Slide 1DEDUCTIONS AND LOSSES (1 of 2)DEDUCTIONS AND LOSSES (2 of 2)Classifying Deductions as for vs. from Adjusted Gross Income (1 of 3)Classifying Deductions as for vs. from Adjusted Gross Income (2 of 3)Classifying Deductions as for vs. from Adjusted Gross Income (3 of 3)Criteria for Deducting Business and Investment ExpensesBusiness or Investment Requirement (1 of 2)Business or Investment Requirement (2 of 2)Ordinary ExpenseNecessary ExpenseReasonable ExpenseExpenses and Losses Must Be Incurred Directly by the TaxpayerGeneral Restrictions on the Deductibility of ExpensesCapitalization vs. Expense DeductionExpenses Related to Exempt IncomeExpenditures that Are Contrary to Public PolicyOther Expenditures Specifically DisallowedProper Substantiation RequirementWhen an Expense Is Deductible Cash Method (1 of 2)When an Expense Is Deductible Cash Method (2 of 2)When an Expense Is Deductible Accrual Method (1 of 2)When an Expense Is Deductible Accrual Method (2 of 2)Special Disallowance RulesWash SalesTransactions between Related Parties (1 of 2)Transactions between Related Parties (2 of 2)Hobby Losses (1 of 2)Hobby Losses (2 of 2)Vacation HomeExpenses of an Office in the HomeTax Planning ConsiderationsCompliance and Procedural Considerations (1 of 2)Compliance and Procedural Considerations (2 of 2)Slide 356-1©2007 Prentice Hall, Inc.©2007 Prentice Hall, Inc.6-2DEDUCTIONS AND DEDUCTIONS AND LOSSESLOSSES(1 of 2)(1 of 2)Classifying deductions as for vs. from adjusted gross incomeCriteria for deducting business and investment expensesGeneral restrictions on the deductibility of expensesProper substantiation requirement©2007 Prentice Hall, Inc.6-3DEDUCTIONS AND DEDUCTIONS AND LOSSESLOSSES(2 of 2)(2 of 2)When an expense is deductibleSpecial disallowance rulesTax planning considerationsCompliance and procedural considerations©2007 Prentice Hall, Inc.6-4Classifying Deductions as Classifying Deductions as forfor vs. vs. from from Adjusted Adjusted Gross IncomeGross Income (1 of 3) (1 of 3)For AGITaxpayer benefits from deduction even if she claims the standard deductionReduces AGI which benefits taxpayerMany deductions and credits are phased out above certain AGI thresholds Reduces AGI floors for certain categories of itemized deductionsNegative effect of reducing certain deduction ceilings©2007 Prentice Hall, Inc.6-5Classifying Deductions as Classifying Deductions as forfor vs. vs. from from Adjusted Adjusted Gross IncomeGross Income (2 of 3) (2 of 3)Most common deductions for AGITrade or business expensesIRAsAlimonyLosses on investmentInterest paid on qualified education loans1/2 of self-employment tax Health insurance costs paid by self-employed individuals©2007 Prentice Hall, Inc.6-6Classifying Deductions as Classifying Deductions as forfor vs. vs. from from Adjusted Adjusted Gross IncomeGross Income (3 of 3) (3 of 3)From AGIItemized deduction only will have tax benefit if total deductions exceed the taxpayer’s standard deduction©2007 Prentice Hall, Inc.6-7Criteria for Deducting Criteria for Deducting Business and Investment Business and Investment ExpensesExpensesBusiness or investment requirementOrdinary expenseNecessary expenseReasonable expenseExpenses and losses must be incurred directly by the taxpayer©2007 Prentice Hall, Inc.6-8Business or Investment Requirement(1 of 2)Activity engaged in for profitUse facts and circumstances testTrade or business (ToB) vs. investment classificationToB losses are ordinary lossesToB expenses are for AGIInvestment losses are capitalInvestment expenses are fr om AGISubject to 2% of AGI floor©2007 Prentice Hall, Inc.6-9Business or Investment Requirement(2 of 2)Losses and expenses related to rents and royalties are for AGI deductionsLegal and accounting feesFor AGI deduction for ToB if incurred in ordinary course of businessFees related to taxes also for AGI for ToBNonbusiness fees related to taxes f rom AGI deduction subject to 2% of AGI floor©2007 Prentice Hall, Inc.6-10Ordinary ExpenseTo be ordinary, an expense must beReasonable in amountBear reasonable proximate relationship to income-producing activity or propertyMust be customary or usual course of a particular industry or business community©2007 Prentice Hall, Inc.6-11Necessary ExpenseAn expense is considered necessary if it is “appropriate and helpful” in the taxpayer’s business©2007 Prentice Hall, Inc.6-12Reasonable ExpenseProblems often occur with salaries for shareholder-employees of closely held businesses©2007 Prentice Hall, Inc.6-13Expenses and Losses Must Be Incurred Directly by the TaxpayerGenerally, a taxpayer cannot take a deduction for a loss or expense of another person©2007 Prentice Hall, Inc.6-14General Restrictions on General Restrictions on the Deductibility of the Deductibility of ExpensesExpensesCapitalization vs. expense deductionExpenses related to exempt incomeExpenditures that are contrary to public policyOther expenditures specifically disallowed©2007 Prentice Hall, Inc.6-15Capitalization vs. Expense DeductionGeneral capitalization requirementsElection to deduct currentlyE.g, certain research and experimental expenditures, cost of qualified tangible personal propertyCapitalization of deduction itemsE.g., carrying charges on unproductive unimproved real estate©2007 Prentice Hall, Inc.6-16Expenses Related to Exempt IncomeDeduction disallowed because income is not taxable©2007 Prentice Hall, Inc.6-17Expenditures that Are Contrary to Public PolicyCannot deduct illegal payments or payment resulting from an illegal actFines and penaltiesBribes and Kickbacks©2007 Prentice Hall, Inc.6-18Other Expenditures Specifically DisallowedPolitical contributions and lobbying expensesBusiness investigation and preopening expensesMay elect to immediately expense up to $5,000Amortize remainder over 180 months beginning when business commencesNo amortization if business not begun©2007 Prentice Hall, Inc.6-19Proper Substantiation Proper Substantiation RequirementRequirementThe taxpayer has the burden of proofThe Cohan ruleCertain expenses may be estimatedMore restrictive substantiation requirements for travel, entertainment, business gifts©2007 Prentice Hall, Inc.6-20When an Expense Is When an Expense Is DeductibleDeductibleCash Method (1 of 2)Cash Method