2013 cch basic principles ch06

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2013 cch basic principles ch06

  1. 1. Chapter 6 Deductions: General Concepts and Trade or Business Deductions©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com
  2. 2. Chapter 6 Exhibits 1. Classification of Deductions 2. Classification: “For” vs. “From” AGI 3. Trade or Business Expenses 4. Production of Income Deductions 5. Deductions for Losses 6. Other Allowable Deductions “For” AGI 7. Business Investigation and Start-Up Expenses 8. Deductibility of Business Investigation and Start-Up Expenses 9. Job Seeking ExpensesChapter 6, Exhibit Contents A CCH Federal Taxation Basic Principles 2 of 43
  3. 3. Chapter 6 Exhibits 10. Business Gifts 11. Travel & Transportation Expenses 12. Moving Expenses 13. Student Loan Interest—Qualified Education Expenses 14. Student Loan Interest 15. Qualified Education Expenses Deduction 16. Health Insurance, HSAs, MSAs 17. Employee Business-Related Expenses 18. Employee v. Self-Employed 19. Limitations on the Deductibility of Expenses and LossesChapter 6, Exhibit Contents B CCH Federal Taxation Basic Principles 3 of 43
  4. 4. Chapter 6 Exhibits 20. Other Limitations on the Deductibility of Expenses and Losses 21. Business Deductions Related to Capital Expenditures 22. Depreciation of Tangible Property 23. MACRS Depreciation of Tangible Property 24. Limitations on Depreciation of Automobiles 25. Depreciation Code Sec. 179 Election 26. Bonus Depreciation Reintroduced by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 27. Amortization 28. Research and Experimental (R & E) 29. DepletionChapter 6, Exhibit Contents C CCH Federal Taxation Basic Principles 4 of 43
  5. 5. Classification of Deductions There are 4 categories of tax deductions allowed to individual taxpayers.1. Trade or business deductions are generally deductible FOR AGI.2. Deductions incurred for the production of income are generally deductible FROM AGI as miscellaneous itemized deductions subject to the 2% floor.3. Deductions for losses incurred on the sale of business or investment assets are generally deductible FOR AGI (though they may be subject to capital loss limitation).4. Personal expenses are generally NOT deductible unless expressly permitted. Allowable personal deductions, such as medical expenses, are deductible as itemized deductions, subject to various limitations.Chapter 6, Exhibit 1 CCH Federal Taxation Basic Principles 5 of 43
  6. 6. Classification: “For” vs. “From” AGI  Deductions “for” AGI are subtracted from income in calculating adjusted gross income  These deductions often reduce earned income subject to self- employment taxes as well  In addition, state income taxes are often based on federal AGI  Many tax benefits are available only for taxpayers whose AGIs do not exceed specified levels (e.g., ability to contribute to Roth IRA, ability to deduct student loan interest, etc.)  Deductions “from” AGI are subtracted from AGI itself in computing taxable income  This category of deductions is generally allowed as an alternative to the standard deduction  Deductions “from” AGI are often subject to limitations calculated as a percentage of AGIChapter 6, Exhibit 2 CCH Federal Taxation Basic Principles 6 of 43
  7. 7. Trade or Business ExpensesBusiness expenses are generally deductible without limitation when thefollowing criteria are met:1. Related to carrying on trade or business activity – taxpayer must demonstrate commitment to and substantial involvement in the activity and must have a legitimate profit motive.2. Ordinary and necessary – commonly incurred by other businesses (not necessarily your own) and appropriate for a particular business.3. Reasonable in amount. This is of main concern to closely held corporations, particularly regarding officers’ salaries. One way to substantiate reasonableness is by presenting documentation of similar expenses by comparable businesses.Chapter 6, Exhibit 3a CCH Federal Taxation Basic Principles 7 of 43
  8. 8. Trade or Business Expenses4. Expense must be paid or incurred during the taxable year:  Expenses not deductible until paid for cash method taxpayers  Accrual method taxpayers generally must demonstrate that expense has been economically incurred  Cash method taxpayers face limitations on deductibility of prepaid expenses  Property taxes must be allocated between seller and buyer in year property is sold  Deduction for business bad debts allowed on partial worthlessness of debt  No deduction for non-business bad debts until debt is wholly worthlessChapter 6, Exhibit 3b CCH Federal Taxation Basic Principles 8 of 43
