Basic Income Tax Business and Profit Seeking Expenses

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Basic Income TaxBusiness and Profit Seeking
Expenses

• Professor Jack Williams

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Deductions

• Various deductions and allowances are permitted
  by the IRC based on tax logic or tax favoritism
• These deductions and allowances are subtracted
  from gross income to arrive at taxable income,
  the tax base under the IRC
• Deductions may be broadly clustered into two
  categories
• Profit-related activities
• Personal activities

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General Rule Business Expenses

• Policy Point Tax is imposed on net income and
  not gross receipts from a business venture
• IRC 162 codifies that policy by providing that
  that it is appropriate to offset gross income by
  expenditures incurred in earning that income
• Business income (loss) is entered on Line 12,
  Form 1040 through Schedule C, for an individual

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Status of Deduction on Form 1040

• IRC 162 is an above the line deduction
• Adjustment to Adjusted Gross Income (AGI)
• Not subject to standard deduction
• No need to itemize deductions to use

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Section 162 Deductions

• IRC permits a deduction for ordinary and
  necessary expenses paid or incurred during a
  taxable year in carrying on a trade or business.
  IRC 162(a).
• Burden of proof on deductions shouldered by the
  taxpayer.

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Methodology IRC 162

• Ordinary and Necessary
• Expenses
• Carry on
• Trade or business

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ORDINARY AND NECESSARY

• Ordinary
• Expenditure is ordinary if it is one that is
  common within the industry even if
  once-in-a-lifetime expenditure for the actual
  taxpayer. Courts employ a horizontal test.
• Necessary
• Expenditure is necessary if appropriate and
  helpful to the business. Court employs a
  reasonableness test.
• If expense can be reimbursed, then it is not
  necessary.

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Proof Issue re Ordinary and Necessary

• Ultimately, the resolution of these issues turns
  on a careful consideration of the facts of each
  case.
• Because of changes in attitudes and business
  norms, what may not have been ordinary and
  necessary in the past may no longer be controlling

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EXPENSES

• Rule 1 A 162 deduction is allowed only for an
  item of expense and not a capital expenditure.
• Rule 2 Capital expenditures (Cap X) may not be
  deducted at the time the amount is paid or
  incurred
• Rather, the Cap X may give rise to deductions for
  depreciation in later years.
• Rule 3 Cap X are generally added to basis under
  IRC 1016(a)(1).

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Deduction v. Cap X

• Recognize, in the business context, the
  difference between deduction and Cap X is one of
  timing and the time value of money.
• However, in personal context, the difference
  between deduction and Cap X may be more
  substantively important
• Personal deductions generally not permitted
• Cap X still added to basis
• What is the difference between a current
  deduction for an expense and a Cap X?
• Courts hold that the difference is a fact
  question.

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Capital Expenditures Clusters of Fact

• Clusters of facts lead to certain results
• Cost of acquisition of assets (tangible or
  intangible) that has a useful life beyond the
  taxable year
• Cost that add to value of property, substantially
  prolong the useful life of property, or adapt the
  property to a new or different use.
• Business acquisition costs
• Cost incurred in perfecting or clearing title to
  assets
• Prepaid expenses

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Deductions That Might Look Like Cap X

• Improvement v. Repair Incidental repair or
  maintenance of business property are expenses
• Fact issue
• Advertising costs are expenses
• Product and service advertising
• Goodwill or institutional advertising

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CARRY ON

• Rule Expenses are deductible only if incurred
  while carrying on a trade or business.
• Expenses incurred in acquiring a new trade or
  business or generally not deductible.
• These expenses are generally added to basis.

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Expanding Existing Trade

• What about the expansion of an existing trade or
  business?
• These expenses are generally deductible

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Investigating New Trade

• What about investigating a new trade or business?
• These expenses are treated as a Cap X.
• If the investigation reaches a transactional
  stage and is dropped before a trade or business
  is developed or acquired, then the transactional
  expenditures may give rise to a loss deduction.
  IRC 165(c)(2).

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Start-Up Expenses

• What about start-up expenditures?
• Violate the carry on element and are not
  deductible
• Rule Some expenses incurred in acquiring or
  starting a new trade or business may be deducted
  as start-up expenditures if the taxpayer
  elects. See IRC 195.
• Under 195, these expenditures are deducted
  ratably over at least 60 months (time period
  selected by taxpayer) and begins in the month in
  which the active business begins.

