Business Expenses

1
Business Expenses

• Chapter 5

2
Code Sections

• Sec. 161 - deductions permitted only for 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)

3
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 recognizes income)
• The obligation of another taxpayer

4
Substantiation

• All taxpayers must maintain records that
  substantiate their expense deductions
• Stringent substantiation requirements for travel,
  entertainment, and gifts
• Amount of expenditure
• Time and place (or date description of gift)
• Business purpose of expenditure
• Business relationship of person entertained or
  receiving a gift

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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
  paid
• Date check is mailed
• Date charged on credit card

6
Cash Method

• When an expense is paid by providing services,
  the expense can be deducted but the value of the
  services provided is also 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

7
Use of Cash Method

• Businesses that sell merchandise to their
  customers must use the accrual method to account
  for purchases and sales of inventory
• Cash method can be used for other than inventory
  and cost of goods sold
• Large corporations with average annual gross
  receipts of more than 5 million cannot use the
  cash method for tax reporting
• All personal service corporations can use the
  cash method

8
Prepaid Expenses

• Prepaid expenses must be capitalized as assets
  and their costs 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 loan
• OID is a form of prepaid interest and must be
  amortized over term of loan

9
Costs of Starting a Business

• Sec. 162 allows deductions for carrying on a
  business. Expenses incurred prior to the
  commencement of operations do not qualify as
  carrying on a business but may be deductible as
  one of the following
• Business investigation expenses
• Start-up expenses
• Organization costs

10
Business Investigation

• Investigation expenses incurred while preparing
  to enter business include travel, market surveys,
  and feasibility studies
• If the taxpayer is in a similar existing business
  - deduction allowed as a current expense
• If taxpayer is not in a similar existing business
• If new business acquired - expenses amortized
  over 60 months
• If new business not acquired - no deduction

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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)
• If the business is related to the taxpayers
  existing business, start-up costs are considered
  continuing costs and are deductible currently
• If the business is not related to an existing
  business, expenses are amortized by the taxpayer
  over 60 months

12
Organization Costs

• Defined as costs related to the 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
• Organization costs are capitalized and amortized
  over 60 months
• Excludes partnership syndications costs and stock
  issuance costs

13
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

14
Meals Entertainment

• The deduction for business meals and
  entertainment expenses is limited to 50 of the
  qualified expenses
• The 50 limit is imposed on whoever (employer or
  employee) ultimately pays the expense

15
Meals Entertainment

• Directly-related expenses - costs incurred when a
  significant business discussion takes place
  between the taxpayer and a customer in atmosphere
  conducive to the serious conduct of business.
• Associated-with expenses - deductible when
  directly preceded or followed by a substantial
  business discussion
• Deduction for entertainment tickets is limited to
  50 of the tickets face value

16
Restriction on Deductions

• No deduction allowed for the costs of owning and
  maintaining entertainment facilities such as
  hunting lodges and yachts
• No deduction allowed for membership dues and fees
  paid to social, athletic, or sporting clubs
• Deductions are allowed for dues to professional
  organizations, public service organizations, and
  trade associations
• Deduction for business gifts limited to 25 per
  donee per year

17
Travel Away From Home

• Travel expenses incurred for temporary travel
  away from home on business are deductible.
• Qualifying expenses include lodging, 50 of
  meals, transportation to destination and back,
  and incidental expenses
• Away from home refers to the persons tax home
  that is, the location of the principal place of
  employment regardless of where the family
  residence is maintained

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Temporary Assignments

• Temporary is defined as 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 for more than one year shifts tax home
  to the new location (no deduction for travel and
  living costs)

19
Transportation Expenses

• Certain transportation expenses incurred when the
  taxpayer is not away from home are deductible and
  include
• the cost of transportation from one work location
  to another
• transportation between home and a temporary work
  location if the taxpayer has a regular place of
  business
• any meal costs are excluded, however

20
Transportation Expenses

• The prorated business portion of actual
  automobile expenses or a standard mileage rate
  (37.5 for 2004) plus related parking and tolls
  can be deducted
• Commuting expenses (between home and the regular
  place of business) are a personal nondeductible
  expense

21
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
• Primary purpose is determined by the number of
  days on business versus personal days

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Combining Business with Pleasure Travel

• Meals lodging are deductible only for days on
  which business is conducted
• If a taxpayer remains in a temporary location to
  reduce costs as a result of
• reduced airfare for Saturday night stays or
• for business conducted on both Friday and Monday
• the costs for additional days are deductible if
  they are less than the cost of returning home
  when business is completed

23
Foreign Travel

• Transportation expenses must be allocated between
  business and personal days unless
• Trip does not exceed one week or
• Less than 25 of total time spent for personal
  purposes
• If trip primarily personal, no deduction for
  transportation

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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

25
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

26
Legal Expenses

• Legal Fees deductible only if related to a trade
  or business
• Legal fees incurred to defend title to property
  are added to the assets basis
• Criminal defense fees are deductible only if the
  legal action has a direct relationship to a
  profit-seeking activity
• Personal legal expenses are not deductible

