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Chapter 6- Deductions & Losses: Certain Business Expenses & Losses

Business expenses and losses are reductions of gross income to arrive at the taxpayers AGI o Expenses & losses incurred in connection with a transaction entered into for profit & attributable to rents and royalties are deducted for AGI o All other expenses & losses incurred in a transaction entered into for profit are deducted from AGI Deductible losses on personal use property are deducted as an itemized deduction; itemized deductions are deductions from AGI A business bad debt is classified as a deduction for AGI; a non-business bad debt is classified as a short-term capital loss

Bad Debts
A bad debt deduction is permitted only if income arising from the creation of the account receivable was previously included in income o No deduction is allowed from a bad debt arising from the sale of a product or service when the taxpayer is on the cash basis This is because no income is reported until the cash has been collected o If a bad debt deduction was allowed for a cash basis taxpayer, it would amount to a double deduction This is because the expenses of the product or service rendered are deducted when payments are made to suppliers & to employees, or at the time of the sale A bad debt can also result from the non-repayment of a loan made by the taxpayer or from purchased debt instruments Specific Charge-Off Method Taxpayers (other than certain financial institutions) may use only the specific charge-off method in accounting for bad debts o Certain financial institutions are allowed to use the reserve method for computing deductions for bad debts A taxpayer using the specific charge-off method may claim a deduction when a specific business debt becomes either partially or wholly worthless or when a specific non-business debt becomes wholly worthless o Taxpayer must satisfy the IRS that the debt is partially worthless & demonstrate the amount of worthlessness If a business debt previously deducted as partially worthless becomes totally worthless in a future year, only the remainder not previously deducted can be deducted in the future year In the case of total worthlessness, a deduction is allowed for the entire amount in the year the debt becomes worthless o The amount depends on the taxpayers basis in the bad debt If the debt arose from the sale of services/products & the face amount was previously included in income, that amount is deductible If the taxpayer purchased the debt, the deduction is equal to the amount the taxpayer paid for the debt instrument

The loss is deductible only in the year of partial or total worthlessness for business debts & only in the year of total worthlessness for non-business debts o Bankruptcy is generally an indication of at least partial worthlessness of a debt If it creates worthlessness before the settlement date, the deduction may be taken in the year of worthlessness If a receivable has been written off (deducted) as uncollectible during the current tax year & is subsequently collected during the current tax year, the write-off entry is reversed o If a receivable has been written off as uncollectible, the collection of the receivable in a later tax year may result in income being recognized Income will result if the deduction yielded a tax benefit in the year it was taken Business versus Non Business Debts A non-business bad debt is a debt unrelated to the taxpayers trade or business either when it was created or when it became worthless o The nature of a debt depends on whether the lender was engaged in the business of lending money or whether there is a proximate relationship between the creation of the debt & the lenders trade or business o The use to which the borrowed funds are put by the debtor is irrelevant o Loans to relatives or friends are the most common type of non-business bad debt A business bad debt is deductible as an ordinary loss in the year incurred; a non-business bad debt is always treated as a short-term capital loss o The deduction of a non-business bad debt may be of limited benefit due to the limitations on capital loss deductibility in any one year The maximum amount of a net-short term capital loss an individual can deduct against ordinary income in any one year is $3,000 Although no deduction is allowed when a non-business bad debt is partially worthless, the taxpayer is entitled to deduct the net amount of the loss upon final settlement Non-business bad debt provisions are NOT applicable to corporations; it is assumed that any loans made by a corporation are related to its trade or business Loans between Related Parties Loans between related parties raise the issue of whether the transaction was a bona fide loan or a gift Regulations state that a bona fide debt arises from a debtor-creditor relationship based on a valid & enforceable obligation to pay a fixed or determinable sum of money o Individual circumstances examined include if the note was properly executed, if there was a reasonable rate of interest, if collateral was provided, the collection efforts that were made & the intent of the parties

Worthless Securities
A loss is allowed for securities that become completely worthless during the year (worthless securities) o Such securities are shares of stock, bonds, notes or other evidence of indebtedness issued by a corporation or government Losses generated are treated as capital losses deemed to have occurred on the last day of the taxable year; a loss otherwise classified as short term may be classified as a long-term capital loss ($3,000 limitation)

Small Business Stock General rule: shareholders receive capital gain or loss treatment upon the sale or exchange of stock However, it is possible to receive an ordinary loss deduction if the loss is sustained on a small business stock; this loss could arise from a sale of the stock or the stock becoming worthless o Only individuals who acquired the stock from the corporation are eligible to receive ordinary loss treatment Ordinary loss treatment is limited to $50,000 ($100,000 married filing jointly) Losses in excess of statutory limits receive capital loss treatment o The corporation must meet certain requirements for the loss on such stock to be treated as an ordinary (rather than capital) loss Major requirement: the total amount of money & other property received by the corporation for stock as a contribution to capital (or paid-in surplus) does not exceed $1 million Test is made at the time the stock is issued Stock can be common or preferred This section only applies to losse3s; if such stock is sold at a gain, the gain is a capital gain

