Chapter 6

Deductions and Losses:

In General
Comprehensive Volume
2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture (slide 1 of 2)

Dr. Cliff Payne determines that his deductible expenses associated with his
dental practice are as follows:
Salaries including FICA (unpaid at year-end of $5,000)
$120,000
Building rent
24,000
Depreciation of dental equipment and office
furnishings and equipment
52,000
Insurance (malpractice and of dental equipment
and office furnishings and equipment)
22,000
Dental supplies
16,000
Office supplies
3,000
Investigation expenses 6,000
Contribution to U.S. Senate campaign fund of Tom Smith
1,000
Contribution to U.S. Senate campaign fund of Virginia White 1,000
Legal expenses associated with patient lawsuit (jury decision for
defendant)
4,000
Fine imposed by city for improper disposal of medical waste
3,000
Draw by Dr. Payne for living expenses ($5,000 monthly)
60,000
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The Big Picture (slide 2 of 2)

Has Dr. Payne correctly calculated the business
expenses for his dental practice?
Read the chapter and formulate your response.

Deductions
Exclusive definition of deductions
Deductions are allowed based on legislative grace
and defined narrowly
Substantiation requirements
Taxpayer has burden of proof for substantiating all
expenses deducted on return
Thus, adequate records of expenses must be maintained

Deductions for and

from AGI (slide 1 of 3)
Deductions for AGI
Can be claimed even if taxpayer does not itemize
Important in determining the amount of certain
itemized deductions
Certain itemized deductions are limited to amounts in
excess of specified percentages of AGI
e.g., Medial expenses (7.5% or 10% of AGI), misc. itemized
deductions ( 2% of AGI)

Deductions for and

from AGI (slide 2 of 3)
Deductions from AGI:
In total, must exceed the standard deduction to
provide any tax benefit
Called below the line or itemized deductions

Deductions for and

from AGI (slide 3 of 3)
Comparison of deductions for and from AGI
(2013 tax year)
Single taxpayer has gross income of $45,000 and
a $6,500 deduction
For AGI From AGI
Gross income
$45,000 $45,000
Less: for AGI ded.
6,500
AGI
$38,500
$45,000
Less: from AGI ded.
6,100
Less: personal exempt.
3,900
Taxable income
$28,500 $34,600

0
6,500
3,900

Deductions for AGI

(slide 1 of 3)

Partial list includes:

Trade or business expenses
Reimbursed employee business expenses
Deductions from losses on sale or exchange of
property
Deductions from rental and royalty property
Alimony
One-half of self-employment tax paid
8

Deductions for AGI

(slide 2 of 3)

Partial list includes:

100% of health insurance premiums paid by a selfemployed individual
Contributions to pension, profit sharing, annuity
plans, IRAs, etc.
Penalty on premature withdrawals from time
savings accounts or deposits
Moving expenses

Deductions for AGI

(slide 3 of 3)

Partial list includes:

Interest on student loans
Qualified tuition and related expenses under 222
Up to $250 for teacher supplies for elementary and
secondary school teachers (if extended to 2014 by
Congress)

10

Deductions from AGI

Itemized deductions include:

Medical expenses (in excess of 7.5% or 10% of AGI)

Certain state and local taxes
Contributions to qualified charitable organizations
Personal casualty losses (in excess of 10 % of AGI and a
$100 floor per casualty)
Certain personal interest expense (e.g., mortgage interest
on a personal residence)
Miscellaneous itemized deductions (in excess of 2% of
AGI)
11

Trade or Business Deductions

(slide 1 of 2)

Section 162(a) permits a deduction for all

ordinary and necessary expenses paid or
incurred in carrying on a trade or business
including:
Reasonable salaries paid for services
Expenses for the use of business property
One-half of self-employment taxes paid

Such expenses are deducted for AGI

12

Trade or Business Deductions

(slide 2 of 2)

In order for expenses to be deductible, they

must be:
Ordinary: normal, usual, or customary for others in
similar business, and not capital in nature
Necessary: prudent businessperson would incur
same expense
Reasonable: question of fact
Incurred in conduct of business

13

Section 212 Expenses (slide 1 of 2)

Section 212 allows deductions for ordinary
and necessary expenses paid or incurred for
the following:
The production or collection of income
The management, conservation, or maintenance of
property held for the production of income
Expenses paid in connection with the
determination, collection, or refund of any tax

14

Section 212 Expenses (slide 2 of 2)