  9. 9. Production of Income Deductions  Production of income expenses are generally deductible FROM AGI as miscellaneous itemized deductions, to the extent they exceed 2% of AGI.  Production of income expenses are related to the production of non business income, such as investment expenses and tax planning and compliance expenses.  They must meet the same criteria for deductibility as trade or business expenses, except they do not have to relate to a trade or business.Chapter 6, Exhibit 4a CCH Federal Taxation Basic Principles 9 of 43
  10. 10. Production of Income Deductions The following is a list of typical production of income expenses which are deductible FROM AGI.  Safe deposit box rentals  Subscriptions to investment related journals and newspapers  Legal and accounting fees related to investments  Cost of having a tax return prepared by a CPA  Tax planning expenses  Tax advice for divorce proceedings There is an exception for expenses associated with the production of rent and royalty income, which are deductible FOR AGI.Chapter 6, Exhibit 4b CCH Federal Taxation Basic Principles 10 of 43
  11. 11. Deductions for Losses For individual taxpayers, losses are restricted to the following (subject to limitations): 1. Business losses (including casualty and theft). 2. Investment losses. 3. Personal casualty and theft losses. Business and investment losses are deductible FOR AGI, while personal casualty and theft losses are deductible FROM AGI. Business losses generally reduce ordinary income, while investment losses are classified as capital losses subject to more stringent limitations. To be deductible, losses must be realized during the year and not compensated by insurance.Chapter 6, Exhibit 5 CCH Federal Taxation Basic Principles 11 of 43
  12. 12. Other Allowable Deductions “For” AGI Business investigation & start-up costs Business gifts Transportation expenses Travel expenses Moving expenses Student loan interest and qualified tuition expenses Health insurance premiums for self-employed taxpayers Contributions to Health Savings Accounts Manufacturing deductionChapter 6, Exhibit 6 CCH Federal Taxation Basic Principles 12 of 43
  13. 13. Business Investigation and Start-Up Expenses Type of Investigation Expenses Start-Up Expenses Expense Definition Expenditures that help determine Pre-operational costs whether to create or buy a business Timing Occur before a decision to make Occur after a "go for it" decision is or buy is reached reached, but before the doors open for business Examples Travel, marketing surveys, legal, Employee training and stationery accounting, and engineeringChapter 6, Exhibit 7 CCH Federal Taxation Basic Principles 13 of 43
  14. 14. Deductibility of Business Investigation and Start-Up Expenses Type Pursue business? Decline?Business Similar business ⇒ Deductible in the Similar business ⇒ Deductible in theInvestigation year paid or incurred. year paid or incurred.Expenses New business ⇒ $5,000 can be New business ⇒ Not deductible or expensed, the remainder is capitalized capitalized, but lost and amortized over 180 monthsBusiness Start- Similar business ⇒Deductible in the N/A – if taxpayer declines to pursue theup Expenses year paid or incurred. opportunity, there will be no start-up costs, only investigation expenses. New business ⇒ $5,000 can be expensed, the remainder is capitalized and amortized over 180 months Chapter 6, Exhibit 8 CCH Federal Taxation Basic Principles 14 of 43
  15. 15. Business Gifts Deduction limited to $25 per client/customer  Inexpensive (< $4) tokens not treated as gifts if taxpayer’s name or business name is permanently imprinted on item.  Promotional materials to be used on business premises not treated as gifts  Employment service/achievement awards not treated as gifts if value < $400Chapter 6, Exhibit 10 CCH Federal Taxation Basic Principles 15 of 43
  16. 16. Travel & Transportation Expenses Self-employed taxpayers – deductible “for” AGI Employees – deductible as miscellaneous itemized deductions if qualified:  Not reimbursed by employer  “Temporarily” away from home (> 1 night; < 1 year)  Travel between work sites during work day No deduction for commuting expenses, regardless of distanceChapter 6, Exhibit 11a CCH Federal Taxation Basic Principles 16 of 43
