losses from the rentals against non-passive income. She will report her rental activities on Schedule E, and her realtor’s commissions on Schedule C. Her losses are not limited.
14
Q
Hotels and Motels
A
- Operators of hotels, motels, boarding houses, and bed and breakfasts must report their rental income on Schedule C, not Schedule E.
- If the property is rented only for short periods and if the owner provides “substantial services” to the tenant, such as daily maid service, laundry service, or regular breakfast service, the property owner should report the rental income and expenses on Schedule C (Form 1040), Profit or Loss from Business, rather than Schedule E.
- In some cases, renting out part of a house can be classified for tax purposes as the equivalent of running a bed-and-breakfast. The facts and circumstances of each situation must be considered to determine if the taxpayer is providing “substantial services” to a tenant.
- Example: Hattie owns a small, 10-unit motel near downtown Cincinnati. The hotel does not offer long-term rentals, and Hattie’s hotel license only permits guests to stay a maximum of 30 days or less. Her hotel offers full maid service, cleaning, and breakfast daily. Since Hattie provides “significant services” as the motel owner, the income and expenses would be reported on her Schedule C.
- Example: Mandy lives in a popular tourist area in Palm Springs, CA. She has a small granny cottage behind her home. Mandy listed her granny cottage on a popular website for vacation rentals, Airweb. She used Airweb to rent her cottage 140 days last year to several guests. She provides daily cleaning service, continental breakfast service, and fresh towels and linens, just like a hotel would. Even though she is not a real estate professional, Mandy would report the rental income and related expenses on Schedule C, not Schedule E, because she is providing a short-term rental and “substantial services” to her tenants.
15
Q
Real Estate Developers and Dealers
A
- A “real estate developer” (or real estate “dealer”) is someone primarily engaged in the business of purchasing land or real estate for development, managing the construction process, and selling real estate to customers. For a real estate developer, the real estate is treated as inventory. Note that this is not the same thing as a “real estate professional.” Income earned by a real estate developer is reported on Schedule C, if the taxpayer is self-employed. The income is subject to self-employment tax.
- Example: Bobby is a self-employed real estate developer. He purchases tracts of land, subdivides and constructs houses and condominiums for resale. Occasionally he will sell off individual parcels to other developers or private buyers. Bobby is a professional real estate dealer. The land he purchases is inventory, because all the land he is buying is specifically for resale. He would report his income on Schedule C, and all his profits would be subject to SE tax.
16
Q
Grouping Business Activities
A
- A taxpayer may elect to “group” multiple business activities or multiple rentals as a single activity for purposes of the passive loss restrictions. If two activities are grouped into one larger activity, a taxpayer needs only to show material participation in the activity as a whole.
- In other words, grouping activities together allows taxpayers to treat them as one when applying the tests to determine material participation. If activities are not grouped, the taxpayer must show material participation in each one.
- This type of election is called a “Section 469 grouping” election.
- This election is irrevocable and will remain in effect for any future tax years. The election to group activities is made by filing a statement with the taxpayer’s original income tax return for the taxable year.
- If one component of a grouping is disposed of in a fully taxable transaction, then the suspended passive losses from that activity are not released until the entire grouping is disposed of in a fully taxable transaction.
- Example: Douglas is a minority owner in four businesses, all of which are farming businesses. His ownership stake in each business is as follows:
- 5% limited partnership interest in a timber farm
- 5% S corporation shareholder in a mushroom farm
- 10% limited partnership interest in a hog farm
- 15% S corporation shareholder in a dairy farm
- Douglas works in each business sporadically and does not meet the material participation tests for any of the businesses individually. However, he can meet the 500-hour material participation test if he groups all the activities together in a single economic unit. He makes the election by attaching a statement to his individual Form 1040 for the year. This is an example of a Section 469 election.
17
Q
Appropriate Economic Units
A
- Multiple business activities can be grouped, and multiple rental activities can also be grouped.
- In general, a rental activity cannot be grouped with a trade or business activity. However, they can be grouped together if the activities form an “appropriate economic unit.”
- Whether activities constitute an appropriate economic unit depends upon all the relevant facts and circumstances.
