Chapter 6 Business Expenses ©2009 South-Western, a part of Cengage Learning Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

Chapter 6Chapter 6

Business ExpensesBusiness Expenses

©2009 South-Western, a part of Cengage Learning©2009 South-Western, a part of Cengage Learning©2009 South-Western, a part of Cengage Learning©2009 South-Western, a part of Cengage Learning

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Kevin MurphyKevin MurphyMark HigginsMark Higgins

6-26-2©2009 South-Western, a part of Cengage Learning©2009 South-Western, a part of Cengage Learning

All deductions are a matter of Legislative Grace

All deductions are a matter of Legislative Grace

Just because GAAP allows a deduction, don’t assume tax law will too!


Business ExpensesBusiness Expenses

All expenses must first meet the basic tests for deductibility - Have a business purposeBe ordinary, necessary, and reasonableBe allowed under the Legislative Grace

Concept


Business ExpensesSubstantiation Requirements

Business ExpensesSubstantiation Requirements

Expenses related to Meals, Entertainment, Automobile Usage, Travel, and Business Gifts are deductible subject to limitations and strict documentation requirementsAmountTime and placeDate and descriptionBusiness purposeBusiness relationship of other person(s)


Meals and EntertainmentMeals and Entertainment

Meals and entertainment expenses must be directly related to or associated with the active conduct of a business activity.


Meals and EntertainmentDirectly Related Test

Meals and EntertainmentDirectly Related Test

The “directly related to” test is met ifThere is more than a general expectation

of business benefitA bona fide business activity takes place

during the meal or entertainmentThe principal reason for the meal or

entertainment is businessThe expenses are related to the taxpayer

and people involved in the business activity


Meals and EntertainmentAssociated With Test

Meals and EntertainmentAssociated With Test

The “associated with” test is met ifThere is a clear business purpose for the

meal or entertainmentThe meal or entertainment directly

precedes or directly follows a substantial business discussion


Meals and EntertainmentCosts

Meals and EntertainmentCosts

Meal costs include food, beverage, tax, and tips

Entertainment costs include expenses for clubs, theaters, and sporting eventsOnly the face amount of a ticket is allowedClub dues do not qualify


Meals and EntertainmentCost Limitations

Meals and EntertainmentCost Limitations

Only 50% of the allowable costs may be deducted

Exceptions to the 50% limitationReimbursed expensesExpenses that are taxable income to a

non-employee recipient (awards, prizes)Expenses for recreational or social

activities which benefit employees


Auto ExpensesGeneral Requirements

Auto ExpensesGeneral Requirements

The cost of using an automobile for business is deductibleUse of the automobile must be for travel

Out of town From home to a temporary workplace From the regular to a temporary workplace From the workplace to a second job

The cost of commuting is never deductible.


Auto ExpensesAuto Expenses

Auto expenses may be computed under one of two methods:Actual CostStandard Mileage Rate


Auto ExpensesActual Cost Method

Auto ExpensesActual Cost Method

The actual cost of using the automobile may be deductedThe business percentage of depreciation,

gas and oil, repairs, insurance, interest, license fees, etc. is deductible

Deduction amount is often larger than the standard rate


Auto ExpensesStandard Mileage Rate

Method

Auto ExpensesStandard Mileage Rate

MethodThe administrative convenience concept

allows a deduction based on the number of business miles driven during the yearRate is $0.505 per mile (2008)Tolls, parking, interest and property taxes may be

added

Standard rate method is not allowed if multiple cars are used


Travel ExpensesTravel Expenses

Travel expenses incurred while on business away from the tax home overnight are deductibleTax home is the principal area in which

business is conductedOvernight means longer than a regular

workday


Travel ExpensesLimitations

Travel ExpensesLimitations

Over 50% of the activity requiring travel must have a business purposePersonal activity costs on a business trip

are not deductibleIncidental business expenses on a

personal trip are deductibleTravel for general educational purposes or

for investment related meetings is not deductible


Business GiftsBusiness Gifts

The cost of a gift given to a business customer may not be fully deductibleThere is an overall limitation of $25 per

person, per yearGifts are not subject to the 50%

entertainment limitsDelivery, gift wrap, engraving, etc., do not

count toward the $25


Education ExpensesEducation Expenses

Costs of education are deductible ifRequired by law (or employer) to maintain

employment, orMaintains or improves current job skills

Costs of education are not deductible ifNecessary to meet minimum job requirements, orQualifies taxpayer for new trade or business


