Chapter 7   Deductions and Losses:   Certain Business Expenses   and Losses   Individual Income Taxes© 2013 Cengage Learni...
The Big Picture (slide 1 of 2)• Martha is nearing the end of a year that she would like to  forget.• Several years ago she...
The Big Picture (slide 2 of 2)• Martha has owned and operated a bookstore as a sole  proprietorship for the past 10 years....
Bad Debts• If an account receivable arising from credit  sale of goods or services becomes worthless  – A bad debt deducti...
The Big Picture - Example 2          Bad Debts - Cash Basis Taxpayer• Return to the facts of The Big Picture on p. 7-1.• M...
Business Bad Debts                     (slide 1 of 4)• Specific charge-off method must be used  – Exception: Reserve metho...
Business Bad Debts                     (slide 2 of 4)• If a business bad debt previously deducted as  partially worthless ...
Business Bad Debts                             (slide 3 of 4)• In the case of total worthlessness, deduction is  allowed f...
Business Bad Debts                       (slide 4 of 4)• If a receivable has been written off  – The collection of the rec...
Nonbusiness Bad Debts                      (slide 1 of 2)• Nonbusiness bad debt  – Debt unrelated to the taxpayer’s trade ...
Nonbusiness Bad Debts                      (slide 2 of 2)• Related party (individuals) bad debts are  generally suspect an...
Classification of Bad Debts• Individuals will generally have nonbusiness  bad debts unless:  – In the business of loaning ...
The Big Picture - Example 5             Nonbusiness Bad Debts• Return to the facts of The Big Picture on p. 7-1.• Martha l...
Worthless Securities• Loss on worthless securities is deductible in  the year they become completely worthless  – These lo...
The Big Picture - Example 8                Worthless Securities• Return to the facts of The Big Picture on p. 7-1.• Martha...
Bad Debt Deductions SummaryConcept Summary 7.2                                    16
Section 1244 Stock                          (slide 1 of 3)• Sale or worthlessness of § 1244 stock results  in ordinary los...
Section 1244 Stock                      (slide 2 of 3)• Section 1244 loss treatment is limited to stock  owned by original...
Section 1244 Stock                        (slide 3 of 3)• Example of § 1244 loss  – In 2009, Sam purchases from XYZ Corp. ...
Losses of Individuals• Only the following losses are deductible by  individuals:  – Losses incurred in a trade or business...
Definition of Casualty            & Theft (C & T)• Losses or damages to the taxpayer’s property  that arise from fire, sto...
Definition of Theft• Theft includes robbery, burglary,  embezzlement, etc.  – Does not include misplaced items            ...
When Casualty & Theft Is Deductible• Casualties: year in which loss is sustained  – Exception: If declared “disaster area”...
The Big Picture - Example 14                     Disaster Area Losses•   Return to the facts of The Big Picture on p. 7-1....
Effect of Claim for Reimbursement• If reasonable prospect of full recovery:  – No casualty loss is permitted  – Deduct in ...
Amount of C&T Deduction• Amount of loss and its deductibility depends  on whether:  – Loss is from nonpersonal (business o...
Amount of Nonpersonal             C&T Losses• Theft or complete casualty (FMV after = 0)  – Adjusted basis in property les...
C&T Examples• Business and production of income losses  (no insurance proceeds received)      Adjusted    FMV      FMV  It...
Nonpersonal C&T Losses• Losses on business, rental, and royalty properties   – Deduction will be for AGI   – Not subject t...
Nonpersonal C&T Gains• Depending on the property, gain can be  ordinary or capital• Amount of nonpersonal gains  – Insuran...
Personal C&T Gains and Losses                           (slide 1 of 4)• Casualty and theft losses attributable to personal...
Personal C&T Gains and Losses                           (slide 2 of 4)• If a taxpayer has both personal casualty and theft...
Personal C&T Gains and Losses                        (slide 3 of 4)• If netting personal casualty gains and losses  result...
Personal C&T Gains and Losses                        (slide 4 of 4)• If netting personal casualty gains and losses  result...
Example of C&T Limitation                        (slide 1 of 2)• Karen (AGI = $40,000) has the following  C&T in 2011 (amo...
Example of C&T Limitation                         (slide 2 of 2)• Example of C&T limitation (cont’d)• Karen has no insuran...
Research and Experimental          Expenditures (slide 1 of 2)• Definition of research and experimental (R&E)  expenditure...
Research and Experimental          Expenditures (slide 2 of 2)• Three alternatives are available for R&E  expenditures  – ...