  17. 17. Travel & Transportation Expenses Deductible Expenses include:  Lodging & meals (subject to 50% limit).  Airfare, automobile expenses, etc.  For automobile expenses, taxpayer may choose standard mileage allowance rather than actual costs. For 2012, the mileage rate is 55.5 cents per mile.  Tax “home” is geographic location where taxpayer works.Chapter 6, Exhibit 11b CCH Federal Taxation Basic Principles 17 of 43
  18. 18. Moving Expenses Moving expenses are deductible FOR AGI. Qualified moving expenses. 1. Transporting household goods and personal effects 2. Traveling from old residence to new residence 3. Lodging during the move Nonqualified moving expenses. 1. Pre-move house hunting 2. Temporary living quarters at new location 3. Meals during a qualified move 4. Real estate commissions on sale of old residenceChapter 6, Exhibit 12a CCH Federal Taxation Basic Principles 18 of 43
  19. 19. Moving Expenses Time Requirement for the Moving Expense Deduction Self-Employed Employee Work full time at new job > 39 Work full time at new job > 39 weeks during first 12 months, AND weeks during first 12 months Work full time at new job > 78 weeks during first 24 monthsChapter 6, Exhibit 12b CCH Federal Taxation Basic Principles 19 of 43
  20. 20. Moving Expenses Distance Requirement for the Moving Expense Deduction If the move is due to a relocation:  Distance from the old residence to the new job must be 50 miles further than the  Distance from the old residence to the old job.Chapter 6, Exhibit 12c CCH Federal Taxation Basic Principles 20 of 43
  21. 21. Student Loan Interest Qualified Education Expenses Tax Treatment. Deductible “for” AGI. Thus, a student can claim the student loan interest deduction even if the standard deduction is used. Deductible Limitation: $2,500 for student loan interest up to $4,000 qualified tuition & fees Qualified Student Loans. To be eligible for the deduction, the education loan must be used solely to pay for any of the following expenses: tuition, student activity fees, room and board, books and supplies, and other related expenses.Chapter 6, Exhibit 13 CCH Federal Taxation Basic Principles 21 of 43
  22. 22. Student Loan Interest Phaseout of Student Loan Interest Deduction Filing Status Threshold for Modified AGI Floor Ceiling Phaseout Range Single, head of household, $60,000 $75,000 $15,000 surviving spouse Married filing jointly $120,000 $150,000 $30,000 Married filing separately N/A N/A N/AChapter 6, Exhibit 14 CCH Federal Taxation Basic Principles 22 of 43
  23. 23. Qualified Education Expenses Deduction Amount of deduction depends on taxpayer’s filing status and income:  Single taxpayers:  AGI < $65,000 $4,000  AGI > $65,000, < $80,000 $2,000  AGI > $130,000 zero  Married taxpayers:  AGI < $130,000 $4,000  AGI > $130,000, < $160,000 $2,000  AGI > $160,000 zero  Married filing separate return – no deduction allowedChapter 6, Exhibit 15 CCH Federal Taxation Basic Principles 23 of 43
  24. 24. Health Insurance and HSAs Self-employed taxpayers allowed to deduct health insurance premiums “for” AGI Self-employed taxpayers and small employers (< 50 employees) with “high deductible” insurance may deduct contributions to health savings accounts of up to $6,250 for 2012 ($3,100 if taxpayer has “self-only” high deductible medical insurance). Neither earnings nor qualified distributions of HSAs are taxable.Chapter 6, Exhibit 16 CCH Federal Taxation Basic Principles 24 of 43
  25. 25. Employee Business-Related Expenses If an individual is an employee, unreimbursed employment expenses are deductible as miscellaneous itemized deductions, to the extent they exceed 2% of the taxpayer’s AGI. The following are examples of typical employment related expenses deductible as miscellaneous itemized deductions:  Professionalsociety dues  Subscriptions to professional journals  Travel expenses  Home office expenses Note: Commuting expenses incurred going to and from work are not deductible. However, the expenses of going from one job to another job on the same workday are deductible.Chapter 6, Exhibit 17 CCH Federal Taxation Basic Principles 25 of 43