Losses of Individuals
An individual may deduct the following losses: o Losses incurred in a trade or business o Losses incurred in a transaction entered into for profit o Losses caused by fire, storm, shipwreck, or other casualty or by theft Examples of losses to property used in trade or business or to property used in a transaction entered in to for profit: o Loss on a property used in a proprietorship, a loss on a property held for rent, or a loss on stolen bearer bonds o Such losses are not limited to losses caused by fire, storm, shipwreck, or other casualty or by theft An individual taxpayer suffering losses from damage to non-business property can deduct only those losses attributable to fire, storm, shipwreck, or other casualty or theft o Other casualty means casualties analogous to fire, storm or shipwreck It also include accidental loss of property provided the loss qualifies under the same rules as any other casualty The loss must result from an event that is: 1. Identifiable 2. Damaging to property and 3. Sudden, unexpected & unusual in nature o A sudden event is one that is swift & precipitous & not gradual or progressive o An unexpected event is an event that is ordinarily unanticipated & occurs without the intent of the individual who suffers the loss o An unusual event is one that is extraordinary & non-recurring & does not commonly occur during the activity in which the taxpayer was engaged when the destruction occurred

o Damage must be done to the taxpayers property to qualify as a casualty loss A taxpayer can take a deduction for a casualty loss from a car accident only if the damage was not caused by the taxpayers willful act or negligence Events That Are Not Casualties Examples of non-sudden events that generally do not qualify as casualties include disease & insect damage (i.e. termites) o Some courts have held that termite damage over periods of up to 15 months after infestation constituted a sudden event and was deductible as a casualty loss o The current position of the IRS is that termite damage is not deductible Other examples of events that are not casualties are losses resulting from a decline in value rather than an actual loss of the property and erosion due to wind or rain Theft Losses Theft includes, but is not limited to, larceny, embezzlement & robbery; it does not include misplaced items Theft losses are computed like other casualty losses, but the timing for the recognition of the loss differs o A theft loss is deducted in the year of discovery, not in the year of theft (unless discovery occurs in the same year as the theft) o If, in the year of discovery, a claim exists & there is a reasonable expectation of recovering the adjusted basis of the asset from the insurance company, no deduction is permitted o If, in the year of settlement, the recovery is less than the assets adjusted basis, a partial deduction may be available If the recovery is greater than the assets adjusted basis, gain may be recognized When to Deduct Casualty Losses General Rule- generally, a casualty loss is deducted in the year the loss occurs o However, no casualty loss is permitted if a reimbursement claim with a reasonable prospect of full recovery exists o If the taxpayer has a partial claim, only part of the loss can be claimed in the year of the casualty, and the remainder is deducted in the year the claim is settled o If a taxpayer received reimbursement for a casualty loss sustained & deducted in a previous year, an amended return is not filed for that year Instead, the taxpayer must include the reimbursement in gross income on the return for the year in which it is received to the extent that the previous deduction resulted in a tax benefit Disaster Area Losses- an exception to the general rule; applies to casualties sustained in an area designated as a disaster area by the President of the United States o In such cases, the taxpayer may elect to treat the loss as having occurred in the taxable year immediately preceding the taxable year in which the disaster actually occurred (accelerated tax benefit) o If the due date, plus extensions, for the prior years return has not passed, a taxpayer makes the election to claim the disaster area loss on the prior years tax return o If the disaster occurs after the prior years return has been filed, it is necessary to file either an amended return or a refund claim o Disaster loss treatment also applies in the case of a personal residence that has been rendered unsafe for use as a residence because of a disaster

This provision applies when, within 120 days after the President designates the area as a disaster area, the state or local government where the residence is located orders the taxpayer to demolish or relocate the residence Measuring the Amount of the Loss Amount of Loss- the rules depend in part on whether business use, income-producing use, or personal use property was involved; another factor considered is whether the property was partially or completely destroyed o If business property or property held for the production of income is completely destroyed, the loss is equal to the adjusted basis of the property at the time of destruction o A different rule applies for partial destruction of business & income-producing property and for partial or complete destruction of personal use property; in these situations, the loss is the lesser of: The adjusted basis of the property The difference between the fair market value of the property before the event & the fair market value immediately after the event o The deduction for the loss of property that is part business & part personal must be computed separately for the business & personal portion o Any insurance recovery reduces the loss for business, production of income & personal use losses (taxpayer may realize a gain if insurance proceeds> amount of loss) o A taxpayer is not permitted to deduct a casualty loss for damage to insured personal property unless a timely insurance claim is filed with respect to the damage to the property This rule applies to the extent that any insurance policy provides for full or partial reimbursement for the loss o Generally, an appraisal before & after the casualty is needed to measure the amount of the loss However, the cost of repairs to the damaged property is acceptable as a method of establishing the loss in value provided the following criteria are met: The repairs are necessary to restore the property to its condition immediately before the casualty The amount spent for such repairs is not excessive The repairs do not extend beyond the damage suffered The value of the property after the repairs does not, as a result of the repairs, exceed the value of the property immediately before the casualty Reduction for $100 & 10% of AGI Floors o The amount of the loss for personal use property must be further reduced by a $100 per event floor & a 10% of AGI aggregate floor4 The $100 floor applies separately to each casualty & applies to the entire loss from each casualty The losses are then added together & the total is reduced by 10% of the taxpayers AGI The resulting loss is the taxpayers itemized deduction for casualty & theft losses

