* Trade or business vs.
investment classification – distinction important only to individuals * Expenses incurred in a trade or business are deductions for AGI * Investment expenses, other than those incurred to produce rents and royalties are deductions from AGI Legal and accounting fees – may deduct if incurred in conduct of trade or business or for the production of income.
* Deductions for AGI if incurred in trade or business and any fees incurred in the determination or collection of taxes * All other legal and acct fees incurred by taxpayer are from AGI * Cannot deduct legal fees incurred in the acquisition of property (these are capitalized) Ordinary expense – reasonable in amount, bears reasonable and proximate relationship to the income-producing activity or property.
* Does not mean the property must be producing income currently Necessary expense – appropriate and helpful in the taxpayer’s business Reasonable – compensation does not exceed the value of work put in Expenses and losses incurred directly by the taxpayer – taxpayers may not take a deduction for a loss or expense of another person * In order for a business to deduct personal employee expenses one of two things must happen… * The employee must report additional compensation, or * The employee must reimburse the company for the compensation received * Exception: medical expenses paid on behalf of a dependent Capitalization vs. Expense deduction.
General capitalization requirements – taxpayer may not take current deduction for capital expenditures Capital expenditures – expenses that add to the value of, substantially prolong the useful life of, or change the use of the property Depreciable/amortizable assets – buildings, machinery, equipment, furniture, purchased goodwill Non depreciable/amortizable assets – land, stock, partnership interests Maintenance/repair expenditures – deductable only if they do not increase the value or prolong the useful life of the asset Expenses related to tax exempt income - may not deduct any expense allocated or related to tax-exempt income.
* Purpose – to prevent taxpayer from receiving a double tax benefit * Also disallows interest expense on debt the taxpayer incurs in order to purchase or hold tax-exempt securities * Depends on intent of the loan, intent determined w/tax-exempt securities if the securities themselves are used as collateral to secure the loan Expenditures contrary to public policy – not deductable If payment itself is illegal or if it is a penalty or fine from an illegal act.
* Bribes and kickbacks – applies to pmts made to federal officials, state, local, and foreign governments, and officials of an agency of government. * Fines and penalties – deductions not allowed * Expenses related to illegal activity – deductable if they are ordinary, necessary, and reasonable and the taxpayer reports the income from the illegal activity * However, disallows any illegal business of trafficking or drug dealing Political Contributions and lobbying expenses – may not deduct if made in connection w/the following… * Influencing legislation * Participating or intervening in a political campaign.
* Attempting to influence the general public w/respect to election matters * Communicating directly w/the president, vice president, or other federal employees * No deduction if contribution made to tax-exmpt organizations that carry on lobbying activities * CAN DEDUCT lobbying expenses incurred to influence legislation on a LOCAL level if the legislation directly influences the taxpayer’s business. However CANNOT if STATE or FEDERAL legislation Business investigation and Preopening expenses – current deduction in the year when business starts.
* Deductions is lesser of the amount of start-up expenditures or $5,000 * Dollar for dollar phase out for amounts over $50,000 * Remaining portion of expenditures are capitalized and amortized over period of 180 months, starting with month new business begins * Start up expenditures include…
* Investigation expenses – costs incurred in reviewing a prospective business before deciding to acquire it. * Preopening/start-up costs – costs incurred prior to start of business activity * Must not be incurred by a taxpayer already engaged in any existing business * Expenses incurred in connection with an investment activity – expenses incurred with investment that the taxpayer believes will become an active trade or business. When an expense is deductable Cash method – expenses deductable when actually paid * Payment by credit card considered cash * Prepaid expenses – no current deduction if expenditure creates an asset having a useful life that is longer than the close of the tax year.
* Prepaid interest – deduction over period of the loan to which the interest is allocated * Receipt of discounted loan does not represent prepaid interest expense Accrual method – deducts expenses in the period in which they accrue, must meet allevents test and economic performance test * All events test – met if the existence of a liability is established, and the amt of the liability is determined with reasonable accuracy * Cannot deduct additions to reserves for estimated expenses such as warranty expenses * Economic performance test – when it occurs depends on the type of transaction * Exception: Taxpayers may take current deduction for recurring liabilities if…
* The item meets the all-events test * Economic performance of the item occurs within less than 8 ? months after the close of the tax year * The expense is recurring * Accrual of item results in more proper matching with income Special Disallowance Rules Wash Sales – occurs when taxpayer realizes a loss on the sale of stock or securities, and the taxpayer acquires “substantially identical” stock within a 61 day period that extends 30 days prior to the sale of the security and 30 after the sale of the security. * Purpose: to prevent taxpayers from generating artificial losses in situations where they do not intend to reduce their holdings in the stock sold.
