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
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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 Expenses
Chapter 6, Exhibit Contents A
Chapter 6 Exhibits
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10. Business Gifts11. Travel & Transportation Expenses12. Moving Expenses13. Student Loan Interest—Qualified Education Expenses14. Student Loan Interest15. Qualified Education Expenses Deduction16. Health Insurance, HSAs, MSAs17. Employee Business-Related Expenses18. Employee v. Self-Employed19. Limitations on the Deductibility of Expenses and Losses
Chapter 6, Exhibit Contents B
Chapter 6 Exhibits
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20. Other Limitations on the Deductibility of Expenses and Losses21. Business Deductions Related to Capital Expenditures 22. Depreciation of Tangible Property23. MACRS Depreciation of Tangible Property24. Limitations on Depreciation of Automobiles25. Depreciation Code Sec. 179 Election26. Bonus Depreciation Reintroduced by the Tax Relief, Unemployment Insurance
Reauthorization and Job Creation Act of 201027. Amortization28. Research and Experimental (R & E)29. Depletion
Chapter 6, Exhibit Contents C
Chapter 6 Exhibits
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Classification of DeductionsThere 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 6 of 43
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 AGI
Chapter 6, Exhibit 2
CCH Federal Taxation Basic Principles 7 of 43
Business expenses are generally deductible without limitation when the following 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
Trade or Business Expenses
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Trade or Business Expenses
4. 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 worthless
Chapter 6, Exhibit 3b
CCH Federal Taxation Basic Principles 9 of 43
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 10 of 43
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 productionof rent and royalty income, which are deductible FOR AGI.
Chapter 6, Exhibit 4b
CCH Federal Taxation Basic Principles 11 of 43
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 12 of 43
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 deduction
Chapter 6, Exhibit 6
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Type of Expense
Investigation Expenses Start-Up Expenses
Definition Expenditures that help determine whether to create or buy a business
Pre-operational costs
Timing Occur before a decision to make or buy is reached
Occur after a "go for it" decision is reached, but before the doors open for business
Examples Travel, marketing surveys, legal, accounting, and engineering
Employee training and stationery
Business Investigation and Start-Up Expenses
Chapter 6, Exhibit 7
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Type Pursue business? Decline?
Business Investigation Expenses
Similar business Deductible in the year paid or incurred.
New business $5,000 can be expensed, the remainder is capitalized and amortized over 180 months
Similar business Deductible in the year paid or incurred.
New business Not deductible or capitalized, but lost
Business Start-up Expenses
Similar business Deductible in the year paid or incurred.
New business $5,000 can be expensed, the remainder is capitalized and amortized over 180 months
N/A – if taxpayer declines to pursue the opportunity, there will be no start-up costs, only investigation expenses.
Deductibility of Business Investigation and Start-Up Expenses
Chapter 6, Exhibit 8
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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 < $400
Chapter 6, Exhibit 10
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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 distance
Chapter 6, Exhibit 11a
Travel & Transportation Expenses
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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
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Moving ExpensesMoving expenses are deductible FOR AGI.
Qualified moving expenses.
1. Transporting household goods and personal effects2. Traveling from old residence to new residence3. 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 residence
Chapter 6, Exhibit 12a
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Time Requirement for the Moving Expense Deduction
Self-Employed Employee
Work full time at new job > 39 weeks during first 12 months, AND
Work full time at new job > 78 weeks during first 24 months
Work full time at new job > 39 weeks during first 12 months
Chapter 6, Exhibit 12b
Moving Expenses
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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
Moving Expenses
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Student Loan InterestQualified 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
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Student Loan Interest
N/AN/AN/AMarried filing separately
$30,000$150,000$120,000Married filing jointly
$15,000$75,000$60,000Single, head of household, surviving spouse
Phaseout RangeCeilingFloor
Threshold for Modified AGIFiling Status
Phaseout of Student Loan Interest Deduction
Chapter 6, Exhibit 14
CCH Federal Taxation Basic Principles 23 of 43
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 allowed
Chapter 6, Exhibit 15
CCH Federal Taxation Basic Principles 24 of 43
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 25 of 43
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:
Professional society duesSubscriptions to professional journalsTravel expensesHome 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 26 of 43
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
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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
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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
Limitations on the Deductibility of Expenses and Losses
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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 deduction
Chapter 6, Exhibit 19c
Limitations on the Deductibility of Expenses and Losses
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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 31 of 43
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 32 of 43
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 33 of 43
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 bores
Chapter 6, Exhibit 23a
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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 35 of 43
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
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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.
MACRS Depreciation of Tangible Property
Chapter 6, Exhibit 23d
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Limitations on Depreciation of Automobiles
Depreciation (including Code Sec. 179 deduction) for cars purchased in 2012 limited to:
Passenger Cars Trucks and Vans
First year $3,060 $3,260
Second year $4,900 $5,200
Third year $2,950 $3,150
Subsequent years $1,775 $1,875
Chapter 6, Exhibit 24
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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 39 of 43
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 pounds
Chapter 6, Exhibit 26
CCH Federal Taxation Basic Principles 40 of 43
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 41 of 43
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 42 of 43
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 sales
Chapter 6, Exhibit 29a
CCH Federal Taxation Basic Principles 43 of 43
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
Depletion
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