- Example: Joseph and Tammy are married and file jointly. Joseph is the only shareholder of Eco-Dry Cleaners, an S corporation. Tammy is the only shareholder of Tammy-Holdings, an S corporation that owns a commercial office building, part of which is rented to Eco Dry Cleaners (her husband’s business). Since Joseph and Tammy file a joint return, they are treated as one taxpayer for purposes of the passive activity rules. Common ownership applies (Joseph and Tammy, who are a married couple) to both businesses, with the same ownership interest (100% in each). Joseph and Tammy may conclude that Tammy-Holdings’ rental activity and Eco-Dry Cleaners form an appropriate economic unit and group them as a single business activity, if they wish.
18
Q
Grouping Statement
A
- The statement required must identify the names, addresses, and employer identification numbers (if applicable), for the activities being grouped together.
- Further, the statement must contain a declaration that “the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of Section 469.”
19
Q
Business-Related Court Awards and Damages
A
- Court awards and settlements that grant compensation for physical injuries or illness are generally excluded from taxation (except for any punitive damages, which are always taxable). Most other types of court awards and settlements are taxable income, such as damages for:
- Patent or copyright infringement,
- Breach of contract, or interference with business operations.
- Compensation for lost profits.
- Compensatory damages for other financial losses.
- Interest earned on any type of court award.
- Punitive damages related to business income or business activity.
- Note: With respect to court awards, punitive damages may be awarded in addition to compensatory damages for actual monetary losses. Punitive damages are generally meant to “punish” the defendant for a willful or malicious act. Punitive damages are subject to income tax but are not subject to self-employment tax.
- Example: Jeff is a professional trucker. He was in a serious car accident during one of his long hauls. He sustained physical injuries and permanent damage to his foot, which was crushed during the accident. Jeff sued the truck manufacturer when it was discovered that the brakes on his semi-truck were faulty. During the trial, it was discovered that the manufacturer knew about the defect for several years but chose not to warn customers. Jeff wins his case. The jury awards him $500,000 in compensatory damages for his injuries, and $2 million in punitive damages. Even though Jeff is self-employed, the $500,000 in compensatory damages are not taxable to Jeff and do not need to be reported as business income, because they are compensation for his injury. The $2 million in punitive damages are taxable, but the award is not considered self-employment income and therefore, not subject to self-employment tax, even though the income is somewhat related to his trucking activity.
20
Q
Not Considered Business Income
A
- Just as with individual taxpayers, certain types of business-related income and property transfers are not taxable or reportable. Others may be partially taxable, and in some instances, the recognition of income is delayed until a later date. Examples include:
- Issuances of stock, including the sale of Treasury stock
- Most business loans (loans create debt, not income)
- Sales tax collected; these amounts are not included in the company’s revenues, and the amounts are also not treated as a business expense if imposed on the customer)
- Like-kind exchanges of property (section 1031 exchanges)
- Gain from an involuntary conversion, if the gain is reinvested properly.
- Example: Bloomer’s Floral Shop sells floral arrangements for weddings and special events in a state that imposes sales tax on the buyer. Each bouquet that is sold is subject to sales tax, which the shop collects from its customers at the time of purchase. The sales tax is not included in the gross receipts of the business. Instead, the amount collected is treated as a liability and listed on the company’s balance sheet. At the end of each month, Bloomer’s Floral Shop prepares a sales tax return and remits all the collected sales tax to the state. The sales tax collected is neither income nor an expense, and it is not included in the company’s sales revenues.
21
Q
Business Expenses
A
- Business expenses are the costs of carrying on a trade or business and are usually deductible if the business operates to make a profit. However, some costs must be capitalized and depreciated or amortized.
- To be deductible, a business expense must be both ordinary and necessary.
- An ordinary expense is one that is common and accepted in the taxpayer’s industry. A necessary expense is one that is helpful and appropriate for the particular trade or business. However, an expense does not have to be indispensable to be considered necessary.
22
Q
Start-Up and Organizational Costs
A
- Business start-up costs include investigating whether to open a business, legal costs to purchase an existing business, and training new employees before the business actually opens. Start-up costs are amounts paid or incurred for: (a) creating an active trade or business; or (b) investigating the creation or acquisition of an active trade or business.