Unreimbursed allowable costs are deductible as miscellaneous itemized deduction

Employee may exclude up to $5,250 of reimbursed expenses from a qualified plan

Education ExpensesEducation Expenses


Compensation of EmployeesCompensation of Employees

Wages, salaries, bonuses and other compensation paid to employees is deductible if two basic tests are met:Employees must perform actual servicePayment must be reasonable in amount


Compensation of EmployeesReasonable Compensation


Some factors considered when determining if compensation is reasonable areDuties, responsibilities and pay history of the

employeeVolume and complexity of the businessTime required to do the workAbility and accomplishments of the employeeCompany pay policy




Payments to a related party may be examined closely forLack of a business purposeAn arms-length transaction Reality of compensation in a closely-held

business




Size of deduction for salary paid to a covered employee is limited Covered employees = CEO and the four highest

paid officers$1,000,000 limit on compensation deduction per

employeeSome amounts are exempt from the limit

commissions and performance based payments pension plan contributions fringe benefits


Bad DebtsBad Debts

Business bad debts are deductible only under the accrual method

Nonbusiness (investment) bad debts are deductible if the debt is bona fideReport as a short-term capital lossNo deduction is allowed if the debt is voluntarily forgiven

Bad debts are generally deductible under the capital recovery concept.


Qualified Production Activities Deduction


Amount Of Deduction6% of the lesser of:

Qualified Production Activities Income OR Taxable Income before Qualified Production

Activities Deduction

Cannot Exceed 50% of W-2 wages paid by Taxpayer




Qualified Production Activities Income equals:Domestic Gross Production Receipts

Less the allocable:

Cost of Goods Sold

Direct Expenses and Losses

Indirect Expenses and Losses




Domestic Gross Production Receipts arise fromSale, exchange, lease, rental or other disposition

of: Qualifying property manufactured, produced, grown, or

extracted in the U.S. Qualified films produced Electricity, natural gas, or potable water produced in the

U.S.

Construction activities performed in the U.S.Engineering or architectural services performed in

the U.S.




Qualified Production PropertyTangible Personal PropertyComputer SoftwareSound Recordings




Retailers who buy from taxpayers with qualified production activities may not claim sales of those products as gross production receipts


QPAD exampleQPAD example

Carlton, Inc. has gross receipts from qualified production activities of $7,500,000. The COGS related to these activities is $3,000,000. The related direct costs are $250,000. Carlton estimates that 40% of the $500,000 indirect costs is attributable to the activities. Taxable income before the QPAD is $4,600,000.

What is Carlton’s QPA income?

($7,500,000 - $3,000,000 - $250,000 – (.40 x $500,000) = $4,050,000

What is Carlton’s QPAD?

6% x ($4,050,000 or $4,600,000) = 6% x $4,050,000 = $243,000


InsuranceInsurance

Fire, theft, casualty or liabilityGroup medical, term-life and worker’s

compensationPerformance and fidelity bondsBusiness interruption

Insurance premiums paid to protect a business from the following losses are deductible.


TaxesTaxes

Exceptions:Sales taxes related to long-lived assets must be

capitalizedProperty taxes related to real estate bought or

sold during the year must be allocated between buyer and seller

Assessments for local benefits are added to the property’s basis

Most business related taxes are deductible unless paid to the federal government.


Legal FeesLegal Fees

Legal fees are deductible if they were paid to defend business income, reputation, or goodwillIf fees are related to property ownership,

they are capitalized with the cost of the property


Individual DeductionsFor Adjusted Gross Income

Individual DeductionsFor Adjusted Gross Income

Expenses paid by individuals for a business purpose, orspecifically allowed by Congress to create

equity in tax treatment

are allowed as deductions for AGI.


Accountable PlanAccountable Plan

Reimbursements = expenses nothing is reported

Reimbursements < expenses reimbursement is reported as income expenses = reimbursement income are deducted for AGI excess expenses are deducted from AGI

Reimbursements > expenses and excess is not returned excess reimbursement is reported as income

Employees are required to make an adequate accounting of their expenses.


Nonaccountable PlanNonaccountable Plan

Employees are not required to make an adequate accounting of their expenses.