* Basis of stock – if loss is disallowed, the disallowed loss increased the basis of the recently acquired stock * The increase in basis causes the disallowed loss to be deferred Hobby losses – in cases where clear profit motive cannot be shown a test is performed to determine if the activity is engaged in for profit * The test: met if activity shows a profit for any 3 years during a consecutive 5 year period * If determined the activity is a business, taxpayer may deduct all qual business expenses, even if a net loss occurs * If determined activity is a hobby, expenses are deductible as misc itemized deductions .
* Limited to extent of gross income generated from hobby * Net loss may not be reported * Deductible expenses are those that would have been incurred in a trade/business or investment activity, deductions FROM AGI * If hobby expenses exceed amount of gross income generated from the hobby, they offset income in this order… * Tier 1: itemized deductions such as taxes, certain interest, and casualty losses * Tier 2: utilities, maintenance exp * Tier 3: depreciation on fixed assets used in the hobby CHAPTER 7 – ITEMIZED DEDUCTIONS (FROM AGI) Medical expenses – deductible only to the extent in which they exceed 7. 5% of AGI No deduction can be taken for any reimbursed expenses.
Qualified individuals – taxpayers pay medical expenses on behalf of themselves, spouse, or dependent * Dependent – only has to pass the support, relationship, and citizenship tests * Divorced parents – as long as one divorced parent qualifies to claim dependency, either one can take medical expense deduction Qualified medical expenses – medical care is defined as amounts paid for… * The diagnosis, cure, mitigation, treatment, or prevention of disease * Non-deductible expenses: expenditures for prescriptions, drugs, vitamins, health food.
* The purpose of affecting any structure or function of the body * Cosmetic surgery does not qualify unless it is necessary to correct a deformity from an accident * Transportation primarily for the items listed above * Deduction not allowed if any recreational activity takes place during travel * 16. 5 cents for every mile driven * Meals and lodging included – meals subject to 50% rule, limit of 50$ per person/per night for lodging * Qualified long-term care services – medical services required by a chronically ill individual * Insurance covering all above items.
Capital expenditures for medical care – deduction available if cap ex is made to acquire an asset primarily for the medical care of the taxpayer. Deductible items include… * Eye glasses, dogs to assist the blind and deaf, artificial limbs and teeth, wheelchairs, crutches, portable air conditioners, etc. * Fully deductible * Expenditures that permanently improve the residence and provide care, e. g. swimming pool * Deductible to extent amt of expenditure exceeds the increase of the FMV of the home * Expenditures to remove structural barriers – constructing ramps, widening doorways, etc. * Fully deductible Entire cost of in-patient hospital care qualifies as medical expense All premiums paid for medical insurance are deductible.
Taxpayers deduct medical expenses only in the year they are paid, regardless of method of acct * If prepaid, deduction is deferred until the year care is received Medical insurance reimbursement – only deduct unreimbursed medical expenditures * If reimbursement is received, the deduction is reduced by the amount received, taking into consideration the amount of tax benefit received in the previous year.
Taxes Fees, assessments, or fines imposed for specific privileges or services are not deductible as taxes * If a business incurs these fees, they can capitalize the cost or deduct as ordinary business expenses Deductible taxes * State, local, and foreign real property taxes * State and local personal property taxes if based on value * State, local, and foreign income taxes * Environmental tax * Other state, local, and foreign taxes paid in either trade or business or income producing activity Taxes imposed by the federal gov are not deductible.
* However, customs and excise taxes incurred in the taxpayer’s business are deductible as bus exp * ER side of SS is deductible for the ER State and Local Income Taxes – itemized deductions from AGI * Cash-method tax payers deduct all state and local income taxes paid or withheld during the year, even if the taxes are attributable to another year State and Local Sales Tax – taxpayers allowed to deduct in lieu of state and local income taxes Personal Property Tax – To qualify as deductible the property’s value must determine the tax and the tax must be imposed on an annual basis. **Apportionment of Real Estate taxes – when real estate is sold during the year, the deduction for real estate taxes is divided between the buyer and seller.
Real property assessments for local benefits – if the tax is only against the property that will benefit from the improvements, it is not deductible Additional Standard deduction for real property taxes – if homeowner takes std deduction instead of itemizing can take the lesser of…
* The amt that would have been deductible if the taxpayer itemized, or * $500 ($1000 for MFJ) Self employment tax – double the SS rate(12. 4% and 2. 9%), can deduct ? of self employment taxes paid for AGI Nondeductible taxes – federal income tax, federal estate and gift tax, EE portion of SS, State and local taxes on inheritance Interest May not deduct personal interest expenses, interest incurred in trade or business is always deductible.
Definition of interest – compensation for the use or forbearance of money Charge for services – unless incurred in a trade or business, not deductible Bank service charges and finance charges – nondeductible If borrowed funds and personal funds are mingled in the same account, expenditures from that account are treated as coming first from the borrowed funds Investment interest – interest expense on indebtedness allocable to property held for investment * limited deduction equal to the taxpayer’s net investment income for the taxable yr * Net investment income – excess of the taxpayer’s investment income over expenses *.
Excludes qualified dividends and net long term capital gains * Investment expenses – all deductions that are directly connected to the production of investment income (deductible only to extent they exceed 2% of AGI) * Any disallowed interest expense deduction is carried forward to subsequent years * Included property that generates portfolio types of income: dividends, annuities, royalties .
* DOES NOT INCLUDE: business interest, personal interest, qualified residence interest, passive act Qualified Residence Interest – deductible, interest pmt must be acquisition indebtedness or home equity indebtedness ( two separate limits, total limit = $1,100,000) * Acquisition indebtedness – any debt secured by the residence and incurred in acquiring, constructing, or improving the qualified residence * Amount of deduction can never exceed the principle balance of the mortgage * Limitation = $1,000,000, * Home Equity Indebtedness – limited to the lesser of… * The FMV of the residence in excess of the acquisition indebtedness, or * $100,000.
* Points as qualified residence interest – 1 point is equal to 1% of the loan amount * Points represent prepaid interest when the stated rate of interest for the loan is lower than the current rate of interest For any tax year, a taxpayer may have two qualified residences * For the 2nd property, the tax payer must have personally used it for 14 or more days or for 10% of any rental days Student Loan Interest – Take a FOR AGI deduction for interest paid on qualified education loans.
* Max annual interest deduction is $2500,phased out ratably with AGIs from $60k to 75k (double MFJ) Interest paid with loan proceeds * if individual borrows money from 3rd party to make pmt on loan, interest pmt portion deductible * if individual borrows from same lender loan is from, cannot deduct interest portion of pmt Charitable Contributions Taxpayer takes deduction in the year the contribution is made, regardless of acct method Contributions made directly to individuals are not deductible, must go to qualified organization Qualified Organizations include… * The US, state or possession of the US * Corporate trust, foundation created under laws of US, * Post or organization of war vets.
Qualified organizations are further classified into public charities and nonoperating foundations Contribution of Long-Term Capital Gain Property – amt of donation is the property’s FMV * Capital gain property – property held over one year in which the taxpayer would recognize a LTCG if the taxpayer sold it at FMV on the date of contribution * If a capital loss or STCG would be recognized the property is considered ordinary income property for charitable contribution deduction purposes.
* Contribution to private nonoperating foundation – amt of contribution is the property’s FMV reduced by the capital gain that would have resulted if sold * Private nonoperating foundation – organization that does not receive funding from the general public * Unrelated use property – capital gain property contributed to a public charity and used by the organization for purposes unrelated to the charity’s function * Deduction = property’s FMV less the Capital gain the would be recognized if sold * Certain intangibles – deduction = FMV reduced by the LTCG * Includes patents, trademarks, trade name, copyright.