- The following costs related to a new business may be deductible as current expenses, without the need for amortization:
- Up to $5,000 to organize a corporation, partnership, or LLC, and
- Up to $5,000 of start-up costs. In order to currently deduct start-up expenditures, the taxpayer must elect to deduct these expenditures, and they cannot be deducted until the year the business begins.
- If organizational or start-up costs incurred exceed $50,000, there is a dollar-for-dollar reduction in the available immediate deduction until the current deduction for either item is eliminated.
- Organizational costs or start-up costs that are not currently deductible may be amortized ratably over 180 months (15 years) on Form 4562, Depreciation and Amortization. The amortization period starts with the month the taxpayer opens the business for regular operations.
- Example: Supply Village, Inc. incurs start-up expenses of $51,000 in the current year, which includes wages to train new employees before their first store actually opened. Supply Village is $1,000 over the $50,000 phaseout threshold, so it must reduce its deduction for start-up expenses by the amount that it is over the threshold. Supply Village can deduct $4,000 of its start-up expenses ($5,000 allowable deduction minus the excess $1,000). The remaining amount of start-up expenses, $47,000 ($51,000 - $4,000 allowable deduction), must be amortized over 180 months.
- Example: Beeswax Bottlers, Inc. opened for business on November 1. Prior to opening, the company incurred $21,200 of start-up expenses for advertising and new employee training. Since Beeswax Bottlers had less than $50,000 of start-up costs, the company can deduct the full $5,000 on its corporate tax return and can also claim $180 of amortization ([$21,200 - $5,000]/180 = $90 per month × 2 [two months, November and December]) for a total of $5,180 for the year.
23
Q
Start-Up Costs
A
- Start-up costs include amounts paid or incurred in connection with an existing activity engaged in for profit, and for the production of income in anticipation of the activity becoming an active trade or business. Common start-up costs include:
- An analysis or survey of potential markets and investigative costs
- Paying for government permits and business licenses
- Advertisements to announce the opening of a business (before it actually opens)
- Salaries and wages for employees who are being trained and their instructors
- Travel costs for securing prospective distributors, suppliers, or customers
- Salaries and fees for executives and consultants, or for similar professional services.
- By definition, business start-up costs are incurred before a business actually begins operations. Start-up costs generally do not include deductible interest, taxes, or research and experimental costs.
24
Q
Investigative Costs
A
- All amounts paid to “investigate” a business before actually creating the business are treated as amortizable start-up costs. Amortizable start-up costs for purchasing a business include only investigative costs incurred in the course of a general search for or preliminary investigation of the business. These are costs that help someone decide whether or not to purchase a business.
- Example: Blanca is interested in purchasing Cliffside Camping, a campground business owned by a friend who is about to retire. Blanca hires an attorney to investigate the business and make sure there are no legal claims against the business. The attorney charges Blanca $7,700 for this investigative service. Blanca purchases all the assets of Cliffside Camping and takes over the business on December 1 and decides to run it as a sole proprietorship. $5,000 of Blanca’s legal fees would be deductible immediately as start-up costs. The remaining $2,700 would be amortized ratably over 180 months starting on December 1. Blanca can deduct $5,000 on her tax return, (Schedule C) and can also claim an additional $15 of amortization ([$7,700 - $5,000]/180 = $15 per month × 1 [one month (December)]. The total deductible start-up costs on her Schedule C would be $5,015. The remaining start-up costs will be deducted in future years through amortization.
25
Q
Qualifying Organizational Costs
A
- Organizational costs are classified somewhat differently than start-up costs. Organizational costs are costs that are incurred that directly relate to a business’s formation. These include costs to create and file articles of incorporation or articles of organization with the Secretary of State.
- Organizational costs also include any legal costs to create contracts, such as a formal partnership agreement. Organizational costs also include any other type of filing fees that are required by state governments.
