Deductions: General Concepts and Trade Or Business Deductions

Chapter 6

Deductions: General Concepts and Trade or Business Deductions (Revised 01-04-17)

Tax deductions are allowed to taxpayers ONLY if specifically authorized by the Internal Revenue Code (IRC).

Classifications of Deductions:

 Trade or Business  Production of Income  Deductions for Losses  Personal

The type of deduction dictates where the taxpayer reports the deduction – either “for” or “from” Adjusted Gross Income – “above the line” or “below the line” – “ the line” is AGI and it is used for many purposes including state taxes.

Trade or Business Deductions:

 Expenses that are allowed by IRC Section 162(a) and are usually reported on Schedule C, Form 1040 for sole proprietors on a cash basis.

 All ordinary and necessary expenses that are paid or incurred in carrying on a trade or business for profit–not personal expenses.

 The expenses must be reasonable and directly related to the business, and must not be capital expenditures, or related to generating tax-exempt income, or against public policy e.g. fines, kickbacks, drug activities, etc.

 Most, but not all are allowed as deductions for AGI (above the line).

 The trade or business must be carried on with the intent of making a profit, and with a regularity of activities or time spent.

 A lack of profit motive means that the activity would be classified as a hobby. Hobby loss rules will be discussed again in the Chapter 7.

o NOT showing a profit in 3 of 5 years indicates the business is a hobby, however the taxpayer may still show by evidence that a profit motive exists.

1 o Hobby (loss) rules may apply where deductions for an activity not carried on for profit cannot exceed “hobby” income.

Employee Business-Related Expenses:

 Must be "ordinary & necessary" and also be an employee (not an independent contractor)

 Reimbursed expenses are deductible for AGI; but only to the extent the reimbursement was included in the employee’s gross income. Most employee business expenses however, are reimbursed as part of an “accountable” plan, and are deducted by the employer and are not usually taxable to the employee.

 Unreimbursed employment related expenses of an employee may be deducted only as a miscellaneous itemized deduction, subject to 2% of AGI.

 Unreimbursed expenses for which the employee could have been reimbursed, but was not, are non-deductible expenses considered as not necessary.

 Most expenses incurred by an employee are personal, and are not deductible, e.g. commuting, street clothing, meals, etc.

 The following are some allowable employee business expenses deductible on Schedule A, Itemized Deductions (Chapter 8), subject to 2% of AGI:

 Transportation costs exceeding reimbursements.  Away from home travel costs exceeding reimbursements.  Job-hunting expenses.  Uniforms that are required as a condition of employment, and are not adaptable to ordinary wear.  Union dues.  Certain meals of firefighters/policeman, if non-voluntary participation.

Expenses Related to the Production of Income – IRC Sec. 212:

 Expenses are deductible “below the line” as a miscellaneous itemized deduction, subject to 2% of AGI, if they are for:

o The production or collection of income. o The management, conservation, or maintenance of property held for the production of income. o In connection with the determination, collection, or refund of any tax.

2  Expenses incurred in a trade or business, e.g. sole proprietorships, rents or royalties, are deducted “above the line”.

Personal Deductions:

 Personal, living and family expenses are NOT deductible unless expressly permitted by the IRC, and would be reported as an Itemized Deduction.

Loss Deductions:

 There are three types of losses:

o Losses incurred in a trade or business, including investigating a business opportunity not taken.

o Losses incurred in transactions entered into for profit, not connected with a trade or business, e.g. loss on the sale of stock.

o Casualty losses from "fire, storm, shipwreck, theft, etc.

 Must reduce each casualty by $100  Must reduce total net casualties by 10% of AGI  Must reduce casualty by any insurance recovery

Tax Accounting Methods:

 Cash - recognize revenue when cash is received and expenses when paid.  Accrual – recognize revenue when earned, expenses when incurred.  Most individuals are on the cash basis, and bad debts can be recognized only if the related revenue has been recognized.

Substantiation of Tax Deductions:

 Tax deductions are allowed to taxpayers only if they are specifically authorized by the IRC Code, and can be substantiated to the satisfaction of the IRS.