212 expenses that are deductions for AGI include:
Expenses related to rent and royalty income
Expenses paid in connection with the determination,
collection, or refund of taxes related to the income of sole
proprietorships, rents and royalties, or farming operations

All other 212 expenses are itemized deductions

(deductions from AGI)
For example, investment-related expenses (e.g., safe
deposit box rentals) are deductible as itemized deductions
attributable to the production of investment income
15

Business And
Nonbusiness Losses
Deductible losses of individual taxpayers are
limited to those:
Incurred in a trade or business,
Incurred in a transaction entered into for profit

Individuals may also deduct casualty losses

from fire, storm, shipwreck, and theft

16

Methods of Accounting
The method of accounting affects when
deductions are taken
Cash: expenses are deductible only when paid
Accrual: expenses are deductible when incurred
Apply the all events test and the economic performance
test
Exception to the economic performance test for recurring
items

17

Disallowance Possibilities
The tax law disallows the deduction of certain types
of expenses for a variety of reasons
e.g., May restrict taxpayer attempts to deduct certain items
that, in reality, are personal expenditures

Certain disallowance provisions are a codification or

extension of prior court decisions
e.g., After courts denied deductions for payments in
violation of public policy, tax law was changed to provide
specific authority for the disallowance

18

Expenditures Contrary
To Public Policy
Deductions are disallowed for certain specific
types of expenditures that are considered
contrary to public policy
Examples: penalties, fines, illegal bribes or
kickbacks, two-thirds of treble damage payments
for violation of anti-trust law

19

The Big Picture - Example 13

Nondeductible Fines
Return to the facts of The Big Picture on p. 6-1.

Dr. Payne had not instituted proper procedures for

disposing of medical waste from his laboratory.
During the current tax year, he was fined $3,000 by
the city.
Dr. Payne believes the fine should be deducted as
an ordinary business expense.

However, because the fine was due to a

violation of public policy, the $3,000 is not
deductible.
20

Legal Expenses Incurred In Defense

Of Civil Or Criminal Penalties
To deduct legal expenses
Must be directly related to a trade or business, an
income producing activity, or the determination,
collection, or refund of a tax
e.g., Corporate officers legal fees in defending against
price-fixing charges
e.g., Landlords legal fees associated with eviction of
tenant

21

Expenses Relating To
An Illegal Business
Usual expenses of operating an illegal business
are deductible
However, deduction for fines, bribes to public
officials, illegal kickbacks, and other illegal
payments are disallowed

Trafficking in controlled substances: only cost

of goods sold can reduce gross income

22

Political Contributions And

Lobbying Activities
Generally, no business deduction is allowed
for payments made for political purposes or
for lobbying
Exceptions are allowed for lobbying:
To influence local legislation,
To monitor legislation, and
De minimis in-house expenses (limited to $2,000)
If greater than $2,000, none can be deducted

23

The Big Picture - Example 17

Political Contributions
Return to the facts of The Big Picture on p. 6-1.
Dr. Payne made political contributions to the State Senate
campaigns of Tom Smith and Virginia White.
Dr. Payne made these contributions to encourage these
senators to support a new bill that is beneficial to the states
dental profession.
Therefore, he assumed that these would be deductible
business expenses.

However, political contributions are not deductible,

so he will receive no tax benefit from them.
24

Excessive Executive Compensation

(slide 1 of 2)

For publicly held corporations:

Deduction for compensation of CEO and four
other highest compensated officers is limited to $1
million each
Does not include:
Certain performance-based compensation
Payments to qualified retirement plans
Payments excludible from gross income

25

Excessive Executive Compensation

(slide 2 of 2)

An additional limitation applies only to

covered executives of companies receiving
Troubled Asset Relief Program (TARP)
assistance
The deduction for compensation paid to a covered
executive is limited to $500,000
Covered employees include the CEO, the CFO,
and the three other most highly compensated
officers

26

Investigation Of A Business
(slide 1 of 3)

Investigation expenses - incurred to determine the

feasibility of entering a new business or expanding an
existing business
Include costs such as travel, engineering, architectural
surveys, marketing reports, various legal and accounting
services

Tax treatment of these expenses depends on:

The current business, if any, of the taxpayer

The nature of the business being investigated
The extent to which the investigation has proceeded
Whether or not the acquisition actually takes place
27

Investigation Of A Business
(slide 2 of 3)

If the taxpayer is in a business the same as or

similar to that being investigated
Investigation expenses are deductible in the year
paid or incurred
The tax result is the same whether or not the taxpayer
acquires the business being investigated

28

Investigation Of A Business
(slide 3 of 3)

When the taxpayer is not in a business the same as or

similar to that being investigated
Tax result depends on whether new business is acquired
If not acquired
All investigation expenses generally are nondeductible

If acquired
Investigation expenses must be capitalized
May elect to deduct the first $5,000 of expenses currently
Any excess expenses can be amortized over a period of not less than
180 months (15 years)
In arriving at the $5,000 immediate deduction allowed, a dollar-fordollar reduction must be made for those expenses in excess of
$50,000

29

The Big Picture - Example 19

Investigation Of A Business (slide 1 of 2)

Return to the facts of The Big Picture on p. 6-1.

