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Deductions and Losses: In General


Taxpayer has burden of proof for substantiating all expenses ... e.g., Landlord's legal fees associated with eviction of tenant. Investigation of a Business ... – PowerPoint PPT presentation

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Title: Deductions and Losses: In General

Deductions and Losses In General
  • Chapter 6

  • Exclusive definition of deductions
  • Deductions allowed based on legislative grace and
    defined narrowly
  • Substantiation requirements
  • Taxpayer has burden of proof for substantiating
    all expenses deducted on return
  • Thus, adequate records of expenses must be

Deductions FOR and FROM AGI (slide 1 of 3)
  • Deductions FOR AGI
  • Those listed in 62
  • Can be claimed even if taxpayer does not itemize
  • Called above the line deductions
  • AGI is important in determining the amount of
    certain itemized deductions
  • Certain itemized deductions are limited to
    amounts in excess of specified percentages of AGI
  • e.g., Medial expenses (7.5 of AGI), misc.
    itemized deductions ( 2 of AGI)

Deductions FOR and FROM AGI (slide 2 of 3)
  • Deductions FROM AGI
  • Those not listed in 62
  • In total must exceed standard deduction to
    provide any tax benefit
  • Called below the line or itemized deductions

Deductions FOR and FROM AGI (slide 3 of 3)
  • Comparison of deductions FOR and FROM AGI (2007
    tax year)
  • Single taxpayer has gross income of 45,000 and a
    6,000 deduction
  • For AGI From AGI
  • Gross income 45,000 45,000
  • Less for AGI ded. 6,000
  • AGI 39,000 45,000
  • Less from AGI ded. 5,350
  • Less personal exempt. 3,400 3,400
  • Taxable income 30,250 35,600

Types of Deductions
  • Trade or Business
  • Usually for AGI, except employee expenses
  • Nonbusiness
  • Related to the production of nonbusiness income
  • Tax determination
  • Usually from AGI, except rent or royalty income
  • Personal
  • Mostly from AGI

Deductions FOR AGI (slide 1 of 3)
  • Partial list includes
  • Trade or business expenses
  • Reimbursed employee business expenses
  • Deductions from losses on sale or exchange of
  • Deductions from rental and royalty property
  • Alimony
  • One-half of self-employment tax paid

Deductions FOR AGI (slide 2 of 3)
  • Partial list includes
  • 100 of health insurance premiums paid by a
    self-employed individual
  • Contributions to pension, profit sharing, annuity
    plans, IRAs, etc.
  • Penalty on premature withdrawals from time
    savings accounts or deposits
  • Moving expenses

Deductions FOR AGI (slide 3 of 3)
  • Partial list includes
  • Interest on student loans
  • Qualified tuition and related expenses under
  • Up to 250 for teachers supplies for elementary
    and secondary school teachers

Deductions FROM AGI
  • Itemized deductions include
  • Medical expenses (in excess of 7.5 of AGI)
  • Certain state and local taxes
  • Contributions to qualified charitable
  • Personal casualty losses (in excess of 10 of
    AGI and a 100 floor per casualty for
  • Certain personal interest expense (e.g., mortgage
    interest on a personal residence)
  • Miscellaneous itemized deductions (in excess of
    2 of AGI)

Business and Nonbusiness Losses of Individuals
  • Deductible losses of individual taxpayers are
    limited to those
  • Incurred in a trade or business,
  • Incurred in a transaction entered into for profit
  • Individuals may also deduct casualty losses from
    fire, storm, shipwreck, and theft

Trade or Business Deductions
  • Section 162(a) permits a deduction for all
    ordinary and necessary expenses paid or incurred
    in carrying on a trade or business including
  • Reasonable salaries paid for services
  • Expenses for the use of business property
  • One-half of self-employment taxes paid
  • Such expenses are deducted for AGI

Trade or Business Deductions
  • In order for expenses to be deductible, they must
  • 1. Ordinary normal, usual, or customary for
    others in similar business, and not capital in
  • 2. Necessary prudent businessperson would incur
    same expense
  • 3. Reasonable question of fact
  • 4. Activity is deemed to be a trade or business

Trade or Business Deductions
  • 5. Not a capital expenditure
  • 6. Not related to the production of tax-exempt
  • 7. Not contrary to public policy
  • 8. For a business purpose rather than a personal

Reasonable in amount Example Excessive Executive
  • For publicly held corporations
  • Deduction of salaries for chief executive officer
    and four highest compensated executives is
    limited to 1 million each
  • Does not include
  • Performance-based compensation and commissions
  • Payments to qualified retirement plans
  • Payments excludible from gross income

4. Incurred in conduct of business
  • Activities are either
  • Business
  • Intent to make a profit
  • Involves entrepreneurial effort
  • Investment
  • Intent to make a profit
  • No entrepreneurial effort
  • Hobby
  • No intent to make a profit
  • Involves entrepreneurial effort

Hobby Losses
  • Hobby defined
  • Activity not entered into for profit
  • Personal pleasure associated with activity
  • Examples raising horses, fishing boat charter
  • Often it is difficult to determine if an activity
    is profit motivated or a hobby
  • Regulations provide nine factors to consider in
    making this determination

Hobby Losses
  • Profit activity
  • If activity is entered into for profit, taxpayer
    can deduct expenses FOR AGI even in excess of
    income from the activity
  • (At-risk and passive loss rules may apply)
  • If an activity is not engaged in for profit, the
    hobby loss rules apply
  • Hobby expenses are deductible only to the extent
    of hobby income