Contribution of Ordinary Income Property – deduction amt = property’s FMV less the amount of gain that would be recognized if sold * Ordinary income property – any property that would result in the recognition of ordinary income rates if the taxpayer sold the property * Inventory, capital assets held for less than a year * Donation of inventory by a corporation – provides larger deduction that adjusted basis of property * Available when charity uses inventory solely for care of the ill, needy, or infants, also if the donation is scientific equip donated to a college or university, also if the contribution is computer technology to secondary schools and elementary schools.
* Contribution = FMV, reduced by 50% of the gain that would had been recognized Contribution of services – only deduct unreimbursed expenses incurred while rendering services, no deduction for value of service * Includes out-of-pocket expenses, transportation costs (14 cents per mile), cost of lodging and 50% cost of meals Overall 50% limitation – contribution deductions limited to no more than 50% of taxpayer’s AGI * Any excess contributions are carried forward for the next 5 tax years 30% limitation – Contributions of capital gain property cannot exceed 30% of taxpayer’s AGI, also applies to all cash and ordinary income property contributed to nonoperating foundations, does not apply to these situations… * Capital gain property donated and not put to related use by the charity.
* Taxpayer elects to reduce the amount of the contribution by the capital gain that it would recognize 20% limitation on capital gain property contributed to nonoperating foundations Contributions for athletic events – if contribution is made to college and the right to purchase tickets is given in return, only 80% of the pmt is deductible Applying the deduction limitations – contributions subject only to the 50% AGI limit are accounted for 1st, then contributions subject to the 30% limit are accounted for CHAPTER 8 – PASSIVE AND CASUALTY LOSSES Passive Losses Taxpayers must classify income into 3 different categories.
* Active income – wages, salaries, and active business income * Investment income – dividends, interest annuities, and royalties * Passive income – income from an activity in which the taxpayer does not materially participate and rental activity Passive income and losses – compute each passive income/loss from each activity separately * Taxpayer may use losses from one passive activity to offset income from another passive activity * May not use passive losses to offset active or investment income Carryovers – passive loss is limited to passive income, any disallowed passive loss is carried forward into subsequent tax years, known as a “suspended loss” *.
/C/F loss is allocated between all activities via pro rata portions Disposition of passive activity – can deduct suspended loss of activity (if existent) against other income * Must first offset any other passive income before offsetting other income activities * If disposed to related party, may not deduct until related party sells to unrelated person * Related party – spouse, brother/sister, ancestors, corp where indiv has > 50% ownership * Death of taxpayer not disposition of passive asset.
* Deduction = amt of suspended loss that exceeds increase in basis of the property Former passive activity – determination of whether an activity is passive must be made annually * If activity was found passive in previous year and is not in current year, any carryover from previous year may be deducted against current income even if the income is not passive for that year Taxpayer may use credits generated in passive activity against portion of tax liability attributable to passive income Definition of passive activity based on…
* Identification of activity – may treat one or more activities as single activity, these receive greatest weight… * Similarities in type of business * Extent of common control * Extent of common ownership * Geographical location * Interdependence between operations.
* Taxpayers generally may not group rental operations with trade or business operations * Material Participation – taxpayer must not materially participate in order to be passive activity, taxpayers materially participate if… (participation of taxpayers spouse is taken into account) * Individual participates in activity for more than 500 hours during year * If individuals participation in activity for year constitutes all activity by all individuals who do not own any interest in the activity *.
Individual participates more than 100 hours and more than any other in the activity for year * Individual materially participated in any five years during the preceding 10 taxable years Limited partnerships – most income passed through to limited partner are passive Interest in Oil and Gas Property – if responsible for cost of development or operation, activity is not passive Partnerships and S corps – passive loss rules do not apply (loss is flow-through to the owners).
Closely held C-Corp – where more than 50% of the stock is owned by 5 or fewer ppl * Passive losses may offset income from active business operations Personal Service Corporation (PSC) – regular c-corp whose principal activity is the performance of personal services that are performed by owner-employees (EEs who own > 10% of stock).
* Passive losses may not offset active business income or investment income Material participation by PSCs and closely held C-Corps – If 1 or more shareholder who own >50% of outstanding stock materially participate in the activity Publically Traded Partnerships – any partnership traded on an established securities market * I f corp tax laws apply to PTP – passive losses rules do not apply * If partnership tax provision apply to PTP – passive loss rules apply at partner level.