Dr. Payne believes that his administrative and

business skills can be used to turn around dental
practices whose revenues have been declining.
He investigates Teeth Restoration, LLC, a local dental
practice that is for sale.

Expenses paid to consultants and accountants as

part of this investigation totaled $6,000.
He determined that Teeth Restoration would not be
a good investment, so he did not buy it.
30

The Big Picture - Example 19

Investigation Of A Business (slide 2 of 2)

Return to the facts of The Big Picture on p. 6-1.

The $6,000 spent to investigate this business is

deductible as a business expense because Dr. Payne is
already in the dental business.
Investigating new business opportunities in ones current
trade or business is an ordinary and necessary business
expense.

31

Hobby Losses (slide 1 of 8)

Hobby defined
Activity not entered into for profit
Personal pleasure associated with activity
Examples: raising horses, fishing boat charter

If an activity is not engaged in for profit, the

hobby loss rules apply
Hobby expenses are deductible only to the extent
of hobby income

32

Hobby Losses (slide 2 of 8)

Profit activity
If activity is entered into for profit, taxpayer can
deduct expenses for AGI even in excess of income
from the activity
At-risk and passive loss rules may apply

Often it is difficult to determine if an activity

is profit motivated or a hobby
Regulations provide nine factors to consider in making
this determination
33

Hobby Losses (slide 3 of 8)

Presumptive rule of 183
If activity shows profit 3 out of 5 years (2 out of 7
years for horses), the activity is presumed to be a
trade or business rather than a personal hobby
Rebuttable presumption, shifts burden of proof to IRS

Otherwise, taxpayer has burden to prove profit

motive

34

Hobby Losses (slide 4 of 8)

Year

Income (loss)

2008
2009
2010
2011
2012
2013
2014

$500
(1,500)
700
(1,000)
900
(500)
1,200

Hobby?

Yes
Yes
Yes
Yes
No, profit 3 of 5 years
Yes, profit only 2 of 5 years
No, profit 3 of 5 years
35

Hobby Losses (slide 5 of 8)

If an activity is deemed to be a hobby
Can only deduct expenses to extent of income
from activity (i.e., cannot deduct hobby losses)

36

Hobby Losses (slide 6 of 8)

If an activity is a hobby:
Expenses are deductible from AGI
Treated as miscellaneous itemized deductions subject to
the 2% of AGI limitation
Exception: expenses that are deductible without regard
to profit motive are deductible in full, such as
Home mortgage interest
Property taxes

37

Hobby Losses (slide 7 of 8)

Order in which hobby expenses are deductible:
First: Those otherwise deductible: e.g., home
mortgage interest and property taxes
Then: Expenses that do not affect adjusted basis:
e.g., maintenance, utilities
Then: Expenses that affect adjusted basis: e.g.,
depreciation (or cost recovery)

38

Hobby Losses (slide 8 of 8)

Example of hobby expenses: Taxpayer sells

horses raised as a hobby for $15,500

Amount

Order

Amount

Income

$15,500

Interest

6,000

$ 6,000

Taxes

3,000

3,000

Vet Bills

2,000

2,000

Feed

4,000

4,000

Depreciation

1,000

Ltd. to 500

Total

15,500

39

Rental Vacation Homes

(slide 1 of 9)

May have both personal and rental use of a

vacation home
Deduction of rental expenses may be limited
to rental income if primarily used for personal
purposes
Determination of vacation home treatment is
dependent on personal use vs. rental use

40

Rental Vacation Homes

(slide 2 of 9)

Rental days
Less than 15 days: No gross income recognized
from rentals and no deductible rental expenses
Mortgage interest and property taxes treated as if on
personal residence (generally deductible in full)

More than 14 days: Treatment depends on amount

of personal use

41

Rental Vacation Homes

(slide 3 of 9)

