Martha experienced significant financial losses in the current year. She loaned a friend money to start a business that failed, resulting in a bad debt. She also lost money investing in a pharmaceutical company that declared bankruptcy. Additionally, her sole proprietorship bookstore experienced losses due to increased competition. Martha is hoping that tax law provisions related to deductions and losses can provide some relief.

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Bad Debt Deductions Summary
Concept Summary 7.2
16

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. 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. 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. 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. 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. Definition of Theft
• Theft includes robbery, burglary,
embezzlement, etc.
– Does not include misplaced items
22

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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