  26. 26. Employee v. Self-Employed Independent contractors sell services to the public, and are considered self-employed. All trade or business expenses are deductible FOR AGI. The following criteria should be considered when determining if an individual is an employee or self-employed: 1. Does the individual work for many clients, or just one? 2. Does the individual make services available to the public? 3. Does the individual determine work hours and schedules? 4. Does the individual received payments from one firm, or many firms?Chapter 6, Exhibit 18 CCH Federal Taxation Basic Principles 26 of 43
  27. 27. Limitations on the Deductibility of Expenses and Losses Hobby expenses and losses – expenses deducted to extent of income only Personal expenses and losses – generally not deductible, unless specifically authorized by Code No deduction for expenses that frustrate public policy:  Fines or penalties paid to government  Illegal kickbacks, bribes, and other illegal payments  Illegal trafficking in controlled substances (although expenses incurred in other illegal businesses are generally deductible)Chapter 6, Exhibit 19a CCH Federal Taxation Basic Principles 27 of 43
  28. 28. Limitations on the Deductibility of Expenses and Losses Lobbying – expenses deductible only if incurred to influence legislation at local level in which taxpayer has direct interest (e.g., local business lobbying city officials on local zoning laws) Political contributions – no deduction Meals & entertainment – fifty percent deductible for expenses “directly related to” or “associated with” taxpayer’s business, if such expenses are substantiated.Chapter 6, Exhibit 19b CCH Federal Taxation Basic Principles 28 of 43
  29. 29. Limitations on the Deductibility of Expenses and Losses Meals and Entertainment Tax Treatment Self-Employed Individuals Nonreimbursed Employees 50% deductible 50% deductible, and limited to the 2% AGI floor “For” AGI “From” AGI as a miscellaneous itemized deductionChapter 6, Exhibit 19c CCH Federal Taxation Basic Principles 29 of 43
  30. 30. Other Limitations on the Deductibility of Expenses and Losses Expenses and interest related to tax-exempt income are not deductible (because income is not taxable) Transactions between related parties:  Losses not deductible, but may be used to offset gain subsequently realized by buyer on “re-sale” of property  Payment by accrual method taxpayer to related cash method taxpayer may not be deducted by payer until tax year in which recipient reports payment in income. No deduction allowed for payment of expenses of another (e.g., payment by shareholder of corporate business expense).Chapter 6, Exhibit 20 CCH Federal Taxation Basic Principles 30 of 43
  31. 31. Business Deductions Related to Capital Expenditures Capital expenditures are expenditures that will benefit more than one tax year. Generally, capital expenditures do not qualify as deductions in the year the expenditure is made, but must be allocated to the tax years expected to benefit from the expenditure. Tangible capital expenditures placed in service for business or investment purposes after 1986 should be depreciated using MACRS depreciation. Tangible property placed after 1980 and before 1987 should be depreciated using ACRS depreciation.Chapter 6, Exhibit 21 CCH Federal Taxation Basic Principles 31 of 43
  32. 32. Depreciation of Tangible Property Personal property refers to the physical nature of the property. It means that the property is mobile.  This is different than “Personal-use” property which refers to the function of property. This is property held for the taxpayer’s own enjoyment. Real property also refers to the physical nature of the property. It means the property is immobile.Chapter 6, Exhibit 22 CCH Federal Taxation Basic Principles 32 of 43
  33. 33. MACRS Depreciation of Tangible Property Class of property Personal property is divided into 6 classes: 3-year, 5-year, 7-year, 10-year, 15-year and 20-year property. Real property is divided into 3 classes: 27.5-year residential rental property 39-year non-residential real property (ex. office buildings) 50-year property railroad gradings and tunnel boresChapter 6, Exhibit 23a CCH Federal Taxation Basic Principles 33 of 43
  34. 34. MACRS Depreciation of Tangible Property Depreciation method 200% declining balance applies to 3-year, 5-year, 7-year and 10-year classes of property. 150% declining balance applies to 15-year and 20-year classes of property. Straight-line is used for 27.5-year and 39-year classes of property. Do not consider salvage value.Chapter 6, Exhibit 23b CCH Federal Taxation Basic Principles 34 of 43
