Upgrade to remove ads
Chapter 6 Vocab
Terms in this set (44)
Deductions for AGI
The Federal income tax is not imposed upon gross income. Rather, it is imposed upon taxable income. Congressionally identified deductions for individual taxpayers are subtracted either from gross income to arrive at AGI. Can be claimed whether or not the taxpayer itemizes. May directly affect the amount of itemized deductions because many itemized deductions are limited to amounts in excess of specified percentages of AGI.
Ordinary and Necessary
An ordinary expense is common and accepted in the general industry or type of activity in which the taxpayer is engaged. It comprises one of the tests for the deductibility of expenses incurred or paid in connection with a trade or business; for the production or collection of income; for the management, conservation, or maintenance of property held for the production of income; or in connection with the determination, collection, or refund of any tax. A necessary expense is appropriate and helpful in furthering the taxpayer's business or income-producing activity. To be deductible, any trade or business expense must be ordinary AND necessary.
The Code includes a reasonableness requirement with respect to the deduction of salaries and other compensation for services. What constitutes reasonableness is a question of fact. If an expense is unreasonable, the amount that is classified as unreasonable is not allowed as a deduction. The question of reasonableness generally arises with respect to closely held corporations where there is no separation of ownership and management. In closely held companies, transactions between shareholders may result in the disallowance of deductions (because the salaries may be treated as dividends).
The method under which income and expenses are determined for tax purposes. Important accounting methods include the cash basis and the accrual basis. Special methods are available for the reporting of gain on installment sales, recognition of income on construction projects, and the valuation of inventories. Method used determines when an item is includible in income and when it is deductible. Usually the taxpayer's regular method of record keeping is used for income tax purposes.
Expenditures paid or incurred prior to the beginning of the business that would have been deductible as an ordinary and necessary business expense if business operations had begun. Examples include advertising; salaries and wages; travel and other expenses incurred in lining up distributors, suppliers, or customers; and salaries and fees to executives, consultants, and professional service providers. A taxpayer will immediately expense the first $5,000 (subject to phase-out) of startup expenditures and amortize the balance over a period of 180 months, unless the taxpayer elects not to do so.
Losses from an activity not engaged in for profit. The Code restricts the amount of losses that an individual can deduct for hobby activities so that these transactions cannot be used to offset income from other sources. Hobby expenses are deductible only to the extent of hobby income.
The Code places restrictions upon taxpayers who rent their residences or vacation homes for a part of the tax year to prevent taxpayers from deducting essentially personal expenses as rental losses. The restrictions may result in a scaling down of the expense deductions for the taxpayers. Section 208Adoes not allow a loss for property that is not used primarily for rental purposes (only a break-even situation is allowed).
The tax law places restrictions upon the recognition of gains and losses between related parties because of the potential for abuse. For example, restrictions are placed on the deduction of losses from the sale or exchange of property between related parties. In addition, under certain circumstances, related-party gains that would otherwise be classified as capital gain are classified as ordinary income. The Code disallows any losses from sales or exchanges of property directly or indirectly between related parties. A loss can be disallowed even if the asset is sold to an unrelated party if a related party repurchases the asset on or near the same day and the two sales were prearranged.
are disallowed unless a specific provision in the tax law permits them.
cannot be excluded unless there is a specific statement to that effect in the Internal Revenue Code.
Deductions from AGI
The Federal income tax is not imposed upon gross income. Rather, it is imposed upon taxable income. Deductions from AGI are subtracted from adjusted gross income to arrive at the tax base, taxable income. Result in a tax benefit only if they exceed the taxpayer's standard deductions. If itemized deductions (from AGI) are less than the standard deduction, they provide no tax benefit.
Three Mutually Exclusive Activity Categories
(1) Investment/production of income (SS212), (2) Trade or business (SS162), and (3) Personal (various sections)
Section 212 Expenses
Section 212 allows deductions for ordinary and necessary expenses paid or incurred for the following: (1) the production of income, (2) the management, conservation, or maintenance of property held for the production of income, and (3) expenses paid in connection with the determination, collection, or refund of any tax. May be for or from AGI.
Section 162 Trade or Business Expenses
Section 162 permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business. This includes reasonable salaries, expenses for the use of business property, and 1/2 of self-employment taxes paid. The following items are excluded from classification as trade or business expenses: Charitable contributions or gifts, illegal bribes and kickbacks and certain treble damage payments, and fines and penalties.
Not deductible unless a specific Code section authorizes the deduction. Usually deductions from AGI and, in some cases, must be less than (or greater than) a certain percentage of the AGI. Examples include: contributions to qualified charitable organizations, medical expenses, certain state and local taxes, personal casualty losses, certain personal interest, and legal fees related to the determination of a tax liability.
Business and Nonbusiness Losses
Section 165 provides for a deduction for losses not compensated for by insurance. Limited to those incurred in a trade or business transaction entered into for profit. Deductions are also allowed for casualties including fire, storm, shipwreck, and theft. Personal casualty loss is an itemized deduction from AGI.
Refers to the cash basis taxpayer who gets a deduction only in the year of payment.
Concerns the accrual basis taxpayer who obtains the deduction in the year in which the liability for the expense becomes certain.
Expenses are only deductible when they are actually paid with cash or other property. (The payment can be made with borrowed funds.) Cash and accrual taxpayers cannot take a current deduction for capital expenditures except through amortization, depreciation, or depletion. An expenditure that creates an asset having a useful life that extends substantially beyond the end of the tax year must be capitalized. An asset that will expire or be consumed by the end of the tax year following the year of payment must be prorated. The payment must be required (for business purpose) to obtain the current deduction under the one-year rule.
The period in which an accrual basis taxpayer can deduct an expense is determined by applying the all events test and the economic performance test. A deduction can not be claimed until (1) all the events have occurred to create the taxpayer's liability and (2) the amount of the liability can be determined with reasonable accuracy. Once these are satisfied, the deduction is permitted only if economic performance has occurred. This test is me only when the service, property, or use of property giving rise to the liability is actually performed for, provided to, or used by the taxpayer.
Exceptions to the Economic Performance Requirement
Exceptions are allowed for certain recurring items to be deducted if all the following are met: (1) the item is recurring in nature and is treated consistently by the taxpayer (2) Either the accrued item is not material or accruing it results in better matching of income and expenses (3) All of the events have occurred that determine the fact of the liability, and the amount of the liability can be determined with reasonable accuracy (4) Economic performance occurs within a reasonable period (not later than 8.5 months after the close of the taxable year).
Reserves for Estimated Expenses
Generally are not allowed for tax purposes because the economic performance test cannot be satisfied.
Time Value of Tax Deductions
A cash basis taxpayer must consider time value of money and cash-flow problems when deciding to make an early payment for a tax deduction in the current year.
Public Policy Limitation
Payment in violation of public policy is not a necessary expense and is not deductible. A deduction would be indirectly subsidizing a taxpayer's wrongdoing. Deductions for bribes and kickbacks, including those associated with Medicare or Medicaid and fines AND penalties paid to a government for violation of law are disallowed AND 2/3 of the treble damage payments made to claimants resulting from violation of the antitrust law.
Bribe or Kickback Disallowance
To be disallowed, the bribe or kickback must be illegal under either Federal or state law and must also subject the payor to a criminal penalty or the loss of a license or privilege to engage in a trade or business. For a bribe or kickback under state law, a deduction is denied if the state law is generally enforced.
Legal Expenses Incurred in Defense of Civil or Criminal Penalties
To deduct legal penalties, the taxpayer must be able to show that the origin and character of the claim are directly related to a trade or business; an income-producing activity; or the determination, collection, or refund of a tax. Deductible legal expenses associated with the following are deductible for AGI: (1) ordinary and necessary expenses incurred in connection with a trade or business, and (2) ordinary and necessary expenses incurred in conjunction with rental or royalty property held for the production of income. All other deductible legal expenses are deductible from AGI.
Expenses Relating to an Illegal Business
The usual expenses of operating an illegal business are deducible. While this may seem inappropriate, remember the law taxes net income from a business operation, not gross revenue. Drug dealers, however, are not allowed a deduction for ordinary and necessary business expenses. In arriving at gross income from the business, however, dealers may reduce total sales by the COGS.
Political Contributions and Lobbying Activities
No business deduction is permitted for direct or indirect payments for political purposes. Lobbying expenses incurred in attempting to influence state or Federal legislation are not deductible. This disallowance also applies to a pro rata portion of the membership dues of trade associations and other groups that are involved in lobbying activities. There are three exemptions to the disallowance of lobbying activities: (1) an exception is provided for influencing local legislation, (2) the disallowance provision does not apply to activities devoted solely to monitoring legislation, and (3) a de minimis exception is provided for annual in-house expenditures (lobbying expenses other than those paid to professional lobbyists or any portion of dues used by associations for lobbying) if such expenditures don't exceed $2,000. If $2,000 is exceeded, none of the in-house expenditures can be deducted.
Excessive Executive Compensation
Deduction of executive compensation is subject to two limitations: (1) the compensation of shareholder-employees of closely held corporations is subject to the reasonableness requirement and (2) the millionaires' provision applies to publically held corporations. The millionaire's provision limits the amount the employer can deduct for the taxable compensation of a covered executive to $1 million annually. The disallowance does not apply to commissions based on individual performance or overall company performance.
Investigation of a Business
How investigation expenses are treated depends on: (1) The current business of the taxpayer, if any. (2) The nature of the business being investigated. (3) The extent to which the investigation has proceeded. (4) Whether the acquisition takes place. If the taxpayer is in a business that is similar or the same as that being investigated, all investigation expenses are deductible in the year paid or incurred (whether the investigated business is acquired or not). When the taxpayer is not in a business that is the same as or similar to the one being investigated, the tax result depends on whether the new business is acquired. If the business is not acquired, the investigation expenses are nondeductible. If the taxpayer is not in a business that is the same as or similar to the one being investigated and actually acquires the new business, the expenses must be capitalized as startup expenditures.