Primarily rental use

If rented for 15 days or more and personal use
days NOT more than the greater of 14 days or 10
percent of fair rental days
Can deduct all expenses allocated to rental use
even if loss results
Rental loss subject to at-risk and passive loss rules

42

Rental Vacation Homes

(slide 4 of 9)

Personal/rental use
If rented for 15 days or more and personal use
days exceed the greater of 14 days or 10% of fair
rental days
Treated similar to hobby
Rental expenses deducted in three step process
No rental loss allowed
Carryforward of disallowed rental expenses

43

Rental Vacation Homes

(slide 5 of 9)

Example of personal use

Rental days: 200 (10% = 20)
Personal use
7 days
18 days
25 days

Not Significant
X
X

Significant

X
44

Rental Vacation Homes

(slide 6 of 9)

Example of personal use

Rental days: 100 (10% = 10)
Personal Use
7 days
14 days
18 days

Not Significant
X
X

Significant

X
45

Rental Vacation Homes

(slide 7 of 9)

Allocation of expenses between personal and

rental
Mortgage interest and real estate taxes
IRS requires allocation based on total days used
Courts have allowed allocation based on days in year

Other expenses are allocated based on total days

used

46

Rental Vacation Homes

(slide 8 of 9)

Tax treatment of income and expenses of a

primarily rental vacation home
Rental income included in gross income
Rental expenses deductible for AGI
Rental income and expenses reported on Sch. E

47

Rental Vacation Homes

(slide 9 of 9)

Treatment of allocated personal portion of

vacation home expenses
Primarily rental use: taxes deductible from AGI,
mortgage interest nondeductible (personal interest)
Personal/rental use: mortgage interest and taxes
deductible from AGI
Personal portion of other expenses (e.g., insurance,
maintenance) nondeductible

48

Expenditures Incurred for Taxpayers

Benefit or Obligation
No deduction is allowed for payment of
another taxpayers expenses
Must be incurred for taxpayers benefit or arise
from taxpayers obligation
Exception: Payment of medical expenses for a
dependent

49

Personal Expenditures
Unless otherwise provided in the Code,
personal expenses are not deductible

50

Capital Expenditures
Amounts are capitalized
Asset may be subject to depreciation (or cost
recovery), amortization, or depletion

51

Transactions Between Related Parties

(slide 1 of 2)

Section 267 disallows losses from direct or

indirect sales or exchanges of property
between related parties
Family and entity relationships apply
Constructive ownership rules apply
Loss disallowed may reduce gain on subsequent
disposition to unrelated third party

52

Transactions Between Related Parties

(slide 2 of 2)

Section 267 also requires the matching

principle be applied for unpaid expenses and
interest when different accounting methods
used
Example: An accrual basis, closely held
corporation, cannot deduct accrued, but unpaid,
salary to cash basis related party
employee/shareholder until it is actually paid

53

Expenses and Interest Relating to

Tax-Exempt Income
Expenses relating to production of tax-exempt
income are nondeductible
Example: interest expense on loan where funds
used to acquire municipal bonds

54

The Big Picture - Example 42

Tax Planning - Shifting Deductions
Referring to the facts of The Big Picture on p. 6-1,

Assume that Dr. Paynes marginal tax rate in 2014 is

25% but that he estimates his rate in 2015 to be 40%.
In this case, he should consider deferring the
charitable contribution to UNA College until 2015.
His tax benefit in 2015 will be $2,000.
(40% X $5,000)
His tax benefit in 2014 would only be $1,250.
(25% $5,000)

55

Refocus On The Big Picture (slide 1 of 2)

Of the expenses incurred by Dr. Payne, several comments need
to be made.
Being personal in nature, none of the $5,000 monthly draw
is deductible and the amount involved is not subject to the
reasonableness test (see Example 6).
Dr. Payne is a sole proprietor and not in an employment
relationship.

The fine paid for violating waste control rules comes under
the public policy limitations (see Example 13) and is
specifically made nondeductible by Code 162(f).
Along the same line are the political contributions
(Example 17) made nondeductible by 162(e).
56

Refocus On The Big Picture (slide 2 of 2)

However, Dr. Paynes investigation of the
practice of another dental firm (Example 19)
appears reasonable and the expense incurred
deductible.
Although not specifically discussed in the text,
Dr. Paynes legal fees incurred in connection
with a lawsuit filed by a patient appear related
to his practice (Example 15).
As such, they are ordinary and necessary to his
trade or business.

57

If you have any comments or suggestions concerning this

PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta

2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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