Domestic Production Activities         Deduction (slide 1 of 4)• The American Jobs Creation Act of 2004  created a new ded...
Domestic Production Activities          Deduction (slide 2 of 4)• Qualified production activities income is the  excess of...
Domestic Production Activities           Deduction (slide 3 of 4)• Domestic production gross receipts include the followin...
Domestic Production Activities          Deduction (slide 4 of 4)• Eligible taxpayers include:  – Individuals, partnerships...
Net Operating Losses                      (slide 1 of 7)• NOLs from any one year can be offset against  taxable income of ...
Net Operating Losses                         (slide 2 of 7)• No nonbusiness (personal) losses or  deductions may be used i...
Net Operating Losses                            (slide 3 of 7)• Carryover period  – Must carryback to 2 prior years, then ...
Net Operating Losses                        (slide 4 of 7)• Example of NOL carryovers  – Ken has a NOL for 2012  – Ken mus...
Net Operating Losses                         (slide 5 of 7)• Computing NOL amount  – Individual must start with taxable in...
Net Operating Losses                          (slide 6 of 7)• Effect of NOL in carryback year  – Taxpayer must recompute t...
Net Operating Losses                      (slide 7 of 7)• Calculating remaining NOL after carryovers  – After using the NO...
Refocus On The Big Picture (slide 1 of 2)• Martha can receive tax benefits associated with her  unfortunate occurrences du...
Refocus On The Big Picture (slide 2 of 2)•   Loss from Bookstore     – The $180,000 loss from the bookstore is reported on...
If you have any comments or suggestions concerning this                    PowerPoint Presentation for South-Western Feder...
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P pt ch 07

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P pt ch 07

  1. 1. Chapter 7 Deductions and Losses: Certain Business Expenses and Losses Individual Income Taxes© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1
  2. 2. The Big Picture (slide 1 of 2)• Martha is nearing the end of a year that she would like to forget.• Several years ago she loaned a friend $25,000 to enable him to start a business. – The friend had made scheduled payments of $7,000 ($1,000 of this was interest) when he unexpectedly died in January. • At the time of his death, he was insolvent. – Martha’s attempts to collect on the debt were fruitless.• Last October Martha invested $50,000 in the stock of a pharmaceutical company that previously had been profitable. – The company lost a patent infringement suit and declared bankruptcy in May of this year. – Martha is notified by the bankruptcy trustee that she can expect to receive nothing from the company. 2
  3. 3. The Big Picture (slide 2 of 2)• Martha has owned and operated a bookstore as a sole proprietorship for the past 10 years. – The bookstore previously has produced annual profits of about $75,000. – Due to a chain bookstore opening down the street, Martha’s bookstore sustained a net loss of $180,000 this year.• In September, a hurricane caused a large oak tree to blow over onto Martha’s house. – The cost of removing the tree and making repairs was $32,000. – Martha received a check for $25,000 from her insurance company in final settlement of the claim. – Her adjusted basis for the house was $280,000.• Can you help to relieve Martha’s feeling of hopelessness by making her aware of beneficial loss provisions in the tax law? – Read the chapter and formulate your response. 3
  4. 4. Bad Debts• If an account receivable arising from credit sale of goods or services becomes worthless – A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income – No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected 4
  5. 5. The Big Picture - Example 2 Bad Debts - Cash Basis Taxpayer• Return to the facts of The Big Picture on p. 7-1.• Martha is a cash basis taxpayer – She cannot take a bad debt deduction for unpaid accrued interest on the loan to her friend because it was never recognized as income. 5
  6. 6. Business Bad Debts (slide 1 of 4)• Specific charge-off method must be used – Exception: Reserve method is allowed for some financial institutions• Deduct as ordinary loss in the year when debt is partially or wholly worthless 6
  7. 7. Business Bad Debts (slide 2 of 4)• If a business bad debt previously deducted as partially worthless becomes totally worthless in a future year – Only the remainder not previously deducted can be deducted in the future year 7
  8. 8. Business Bad Debts (slide 3 of 4)• In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless• Deductible amount depends on basis in bad debt – If debt arose from sale of services or products and the face amount was previously included in income • That amount is deductible – If the taxpayer purchased the debt • Deduction is equal to amount paid for debt instrument 8
  9. 9. Business Bad Debts (slide 4 of 4)• If a receivable has been written off – The collection of the receivable in a later tax year may result in income being recognized – Income will result if the deduction yielded a tax benefit in the year it was taken 9
  10. 10. Nonbusiness Bad Debts (slide 1 of 2)• Nonbusiness bad debt – Debt unrelated to the taxpayer’s trade or business• Deduct as short-term capital loss in year amount of worthlessness is known with certainty – No deduction is allowed for partial worthlessness of a nonbusiness bad debt 10
  11. 11. Nonbusiness Bad Debts (slide 2 of 2)• Related party (individuals) bad debts are generally suspect and may be treated as gifts – Regulations state that a bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money – Thus, individual circumstances must be examined to determine whether advances between related parties are gifts or loans 11
  12. 12. Classification of Bad Debts• Individuals will generally have nonbusiness bad debts unless: – In the business of loaning money, or – Bad debt is associated with the individual’s trade or business• Determination is made either at the time the debt was created or when it became worthless 12
  13. 13. The Big Picture - Example 5 Nonbusiness Bad Debts• Return to the facts of The Big Picture on p. 7-1.• Martha loaned her friend, Jamil, $25,000. – Jamil used the money to start a business, which subsequently failed. – When Jamil died after having made payments of $7,000 on the loan, he was insolvent.• Even though the proceeds of the loan were used in a business, the loan is a nonbusiness bad debt – The business was Jamil’s, not Martha’s. 13
  14. 14. Worthless Securities• Loss on worthless securities is deductible in the year they become completely worthless – These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless – Capital losses may be of limited benefit due to the $3,000 capital loss limitation 14
  15. 15. The Big Picture - Example 8 Worthless Securities• Return to the facts of The Big Picture on p. 7-1.• Martha, a calendar year taxpayer, owned stock in Owl Corporation (a publicly held company). – She acquired the stock on October 1, 2011 • Cost was $50,000. – On May 31, 2012, the stock became worthless as the company declared bankruptcy.• The stock is deemed to have become worthless as of December 31, 2012 – Martha has a long-term capital loss 15
  16. 16. Bad Debt Deductions SummaryConcept Summary 7.2 16
  17. 17. Section 1244 Stock (slide 1 of 3)• Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals – Ordinary loss treatment (per year) is limited to $50,000 ($100,000 for MFJ taxpayers) • Loss in excess of per year limit is treated as capital loss 17
  18. 18. Section 1244 Stock (slide 2 of 3)• Section 1244 loss treatment is limited to stock owned by original purchaser who acquired the stock from the corporation• Corporation must meet certain requirements for stock to qualify – Major requirement is limit of $1 million of capital contributions• Section 1244 does not apply to gains 18
  19. 19. Section 1244 Stock (slide 3 of 3)• Example of § 1244 loss – In 2009, Sam purchases from XYZ Corp. stock costing $150,000. (Total XYZ stock outstanding is $800,000.) In 2012, Sam sells the stock for $65,000. – Sam, a single taxpayer, has the following tax consequences: • $50,000 ordinary loss • $35,000 long-term capital loss 19
  20. 20. Losses of Individuals• Only the following losses are deductible by individuals: – Losses incurred in a trade or business, – Losses incurred in a transaction entered into for profit, – Losses caused by fire, storm, shipwreck, or other casualty or by theft 20
  21. 21. Definition of Casualty & Theft (C & T)• Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft – Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature – Events not treated as casualties include losses from disease and insect damage 21
  22. 22. Definition of Theft• Theft includes robbery, burglary, embezzlement, etc. – Does not include misplaced items 22
  23. 23. When Casualty & Theft Is Deductible• Casualties: year in which loss is sustained – Exception: If declared “disaster area” by President, can elect to deduct loss in year prior to year of occurrence• Thefts: year in which loss is discovered 23
  24. 24. The Big Picture - Example 14 Disaster Area Losses• Return to the facts of The Big Picture on p. 7-1.• On September 28, 2012, Martha’s personal residence was damaged when a hurricane caused an oak tree to fall onto the house. – The amount of her uninsured loss was $7,000. – Because of the extent of the damage in the area, the President of the United States designated the area a disaster area.• Because Martha’s loss is a disaster area loss, Martha has 2 options. – She may elect to file an amended return for 2011 and take the loss in that year. • The amount of the loss will be reduced first by $100 and then by 10% of her 2011 AGI. – Alternatively, she may take the loss on her 2012 income tax return. • The amount of the loss will be reduced first by $100 and then by 10% of her 2012 AGI. 24
  25. 25. Effect of Claim for Reimbursement• If reasonable prospect of full recovery: – No casualty loss is permitted – Deduct in year of settlement any amount not reimbursed• If only partial recovery is expected, deduct in year of loss any amount not covered – Remainder is deducted in year claim is settled 25