Real Estate Business – involves the development, construction, acquisition, conversion, rental, operation, mgmt, leasing, or brokering of real property. Passive loss rules do not apply if 1 of 2 apply… * More than ? of the personal services the taxpayer performs during the year are involved in real property in which they materially participate * Taxpayer performs > 750 hours during the year in real property trades in which they materially participate Other rental real estate properties – taxpayer may deduct against other income up to $25,000 of annual losses from these activities * Loss only allowed if they do both of the following…
* Actively participate in the activity, and * Own at least 10% of the value of the activity for the entire year * Limitation of loss – taxpayers must first apply rental real estate loses against other net passive income for the year * The $25,000 reduction is only allowed after all other passive income is offset * Phase out: Reduction of $25,000 limit by 50% for taxpayers with AGI > $100,000 * Therefore if AGI is $150,000 or more, no additional deduction is allowed.
* Limitation of loss applies to deductions and credits – if additional amt of limit is available, any credits associated with tax liability of activity may be used to extent of marginal tax rate Casualty and Theft Losses Taxpayers may take a limited deduction if the loss on personal use property arises from fire, storm, shipwreck, other casualty, or theft Casualty loss – one that occurs in an identifiable event that is sudden, unexpected, or unusual * Identifiable event – act of losing or misplacing property is generally not an identifiable event * Sudden event – one that is swift, not gradual or progressive * Unexpected – ordinarily unanticipated and not intended * Unusual – not day-to-day in occurrence.
Theft – larceny, embezzlement, robbery, blackmail extortion, and kidnapping for ransom Measuring the loss – amt of loss is the amount by which the casualty reduces the property’s FMV * May not include any reduction in the FMV of the surrounding but undamaged property * Cost of protecting property to prevent damage from a casualty loss is not deductable * If property is only partially destroyed – amt of loss is lesser of reduction in the property’s FMV or the taxpayer’s adjusted basis of the property * If business or investment property totally destroyed in casualty – amt of loss is taxpayer’s adjusted basis, even if it is greater than the FMV Taxpayers must establish the reduction in the FMV of the property via appraisal, if appraisal cannot be obtained they may use the cost of repair if… * The repairs bring the property back to the same condition right before the casualty * The cost of repairs are not excessive.
* Repairs do not repair more than what was damaged by the casualty * Repairs do not increase the FMV of the property over what is was before casualty Insurance received reduces the amount of loss allowed Limitations on personal use property – limited to… * Losses sustained in each separate casualty must be reduced by $100 * Total net amount of all casualty losses for personal use property is reduced by 10% of AGI Netting casualty gains/losses on personal use property – must net g/l incurred, do not combine with casualty g/L on business and investment property * For netting purposes, the loss should be reduced by the $100 amount, 10% limit does not apply yet Casualty G/L attributable to business and investment property – net G/L for property held > 1 yr * If losses > gains, a deduction FOR AGI is taken.
* If property is held for < 1 yr, G/L are treated as ordinary Taxpayer must subtract reimbursement for compensation if they haven’t received it, yet it there is a reasonable prospect that the taxpayer will receive it in the future. Disaster Losses – Under certain circumstances taxpayer may elect to deduct casualty loss in preceding year in which loss actually occurs * President must declare area a disaster area CHAPTER 10 – DEPRECIATION, COST RECOVERY, DEPLETION, AND AMORTIZATION Depreciation relates to deductions for most tangible personal property Amortization related to deductions for intangible property Depletion relates to deductions for natural resources Depreciation and Cost Recovery.
Property placed in service after Dec 31, 1986 must use the MACRS, common rules are… * Depreciation may be claimed only on property used in a trade or business for the production of income * No depreciation is permitted for land or other assets that have an indefinite life * First year depreciation is permitted only in the year the asset is placed in service * Taxpayers must consistently use the method selected in the year the asset was placed in service.