Hobby Losses
  • Presumptive rule of 183
  • If activity shows profit 3 out of 5 years (2 out
    of 7 years for horses), the activity is presumed
    to be a trade or business rather than a personal
  • Rebuttable presumption, shifts burden of proof to
  • Otherwise, taxpayer has burden to prove profit
  • (If the activity generates a loss, it is
    generally better for it not to be considered a

Hobby Losses
Hobby Losses
  • Hobby activity
  • Can only deduct expenses to extent of income from
    activity (i.e., cannot deduct hobby losses)

Hobby Losses
  • If an activity is a hobby
  • Expenses are deductible FROM AGI
  • Treated as miscellaneous itemized deductions
    subject to the 2 of AGI limitation
  • Exception expenses that are deductible without
    regard to profit motive, such as
  • Mortgage interest
  • Property taxes

Hobby Losses
  • Order in which hobby expenses are deductible
  • First Those otherwise deductible e.g., home
    mortgage interest and property taxes
  • Then Expenses that do not affect adjusted basis
    e.g., maintenance, utilities
  • Then Expenses that affect adjusted basis e.g.,
    Depreciation (or cost recovery)

Hobby Losses
  • Example of hobby expenses Taxpayer sells horses
    raised as a hobby for 15,500

5. Not a capital expenditure
  • Amounts are capitalized
  • Asset may be subject to depreciation (or cost
    recovery), amortization, or depletion

6. Is not related to the production of tax-exempt
  • Expenses relating to production of tax-exempt
    income are nondeductible
  • Example interest expense on loan where funds
    used to acquire municipal bonds

7. Contrary to public policy
  • Deductions are disallowed for certain specific
    types of expenditures that are considered
    contrary to public policy
  • Examples penalties, fines, illegal bribes or
    kickbacks, two-thirds of treble damage payments
    for violation of anti-trust law
  • See Tank Truck Rental, Inc. v. CIR

Legal Expenses Incurred in Defense of Civil or
Criminal Penalties
  • To deduct legal expenses
  • Must be directly related to a trade or business,
    an income producing activity, or the
    determination, collection, or refund of a tax
  • e.g., Corporate officers legal fees in defending
    against price-fixing charges
  • e.g., Landlords legal fees associated with
    eviction of tenant

Investigation of a Business
  • Investigation expenses - incurred to determine
    the feasibility of entering a new business or
    expanding an existing business
  • Include costs such as travel, engineering,
    architectural surveys, marketing reports, various
    legal and accounting services
  • Tax treatment of these expenses depends on
  • The current business, if any, of the taxpayer
  • The nature of the business being investigated
  • The extent to which the investigation has
  • Whether or not the acquisition actually takes

Investigation of a Business
  • If the taxpayer is in a business the same as or
    similar to that being investigated
  • Investigation expenses are deductible in the year
    paid or incurred
  • The tax result is the same whether or not the
    taxpayer acquires the business being investigated

Investigation of a Business
  • When the taxpayer is not in a business the same
    as or similar to that being investigated
  • Tax result depends on whether new business is
  • If not acquired
  • All investigation expenses generally are
  • If acquired
  • Investigation expenses must be capitalized
  • May elect to deduct the first 5,000 of expenses
  • Any excess expenses can be amortized over a
    period of not less than 180 months (15 years)
  • In arriving at the 5,000 immediate deduction
    allowed, a dollar-for-dollar reduction must be
    made for those expenses in excess of 50,000

Expenses Relating to an Illegal Business
  • Usual expenses of operating an illegal business
    are deductible
  • However, deduction for fines, bribes to public
    officials, illegal kickbacks, and other illegal
    payments are disallowed
  • Trafficking in controlled substances only cost
    of goods sold can reduce gross income

Political Contributions And Lobbying Activities
  • Generally, no business deduction is allowed for
    payments made for political purposes or for
  • Exceptions are allowed for lobbying
  • To influence local legislation,
  • To monitor legislation, and
  • De minimis in-house expenses (limited to 2,000)
  • If greater than 2,000, none can be deducted

Expenditures Incurred for Taxpayers Benefit or
  • No deductions is allowed for payment of another
    taxpayers expenses
  • Must be incurred for taxpayers benefit or arise
    from taxpayers obligation
  • Exception Payment of medical expenses for a

Transactions Between Related Parties
  • Section 267 disallows losses from direct or
    indirect sales or exchanges of property between
    related parties
  • Family and entity relationships apply
  • Constructive ownership rules apply
  • Loss disallowed may reduce gain on subsequent
    disposition to unrelated third party

Transactions Between Related Parties
  • Section 267 also requires the matching principle
    be applied for unpaid expenses and interest when
    different accounting methods used
  • Example An accrual basis, closely held
    corporation, cannot deduct accrued, but unpaid,
    salary to cash basis related party
    employee/shareholder until it is actually paid

Disallowance Possibilities
  • The tax law disallows the deduction of certain
    types of expenses for a variety of reasons
  • e.g., May restrict taxpayer attempts to deduct
    certain items that, in reality, are personal
  • Certain disallowance provisions are a
    codification or extension of prior court
  • e.g., After courts denied deductions for payments
    in violation of public policy, tax law was
    changed to provide specific authority for the