- Examples of qualifying organizational costs include:
- The cost of temporary directors
- The cost of organizational meetings
- Organization and filing fees for a corporation, limited partnership, or any other legal entity (such as the costs of forming an LLC or LLP)
- Legal and accounting fees for setting up the business
- Example: Ariana and Piper are both licensed dentists in California. They decide to form a Limited Liability Partnership (an LLP). The state filing fees for the LLP and the legal fees to draft their partnership agreement totaled $6,500. On June 1, they officially open their doors and start offering their medical services to the public. The partnership may immediately deduct $5,000 of the organizational costs. The remainder ($1,500) must be amortized over a period of 180 months, starting in June (the month the business commences operations).
26
Q
Disposal of a Business
A
- If a taxpayer completely disposes of a business before the end of the amortization period, the taxpayer can deduct any remaining unamortized start-up costs or organizational costs.
- Example: Oakbrook Diner, Inc. is a restaurant that began operations five years ago. Oakbrook Diner began having cash-flow difficulties and officially closed its doors on November 30. Oakbrook had $65,000 of unamortized start-up costs on the books when it ceased operations. The entire $65,000 would be deductible on Oakbrook Diner’s final tax return, because unamortized startup costs are deductible as a business loss in the year the business is terminated.
27
Q
Expansion Costs
A
- Costs incurred in expanding an already existing business are generally deductible as ordinary and necessary business expenses. In other words, the amounts do not have to be amortized if the business is already in operations and just adding new locations or expanding an existing location.
- Example: Lean Fitness, Inc. operates a chain of personal fitness gyms. Lean Fitness decides to expand its operations by adding another location outside of its current geographical area. Lean Fitness incurs costs to advertise and prepare the new location, as well as train employees. These costs are deductible as ordinary business expenses and do not have to be amortized as start-up costs, since it is merely an expansion of its existing business operations.
28
Q
Failed Business Start-Ups
A
- If an individual taxpayer attempts to go into business and is ultimately unsuccessful (i.e., the business is never actually created, started, or purchased), the costs incurred may fall into one of two categories:
- Costs incurred before making a decision to purchase or start a specific business, which are considered personal and thus nondeductible.
- Costs incurred in a bona-fide attempt to purchase (or start) a specific business, which are capital costs that may be claimed as a capital loss on Schedule D, Form 1040. Doing this, the taxpayer is limited to a “capital loss limit” of $3,000 per year over any capital gains they might have.
- Only losses from a genuine, failed business venture are deductible.
- However, the rules are different for corporations. If a corporation incurs costs related to an unsuccessful attempt to acquire or start a new business, it can deduct all of its investigatory costs as a business loss.
- Example: Dayna wants to purchase a local bakery. She incurs $5,400 in legal fees as well as contract costs during the negotiation process with the existing owners of the bakery. However, just before the final contract is signed, one of the owners of the bakery changes his mind and decides that he doesn’t want to sell. Dayna may deduct the costs that she incurred in connection with her bona-fide attempt to purchase the bakery as a capital loss on Schedule D.
29
Q
Deductible Taxes
A
- Real Estate Taxes: In order for real estate taxes to be deductible, the taxing authority must calculate the tax based on the assessed value of the real estate.
- Businesses cannot deduct taxes charged for local benefits and improvements that tend to increase the value of the property. These include assessments for streets, sidewalks, water mains, sewer lines, and public parking facilities. A business must instead increase the basis of its property by the amount of the assessment.
- However, a business can deduct taxes that are actually for local benefits such as maintenance, repairs, or interest charges related to capital improvements.
- Example: Emmett owns a business office on Main Street. During the year, the city charged an assessment of $4,000 to each business on Main Street to improve the sidewalks. Emmett cannot deduct this assessment as a current business expense. Instead, he must increase the basis of his property by the amount of the assessment.
30
Q
Business Bad Debts
A
- A taxpayer can claim a business bad debt deduction only if the amount owed was previously included in gross income. Since a cash-basis business does not report any income until paid, cash-basis businesses will generally not have deductible business bad debts.
- Thus, unlike an accrual-basis taxpayer, a cash-basis business does not report income until payment is actually or constructively received from a customer.
- When a business loans money to a client, supplier, employee, or distributor for a business reason and the balance due later becomes worthless, the business can deduct the balance as a bad debt. However, the loan must have a genuine business purpose in order for this treatment to qualify.