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Special Case Employee Seeks Employment

• What about the expenses incurred in obtaining
  employment as an employee?
• Individual may be in the trade of business of
  providing services as employee.
• Expenses incurred in obtaining another job in the
  same line of work are deductible
• Expenses incurred in obtaining another job in a
  new line of work are not deductible
• Expenses incurred in obtaining ones first job
  not deductible
• Section 195 does not seem applicable.

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TRADE OR BUSINESS

• Does the taxpayers profit-seeking activities
  constitute a trade or business?
• Taxpayer must have a profit motive for engaging
  in the activity that gives rise to the expense
• Personal expenses are generally not deductible

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STATUTORY EXAMPLES UNDER SECTION 162

• Reasonable Allowance for Salaries
• Traveling Expenses While Away From Home
• Rentals of Property for Purpose of Trade or
  Business

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Reasonable Allowance of Salaries

• Section 162(a)(1) permits a deduction for
  reasonable allowance of salaries
• Salaries must be
• Reasonable
• For personal services performed

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Factors of Reasonable Compensation

• Factors
• Position
• Hours worked
• Duties performed
• Importance of the employee to business
• Comparison of past duties and performance to
  present
• Horizontal comparison with comparable companies
• Size of company, complexity of business, and
  general economic conditions
• Potentially exploitable relationship (cuts
  against)
• Existence of bonus system that distributes nearly
  all of pre-tax earnings of company (cuts against)

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Contingent Compensation

• If employment agreement provides for compensation
  based on future events, such as percentage of
  profits, then amount actually paid is reasonable
  if fruits of arms length bargain and reasonable
  when the agreement was made.
• If agreement is not product of arms length
  bargaining, then it must be reasonable at time it
  was paid
• Concern Compensation may be disguised dividend
  or de facto dividend.

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Personal Service Performed

• Payment of salary must be for personal
  services actually rendered.
• Payment to taxpayer as partial payment for
  property transferred or as disguised dividend do
  not qualify as salary

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Traveling Expenses While AwayFrom Home

• Rule Deduction is permitted for traveling
  expenses, including lodging and a portion of the
  cost of meals, incurred while a taxpayer is away
  from home in the pursuit of a trade or business.
  IRC 162(a)(2).
• Three requirements
• Expense must be reasonable and necessary
  traveling expense (cannot be extravagant or
  lavish)
• Expense must be incurred while away from home
• Expense must be incurred in the pursuit of
  business
• Further limit with meals 50 limit on
  deductibility

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Travel Expenses

• Airplane
• Rental car
• Train
• Taxis
• Meals and lodging
• Incidentals
• Tips, telephone calls, internet access, baggage
  charges, postage, laundry, handicapped traveler
  aid
• Commuter expense do not qualify

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Away From Home

• Taxpayer must have a tax home for federal income
  tax purposes
• A taxpayer may not have a tax home
• Presumption is that the principal place of
  business (and not her abode) is a taxpayers tax
  home
• Principal place of business
• Amount of income earned at each location
• Nature and extent of business activity that takes
  place in each location
• Amount of time spent at each location

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Temporary Assignment

• TAD must be expected to be less than one year
  and must in fact be less than one year.
• If temporary assignment is greater than one year
  (regardless of intent), then no portion of
  expenses may be deducted.

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Overnight Rule

• Rule Deduction permitted for expenses incurred
  in lodging and 50 of meals only if taxpayer is
  away from home overnight.
• Overnight means
• Taxpayer is away from home long enough to require
  her to stop for substantial sleep or rest no
  matter what distance she travels or mode of
  transportation she employs.
• Otherwise, nondeductible personal expense under
  262.

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Travel for Business and Personal

• Rule 1 Expenses for travel to and from are
  fully deductible if the primary reason for the
  trip is business.
• There is no allocation requirement for travel
  expense to and from.
• Rule 2 Expenses once present are deductible
  only to the extent they are properly allocable to
  the business.
• Special rules for foreign travel.
• No deduction for spouse or dependents.

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Meals

• Away from home 50 if not extravagant or lavish
• Not away from home 50 but only if present and
  related directly to trade or business, that is,
  an entertainment expense (more restrictive test)
• IRC 274 (50 limitation)

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Rentals of Property for Purpose of Trade or
Business

• Rule 1 Deductions permitted for rentals or
  other payments for use of property in a
  taxpayers trade or business. IRC 162(a)(3).
• Transfer/Lease-Back
• Is there a legitimate business purpose for the
  transaction?