  26. 26. Amount of C&T Deduction• Amount of loss and its deductibility depends on whether: – Loss is from nonpersonal (business or production of income) or personal property – Loss is partial or complete 26
  27. 27. Amount of Nonpersonal C&T Losses• Theft or complete casualty (FMV after = 0) – Adjusted basis in property less insurance proceeds• Partial casualty – Lesser of decline in value or adjusted basis in property, less insurance proceeds 27
  28. 28. C&T Examples• Business and production of income losses (no insurance proceeds received) Adjusted FMV FMV Item Basis Before After Loss A 6,000 8,000 5,000 3,000 B 6,000 8,000 1,000 6,000 C 6,000 4,000 0 6,000 28
  29. 29. Nonpersonal C&T Losses• Losses on business, rental, and royalty properties – Deduction will be for AGI – Not subject to the $100 per event and the 10% of AGI limitation• Losses not connected with business, rental, and royalty properties – Deduction will be from AGI – Example - theft of a security • Theft losses of investment property are not subject to the 2% of AGI floor on certain miscellaneous itemized deductions 29
  30. 30. Nonpersonal C&T Gains• Depending on the property, gain can be ordinary or capital• Amount of nonpersonal gains – Insurance proceeds less adjusted basis in property 30
  31. 31. Personal C&T Gains and Losses (slide 1 of 4)• Casualty and theft losses attributable to personal use property are subject to the $100 per event and the 10% of AGI limitations – These losses are itemized deductions, but they are not subject to the 2% of AGI floor• Amount of personal C&T losses – Lesser of decline in value or adjusted basis in property, less insurance proceeds• Insurance proceeds may result in gain recognition on certain casualty and thefts 31
  32. 32. Personal C&T Gains and Losses (slide 2 of 4)• If a taxpayer has both personal casualty and theft gains as well as losses, a special set of rules applies – A personal casualty gain is the recognized gain from a casualty or theft of personal use property – A personal casualty loss for this purpose is a casualty or theft loss of personal use property after the application of the $100 floor• Taxpayer must first net (offset) the personal casualty gains and personal casualty losses – Tax treatment depends on the results of this netting process 32
  33. 33. Personal C&T Gains and Losses (slide 3 of 4)• If netting personal casualty gains and losses results in a net gain – Treat as gains and losses from the sale of capital assets • Short term or long term, depending on holding period• Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property 33
  34. 34. Personal C&T Gains and Losses (slide 4 of 4)• If netting personal casualty gains and losses results in a net loss – All gains and losses are treated as ordinary items • The gains—and the losses to the extent of gains—are treated as ordinary income and ordinary loss in computing AGI • Losses in excess of gains are deducted as itemized deductions to the extent the losses exceed 10% of AGI 34
  35. 35. Example of C&T Limitation (slide 1 of 2)• Karen (AGI = $40,000) has the following C&T in 2011 (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6,000) with camera inside ($500) • Earthquake damage: house ($2,000), furniture ($1,000) 35
  36. 36. Example of C&T Limitation (slide 2 of 2)• Example of C&T limitation (cont’d)• Karen has no insurance coverage for either loss: 1. $6,000 + $500 = $6,500 – $100 = $6,400 2. $2,000 + $1,000 = $3,000 – $100 = $2,900• Karen’s deductible C&T loss is $5,300 [$6,400 + $2,900 – (10% $40,000)] 36
  37. 37. Research and Experimental Expenditures (slide 1 of 2)• Definition of research and experimental (R&E) expenditures – Costs for the development of an experimental model, plant process, product, formula, invention, or similar property and improvement of such existing property 37
  38. 38. Research and Experimental Expenditures (slide 2 of 2)• Three alternatives are available for R&E expenditures – Expense in year paid or incurred, – Defer and amortize over period of 60 months or more, or – Capitalize (deductible when project abandoned or worthless)• Tax credit of 20% of certain R&E expenditures is available 38
  39. 39. Domestic Production Activities Deduction (slide 1 of 4)• The American Jobs Creation Act of 2004 created a new deduction based on the income from manufacturing activities – The Domestic Production Activities deduction is based on the following formula: • 9% × Lesser of – Qualified production activities income – Taxable (or modified adjusted gross) income or AMTI • The deduction cannot exceed 50% of an employer’s W–2 wages paid to employees engaged in qualified production activities 39
  40. 40. Domestic Production Activities Deduction (slide 2 of 4)• Qualified production activities income is the excess of domestic production gross receipts over the sum of: – Cost of goods sold attributable to such receipts – Other deductions, expenses, or losses that are directly allocable to such receipts – A share of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income 40
