Chapter 8 Business Deductions and Accounting Methods

I. General business deductions A. Three requirements

(1)

ordinary normal, common, and accepted under regular business circumstances.

(2) necessarymust be appropriate and helpful to the taxpayers business activity

(3) reasonable in amount an expense will not satisfy the ordinary and necessary test unless it is reasonable.

Example: If I paid my 3-year old son $5,000 for bookkeeping services, could I deduct it (assuming the $5,000 was FMV)?

B. Limitations on business deductions - 162 a. Expenditures against public policy e.g., fines, bribes, penalties, etc.

b. Political contributions and most lobbying costs

c. Capital expenditures

d. Expenses for producing tax exempt income

e.

C. Mixed motive expenditures

(1) M&E (covered in Ch. 6) generally 50% deductible, exception

qualified/accountable plan, er limited to 50%, non-qualified/non-accountable plan, ee limited to 50%

(2) Travel & transportation generally deductible, though transportation only deductible if primary purpose of trip is business

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(3) Property use (e.g., computer, cars, phones) must allocate expenses between business & personal

Transportation Expenses direct cost of transporting TP to and from business sites .

Travel Expenses - lodging, 50% meals and entertainment costs, incidental expenses

Deductible if away from tax home overnight

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 If business purpose > 50%

NOTE: For international travel, you must prorate transportation costs (e.g., airline ticket) when even if the trip is primarily for business. If business purpose < 50%

Must be for a bona fide business purpose No deduction for spouse/family members unless there is bona fide business purpose (i.e., an employee).

EXAMPLE 1: You are self-employed and you take a trip. The trip is 6 days total and 4 days are for business and 2 are for personal vacation. You incur the following costs: Airfare = 800; Daily Hotel = 200; Daily Meals = 50; Daily Incidentals = 20. How much is deductible?

What if 2 days were for business and 4 days were for personal?

(3) Property use - Automobiles, computers, cell phones deductible only to extent of business use Automobiles - Two Methods for determining deduction:
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1. Standard Mileage Method - [Administrative Convenience], XX cents/mile plus business portion of tolls, property taxes (if based on value of car), parking, interest (only if self-employed). Currently $.555 (2012) cents per mile for each business mile driven - mileage rate covers gas, oil, repairs, insurance, depreciation, etc.

2. Actual Costs - requires more record keeping Deduct depreciation, gas, insurance, licenses, and other expenses of driving the car, like repairs and oil. Also get to deduct the tolls, parking, etc.

How? Restrictions on which method you can use:

What qualifies as business use of car? 1. 2. 3. 4. out of town travel From home to temporary work From regular workplace to temporary work From regular or temporary workplace to 2nd job

DOCUMENT: Must document date, amount of expense, mileage allocation, & business purpose to get the deduction

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EXAMPLE 2: Assume that you are a self-employed taxpayer and incur the following expense: Gas, Oil = 3250; Insurance = 750; Interest = 2,100; Auto tax = 400; tolls to get to a client = 380; Depreciation = 3060. You drive 18,000 miles for business and 2,000 miles for personal reasons. What is your deduction if you use the standard mileage method? Actual cost method?

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D. Specific deductions (1) Start-up and Organizational Expenditures (Ch 9) (2) Bad Debts (Comes from the capital recovery concept) 1. Business (must be related to a transaction that arose in a taxpayers trade or business) (a) For AGI Deduction, (b) use specific charge-off method, only write-off when you know it is bad

2. Nonbusiness (not related to a transaction that is part of a taxpayers trade or business) Must be bona-fide loan

deduct as a short term capital loss deduction only when the taxpayer settles the loan for less than its basis

(3) Domestic Production Activities Deduction read in book

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II. Accounting periods and Methods Tax year A. Three tax years a. Calendar year end 12/31/xx b. Fiscal year end last day of month other than December c. 52/53 week year same day of the week (e.g., last Saturday of May, or Saturday closest to end of May)

B. Taxpayer type determines which year is available a. Individuals / Sole proprietors calendar year only (exceptions extremely rare) b. Flow through entities tax years consistent w/ owners b/c of flow through of income c. Corporations allowed to select any of the three i. Adopts fiscal or calendar year end by filing first tax return ii. Adopts 52/53 week via special election iii. Changes require IRS permission

ACCOUNTING METHODS Accounting Methods very similar to Financial Accounting

(1) Cash report income/expense as cash or cash equivalent is received/paid (can be cash or property; FMV of what you receive) (2) Accrual report income as earned; expenses as incurred (similar to GAAP)

1: Recognize INCOME when all events met: a: ALL EVENTS test all events have occurred and income can be determined with reasonable accuracy b: Test met earliest of: 1: business completes task;
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2: 3:

2: Advanced payments RECEIVED a: recognize immediately if for rent or interest b: may defer if payment is for services or goods, unless

Prepayment for interest or rent 3: Recognize DEDUCTIONS when a. ALL EVENTS test - for deductions must have occurred and it must be able to determine amount of liability with reasonable accuracy; AND b. ECONOMIC PERFORMANCE (EP) occurs no deduction until underlying activity generating the liability occurs receiving goods/services

renting property

providing goods/services

payment liabilities

(3) Hybrid - use cash basis for most items and accrual for inventories

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