Debts of Another Taxpayer:

 Usually if a taxpayer pays a tax deductible expense that is the obligation of another taxpayer, neither taxpayer is entitled to a tax deduction.

Common Business Deductions:

3  Advertising

 Bad Debts:

o A business bad debt is an ordinary business expense, and may be deducted if wholly or partially worthless. o A qualifying non-business bad debt is personal in nature and is deductible only as a short-term capital loss (subject to the $3,000 capital loss rules), and only if totally worthless. o Any bad debt is limited to the adjusted basis of the debt in the hands of the taxpayer. See cash basis taxpayers above. o Any bad debt must be a bona fide bad debt, arising from a valid and enforceable obligation between a debtor and a creditor who attempts to collect the debt.

 Salaries, Wages, and Fringe Benefits

 Interest:

o Most trade or business interest payments are tax deductible, and pre- paid interest for either cash or accrual taxpayers must be allocated over the interest period. o Whether interest is business or non-business depends on the use the funds are put to, not the source of the funds. o Investment interest is deductible only to the extent of investment income. o Interest incurred to purchase tax-exempt securities is not deductible.

 Taxes:

o Most taxes are deductible, except U.S. Income taxes, including state income and property taxes, foreign taxes, BPOL taxes, unemployment compensation taxes, and social security taxes, among others. Sales taxes must be added to the cost of purchases.

o If business property is sold during the year the property tax deduction is allocated between the buyer and seller based on the number of days the property is owned by each, regardless of who actually pays the tax.

The formula for calculating the allocation is:

Annual tax x (# of days of ownership) 365 days

4 For example:

The buyer settles on Feb. 10, the 41st day of the year in which the property taxes are $1,460. The taxes would be allocated as follows:

Seller claims 1,460 x (40/365) = $ 160 Buyer claims 1,460 x (325/365) = $1,300

Total claimed $1,460

 Rental Payments

o Must be actual rental or lease payments, not disguised purchase payments (Operating v/v Capital Leases).

 Insurance Premiums:

o Fire, casualty and burglary insurance premiums are fully deductible business expenses. o Life insurance premiums paid as a fringe benefit on employees is deductible by the business; however, premiums paid on a life insurance policy where the business is a beneficiary of the policy are not deductible.

 Legal and Accounting Fees:

o Are deductible in the year paid or incurred. o Are capitalized if incurred to purchase a capital asset. o Are allocated between business and personal use if applicable.

Restricted Business Deductions

o Political contributions and most lobbying expenses are not deductible. o Business start-up expenses may be expensed up to $10,000, reduced by any amount over $60,000 and any remainder amortized over 180 months. These expenses include business investigation expenses and start-up costs. o Business gifts are restricted to $25 per recipient per year. Excluded from this rule are items costing $4 or less which have the name of the business imprinted on it, some promotional materials, and certain employee awards (length of service or safety, again subject to limits).

5 Other Deductions Available to Taxpayers

 Travel and Transportation

o Costs of transporting a taxpayer, if away from home overnight, including air and taxi fares, automobile expenses, parking fees and tolls, etc. o “Home” is determined to be: - The location of the principal place of business - If a taxpayer has two businesses, the principal business is based on the length of time in each location, the degree of activity in each location, and the relative income earned in each location. o Self-employed taxpayers deduct transportation on Schedule C; employees deduct these expenses only as a miscellaneous itemized deduction, subject to 2% of AGI. o Commuting expenses are not deductible; however the cost of going from one job to another job during the workday is deductible. o Any qualifying meals are only 50% deductible, including if the taxpayer pays for the meal of a client, etc. o Travel expenses are only deductible if the period away from “home” is temporary – not indefinite, or extended beyond one year. o If the travel is part business and part personal, expenses must be allocated between the two purposes. If the travel is primarily personal no expenses are deductible, except those that are directly attributable to business. Foreign travel rules are more restrictive - expenses must be allocated if the foreign travel exceeds 7 days or the personal portion is less than 25% of the total travel time. o Cannot be lavish or extravagant in the circumstances

 Automobile Expenses:

o Are deductible as transportation expenses if incurred in connection with a trade or business, or by an employee performing employment duties and not reimbursed by the employer.

o There are two methods for computing deductible automobile expenses: . Actual operating expenses, including an allowance for depreciation. . The optional method using a standard mileage rate of 53.5 cents per mile for 2017.