All reimbursements are included in incomeAll expenses are deducted from AGI


Deductions for Self-Employed TaxpayersDeductions for Self-Employed Taxpayers

To provide self-employed taxpayers equity with the tax treatment of employees, they are allowed to deduct:

The cost of health insurance premiums paid for themselves

50% of the amount of self-employment tax paid


Retirement Plan Contribution Deductions

Retirement Plan Contribution Deductions

Taxpayers who do not have access to an employer sponsored pension plan are allowed several options:Keogh or H.R.10 plans (for self-employed

taxpayers only)Individual Retirement Accounts (for all

taxpayers)


Individual Retirement Accounts

Contributions

Individual Retirement Accounts

ContributionsAll taxpayers may contribute a

maximum of $5,000 of their earned income to a Deductible or a Roth IRA.Special “Catch-up” rule allows up to $6,000

if 50 or older

A married couple may contribute $10,000 in total ($12,000 if over 50), but not more than $5,000 ($6,000) to any one account.


Three Major IRA TypesThree Major IRA Types

ConventionalRothCoverdell Educational Savings Account


1. Conventional IRA1. Conventional IRA

Contributions limited to lesser of $5,000 ($6,000 if > 50) or amount of earned income Fully deductible if not covered by an

employer’s plan Not linked to spouse’s coverage

If covered, maximum deduction equals:

(Maximum contribution) X [1 – IRA percentage*]

* (AGI - phase-out) / $10,000 ($20,000 MFJ)


Conventional IRA: Phase-out AmountsConventional IRA: Phase-out Amounts

Tax Year Married Single

2008 $85,000 $53,000 2007 $83,000 $52,000


Conventional IRA - ExampleConventional IRA - Example

Single taxpayer with AGI = $58,000 contributes $5,000 to an IRA. How much is deductible if the t/p is covered by a qualified plan?

$5,000 X [ 1 - ($58,000 - $53,000)/10,000]

= $5,000 X [ 1 - 0.50]

= $5,000 X 0.50

= $2,500 maximum deduction


2. Roth IRA2. Roth IRA

Contributions are not deductibleEarnings distributions are tax-free if

IRA has existed for 5 years, andTaxpayer is >59 1/2 years oldNo age limit to begin distributions

Contributions are phased-out like Conventional IRAMarried beginning at $159,000Others beginning at $101,000


3. Coverdell Education Savings Account (CESA)3. Coverdell Education Savings Account (CESA)

Set up as a trust for the benefit of any person under age 18

$2,000 nondeductible contribution per student per yearPhased-out for AGI greater than

Married, from $190,000 Others, from $95,000

Max. contribution X [1 - {(AGI - phase-out) / 15,000}]


3. CESA Continued3. CESA Continued

Tax-free growth in the IRANo tax at time of withdrawal if used for

qualified expensesTuition and fees of student


Higher Education Expense Deduction

Higher Education Expense Deduction

May deduct up to $4,000 of qualifying higher education expenseQualifying = tuition and feesMust have AGI < $65,000 if single

($130,000 for MFJ)Cannot claim in addition to HOPE or

Lifetime Learning Credits (Chapter 8)


Educational Loan InterestEducational Loan Interest

May deduct up to $2,500 for interest paid on education loansTaken as a “for” deductionOnly for payments made during first 60

months of the loanDeduction phased-out when AGI exceeds

Married, from $115,000; Others, from $55,000

Deduction = Amt. Allowed X [1 - {(AGI - phase-out) / 15,000}]


Moving ExpensesMoving Expenses

Moving expenses are deductible if they meet two tests.

1. Distance test

Old house

Old job

x + 51 miles

x m

ilesNew job


Moving ExpensesTime Test

Moving ExpensesTime Test

2. Time TestEmployee taxpayers must be employed in

the new area for 39 weeks of the 12 months after moving

Self-employed taxpayers must be employed in the new area for 78 weeks of the 24 months after moving

Waived for death, disability, or required transfer


Moving ExpensesQualifying Expenses

Moving ExpensesQualifying Expenses

Only two types of expenses are deductible:Costs of moving household goods and

personal items to the new locationTransportation and lodging costs of moving

the taxpayer and family to the new location Mileage is allowed at $0.19 per mile None of the cost of meals is deductible


Moving ExpensesReimbursementsMoving ExpensesReimbursements

Any reimbursement of moving expenses received from an employer is included as income

Documents

Chapter 6 Business Expenses ©2009 South-Western, a part of Cengage Learning Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins