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5 - 1©2005 Prentice Hall, Inc.
Business Expenses
Chapter 5
5 - 2©2005 Prentice Hall, Inc.
Code Sections
Sec. 161 - deductions permitted only for those expenses and losses for which a deduction is authorized
Sec. 162(a) authorizes deductions for ordinary and necessary expenses, that are reasonable in amount, and incurred in actively carrying on a trade or business
Sec. 212 authorizes deductions for expenses related to production of income (investment-related expenses)
5 - 3©2005 Prentice Hall, Inc.
Disallowed Deductions
Unless provided for otherwise in the Code, a deduction will be disallowed if it isContrary to public policy (fines, penalties)Related to tax-exempt incomeAccrued to related party (no deduction until
related party recognizes income)The obligation of another taxpayer
5 - 4©2005 Prentice Hall, Inc.
Substantiation
All taxpayers must maintain records that substantiate their expense deductions
Stringent substantiation requirements for travel, entertainment, and giftsAmount of expenditureTime and place (or date & description of gift)Business purpose of expenditureBusiness relationship of person entertained or
receiving a gift
5 - 5©2005 Prentice Hall, Inc.
Timing of Deductions
Accrual method – expenses deductible when“All events” have occurred that fix liability and“Economic performance” occurs (property or
services provided or used) Cash basis taxpayer - expenses deductible
when paidDate check is mailedDate charged on credit card
5 - 6©2005 Prentice Hall, Inc.
Cash Method
When an expense is paid by providing services, the expense can be deducted but the value of the services provided is also income
Assets with useful lives extending substantially beyond the end of the year must be capitalized with their cost recovered through depreciation, amortization, or depletion
When considering whether to make an early payment of year-end expenses, the tax rates for both years and the time value of money should be considered
5 - 7©2005 Prentice Hall, Inc.
Use of Cash Method
Businesses that sell merchandise to their customers must use the accrual method to account for purchases and sales of inventoryCash method can be used for other than
inventory and cost of goods sold Large corporations with average annual gross
receipts of more than $5 million cannot use the cash method for tax reporting
All personal service corporations can use the cash method
5 - 8©2005 Prentice Hall, Inc.
Prepaid Expenses
Prepaid expenses must be capitalized as assets and their costs prorated if their lives exceed one year and the items will not be consumed by the close of the following year
Prepaid interest must generally be prorated over the life of the loanOID is a form of prepaid interest and must be
amortized over term of loan
5 - 9©2005 Prentice Hall, Inc.
Costs of Starting a Business
Sec. 162 allows deductions for “carrying on” a business. Expenses incurred prior to the commencement of operations do not qualify as “carrying on” a business but may be deductible as one of the following:Business investigation expensesStart-up expensesOrganization costs
5 - 10©2005 Prentice Hall, Inc.
Business Investigation
Investigation expenses incurred while preparing to enter business include travel, market surveys, and feasibility studies
If the taxpayer is in a similar existing business - deduction allowed as a current expense
If taxpayer is not in a similar existing business If new business acquired - expenses amortized
over 60 months If new business not acquired - no deduction
5 - 11©2005 Prentice Hall, Inc.
Start-up Expenses
Start-up expenses are incurred after the decision to proceed with the new business, but before beginning actual operations (employee training and advertising)If the business is related to the taxpayer’s
existing business, start-up costs are considered continuing costs and are deductible currently
If the business is not related to an existing business, expenses are amortized by the taxpayer over 60 months
5 - 12©2005 Prentice Hall, Inc.
Organization Costs
Defined as costs related to the formation of a corporation or partnership (fees paid to the state for incorporation, legal fees, and accounting fees) and incurred before end of first year
Organization costs are capitalized and amortized over 60 months
Excludes partnership syndications costs and stock issuance costs
5 - 13©2005 Prentice Hall, Inc.
Operating Expenses
Most operating expenses shown on a GAAP income statement are deductible on a business tax return
Examples include: advertising, bank service charges, commissions, office supplies, repairs, taxes, licenses, accounting fees, legal fees, salaries and wages, travel, and utilities
5 - 14©2005 Prentice Hall, Inc.
Meals & Entertainment
The deduction for business meals and entertainment expenses is limited to 50% of the qualified expenses
The 50% limit is imposed on whoever (employer or employee) ultimately pays the expense
5 - 15©2005 Prentice Hall, Inc.
Meals & Entertainment
Directly-related expenses - costs incurred when a significant business discussion takes place between the taxpayer and a customer in atmosphere conducive to the serious conduct of business.
Associated-with expenses - deductible when directly preceded or followed by a substantial business discussionDeduction for entertainment tickets is limited to
50% of the tickets’ face value
5 - 16©2005 Prentice Hall, Inc.
Restriction on Deductions
No deduction allowed for the costs of owning and maintaining entertainment facilities such as hunting lodges and yachts
No deduction allowed for membership dues and fees paid to social, athletic, or sporting clubsDeductions are allowed for dues to
professional organizations, public service organizations, and trade associations
Deduction for business gifts limited to $25 per donee per year
5 - 17©2005 Prentice Hall, Inc.
Travel Away From Home
Travel expenses incurred for temporary travel away from home on business are deductible.
Qualifying expenses include lodging, 50% of meals, transportation to destination and back, and incidental expensesAway from home refers to the person’s tax
home; that is, the location of the principal place of employment regardless of where the family residence is maintained
5 - 18©2005 Prentice Hall, Inc.
Temporary Assignments
Temporary is defined as one year or less Employment away from home in a single
location that is realistically expected to last (and does in fact last) for one year or less, will be treated as temporary
Assignment for more than one year shifts tax home to the new location (no deduction for travel and living costs)
5 - 19©2005 Prentice Hall, Inc.
Transportation Expenses
Certain transportation expenses incurred when the taxpayer is not away from home are deductible and includethe cost of transportation from one work
location to another transportation between home and a temporary
work location if the taxpayer has a regular place of business
any meal costs are excluded, however
5 - 20©2005 Prentice Hall, Inc.
Transportation Expenses
The prorated business portion of actual automobile expenses or a standard mileage rate (37.5¢ for 2004) plus related parking and tolls can be deducted
Commuting expenses (between home and the regular place of business) are a personal nondeductible expense
5 - 21©2005 Prentice Hall, Inc.
Combining Business with Pleasure Travel
For U.S. travel, if the trip is primarily for business, all transportation costs to and from destination are deductible
If primary purpose is pleasure, no deduction for transportation
Primary purpose is determined by the number of days on business versus personal days
5 - 22©2005 Prentice Hall, Inc.
Combining Business with Pleasure Travel
Meals & lodging are deductible only for days on which business is conducted
If a taxpayer remains in a temporary location to reduce costs as a result ofreduced airfare for Saturday night stays or for business conducted on both Friday and
Monday the costs for additional days are deductible if
they are less than the cost of returning home when business is completed
5 - 23©2005 Prentice Hall, Inc.
Foreign Travel
Transportation expenses must be allocated between business and personal days unlessTrip does not exceed one week orLess than 25% of total time spent for personal
purposes If trip primarily personal, no deduction for
transportation
5 - 24©2005 Prentice Hall, Inc.
Bad Debt Expense
Specific charge-off method must be used Investment and personal loans are
considered nonbusiness (capital losses) Loan must be valid debt No bad debt deduction for cash basis
taxpayers who have not previously included amount in income
5 - 25©2005 Prentice Hall, Inc.
Insurance Expense
Premiums for fire, casualty, and theft insurance for business property are deductible
Payments into a self-insurance reserve are not deductible - only actual losses are deductible
Premiums for life insurance when business is beneficiary are not deductible
5 - 26©2005 Prentice Hall, Inc.
Legal Expenses
Legal Fees deductible only if related to a trade or businessLegal fees incurred to defend title to property
are added to the asset’s basisCriminal defense fees are deductible only if
the legal action has a direct relationship to a profit-seeking activity
Personal legal expenses are not deductible
5 - 27©2005 Prentice Hall, Inc.
Taxes
Deductible taxes includeState, local, and foreign real property taxesState and local personal property taxesState, local, and foreign income taxesEmployer’s payroll taxesOther federal, state, local, and foreign taxes
incurred in a business or other income-producing activity
Federal income taxes are not deductible
5 - 28©2005 Prentice Hall, Inc.
Taxes
When real estate is sold, the seller is responsible for taxes through the day before the sale date
Assessments for improvements must be added to basis of property
Sales taxes are added to cost of business property or service
5 - 29©2005 Prentice Hall, Inc.
UNICAP Rules
Uniform capitalization rules apply to businesses whose average annual gross receipts for the preceding three years exceeds $10 millionUNICAP rules require inventory costs to include all
direct costs of manufacturing, purchasing, or storing inventory, along with many indirect costs typically not included in full absorption costing
Nonmanufacturing costs (research, selling, advertising and distribution expenses) are not required to be included in inventory
5 - 30©2005 Prentice Hall, Inc.
Inventory
Acceptable methods for tax accounting include specific identification, FIFO, LIFO, and average cost
When prices are rising, the LIFO method results in a lower inventory valuation and tax savings through a higher deduction for cost of goods sold
The LIFO conformity rule requires use of LIFO for financial statements if LIFO is used for tax
5 - 31©2005 Prentice Hall, Inc.
Residential Rental Property
If rental of real estate is a business, all income is included and all expenses are deductible, even if it creates a loss
Expenses include: advertising, cleaning, maintenance, utilities, insurance, taxes, interest, commissions for collection of rent, travel to collect rental income or to manage the property or maintain the property
5 - 32©2005 Prentice Hall, Inc.
Residential Rental Property
When property is converted from personal to rental property, expenses must be divided between rental and personal use
No depreciation or insurance deduction allowed for personal-use part of year
Mortgage interest and real estate taxes for personal-use can be deducted as itemized deductions
5 - 33©2005 Prentice Hall, Inc.
Rental of a Vacation Home
If the residence is rented for less than 15 days during the year a de minimis exception appliesNo rental income is reported butNo deductions are allowed for expenses
other than mortgage interest and property taxes as itemized deductions
5 - 34©2005 Prentice Hall, Inc.
Rental of a Vacation Home
If rental period is greater than 14 days and If personal use does not exceed the greater of
14 days or 10% of the rental daysAll rent is included in incomeExpenses are allocated between rental and
personal useAll expenses related to the rental use are
deductible (even if this creates a loss)
5 - 35©2005 Prentice Hall, Inc.
Rental of a Vacation Home
If rental period is greater than 14 days but Personal use exceeds the greater of 14 days or
10% of the rental daysRental expenses limited to rental income (no loss)Nondeductible rental expenses can be carried
forward to the future yearsReal estate taxes and mortgage interest for
personal-use portion allowed as itemized deductions
5 - 36©2005 Prentice Hall, Inc.
Home Office Expenses
Home office must be used exclusively on a regular basis and meet one of the following three tests to be deductible
1. the principal place of business for any business of taxpayer, or
2. a place for meeting with clients or customers in the normal course of business, or
3. located in a separate structure
5 - 37©2005 Prentice Hall, Inc.
Home Office Expenses
Principal place of business includes a place used for the administrative or management activities of the business if there is no other fixed location available
Employee must also show that the office is maintained for the convenience of the employer
Deductible expenses include portion of rent or mortgage interest, property taxes, insurance, utilities, repairs, depreciation but are limited to gross income from the business
5 - 38©2005 Prentice Hall, Inc.
Home Office Expenses
Expenses are deducted in this order:1. Expenses directly related to the business other
than home office expenses (supplies)
2. The allocated portion of otherwise deductible itemized deductions (mortgage interest and property taxes)
3. Other home expenses including utilities, insurance, and maintenance
4. Depreciation Excess expenses are carried forward
5 - 39©2005 Prentice Hall, Inc.
Hobby Expenses
Activities that earn income and incur expenses but do not meet the requirements to be a business or investment are hobbies
Regulations list factors to consider in determining if activity is a hobby including:Manner in which activity carried onExpertise of taxpayer and/or consultantsTime and effort spend in activityActual profits earned in one or more yearsElements of pleasure or recreation
5 - 40©2005 Prentice Hall, Inc.
Hobby Expenses
If a profit is realized in 3 out of 5 years (2 out of 7 years for horses) then burden of proof shifts to IRS to prove activity is a hobbyTaxpayer can deduct expenses, even if a
net loss results, by showing activity is run in a businesslike manner
If activity is a hobby, the deduction for expenses is limited to hobby income
5 - 41©2005 Prentice Hall, Inc.
Hobby Expenses
Expenses must be deducted in this order:
1. Otherwise allowable expenses (mortgage interest, taxes, and casualty losses)
2. Expenses that do not reduce the tax basis of the assets used in the hobby (advertising, insurance, utilities and maintenance)
3. Depreciation and amortization
Excess expenses are lost - no carryover
5 - 42©2005 Prentice Hall, Inc.
Accounting for Income Taxes
FAS 109 states that income tax expense reported on financial statements must be based on financial statement income rather than taxable income
Differences fall into two categoriesPermanent differencesTemporary differences
5 - 43©2005 Prentice Hall, Inc.
Permanent Differences
Income that is not taxed but is reported for financial accounting purposesInterest income from municipal bonds
Expenses that can never be deducted on the tax returnFines and penalties
Expenses that have limited deductibility50% of meals and entertainment
5 - 44©2005 Prentice Hall, Inc.
Temporary Differences
Income or expense items that are reported in one year for accounting income and in a different year for taxable incomeExamples: depreciation expense, bad debt
expense, warranty expenses, and prepaid income
Schedule M-1 of Form 1120 reconciles accounting (book) income to taxable income
5 - 45©2005 Prentice Hall, Inc.
Schedule M-1
5 - 46©2005 Prentice Hall, Inc.
Calculating Tax Expense
If only permanent differences, adjust book income byAdding expenses that are not tax deductible andSubtracting tax-exempt income, then
Multiply adjusted book income by the tax rate
5 - 47©2005 Prentice Hall, Inc.
Deferred Taxes
Temporary differences createA deferred tax liability that is a current tax
savings that will have to be paid in a future year
A deferred tax asset that is a prepayment of tax that will be refunded in a future year
5 - 48©2005 Prentice Hall, Inc.
Deferred Tax Assets
To realize the benefit of a deferred tax asset (tax prepayment) the business must have future income and a related tax liability
A more-likely-than-not test is used to determine if a valuation account (contra asset) is needed
5 - 49©2005 Prentice Hall, Inc.
ConsolidatedFinancial Statements
Under FAS 109, income tax expense reported on consolidated financial statements should include the total of all federal, state, local, and foreign income taxes including both current and deferred income taxes
5 - 50©2005 Prentice Hall, Inc.
ConsolidatedFinancial Statements
Exception under APB 23 allows parent to exclude future U.S. income tax on foreign subsidiary income if these earnings are permanently reinvested outside the U.S.Allows U.S. corporation to report higher financial
statement income because its income statement includes the foreign income but excludes the deferred U.S. tax that could eventually be due on this income
Earnings repatriated later can cause a spike in the corporation's effective tax rate in that year
5 - 51©2005 Prentice Hall, Inc.
The End