  35. 35. MACRS Depreciation of Tangible Property Convention A half-year convention applies to personal property. Under this convention, property placed in service (or disposed of) during the tax year is considered placed in service (or disposed of) at the midpoint of the tax year. A mid-month convention applies to real property. Under this convention, property is considered placed in service (or disposed of) in the middle of the month for the first month of service and the last month of service.Chapter 6, Exhibit 23c CCH Federal Taxation Basic Principles 35 of 43
  36. 36. MACRS Depreciation of Tangible Property Convention A mid-quarter convention applies when more than 40% of the cost of all personal property is placed in service during the last quarter of the taxable year. Under the mid-quarter convention, personal property is treated as placed in service (or disposed of) in the middle of the quarter. In determining whether 40% of the aggregate basis of MACRS property is placed in service during the last 3 months of the tax year, property placed in service and disposed of within the same tax year is disregarded.Chapter 6, Exhibit 23d CCH Federal Taxation Basic Principles 36 of 43
  37. 37. Limitations on Depreciation of AutomobilesDepreciation (including Code Sec. 179 deduction) for cars purchased in2012 limited to: Passenger Cars Trucks and VansFirst year $3,060 $3,260Second year $4,900 $5,200Third year $2,950 $3,150Subsequent years $1,775 $1,875Chapter 6, Exhibit 24 CCH Federal Taxation Basic Principles 37 of 43
  38. 38. Depreciation Code Sec. 179 Election For 2012, an election may be made to expense up to $139,000 of tangible personal property used in a trade or business, rather than capitalize and depreciate it. Phaseout. The expense allowance is phased out on a dollar- for-dollar basis for purchases exceeding $560,000.Chapter 6, Exhibit 25 CCH Federal Taxation Basic Principles 38 of 43
  39. 39. Bonus Depreciation Reintroduced by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010  Bonus Depreciation  2011 – 100%  2012 – 50%  First year Code Sec. 280F limitation increased by $8,000  Sec. 179 deduction for autos between 6,000 and 14,000 pounds -- $25,000  Relevant only for 2012 (100% bonus allowed for 2011)  No limit on depreciation or 179 for vehicles weighing more than 14,000 poundsChapter 6, Exhibit 26 CCH Federal Taxation Basic Principles 39 of 43
  40. 40. Amortization Amortizable property is intangible property that is used for business and is of limited life. For example, goodwill, going- concern value, licenses, covenants not to compete, franchises, trademarks, patents, and copyrights. Method. Straight-line method over 15 years. (Code Section 197).Chapter 6, Exhibit 27 CCH Federal Taxation Basic Principles 40 of 43
  41. 41. Research and Experimental (R & E) Qualifying expenditures. Experimental and laboratory costs for pilot models, plant processes, products, formulas, inventions, or similar properties. These costs include R&E salaries. Non qualifying expenditures. Ordinary testing or inspection of materials or products for quality control, management studies, consumer surveys, advertising, or promotions. Tax treatment. R&E expenditures may be expensed immediately, or if elected, amortized over a minimum of 5 years.Chapter 6, Exhibit 28 CCH Federal Taxation Basic Principles 41 of 43
  42. 42. Depletion There are 2 methods available to compute the depletion deduction. The taxpayer should compute the proper deduction under both methods and claim the deduction that is higher. Cost depletion method Cost of natural resources excluding land x (Number of units Recoverable units recovered AND sold) % depletion method Statutory % x Gross income from natural resource* *Gross income equals revenues without regard to cost of salesChapter 6, Exhibit 29a CCH Federal Taxation Basic Principles 42 of 43
  43. 43. Depletion Limitation of % Depletion  Oil and gas properties: 100% of taxable income from natural resources BEFORE depletion.  Other natural resources (copper and gold): 50% of taxable income from natural resources BEFORE depletion.Chapter 6, Exhibit 29b CCH Federal Taxation Basic Principles 43 of 43

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