* If a taxpayer does not take any depreciation during a particular year, the basis of property must be reduced by the amount of depreciation that should have been taken during the year If personal-use property is either converted to business use or held for the production of income the property’s basis for depreciation purposes is the lesser of the FMV at the date of conversion or adjusted basis MACRS differs from depreciation methods used for financial acct methods by…
* Not considering salvage value * Uses specific asset classes * Uses fewer depreciation methods * Half year convention – required for all tangible personal property * Assumes all asset acquisitions or dispositions are made at the midpoint of the tax year Income excluded from MACRS depreciation * Property depreciated under a method not expressed in terms of years, such as the units of production method * Intangible assets * Films, video tapes, or sound recordings.
Section 179 expensing election – in lieu of depreciating the cost of new or used tangible personal property, may elect to expense up to $250,000 of acquisition costs as an ordinary deduction in the year the property is placed in service * Not applicable to real estate * Election made on annual basis * Limitation include… * Must be purchased for use in an active trade or business * Property cannot be acquired from a related party * If 179 benefits are no longer used in trade or business they are recaptured as ordinary income * If total cost of property placed into service during the year is > $800,000, the $250,000 ceiling is reduced on a dollar-for-dollar basis by the excess amount * 179 deduction cannot exceed taxable income, excess is c/f unlimited amount of years.
Bonus Depreciation – qualified property can take an additional 50% of basis deduction in 1st yr of use * Qualified property – MACRS property with recovery period of 20 years or less, computer software, and qualified leasehold improvement property * Remaining basis of property is depreciated under usual rules * If 179 is elected, 179 expense is deducted 1st, followed by bonus, followed by MACRS Mid-Quarter Convention – aggregate basis of all personal property placed in service during the last 3 months of the year exceeds 40% of the cost of all personal property *.
The 40% test is applied after reducing the property’s basis by 179 expensing, but not by bonus dep * If used, use mid quarter convention tables for all property placed in service during the year Year of disposition – depreciation must be taken in year of disposition using the same convention applied in acquisition * Half year convention – take depreciation amount * .
5 * Mid quarter – Depreciation amt * (. 5/4) for 1st quarter, Dep amt* (1. 5/4) for 2nd qtr, Dep amt * (2. 5/4) for 3rd qtr, and Dep amt * (3. 5/4) for 4th qtr Residential rental property – property from which at least 80% of gross rental income is from dwelling units * Dwelling units – houses, apartments, NOT hotels or motels Nonresidential real property – any property other than residential rental property Real property placed in service after 1986 – mid month convention is used in acquisition/disposition yr * Residential rental property = 27. 5 years.
* Non residential real property = 39 years Capital improvements to buildings must be depreciated over the full MACRS period of the improvement, not over the remaining life or recovery period of the building Qualified leasehold improvement property – any improvement to the interior of a nonresidential real property made by lessee or lessor pursuant to a lease * Additional 50% bonus depreciation is allowed for property placed in service in 2008 and 2009 Straight line method election under MACRS – may elect to use for tangible personal property Alternative Depreciation System (ADS) – required for tangible property primarily used outside of the US * Recovery periods are generally longer.
* Straight line method with half year, mid quarter, and mid month convention * If taxpayer elects ADS, bonus dep is allowed. If they are required to use ADS, bonus not allowed Listed Property – automobiles, computers, cell phone, property used for entertainment and recreation * If listed property’s business use is > 50% of its total use, may elect 179 expense, use regular MACRS tables, and use bonus depreciation * If listed property’s business use is < 50%, 179, MACRS tables, and bonus may not be used * EEs who acquire listed property must meet the 50% test and the use of the property must be required as a condition of employment, otherwise 179, MACRS, and bonus are not allowed Amortization.
All intangible assets are amortized on a straight-line basis over a 15 month period beginning with the date of acquisition, major intangibles that may be amortized are… * Goodwill, research and experimental expenses, computer software, start-up expenses Sec 179 expensing applies only to intangible acquired in trade or business, definitions include… *
Goodwill, patents, copyrights, formulas, processes, licenses, permits, covenant not to compete, franchise, trademarks, and trade names Internally created patents are amortized over 17 years, internal copyrights 28 years Research and experimental expenditures – alternatives for treatment include… * Expense in year paid or incurred * Defer and amortize costs over 60 month period * Capitalize and write off costs only when research project is abandoned or worthless.