6 o In either case, adequate records must be maintained to support the amount deducted, and once a method is elected, the taxpayer should not change to the other method for that same automobile. o Business related parking is allowed in addition to the above regardless of the method used.

 Meals and Entertainment:

o Expenses are limited to 50% of the cost of the meals and entertainment. o Any deduction must be “directly related to” or “associated with” the taxpayer’s trade or business. “Associated with” means that the entertainment expense immediately precedes or follows a substantial business discussion. o Many activities are automatically determined to be not directly related unless the taxpayer can prove otherwise, e.g. If the tax payer is not there, night clubs, cocktail lounges, country club dues and other club expenses if other non-business associates are present, and hunting lodges.

 Substantiation of Travel, Meal and Entertainment Expenses:

o Any travel or meal or entertainment expense must be supported by adequate records and sufficient corroborating evidence, including amounts, time and place, business purpose, and business relationship to the taxpayer. o Written evidence is required, including itemized receipts, paid bills, etc. for each meal and entertainment expenditure of $75 or more.

 Moving Expenses:

o Qualified moving expenses are deductible above-the-line (AGI), and then only if paid by the employee or the self-employed individual. If reimbursed by the employer, they are excludable from gross income, and not deductible.

o To qualify for a moving expenses deduction the taxpayer:

 Must incur the moving expense in connection with the commencement of work at a new job location (Employee), or a new principal place of work (Self-employed).  Must work at the new location for at least 39 weeks if an Employee or 78 weeks if Self-Employed, in the following 12 or 24 month period respectively.

7  The distance from the taxpayer’s old residence and new job location must be at least 50 miles further than the distance between the old residence and the old job location.

o Only expenses incurred to (1) move household goods and personal effects; and (2) travel and lodging expenses which are incurred in moving the family from the old location to the new location are deductible. The cost of meals is not deductible. If the move is by automobile, actual car expenses or the optional 17¢ per mile may be deducted.

 Student Loan Interest:

o Qualified student interest is deductible above-the-line (AGI). o Up to $2,500 of interest may be deducted, subject to AGI phase-out rules, if the education loan is used to pay for tuition, fees, room, board, supplies, and related expenses. o The AGI “phase-out” range is between $65,000 and $80,000 for single taxpayers and $130,000 and $160,000 for married filing joint taxpayers. o A taxpayer claimed as a deduction on another’s return, or a married filing separate taxpayer is not eligible for the deduction.

 Qualified Higher Education Expenses:

o Maximum deduction for “qualified” higher education expenses not to exceed $4,000 if AGI is below $65,000 single and $130,000 MFJ. o The deduction is reduced to $2,000 if AGI is between $65,000 and $80,000 for single and $130,000 and $160,000 for married filing joint taxpayers. There is no deduction if AGI is above these amounts. o This deduction cannot be taken in the same year as an American Opportunity Tax Credit (Hope) or Lifetime Learning Credit for the same student

 Health-Related Expenses:

o Self-employed taxpayers are allowed to deduct 100% of the amounts paid for health insurance premiums as an above-the-line deduction, if they, or their spouse, is/are not covered by an employer paid medical plan. o Medical Savings Accounts (MSA) and Health Savings Accounts (HSA) are deductible above-the-line. Medical plans which are available to taxpayers who have catastrophic coverage health insurance plans (MSA) or high deductible insurance plans and

8 deposit funds subsequently used to pay for qualified medical expenses (HSA) qualify for this adjustment deduction.

 Other Deductions form Gross Income:

o Surrendered jury pay. o Forfeited interest or early withdrawal penalties on time-saving accounts or deposits.

Business Deductions Related to Capital Expenditures (Depreciation):

A capital asset is expected to benefit the business for more than one tax year; therefore the cost must be allocated over the life of that asset. The cost of both “real”, e.g. buildings, and personal, e.g. “things”, must be capitalized over their useful lives.

 The terms of the process of allocating the cost of an asset over its useful life is called: o Depreciation – tangible property. o Amortization – intangible property. o Depletion- natural resources or wasting assets.

 Land is a capital asset - but is not depreciable (it does not wear out).

 Both Generally Accepted Accounting Principles (GAAP) and the IRC require the allocation of the cost of a capital asset, however the methods are different. Tax depreciation uses either the Accelerated Cost Recovery System (ACRS) which began in 1981 and was replaced at the end of 1986 by the current method, the Modified Accelerated Cost Recovery System (MACRS) which has been in use since 1987. Both methods are similar, but because ACRS is seldom seen today, only MACRS will be discussed in detail.

 What Can Be Depreciated:

o Property that is: (1) used in a trade or business or (2) used in the production of income.

o Property with a useful life over one year. o Property that wears out or becomes obsolete (not land).

 Terms and concepts:

9 o “In service date" (ISD) is the first date used in the business.

o Accounting conventions:

 1/2 year – all tangible assets placed in service are assumed to have an ISD of 7/1.  1/2 month - all real assets placed in service have an ISD of the15th day of the month in which it was placed in service.  Mid-quarter - ISD is assumed to be mid-point of the 1st quarter the qualifying asset was placed in service.  Cost or Basis: The amount that depreciation is based upon. Keep cost in one account, and depreciation that has been claimed in another.  Cost minus Accumulated Depreciation = Adjusted Basis (tax term, the accounting term is Book Value).  Cost is the "unadjusted basis" (usually) and may be adjusted up for capital improvements, and down for depreciation.

o Classes of depreciable property (Chapter 12):

 Section 1245 – Personal (tangible) business property.

 Section 1250 – Real business property.

 General (Pre-1981) Depreciation Rules

o Reduce cost by salvage value. o Depreciate the asset over its “useful” life. o Pro-rate depreciation if the asset is not used for all 12 months. o Methods:  Straight Line  Declining Balance  Sum of the Years Digits

 MACRS Depreciation

o General Rules:

 Ignore Salvage Value.

 Find the class to which the property belongs.

 Find and use the applicable percentage for the year (or quarter if applicable) for tangible property or month for real property, and multiply this percentage by the assets cost (unadjusted basis).

10  Prorate the depreciation deduction in the year of disposal.

 Anti-churning rules require that personal use assets subsequently converted to business use must use the lesser of the original cost of the asset or FMV on the date the asset is placed in service.

 The IRS considers depreciation on business use assets as allowed or allowable, hence not taking depreciation will not preclude a reduction in the adjusted basis of the asset.

§1245 Property Depreciation (Depreciable items other than Real Estate)

Five year property: Includes cars & light trucks, and some equipment, including computers, furniture used in rental residential real estate

Seven Year Property: Includes office furniture & fixtures and most equipment

11 §1245 Property-Mid Quarter Convention:

 If more than 40% of ALL Section 1245 property is placed in service during the last quarter of the year, depreciate ALL Section 1245 property using the mid-quarter convention tables (this is the so-called pig rule). (See tables at Appendix of chapter Notes)  Easy to avoid

§1250 Property: Depreciable Real Estate:

o Under MACRS, real estate that is placed in service after 12/31/86 is to be depreciated under the straight-line method, ignoring salvage value using the prescribed time periods. o Residential real estate is depreciated over 27.5 years. o Non-residential real estate under construction prior to May 13, 1993 is depreciated over 31.5 years. o Non-residential real estate constructed after May 12, 1993 is depreciated over a 39-year useful life. o A mid-month convention is applied. o Residential Real property is real property from which 80% or more of "Gross rental income" is from renting dwelling units. If any portion of a building is owner occupied, the "gross rental income" includes the rental value of the unit owner occupied. An entire building is only depreciated one way or the other. There is no floor- by-floor depreciation.

 To determine the depreciation deduction for the first year, determine the life of the property, use the month the property was first placed in service, and multiply the percentage given for that month times the cost of the depreciable real estate (not including the land cost).

27.5 year 39 year In service residential non-residential month real estate real estate January 3.4848% 2.45709% February 3.1818 2.24343 March 2.8788 2.02977 April 2.5758 1.81611 May 2.2727 1.60245 June 1.9697 1.38879 July 1.6667 1.1755.53

12 August 1.3636 0.96147 September 1.0606 0.74781 October 0.7576 0.53415 November 0.4545 0.32049 December 0.155.55 0.10683

 To determine future full year’s depreciation using the formula method:

(1) 27.5 - year property: Take 1/27.5 times the assets depreciable cost (2) 31.5 - year property: Take 1/31.5 times the assets depreciable cost. (3) 39 - year property: Take 1/39 times the assets depreciable cost.

Example: If residential rental real estate with a depreciable cost basis of $96,000 is purchased in March, the MACRS depreciation deduction is calculated as follows:

Year 1: 96,000 * 2.879% = $2,764

Year 2, and thereafter: 96,000 * 3.636% = $3,491 (2.576% in the 28th year)

Small differences may be encountered, depending on the method of calculation.

 Automobiles:

o The IRS severely limits the amount of depreciation that may be taken on automobiles. If the car costs over approximately $14,000 (a “luxury” car), the first year depreciation is limited to $3,160 and is adjusted downward if the car is not used 100% for business purposes. Each succeeding year is similarly limited – second year $5,100, third year $3,050 and $1,875 thereafter. Bonus Depreciation is back – additional $8,000 in first year!

 Alternative or Straight-Line MACRS:

o In some situations, business use assets must be depreciated using a straight-line (SL) method, without regard to salvage value, and using a mid-year convention. It may be elected by the tax payer, but it is required to use SL depreciation if the business property is used 50 percent or more for personal use. The percentages are prescribed in the IRS tables.

Section 179 (additional first year) deduction:

o The taxpayer may elect to expense up to the first $500,000 of qualifying property purchased for use in a trade or business each year.

13 o Section 179 deductions cannot exceed the income from the business. o The amount of the Section 179 deduction is reduced by $1 for each dollar of cost of 1245 property bought over $2,000,000 per year (as of this writing). o May be new or previously owned property

Bonus Depreciation:

 50% of the cost of qualifying (NEW only) §1245 property may be expensed if purchased in 2015, 2016 or 2017, but limited for “luxury” cars to $8,000 PLUS the $3,160 max for regular depreciation under the listed property rule below. o Due to state laws, most people elect not to use this.

Listed Property Rules:

 Listed Property are items that are subject to taxpayer abuse, e.g. "luxury" autos, computers, cellular phones, yachts, etc.

 If business use is equal to or less than 50%, you must use Straight-Line MACRS, and the Section 179 deduction is not allowed.

Amortization:

o The process of systematically and rationally allocating the cost of an intangible asset over its estimated useful life. o Intangible assets include patents, copyrights, franchises, trademarks, leaseholds, and goodwill - assets without tangible form. o An intangible asset is amortized using the straight-line method.

Research and Experimental Expenditures

o R&E (or R&D – Research and Development) expenses are costs associated with the research and development of new products, processes, etc. o These costs may be expensed as incurred or amortized over a period of not less than 60 months after any benefits are first realized. GAAP requires that R&D costs be expensed.

Depletion

o The process of allocating the cost of natural resources over their useful life.

14 o Two depletion methods may be used: Cost and Percentage. o The most common natural resource seen by preparers is oil and gas.

15 Appendix: §1245 Property Mid Quarter Convention rates:

 If more than 40% of ALL Section 1245 (depreciable non real-estate property) assets are placed in service during the last quarter of the year, depreciate ALL Section 1245 property bought that year using the mid- quarter convention tables (this is the so-called pig rule).

 Find and use the applicable percentage for the quarter and year the property was placed in service and multiply this percentage by the assets cost (unadjusted basis). 

 Easy to Avoid Using §179 Deduction