- Example: Allure Eyewear, Inc. is an accrual-based corporation that manufactures sunglasses. One of the company’s salesmen, Claude, loses all his sunglass samples and asks his employer for a loan to replace them. Allure Eyewear loans Claude $3,000 to replace his sunglass samples and sample bags. Claude later quits his job without repaying the debt. Allure Eyewear has a business-related bad debt that it can deduct as a business expense.
31
Q
Later Recoveries
A
- An entity may later recover a debt that was previously written off as a bad debt deduction. If a business recovers a bad debt that was deducted in a prior year, the recovered portion must be included as income in the current year tax return. There is no need to amend the prior-year tax return on which the bad debt deduction was claimed.
- Example: The Food Depot is an accrual-based restaurant supply company. One of the restaurants that it does business with, Garden Café, defaults on several invoices and then files for bankruptcy. The Food Depot writes off the bad debt, believing that the invoices were uncollectible. A year later, the owners of the Garden Café approach the Food Depot, attempting to do business again. The Food Depot tells the Garden Café that it will not deliver any products or do business with them again unless all the delinquent invoices are paid. The Garden Café pays the old debt in order to have its customer account reactivated. The Food Depot would recognize the recovery of the previously deducted bad debt on its current-year tax return. It does not need to amend its prior-year tax return.
32
Q
Insurance Expenses
A
- The IRS allows businesses to deduct insurance costs when calculating business income. The following types of insurance premiums are deductible:
- Business property insurance, malpractice insurance, and casualty insurance (that covers fire, storm, theft, accident, or similar losses)
- Business interruption insurance (that reimburses a business if it is temporarily shut down due to a fire or similar disaster)
- Credit insurance that covers losses from business bad debts
- Contributions to a state unemployment insurance fund (these contributions are also deductible as taxes)
- Vehicle insurance that covers business vehicles (not deductible if a business uses the standard mileage rate to figure vehicle expenses)
- Group-term life insurance for employees
- Group accident, health, long-term care, and workers’ compensation insurance for employees
33
Q
Health Insurance
A
- The IRS prescribes a different tax treatment for health insurance premiums for every entity type.
- If a sole proprietor pays accident or health insurance premiums, the amount is not deductible on Schedule C; it is deductible only as an adjustment to income on the individual taxpayer’s Schedule 1 of Form 1040.
- If a partnership pays accident or health insurance premiums for its partners, it generally can deduct them as guaranteed payments to the partners.
- If an S corporation pays accident or health insurance premiums for its more-than-2% shareholder employees, it generally can deduct them and must also include them in the shareholders’ wages subject to federal income tax withholding.
- A C corporation can deduct employee health premiums dollar-for-dollar as a regular business expense, even if the expense creates a business loss for the year.
34
Q
Business Interest Expense
A
- A business can deduct interest paid or accrued during the tax year on debts related to a trade or business for which it is legally liable. It does not matter what type of property secures the loan.
- However, do not confuse business interest expense with investment interest expense. They are not the same thing.
- Business interest expense is the cost of interest that is charged on business loans used to maintain operations, purchase business assets, or purchase inventory. Investment interest expense is the interest paid on money borrowed to purchase taxable investments.
- Example: Gary is the sole proprietor of a small retail shop, Gary’s Trinkets. He takes out a business loan in order to upgrade the shelving and interior of his store. He also takes out a loan to purchase more inventory for his shop. The interest he pays on both loans would be classified as business interest expense. The interest is tax-deductible, dollar-for-dollar, on his Schedule C.
- Example: Margie likes to invest in stocks and cryptocurrency. She is not a professional stockbroker or securities trader. During the year, Margie takes out a $20,000 loan and uses the proceeds to buy various stocks and Bitcoin. The interest is classified as investment interest, not business interest. Margie can only deduct her investment interest expense as an itemized deduction on Schedule A. The amount that she can deduct in a given year is limited to her net taxable investment income for the year.
35
Q
Home Office Deduction
A
- Self-employed taxpayers may be able to deduct certain expenses related to a home office, if the space is “regularly and exclusively” for business and it is:
- The taxpayer’s principal place of business, and/or
- The place used to meet with patients, clients, or customers in the normal course of business; or
- A separate structure not attached to the home that is used in connection with the business.