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Taxes

• Deductible taxes include
• State, local, and foreign real property taxes
• State and local personal property taxes
• State, local, and foreign income taxes
• Employers payroll taxes
• Other federal, state, local, and foreign taxes
  incurred in a business or other income-producing
  activity
• Federal income taxes are not deductible

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Taxes

• When real estate is sold, the seller is
  responsible for taxes through 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

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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 costs 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

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Inventory

• Acceptable methods for tax accounting include
  specific identification, FIFO, LIFO, and average
  cost
• When prices are rising, the LIFO method results
  in a lower inventory valuation and tax savings
  through a higher deduction for cost of goods sold
  
• The LIFO conformity rule requires use of LIFO for
  financial statements if LIFO is used for tax

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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 include advertising, cleaning,
  maintenance, utilities, insurance, taxes,
  interest, commissions for collection of rent,
  travel to collect rental income or to manage the
  property or maintain the property

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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

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Rental of a Vacation Home

• If the residence is rented for less than 15 days
  during the year a de minimis exception applies
• No rental income is reported but
• No deductions are allowed for expenses other than
  mortgage interest and property taxes as itemized
  deductions

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Rental of a Vacation Home

• If rental period is greater than 14 days and
• If personal use does not exceed the greater of 14
  days or 10 of the rental days
• All rent is included in income
• Expenses are allocated between rental and
  personal use
• All expenses related to the rental use are
  deductible (even if this creates a loss)

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Rental of a Vacation Home

• If rental period is greater than 14 days but
• Personal use exceeds the greater of 14 days or
  10 of the rental days
• Rental expenses limited to rental income (no
  loss)
• Nondeductible rental expenses can be carried
  forward to the future years
• Real estate taxes and mortgage interest for
  personal-use portion allowed as itemized
  deductions

36
Home Office Expenses

• Home office must be used exclusively on a regular
  basis and meet one of the following three tests
  to be deductible
• 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

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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 but are limited
  to gross income from the business

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Home Office Expenses

• Expenses are deducted in this order
• Expenses directly related to the business other
  than home office expenses (supplies)
• The allocated portion of otherwise deductible
  itemized deductions (mortgage interest and
  property taxes)
• 3. Other home expenses including utilities,
  insurance, and maintenance
• 4. Depreciation
• Excess expenses are carried forward

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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 activity is a hobby including
• Manner in which activity carried on
• Expertise of taxpayer and/or consultants
• Time and effort spend in activity
• Actual profits earned in one or more years
• Elements of pleasure or recreation

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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 activity is a hobby
• Taxpayer can deduct expenses, even if a net loss
  results, by showing activity is run in a
  businesslike manner
• If activity is a hobby, the deduction for
  expenses is limited to hobby income

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Hobby Expenses

• Expenses must be deducted in this order
• Otherwise allowable expenses (mortgage interest,
  taxes, and casualty losses)
• Expenses that do not reduce the tax basis of the
  assets used in the hobby (advertising, insurance,
  utilities and maintenance)
• Depreciation and amortization
• Excess expenses are lost - no carryover

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Accounting for Income Taxes

• FAS 109 states that income tax expense reported
  on financial statements must be based on
  financial statement income rather than taxable
  income
• Differences fall into two categories
• Permanent differences
• Temporary differences

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Permanent Differences

• Income that is not taxed but is reported for
  financial accounting purposes
• Interest income from municipal bonds
• Expenses that can never be deducted on the tax
  return
• Fines and penalties
• Expenses that have limited deductibility
• 50 of meals and entertainment

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Temporary Differences

• Income or expense items that are reported in one
  year for accounting income and in a different
  year for taxable income
• Examples depreciation expense, bad debt expense,
  warranty expenses, and prepaid income
• Schedule M-1 of Form 1120 reconciles accounting
  (book) income to taxable income

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Schedule M-1
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Calculating Tax Expense

• If only permanent differences, adjust book income
  by
• Adding expenses that are not tax deductible and
• Subtracting tax-exempt income, then
• Multiply adjusted book income by the tax rate

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Deferred Taxes

• Temporary differences create
• A deferred tax liability that is a current tax
  savings that will have to be paid in a future
  year
• A deferred tax asset that is a prepayment of tax
  that will be refunded in a future year

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Deferred Tax Assets

• To realize the benefit of a deferred tax asset
  (tax prepayment) the business must have future
  income and a related tax liability
• A more-likely-than-not test is used to determine
  if a valuation account (contra asset) is needed

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ConsolidatedFinancial Statements

• Under FAS 109, income tax expense reported on
  consolidated financial statements should include
  the total of all federal, state, local, and
  foreign income taxes including both current and
  deferred income taxes

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ConsolidatedFinancial Statements

• Exception under APB 23 allows parent to exclude
  future U.S. income tax on foreign subsidiary
  income if these earnings are permanently
  reinvested outside the U.S.
• Allows U.S. corporation to report higher
  financial statement income because its income
  statement includes the foreign income but
  excludes the deferred U.S. tax that could
  eventually be due on this income
• Earnings repatriated later can cause a spike in
  the corporation's effective tax rate in that year

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The End