Expenses paid or incurred to determine the feasibility of entering a new business or expanding an existing business. Include costs such as travel, engineering and architectural surveys, marketing reports, and various legal and accounting services.
Nine Factors to Consider in Determining if an Activity is a Hobby
(1) Whether the activity is conducted in a businesslike manner.
(2) The expertise of the taxpayers or their advisers.
(3) The time and effort expended.
(4) The expectation that the assets will appreciate in value.
(5) The taxpayer's previous success in conducting similar activities.
(6) The history of income or losses from the activity.
(7) The relationship of profits earned to losses incurred.
(8) The financial status of the taxpayer.
(9) Elements of personal pleasure or recreation in the activity.
Presumptive Rule of Section 183
An activity is profit-seeking if the activity shows a profit in at least three of the previous five tax years. If the activity involves horses, a profit must shown in at least 2 of the last 7 years. If these profitability tests are met, the activity is a trade or business. If not, it is presumed a hobby.
Primarily Personal Use
If the residence is rented for fewer than 15 days in a year, it is treated as a personal residence. The rent income is excluded from gross income, and mortgage interest and real estate taxes are allowed as itemized deductions. No other expenses are deductible.
Primarily Rental Use
If the residence is rented for 15 days or more in a year and is not used for personal purposes for more than the greater of (1) 14 days or (2) 10% of the total days rented, the residence is treated as rental property. If there are personal rental days, the expenses must be allocated. The real estate taxes allocated to personal days are deductible as an itemized deduction. Mortgage interest allocated to personal days cannot be deducted. The deduction of the expenses allocated to rental days can exceed rent income and result in a rental loss. The loss may be deductible.
If the residence is rented for 15 days or more in a year and is used for personal purposes for more than the greater of (1) 14 days or (2) 10% of the total days rented, it is treated as a personal/rental use residence. Expenses must be allocated between personal and rental days. Expenses are only allowed to the extent of rent income. The expenses that are deductible anyway must be deducted first. If a positive net income results, expenses, other than depreciation, that are deductible for rental property are allowed next. If and positive balance remains, depreciation is allowed. Any disallowed expenses allocable to rental use are carried forward and used in future years subject to the same limitations. Expenses must be allocated between personal and rental days before the limit are applied. Courts have held that real estate taxes and mortgage interest are allocated on the basis of 365 days. The IRS allocates real estate taxes and mortgage interest on the basis of total days of use. Other expenses are allocated on the basis of total days used.
Expenditures Incurred for Taxpayer's Benefit or Taxpayer's Obligation
To be deductible, and expense must be incurred for the taxpayer's benefit or arise from a taxpayer's obligation. An individual cannot claim a tax deduction for the payment of the expenses of another individual. Medical expenses, however, are deductible by the payor subject to the normal rules that limit the deductibility of medical expenses.
Disallowance of Personal Expenditures
Except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.
Deduction of Legal Fees in Connection with a Divorce
To be deductible, an expense must relate solely to tax advice in a divorce proceeding.
Disallowance of Deductions for Capital Expenditures
The Code disallows a deduction for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. Incidental repairs and maintenance are not capital expenditures and can be deducted as ordinary and necessary. All costs incurred in acquiring or producing a Unit of Property (UOP) are included in its cost, except for employee compensation and overhead costs; the taxpayer can elect to capitalize one, none, or both.
Related Parties Include
(1) Brothers and sisters, spouse, ancestors, and lineal descendants of the taxpayers.
(2) A corporation that is owned more than 50% by the taxpayer.
(3) Two corporations that are members of a controlled group.
(4) A series of other complex relationships between trusts, corporations, and individual taxpayers.
Under these provisions, stock owned by certain relatives or related entities is deemed to be owned by the taxpayer for purposes of applying the loss and expense deduction disallowance provisions.
The tax law is built on a voluntary compliance system. The taxpayer has the burden of proof for substantiating expenses deducted on the returns and must retain adequate records. Upon audit, the IRS can disallow any undocumented or unsubstantiated deductions. This is important in travel, entertainment, gift expenses, rental property, and the basis of an asset.
Expenses and Interest Relating to Tax-Exempt income
The Code disallows as a deduction the expenses of producing tax-exempt income. Interest on any indebtedness used to purchase or hold tax-exempt obligations is also disallowed. The law does not permit a taxpayer to profit at the expense of the government by excluding interest income and deducting interest expense.
You might also like...
Chapter 6 Deductions and Losses
Exam 3 Federal Tax Accounting
Other sets by this creator
Exam 2 Review
Chapter 13 Vocab
Chapter 12 Vocab
Chapter 11 Vocab
Other Quizlet sets
Abnormal Psychology Chapter 7
Ger101 Final Study Guide
K-6 Social Science Part 1