- A taxpayer can use any reasonable method to calculate the percentage of the home that is used for business. Typically, the square footage of the home used for business is divided by the home’s total square footage.
- Because of the exclusive use rule, a taxpayer is not allowed to deduct business expenses for any part of the home that is used for both personal and business purposes.
- A self-employed taxpayer must complete Form 8829, Expenses for Business Use of Your Home, and then transfer the total to the Schedule C (Form 1040).
36
Q
Simplified Home Office Deduction
A
- A taxpayer may also choose to compute his home office deduction using a simplified calculation formula: a deduction of $5 per square foot is allowed for the space in the home that is used for business, up to a maximum allowable square footage of 300 square feet (for a maximum deduction of $1,500).
- Under this option, a taxpayer can claim the full amount of allowable mortgage interest, real estate taxes, and casualty losses on his home as itemized deductions on Schedule A.
- These deductions do not need to be allocated between personal and business use, as is required under the regular method. The simplified option does not include a deduction for depreciation. Each year, a taxpayer may use either the simplified method or the regular method to calculate the home office deduction.
- Example: Alfred is a self-employed insurance broker with a home office he uses exclusively for business. The office measures 15 × 15, or 225 square feet. Alfred deducts $1,125 ($5 × 225) using the simplified option. He does not have to calculate depreciation or prorate his utilities under the simplified method.
37
Q
Meals and Entertainment
A
- The TCJA eliminated the deduction for most entertainment expenses. However, there are some narrow exceptions. The TCJA does not affect expenses that are typically not considered entertainment, depending on the taxpayer’s business activity.
- The disallowance for deducting entertainment also does not apply to businesses that provide entertainment to the general public.
- Entertainment that is provided to customers, as well as food and drinks, are also not subject to the 50% limit and are fully deductible. For example, the owner of a nightclub can hire a nightly entertainer, and that would be a normal business expense of the nightclub.
- Example: John is a clothing designer. He attends a fashion show to introduce his new designs to potential buyers. The costs for attending the fashion show would not be classified as “entertainment” because the fashion show is directly related to his business as a designer. Any expenses John incurs during the show would be deductible as normal business expenses.
- Example: Eugene is a sportswriter who covers professional soccer. He runs a profitable YouTube channel with over one million followers. Eugene attends dozens of soccer events throughout the year. He often interviews the players in person and posts the videos to his channel. He asks for player signatures on jerseys and game programs. Eugene then runs online contests for the signed jerseys. All of his income comes from sports writing and his YouTube channel. The cost of the sports tickets and travel to the games would be a deductible expense, because he is in the business of writing about sports entertainment.
- Example: Five Star Realty, Inc. hosts open houses once a month. These events are advertised in the local newspaper and on the radio. During the open house, food and drinks are provided, as well as a presentation explaining the property management services that Five Star Realty offers. The events are open to the general public and used primarily as a marketing ploy to find new business customers. All the costs, including the food and drinks provided during the events, are 100% deductible by Five Star Realty.
- Exceptions also exist for company-wide events. In this case, the entertainment as well as the meals would be 100% deductible (there is no 50% limit to the meals in this case). Examples include: team-building activities, holiday parties, and company picnics. In order to be fully deductible, the events cannot discriminate in favor of highly compensated employees. In other words, all the employees must be able to participate, not just highly paid executives or company officers.
- Example: Edison owns an auto repair shop with twenty employees. Every year, Edison organizes a holiday party at Christmastime. All of the employees and their spouses are invited to the holiday party. The party includes professional catering and a music DJ. The cost of the holiday party, including the cost of meals, is 100% deductible as a business expense, because it is a team-building event for the benefit of all the employees.
38
Q
50% Business Meal
A
- Businesses can deduct 50% of the cost of business meals. Any taxes and tips incurred on the meal are also subject to the 50% limit. Per diem meals provided to employees are also subject to the 50% limitation. The 50% limit also applies to meals provided to employees as a fringe benefit, for example, coffee and snacks in an employee breakroom.
- Business meals are deductible if they are incurred while:
- Traveling away from home (whether eating alone or with others) on business,
- Taking customers or clients to a restaurant or other eatery,
- Attending a business convention or reception, business meeting, or business luncheon,
- Obtaining deductible educational expenses, such as meals during a continuing education seminar.
- Food and beverages that are provided during entertainment events (such as a baseball game) will not be considered entertainment if purchased separately from the entertainment, if the cost is stated separately from the entertainment on invoices or receipts.
- Example: Tamara is a licensed attorney. She takes her best client to a baseball game at Tropicana Field in Tampa Bay, Florida. During the game, they eat at Grand Slam Grill, a restaurant located within the stadium. The baseball tickets cost $105 each. The meal inside the park costs $80, and she receives a separate receipt. Tamara may deduct 50% of the meal, or $40. The cost of the baseball tickets would be a nondeductible entertainment expense, even if some type of business activity was conducted during the game.
- Example: Jaime is a self-employed realtor who takes a client to lunch to celebrate the closing of a home sale. The total restaurant bill is $88. She also pays $10 in taxi fare to get to the restaurant. Deductible meal expense ($88 × 50%) = $44, Deductible travel expense = $10.
Total deductible business expense = $54. The taxi fare would be 100% deductible, while the cost of the meal would be subject to the 50% limit.
39
Q
Travel Expenses
A
- Business expenses for travel must be incurred while carrying on a genuine business activity while traveling away from home. The taxpayer must be able to prove that the travel is directly related to the conduct of business.
- Adequate records must be retained to support these expenses. An exception is made for smaller expenses, (other than lodging), that cost less than $75.
- Travel costs for a business purpose are 100% deductible.
- Commuting costs are considered personal and not deductible.
- Taxpayers are considered “traveling away from home” if their duties require them to be away from home substantially longer than an ordinary day’s work and they need to sleep or rest to meet the demands of their work.
40
Q
Per Diems
A
- “Per diem” is a daily allowance paid by a business to its employees for expenses incurred when traveling. To ease recordkeeping requirements, a business may elect to use a federal per diem rate as an alternative to keeping track of employees’ actual expenses during business travel away from home. The allowance is in lieu of tracking actual travel expenses.
- The applicable per diem rates vary based on whether the travel is domestic or foreign, and also by location. For example, the per diem rate in large cities like Los Angeles and New York is higher than for smaller cities.
- A self-employed person can only use a per diem rate for meal costs. Per diem payments are not included in an employee’s taxable wages, if an employee submits an expense report to their employer.
- Claiming the per diem is not mandatory for any business. The IRS allows businesses to use per diems as an alternative to actual meals and travel expenses paid.
- Example: Abbot & Abbot, LLP is a CPA firm that employs dozens of auditors. The company’s main office is located in Texas, but twice a year all the auditors travel to Florida to a different regional office for mandatory employee training. They typically train there for several days. Abbot & Abbot allows the employees to use federal per diem rates when they submit their expense reports for reimbursement. The employees are pleased because they do not have to save receipts for every meal purchase.
- Example: Kaufman Consulting, Inc. is a financial services firm with twenty employees. The company reimburses its employees for meals and incidental expenses when the employees are traveling on work-related business. Instead of using the federal per diem rates, Kaufman Consulting requires all of its employees to submit actual receipts for all their meals and travel costs in order to obtain reimbursement. This is their company policy.
41
Q
Transportation Expenses
A
- Ordinarily, expenses related to the use of a vehicle for business can be deducted as transportation expenses.
- Self-employed individuals may choose to use either the standard mileage rate or actual car expenses in order to figure the deduction for vehicle expenses.
- Corporations generally cannot use the standard mileage rate. However, businesses, including corporations, may reimburse an employee under an accountable plan for business-related use of his or her car using the standard mileage rate.
- A taxpayer who elects to use the standard rate cannot deduct actual expenses of operating a vehicle, such as gas, oil, and insurance. However, parking fees and tolls may be deducted in addition to the standard mileage rate.
- Example: Darius uses a delivery van in his landscaping business. He has no other car, so the van is used for his personal transportation on the weekends. Darius chooses to deduct actual costs, rather than using the standard mileage rate. Based on his records, Darius’ total vehicle expenses are $6,252, which includes the cost of diesel fuel, oil changes, tire replacement, and repairs. Darius uses the vehicle 75% for business, so his allowable auto expense deduction using the actual expense method is $4,689 ($6,252 × 75%).
- Example: Coldwell Dairy Farms, Inc. is a C corporation with twenty-five employees. The corporation has an accountable plan for reimbursing employees for business mileage based on current IRS mileage rates. At the end of each month, each employee submits a detailed spreadsheet that lists their business-related mileage. Coldwell Dairy Farms issues a reimbursement check to each employee on a monthly basis. The reimbursements are not taxable to the employee, and they are fully deductible by the corporation as transportation expenses.
42
Q
Cannot Use STD Mileage
A
- A business is prohibited from using the standard mileage rate if it:
- Operates five or more cars at the same time (this is considered a “fleet”)
- Claimed a depreciation deduction using any method other than straight-line
- Claimed a section 179 deduction or the special “bonus depreciation” allowance on the car
- Claimed actual car expenses for a car that was leased
- Example: Perfect Shuttle, LLC is an airport shuttle service that operates in San Diego, California. Perfect Shuttle provides airport transportation as well as luxury car service. The company employs 10 full-time drivers and operates a fleet of 15 shuttles and limousines. The business cannot use the standard mileage rate, because it operates more than five cars at the same time. The business can deduct the actual costs of maintaining and operating the vehicles.
43
Q
Business Gifts
A
- A business can deduct business-related gifts to clients and customers. The deductible amount is limited to $25 for amounts given to any person during the year. If a taxpayer and a spouse both give gifts, they are treated as one taxpayer for this limit, even if they have separate businesses. A gift to the spouse of a business customer or client is generally considered an indirect gift to the customer or client.
- The $25 limit for business gifts does not include incidental costs such as packaging, insurance, and mailing costs, or the cost of engraving jewelry, which may be deducted separately. Related costs are considered incidental only if they do not add substantial value to a gift.
- Example: Wholesale Produce Inc. gives a large fruit basket to its best customer, Princess Grocery. The fruit basket costs $57, and the shipping and mailing of the basket cost $17. Wholesale Produce Inc. can deduct $25 for the basket and $17 for the cost of mailing, for a total deduction of $42.
44
Q
Promotional Gifts
A
- Promotional Gift Exceptions: The following items are considered promotional in nature and not subject to the $25 gift limit:
- An item with the business name clearly imprinted on it that costs $4 or less (examples include imprinted pens, desk sets, and plastic bags)
- Signs, display racks, or other promotional materials to be used on the business premises of the recipient
- A business may also deduct gifts to employees. Noncash gifts of nominal value that are distributed to employees to promote goodwill may be excluded from taxable compensation.
- Example: Buzzard Poultry, Inc. gives each of its 75 employees a $25 holiday turkey during Thanksgiving each year. The company can deduct the cost of the turkeys ($1,875 = $25 × 75). This noncash gift is not taxable to the employee, and the fair market value of the gift is not included in the employee’s wages.
- The TCJA clarifies that employee awards or gifts don’t include cash, cash equivalents, gift cards, gift coupons, certain gift certificates, tickets to theater or sporting events, vacations, meals, lodging, stocks, bonds, securities, and other similar items. These would be taxable to the employee as compensation and includable in the employee’s wages.
45
Q
Charitable Contributions
A
- Among business entities, only C corporations are permitted to deduct charitable contributions on their income tax returns. This is explained later in the dedicated units for C Corporations.
- Self-employed taxpayers cannot deduct charitable contributions as business expenses but can claim deductions on Schedule A if they itemize deductions.
- Contributions made by partnerships and S corporations are reported on their respective returns as separately stated items and may be deductible by their partners and shareholders.
46
Q
Nondeductible Expenses
A
- The following expenses are not allowed as business deductions:
- Political contributions, including indirect contributions such as advertising in a convention program of a political party
- Lobbying expenses for Federal, state, or local legislation
- Dues for country clubs, golf and athletic clubs, hotel and airline clubs, even if the club is used for business activity
- Penalties and fines paid to any governmental agency for breaking the law, such as parking tickets or fines for violating local zoning codes
- Legal and professional fees for work of a personal nature
