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5 - 1©2004 Prentice Hall, Inc.
Business Expenses
Chapter 5
5 - 2©2004 Prentice Hall, Inc.
Code Sections
Sec. 161 - deductions are only those expenses and losses for which a deduction is authorized
Sec. 162(a) authorizes deductions for ordinary and necessary expenses, that are reasonable in amount, and incurred in actively carrying on a trade or business
Sec. 212 authorizes deductions for expenses related to production of income (investment-related expenses)
5 - 3©2004 Prentice Hall, Inc.
Disallowed Deductions
Unless provided for otherwise in the Code, a deduction will be disallowed if it is:
Contrary to public policy (fines, penalties)
Related to tax-exempt income Accrued to related party (no deduction
until related party includes in income) The obligation of another taxpayer
5 - 4©2004 Prentice Hall, Inc.
Substantiation
All taxpayers must maintain records that substantiate their expense deductions
Stringent substantiation requirements for travel, entertainment, and giftsAmount of expenditureTime and place (or date & description of gift)Business purpose of expenditureBusiness relationship of person entertained or
receiving a gift
5 - 5©2004 Prentice Hall, Inc.
Timing of Deductions
Accrual method – expenses deductible when“All events” have occurred that fix liability
and“Economic performance” occurs (property
or services provided or used) Cash basis taxpayer - expenses deductible
when paidDate check is mailDate charged on credit card
5 - 6©2004 Prentice Hall, Inc.
Cash Method
When an expense is paid by providing services, the expense can be deducted but the value of the services is income
Assets with useful lives extending substantially beyond the end of the year must be capitalized with their cost recovered through depreciation, amortization, or depletion
When considering whether to make an early payment of year-end expenses, the tax rates for both years and the time value of money should be considered
5 - 7©2004 Prentice Hall, Inc.
Use of Cash Method
Businesses that sell merchandize to their customers must use the accrual method to account for purchases and sales of inventoryCash method can be used for other than
inventory and cost of goods sold Large corporation with average annual gross
receipts of more than $5 million cannot use the cash method for tax
Personal service corporations can use the cash method
5 - 8©2004 Prentice Hall, Inc.
Prepaid Expenses
Prepaid assets must be prorated if their lives exceed one year and the items will not be consumed by the close of the following year
Prepaid interest must generally be prorated over the life of the loanOID is a form of prepaid interest and must
be amortized over term of loan
5 - 9©2004 Prentice Hall, Inc.
Costs of Starting a Business
Sec. 162 allows deductions for “carrying on” a business but expenses incurred prior to the commencement of operations do not qualify as “carrying on” a businessBusiness investigation expensesStart-up expensesOrganization costs
5 - 10©2004 Prentice Hall, Inc.
Business Investigation
Investigation expenses incurred while preparing to enter business include travel, market surveys, and feasibility studies
If the taxpayer in a similar business - deduction allowed as current expenses
If taxpayer not in a similar existing business If new business acquired - expenses amortized
over 60 months If new business not acquired - no deduction
5 - 11©2004 Prentice Hall, Inc.
Start-up Expenses
Start-up expenses are incurred after the decision to proceed with the new business, but before beginning actual operations (employee training and advertising)Expenses amortized over 60 months for
taxpayers who are entering a business not related to an existing business
For taxpayer entering a new business related to an existing business, start-up costs are considered continuing costs and are currently deductible
5 - 12©2004 Prentice Hall, Inc.
Organization Costs
Costs relating to formation of a corporation or partnership (fees paid to the state for incorporation, legal fees, and accounting fees) and incurred before end of first year
Organizational costs must be capitalized and can be amortized over 60 months
5 - 13©2004 Prentice Hall, Inc.
Operating Expenses
Most operating expenses shown on a GAAP income statement are deductible on a business tax return
Examples include: advertising, bank service charges, commissions, office supplies, repairs, taxes, licenses, accounting fees, legal fees, salaries and wages, travel, and utilities
5 - 14©2004 Prentice Hall, Inc.
Meals & Entertainment
The deduction for business meals and entertainment expenses is limited to 50% of the amount of qualified expenses
The 50% limit is imposed on whoever (employer or employee) ultimately pays for the expense
5 - 15©2004 Prentice Hall, Inc.
Meals & Entertainment
Directly-related expenses - costs incurred when a discussion takes place between the taxpayer and a customer about specific business activities in an atmosphere conducive to a serious business discussion.
Associated-with expenses - deductible only if directly preceded or followed by a substantial business discussionDeduction for entertainment tickets is based on
the ticket’s face value, then the 50% limit applies
5 - 16©2004 Prentice Hall, Inc.
Restriction on Deductions
No deduction for the costs of owning and maintaining entertainment facilities such as hunting lodges and yachts
No deduction for membership dues and fees paid to social, athletic, or sporting clubsDeductions are allowed for dues to
professional organizations, public service organizations, and trade associations
Deduction for business gifts limited to $25 per donee per year
5 - 17©2004 Prentice Hall, Inc.
Travel Away From Home
Travel expenses include lodging and meals while temporarily away from home on business, transportation to destination and back, and incidental expensesA tax home is the location of the principal
place of employment regardless of where the family residence is maintained
5 - 18©2004 Prentice Hall, Inc.
Temporary Assignments
Temporary is one year or less Employment away from home in a single
location that is realistically expected to last (and does in fact last) for one year or less, will be treated as temporary
Assignment of more than one year shifts tax home to the new location (no deduction for travel and living costs)
5 - 19©2004 Prentice Hall, Inc.
Transportation Expenses
Transportation expenses are incurred when the taxpayer is not away from home (includes cost of transportation from one work location to another, but excluding any meal costs)
The business portion of actual automobile expenses can be deducted or a standard mileage rate (36¢ for 2003) plus parking and tolls can be deducted
5 - 20©2004 Prentice Hall, Inc.
Transportation Expenses
Commuting expenses are personal nondeductible expenses except: Transportation between home and
temporary work location if taxpayer has a regular place of business
Travel from one job to another on the same day
5 - 21©2004 Prentice Hall, Inc.
Combining Business with Pleasure Travel
For U.S. travel, if the trip is primarily for business, all transportation costs to and from destination are deductible
If primary purpose is pleasure, no deduction for transportation
Meals & lodging deductible only for days on which business is conducted
5 - 22©2004 Prentice Hall, Inc.
Travel
If the primary reason the taxpayer remains in a temporary location is because it is less expensive then returning home as soon as business is completed, these costs are deductibleSaturday meals & lodgingBusiness meetings on Friday and Monday
5 - 23©2004 Prentice Hall, Inc.
Foreign Travel
Transportation expenses must be allocated between business and personal days unlessTrip does not exceed one week orLess than 25% of total time spent for
personal purposes If trip primarily personal, no deduction for
transportation
5 - 24©2004 Prentice Hall, Inc.
Bad Debt Expense
Specific charge-off method must be used Investment and personal loans are
considered nonbusiness (capital losses) Loan must be valid debt No bad debt deduction for cash basis
taxpayers who have not previously included amount in income
5 - 25©2004 Prentice Hall, Inc.
Insurance Expense
Premiums for fire, casualty, and theft insurance for business property are deductible
Payments into a self-insurance reserve are not deductible - only actual losses are deductible
Premiums for life insurance when business is beneficiary are not deductible
5 - 26©2004 Prentice Hall, Inc.
Legal Expenses
Legal Fees deductible only if related to a trade or businessLegal fees incurred to defend title to
property are added to the asset’s basisCriminal defense fees are deductible only if
the legal action has a direct relationship to a profit-seeking activity
Personal legal expenses are not deductible
5 - 27©2004 Prentice Hall, Inc.
Taxes
Deductible taxes includeState, local, and foreign real property taxesState and local personal property taxesState, local, and foreign income taxesEmployer’s payroll taxesOther federal, state, local, and foreign
taxes incurred in a business or other income-producing activity
Federal income taxes are not deductible
5 - 28©2004 Prentice Hall, Inc.
Taxes
When real estate is sold, the seller’s portion of taxes ends on the day before the sale date
Assessments for improvements must be added to basis of property
Sales taxes are added to cost of business property or service
5 - 29©2004 Prentice Hall, Inc.
UNICAP Rules
Uniform capitalization rules apply to businesses whose average annual gross receipts for the preceding three years exceeds $10 million
UNICAP rules require inventory to include all direct costs of manufacturing, purchasing, or storing inventory, along with many indirect costs typically not included in full absorption costing
Nonmanufacturing costs (research, selling, advertising and distribution expenses) are not required to be included in inventory
5 - 30©2004 Prentice Hall, Inc.
Inventory
Acceptable methods for tax include specific identification, FIFO, LIFO, and average cost
A low inventory valuation results in tax savings through a higher cost of goods sold deduction
The LIFO conformity rule requires use of LIFO for financial statements if LIFO is used for tax
5 - 31©2004 Prentice Hall, Inc.
Home Office Expenses
Home office must be used exclusively on a regular basis and meet one of the following three tests to be deductible:1. the principal place of business for any
business of taxpayer or
2. a place for meeting with clients or customers in the normal course of business or
3. located in a separate structure
5 - 32©2004 Prentice Hall, Inc.
Home Office Expenses
Principal place of business includes a place used for the administrative or management activities of the business if there is no other fixed location available
Employee must also show that the office is maintained for the convenience of the employer
Deductible expenses include portion of rent or mortgage interest, property taxes, insurance, utilities, repairs, depreciation and are limited to gross income from the business
5 - 33©2004 Prentice Hall, Inc.
Home Office Expenses
Expenses are deducted in this order:
1. Expenses directly related to the business other than home office expenses (supplies)
2. The allocated portion of otherwise deductible itemized deductions (mortgage interest and property taxes)
3. Operating expenses including utilities, insurance, and maintenance
4. Depreciation Excess expenses are carried forward
5 - 34©2004 Prentice Hall, Inc.
Hobby Expenses
Activities that earn income and incur expenses but do not meet the requirements to be a business or investment are hobbies
Regulations list factors to consider in determining if a hobby including:Manner in which activity carried onExpertise of taxpayer and/or consultantsTime and effort spend in activityActual profits earned in one or more yearsElements of pleasure or recreation
5 - 35©2004 Prentice Hall, Inc.
Hobby Expenses
If a profit is realized in 3 out of 5 years (2 out of 7 years for horses) then burden of proof shifts to IRS to prove it is a hobbyEven with losses, taxpayer can deduct
expenses by showing activity run in a businesslike manner
If a hobby, then expenses limited to hobby income
5 - 36©2004 Prentice Hall, Inc.
Hobby Expenses
Expenses must be taken in this order:
1. Otherwise allowable expenses (mortgage interest, taxes, and casualty losses)
2. Expenses that do not reduce the tax basis of the assets used in the hobby (advertising, insurance, utilities and maintenance)
3. Depreciation and amortization Excess expenses are lost - no carryover
5 - 37©2004 Prentice Hall, Inc.
Residential Rental Property
If rental of real estate is a business, all income is included and all expenses are deductible, even if it creates a loss
Expenses may include: advertising, cleaning, maintenance, utilities, insurance, taxes, interest, commissions for collection of rent, travel to collect rental income or to manager the property or maintain the property
5 - 38©2004 Prentice Hall, Inc.
Residential Rental Property
When property is converted from personal to rental property, expenses must be divided between rental and personal use
No depreciation or insurance deduction allowed for personal-use part of year
Mortgage interest and real estate taxes for personal-use can be deducted as itemized deductions
5 - 39©2004 Prentice Hall, Inc.
Rental of a Vacation Home
A home used for both rental and personal use purposes falls into one of 3 categories:
1. Less than 15 days rental
2. More than 2 week rental and primarily rental property
3. More than 2 week rental but primarily personal use property (mixed rental/personal use)
5 - 40©2004 Prentice Hall, Inc.
Rental of a Vacation Home
If the residence is rented out for less than 15 days during the year:No rental income is reported butNo deductions are allowable (except
mortgage interest and property taxes may still be deducted as itemized deductions)
5 - 41©2004 Prentice Hall, Inc.
Rental of a Vacation Home
Primarily rental - if rental period is greater than 14 days and personal use is equal to or less than the greater of 14 days or 10% of the rental days)Expenses allocated between rental and
personal-useRental expenses can exceed rental income
and create a lossNo deduction for personal-use expenses
5 - 42©2004 Prentice Hall, Inc.
Rental of a Vacation Home
Mixed personal/rental use - if the rental period is greater than 14 days and personal-use more than the greater of 14 days or 10% of the rental daysRental expenses limited to rental income (no
loss)Nondeductible rental expenses can be carried
forward to the future yearsMortgage interest & real estate taxes for
personal-use allowed as itemized deductible
5 - 43©2004 Prentice Hall, Inc.
Book/Tax Differences
Permanent differencesInterest income from municipal bondsFines and penaltiesLife insurance proceeds50% of meals and entertainment
Temporary differencesBad debtsDepreciation
5 - 44©2004 Prentice Hall, Inc.
Income Tax Expense
If only permanent differences, adjust book income byAdding expenses that are not tax deductibleSubtracting tax-exempt incomeMultiply adjusted book income by the tax rate
Temporary differences createA deferred tax asset that is a prepayment of tax
that will be refunded in a future year orA deferred tax liability this is a current savings
that will have to be paid in a future year
5 - 45©2004 Prentice Hall, Inc.
The End