  41. 41. Domestic Production Activities Deduction (slide 3 of 4)• Domestic production gross receipts include the following five specific categories: – The lease, license, sale, exchange, or other disposition of qualified production property manufactured, produced, grown, or extracted in the U.S. – Qualified films largely created in the U.S. – The production of electricity, natural gas, or potable water – Construction (but not self-construction) performed in the U.S. – Engineering and architectural services for domestic construction• Items specifically excluded from this definition include: – The sale of food and beverages prepared by a taxpayer at a retail establishment and – The transmission or distribution of electricity, natural gas, or potable water 41
  42. 42. Domestic Production Activities Deduction (slide 4 of 4)• Eligible taxpayers include: – Individuals, partnerships, S corporations, C corporations, cooperatives, estates, and trusts • For a pass-through entity (e.g., partnerships, S corporations), the deduction flows through to the individual owners • For sole proprietors, a deduction for AGI results and is claimed on Form 1040, line 35 on page 1 42
  43. 43. Net Operating Losses (slide 1 of 7)• NOLs from any one year can be offset against taxable income of other years – The NOL provision is intended as a form of relief for business income and losses – Only losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL 43
  44. 44. Net Operating Losses (slide 2 of 7)• No nonbusiness (personal) losses or deductions may be used in computing NOL • Exception: personal casualty and theft losses 44
  45. 45. Net Operating Losses (slide 3 of 7)• Carryover period – Must carryback to 2 prior years, then carryforward to 20 future years • May make an irrevocable election to just carryforward • When there are NOLs from two or more years, use on a FIFO basis – 3 year carryback is available for: • Individuals with NOL from casualty or thefts • Small businesses with NOLs from Presidentially declared disasters – 5-year carryback period and a 20-year carryover period are allowed for a farming loss 45
  46. 46. Net Operating Losses (slide 4 of 7)• Example of NOL carryovers – Ken has a NOL for 2012 – Ken must carryover his NOL in the following order: • Carryback to 2010 and 2011, then carryforward to 2013, 2014, ..., 2032 – Ken can elect to just carryforward his NOL • Carryover would be to 2013, 2014, ..., 2032 46
  47. 47. Net Operating Losses (slide 5 of 7)• Computing NOL amount – Individual must start with taxable income and add back: 1. Personal and dependency exemptions 2. NOLs from other years 3. Excess nonbusiness capital losses 4. Excess nonbusiness deductions 5. Excess business capital losses 47
  48. 48. Net Operating Losses (slide 6 of 7)• Effect of NOL in carryback year – Taxpayer must recompute taxable income and the income tax – All limitations and deductions based on AGI must be recomputed • Exception - charitable contribution deduction – Determined without regard to any NOL carryback but with regard to any other modification affecting AGI – All credits limited by or based on the tax liability must be recomputed 48
  49. 49. Net Operating Losses (slide 7 of 7)• Calculating remaining NOL after carryovers – After using the NOL in the initial carryover year, the taxpayer must determine how much NOL remains to carry to other years 49
  50. 50. Refocus On The Big Picture (slide 1 of 2)• Martha can receive tax benefits associated with her unfortunate occurrences during the current tax year.• Bad Debt – It appears that Martha’s loan to her friend was a bona fide debt. • The amount of the deduction is the unpaid principal balance of $19,000 ($25,000 - $6,000). • Since the bad debt is a nonbusiness bad debt, it is classified as a short-term capital loss.• Loss from Investment – The $50,000 loss is deductible as a long-term capital loss. – Although the actual holding period was not greater than one year (October through May), the disposal date for the stock (a worthless security) is deemed to be the last day of the tax year. 50
  51. 51. Refocus On The Big Picture (slide 2 of 2)• Loss from Bookstore – The $180,000 loss from the bookstore is reported on Schedule C of Form 1040. • It is an ordinary loss, and it qualifies for NOL treatment. • Martha can carry the $180,000 net loss back and offset it against the net income of the bookstore for the past two years. – Any amount not offset (probably about $30,000) can be carried forward for the next 20 years. – The carryback will produce a claim for a tax refund.• Casualty Loss – The loss on the damage to Martha’s personal residence is a personal casualty loss. • Using the cost of repairs method, the amount of the casualty loss is $7,000 ($32,000 - $25,000). • This amount must be reduced by $100 and 10% of AGI. – If Martha’s house is located in an area declared a disaster area by the President, Martha has the option of deducting the casualty loss on the prior year’s tax return. 51
  52. 52. If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 52

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