Basic Income Tax Business and Profit Seeking Expenses

Professor Jack Williams

Deductions
Various deductions and allowances are

permitted by the IRC based on tax logic or tax favoritism These deductions and allowances are subtracted from gross income to arrive at taxable income, the tax base under the IRC Deductions may be broadly clustered into two categories:

Profit-related activities Personal activities

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General Rule: Business Expenses

Policy Point: Tax is imposed on net income

and not gross receipts from a business venture IRC 162 codifies that policy by providing that that it is appropriate to offset gross income by expenditures incurred in earning that income Business income (loss) is entered on Line 12, Form 1040 through Schedule C, for an individual
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Status of Deduction on Form 1040

IRC 162 is an above the line deduction

Adjustment to Adjusted Gross Income (AGI) Not subject to standard deduction No need to itemize deductions to use

Section 162 Deductions

IRC permits a deduction for ordinary and

necessary expenses paid or incurred during a taxable year in carrying on a trade or business. IRC 162(a). Burden of proof on deductions shouldered by the taxpayer.

Methodology: IRC 162

Ordinary and Necessary

Expenses
Carry on Trade or business

ORDINARY AND NECESSARY

Ordinary:

Expenditure is ordinary if it is one that is common within the industry even if once-ina-lifetime expenditure for the actual taxpayer. Courts employ a horizontal test.
Expenditure is necessary if appropriate and helpful to the business. Court employs a reasonableness test. If expense can be reimbursed, then it is not necessary.
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Necessary:

Proof Issue re Ordinary and Necessary

Ultimately, the resolution of these issues

turns on a careful consideration of the facts of each case. Because of changes in attitudes and business norms, what may not have been ordinary and necessary in the past may no longer be controlling

EXPENSES
Rule 1: A 162 deduction is allowed only for

an item of expense and not a capital expenditure. Rule 2: Capital expenditures (Cap X) may not be deducted at the time the amount is paid or incurred

Rather, the Cap X may give rise to deductions for depreciation in later years.

Rule 3: Cap X are generally added to basis

under IRC 1016(a)(1).

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Deduction v. Cap X
Recognize, in the business context, the difference

between deduction and Cap X is one of timing and the time value of money. However, in personal context, the difference between deduction and Cap X may be more substantively important

Personal deductions generally not permitted Cap X still added to basis

What is the difference between a current deduction

for an expense and a Cap X?

Courts hold that the difference is a fact question.

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Capital Expenditures: Clusters of Fact

Clusters of facts lead to certain results: Cost of acquisition of assets (tangible or intangible) that has a useful life beyond the taxable year Cost that add to value of property, substantially prolong the useful life of property, or adapt the property to a new or different use. Business acquisition costs Cost incurred in perfecting or clearing title to assets Prepaid expenses

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Deductions That Might Look Like Cap X

Improvement v. Repair: Incidental repair or

maintenance of business property are expenses

Fact issue Product and service advertising Goodwill or institutional advertising

Advertising costs are expenses

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CARRY ON
Rule: Expenses are deductible only if

incurred while carrying on a trade or business.

Expenses incurred in acquiring a new trade or business or generally not deductible.

These expenses are generally added to basis.

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Expanding Existing Trade

What about the expansion of an existing

trade or business?

These expenses are generally deductible

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Investigating New Trade

What about investigating a new trade or

business?

These expenses are treated as a Cap X.

If the investigation reaches a transactional

stage and is dropped before a trade or business is developed or acquired, then the transactional expenditures may give rise to a loss deduction. IRC 165(c)(2).

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Start-Up Expenses
What about start-up expenditures?

Violate the carry on element and are not deductible

Rule: Some expenses incurred in acquiring

or starting a new trade or business may be deducted as start-up expenditures if the taxpayer elects. See IRC 195.

Under 195, these expenditures are deducted ratably over at least 60 months (time period selected by taxpayer) and begins in the month in which the active business begins.

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Special Case: Employee Seeks Employment

What about the expenses incurred in obtaining

employment as an employee? Individual may be in the trade of business of providing services as employee.

Expenses incurred in obtaining another job in the same line of work are deductible Expenses incurred in obtaining another job in a new line of work are not deductible Expenses incurred in obtaining ones first job not deductible

Section 195 does not seem applicable.

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TRADE OR BUSINESS
Does the taxpayers profit-seeking

activities constitute a trade or business?

Taxpayer must have a profit motive for engaging in the activity that gives rise to the expense Personal expenses are generally not deductible

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STATUTORY EXAMPLES UNDER SECTION 162

Reasonable Allowance for Salaries

Traveling Expenses While Away From Home

Rentals of Property for Purpose of Trade or

Business

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Reasonable Allowance of Salaries

Section 162(a)(1) permits a deduction for

reasonable allowance of salaries Salaries must be:

Reasonable For personal services performed

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Factors of Reasonable Compensation

Factors: Position Hours worked Duties performed Importance of the employee to business Comparison of past duties and performance to present Horizontal comparison with comparable companies Size of company, complexity of business, and general economic conditions Potentially exploitable relationship (cuts against) Existence of bonus system that distributes nearly all of pre-tax earnings of company (cuts against)
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Contingent Compensation
If employment agreement provides for

compensation based on future events, such as percentage of profits, then amount actually paid is reasonable if fruits of arms length bargain and reasonable when the agreement was made.

If agreement is not product of arms length bargaining, then it must be reasonable at time it was paid

Concern: Compensation may be

disguised dividend or de facto dividend.

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Personal Service Performed

Payment of salary must be for personal

services actually rendered. Payment to taxpayer as partial payment for property transferred or as disguised dividend do not qualify as salary

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Traveling Expenses While Away From Home

Rule: Deduction is permitted for traveling expenses,

including lodging and a portion of the cost of meals, incurred while a taxpayer is away from home in the pursuit of a trade or business. IRC 162(a)(2). Three requirements:

Expense must be reasonable and necessary traveling expense (cannot be extravagant or lavish) Expense must be incurred while away from home Expense must be incurred in the pursuit of business Further limit with meals: 50% limit on deductibility

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Travel Expenses

Airplane Rental car Train Taxis Meals and lodging Incidentals

Tips, telephone calls, internet access, baggage charges, postage, laundry, handicapped traveler aid
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Commuter expense do not qualify

Away From Home

Taxpayer must have a tax home for federal income

tax purposes

A taxpayer may not have a tax home

Presumption is that the principal place of business

(and not her abode) is a taxpayers tax home Principal place of business:

Amount of income earned at each location Nature and extent of business activity that takes place in each location Amount of time spent at each location

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Temporary Assignment
TAD must be expected to be less than one

year and must in fact be less than one year. If temporary assignment is greater than one year (regardless of intent), then no portion of expenses may be deducted.

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Overnight Rule
Rule: Deduction permitted for expenses

incurred in lodging and 50% of meals only if taxpayer is away from home overnight. Overnight means:

Taxpayer is away from home long enough to require her to stop for substantial sleep or rest no matter what distance she travels or mode of transportation she employs. Otherwise, nondeductible personal expense under 262.
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Travel for Business and Personal

Rule 1: Expenses for travel to and from are

fully deductible if the primary reason for the trip is business.

There is no allocation requirement for travel expense to and from.

Rule 2: Expenses once present are

deductible only to the extent they are properly allocable to the business. Special rules for foreign travel. No deduction for spouse or dependents.
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Meals
Away from home: 50% if not extravagant or

lavish Not away from home: 50% but only if present and related directly to trade or business, that is, an entertainment expense (more restrictive test) IRC 274 (50% limitation)

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Rentals of Property for Purpose of Trade or Business

Rule 1: Deductions permitted for rentals or

other payments for use of property in a taxpayers trade or business. IRC 162(a)(3). Transfer/Lease-Back:

Is there a legitimate business purpose for the transaction?

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Miscellaneous Business Deductions

Interest (IRC 163)

Education
Entertainment Uniforms

Dues
Periodicals Utilities Taxes (IRC 164) Health insurance for self-employed individuals Charitable donations (IRC 170)
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Payment of Interest
Deduction for interests payments on business

loans (IRC 163). Generally no deduction for payments of interest on personal loans with several important exceptions:

Home mortgage interest deductions Certain qualified student loans for qualifying taxpayers

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Payment of Educational Expenses

Deduction permitted if either the education

maintains or improves skills required by a taxpayer in his employment or other trade or business or if education meets express requirements imposed by law or a taxpayers employment, status, or rate of compensation. Treas. Reg. 1.162-5(a). No deduction if education is necessary to qualify for trade or business or meet minimum educational requirements.
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Travel and Education

Travel as education: No deduction.

Travel to obtain education: Deductible if

162 requirements are met.

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Miscellaneous Deductions contd

Entertainment

Uniforms

Meals and entertaining: Must show demonstrable business benefit. Generally 50% limit. Section 274 limitation.

Work clothing specifically required as condition of employment and not adaptable to general use. Think police, nurses, sports uniforms, Mr. Goodwrench, fire fighters, etc. Do not think military uniforms of full-time active duty personnel If uniform cost is deductible, then maintenance is deductible.
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Miscellaneous Deductions contd

Dues Deduction permitted for dues directly related to taxpayers employment or other trade or business. Periodicals Deduction permitted for periodicals and books whose useful life is short if they relate to taxpayers business.

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Miscellaneous Deductions contd

Utilities Deductible if they are necessary for carrying on trade or business. Taxes Deductible if specifically enumerated under IRC 164, including certain state and local and foreign taxes.

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Miscellaneous Deductions contd

Health insurance for

self-employed individuals

Self-employed taxpayer may deduct the costs of medical insurance coverage for himself, spouse, and dependents

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Substantiation
Rule: If a taxpayer does not have

substantiation of a deduction, then a court may allow an estimate of the expense unless the IRC specifically requires substantiation.

Estimation is known as the Cohan rule. IRC 274(d) requires substantiation for the following expenses:

Traveling expenses (including lodging and meals away from home), business gifts, entertainment expenses, and business meals.
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Section 212: Profit-Seeking Activity

Section 212 permits a deduction in certain

circumstances for ordinary and necessary expenses incurred or paid in furtherance of profit-seeking activity, specifically:

The production or collection of income Dealing with property that is being held for the production of income Dealing with tax matters

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212: General Rule

Item must be:

Ordinary and necessary Expense Must not be inherently personal in nature Must be individual (or by extension, estate or trust by personal representative or trustee)

Cannot be a corporation and use 212

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212: Production or Collection of Income

Ordinary and necessary expenses incurred in

a taxable year for the production or collection of income are deductible by individual taxpayer. Expenses need not match income in the same year.

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212: Management of Income Producing Property

Ordinary and necessary expenses incurred in

a taxable year for the management, conservation, or maintenance of property held for the production of income are deductible. This is the case even where the property is not currently producing income or even where the property may be sold for a loss.

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212: Expense in Connection with Taxes

Deduction for expenses incurred in

connection with the determination, collection, or refund of any tax. Includes:

Preparing return, contesting tax liability, or determining tax consequences of proposed action

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Key Differences Between 162 and 212

Section 212 deduction is below the line, that

is, that a taxpayer must itemize deductions to receive any tax benefit. Section 162 is an above the line deduction no need to itemize to receive a tax benefit. Section 212 does not require that taxpayer is actually carrying on trade or business to qualify. Section 162 requires carrying on trade or business.
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Conclusion
Questions?

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