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Miscellaneous Business Deductions

• Interest (IRC 163)
• Education
• Entertainment
• Uniforms
• Dues
• Periodicals
• Utilities
• Taxes (IRC 164)
• Health insurance for self-employed individuals
• Charitable donations (IRC 170)

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Payment of Interest

• Deduction for interests payments on business
  loans (IRC 163).
• Generally no deduction for payments of interest
  on personal loans with several important
  exceptions
• Home mortgage interest deductions
• Certain qualified student loans for qualifying
  taxpayers

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Payment of Educational Expenses

• Deduction permitted if either the education
  maintains or improves skills required by a
  taxpayer in his employment or other trade or
  business or if education meets express
  requirements imposed by law or a taxpayers
  employment, status, or rate of compensation.
  Treas. Reg. 1.162-5(a).
• No deduction if education is necessary to qualify
  for trade or business or meet minimum educational
  requirements.

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Travel and Education

• Travel as education No deduction.
• Travel to obtain education Deductible if 162
  requirements are met.

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Miscellaneous Deductions contd

• Entertainment
• Meals and entertaining Must show demonstrable
  business benefit.
• Generally 50 limit.
• Section 274 limitation.

• Uniforms
• Work clothing specifically required as condition
  of employment and not adaptable to general use.
• Think police, nurses, sports uniforms, Mr.
  Goodwrench, fire fighters, etc.
• Do not think military uniforms of full-time
  active duty personnel
• If uniform cost is deductible, then maintenance
  is deductible.

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Miscellaneous Deductions contd

• Dues
• Deduction permitted for dues directly related to
  taxpayers employment or other trade or business.

• Periodicals
• Deduction permitted for periodicals and books
  whose useful life is short if they relate to
  taxpayers business.

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Miscellaneous Deductions contd

• Utilities
• Deductible if they are necessary for carrying on
  trade or business.

• Taxes
• Deductible if specifically enumerated under IRC
  164, including certain state and local and
  foreign taxes.

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Miscellaneous Deductions contd

• Health insurance for self-employed individuals
• Self-employed taxpayer may deduct the costs of
  medical insurance coverage for himself, spouse,
  and dependents

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Substantiation

• Rule If a taxpayer does not have substantiation
  of a deduction, then a court may allow an
  estimate of the expense unless the IRC
  specifically requires substantiation.
• Estimation is known as the Cohan rule.
• IRC 274(d) requires substantiation for the
  following expenses
• Traveling expenses (including lodging and meals
  away from home), business gifts, entertainment
  expenses, and business meals.

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Section 212 Profit-Seeking Activity

• Section 212 permits a deduction in certain
  circumstances for ordinary and necessary expenses
  incurred or paid in furtherance of profit-seeking
  activity, specifically
• The production or collection of income
• Dealing with property that is being held for the
  production of income
• Dealing with tax matters

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212 General Rule

• Item must be
• Ordinary and necessary
• Expense
• Must not be inherently personal in nature
• Must be individual (or by extension, estate or
  trust by personal representative or trustee)
• Cannot be a corporation and use 212

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212 Production or Collection of Income

• Ordinary and necessary expenses incurred in a
  taxable year for the production or collection of
  income are deductible by individual taxpayer.
• Expenses need not match income in the same year.

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212 Management of Income Producing Property

• Ordinary and necessary expenses incurred in a
  taxable year for the management, conservation, or
  maintenance of property held for the production
  of income are deductible.
• This is the case even where the property is not
  currently producing income or even where the
  property may be sold for a loss.

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212 Expense in Connection with Taxes

• Deduction for expenses incurred in connection
  with the determination, collection, or refund of
  any tax.
• Includes
• Preparing return, contesting tax liability, or
  determining tax consequences of proposed action

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Key Differences Between 162 and 212

• Section 212 deduction is below the line, that
  is, that a taxpayer must itemize deductions to
  receive any tax benefit.
• Section 162 is an above the line deduction no
  need to itemize to receive a tax benefit.
• Section 212 does not require that taxpayer is
  actually carrying on trade or business to
  qualify.
• Section 162 requires carrying on trade or
  business.

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Conclusion

• Questions?