When a non-business casualty loss is spread between 2 taxable years because of the reasonable prospect of recovery doctrine, the loss in the 2nd year is not reduced by the $100 floor However, the loss in the 2nd year is still subject to the 10% floor based on the taxpayers second year AGI o Taxpayers who suffer qualified disaster area losses can elect to deduct the losses in the year preceding the year of occurrence The disaster loss is treated as having occurred in the preceding taxable year The 10% of AGI floor is determined by using the AGI of the year for which the deduction is claimed Statutory Framework for Deducting Losses of Individuals Casualty & theft losses incurred by an individual in connection with a trade or business are deductible for AGI; these losses are not subject to the $100/event & 10% of AGI limitations Casualty & theft losses incurred by an individual in a transaction entered into for profit are not subject to the $100/event & 10% of AGI limitations o If these losses are attributable to rents or royalties, the deduction is for AGI If they are not, they are deductions from AGI Such losses are classified as other miscellaneous itemized deductions i.e. Theft of a security theft losses of investment property are not subject to the 2% of AGI floor on certain miscellaneous itemized deductions Casualty & theft loses attributable to personal use property are subject to the $100 per event & the 10% of AGI limitations o These losses are itemized deductions, but they are not subject to the 2% of AGI floor Personal Casualty Gains & Losses A personal casualty gain is the recognized gain from a casualty or theft of personal use property A personal casualty loss for this purpose is a casualty or theft loss of personal use property after the application of the $100 floor A taxpayer who has both gains & losses for the taxable year must first net (offset) the personal casualty gains & personal casualty losses o If the gains > losses, the gains & losses are treated as gains & losses from the sale of capital assets The capital gains & losses are short term or long term, depending on the period the taxpayer held each of the assets o In the netting processes, personal casualty & theft gains & losses are not netted with the gains & losses on business& income producing property o If personal casualty losses > gains, all gains & losses are treated as ordinary items The gains & the losses to the extent of gains are treated as ordinary income & ordinary loss in computing AGI Losses in excess of gains are deducted as itemized deductions to the extent the losses exceed 10% of AGI

Research & Experimental Expenditures


Research & experimental expenditures as defined by the Regulations: All such costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property & the improvement of already existing property of the type mentioned. The term does not include expenditures such as those for the ordinary testing or

inspection of materials or products for quality control or those for efficiency surveys, management studies, consumer surveys, advertising or promotions o Expenses in connection with the acquisition or improvement of land or depreciable property are not research & experimental expenditures They increase the basis of the land/depreciable property o Depreciation on a building used for research may be a research & experimental expense Only the depreciation that is a research & experimental expense (not the cost of the asset) is subject to 3 alternatives o Law permits the following 3 alternatives for the handling of research & experimental expenditures: Expensed in the year paid or incurred Deferred & amortized Capitalized If the costs are capitalized, a deduction is not available until the research project is abandoned or deemed worthless It is generally preferable to elect an immediate write-off because of the time value of the tax deduction o The law also provides for a research activities credit Credit amounts to 20% of certain research & experimental expenditures Expense Method A taxpayer can elect to expense all of the research & experimental expenditures incurred in the current year & all subsequent years Once the election is made, the taxpayer must continue to expense all qualifying expenditures unless a request for change is made to & approved by the IRS If the taxpayer incurs research & experimental expenditures before actually engaging in any trade or business activity, the Supreme Court permits a deduction in the year of incurrence Deferral & Amortization Method Under such an election, research & experimental expenditures are amortized ratably over a period of not less than 60 months A deduction is allowed beginning with the month in which the taxpayer first realizes benefits from the experimental expenditures Election is binding & a change requires permission from the IRS This method is usually employed when a company does not have sufficient income to offset such expenses o Used in lieu of creating net operating loss carryovers that might not be utilized because of the 20 year limitation on such carryovers This method should be considered if the taxpayer expects higher tax rates in the future

Domestic Production Activities Deduction


The American Jobs Creation Act of 2004 was enacted to replace certain tax provisions that our world trading partners regarded as allowing unfair advantage to U.S. exports The Act created a deduction based on the income from manufacturing activities (designated as production activities) called domestic production activities deduction Operational Rules Calculation of the domestic production activities deduction (DPAD)- for tax years beginning in 2010 & thereafter, DPAD is based on the following formula:

9% x Lesser of qualified production activities income (QPAI) OR Taxable (or modified adjusted gross) income or alternative minimum taxable income 2005/2006- 9% was 3%; 2007-2009- 9% was 6% o Taxable income is determined without regard to the DPAD In the case of an individual (a sole proprietorship or an owner of a flow-through entity), modified adjusted gross income is substituted for taxable income The taxable income limitation is determined after the application of any net operating loss deduction for the tax year i.e. a company with a NOL carry forward for a tax year is ineligible for the DPAD if the carry forward eliminates current taxable income i.e. a taxpayer that has an NOL carry back may lose part or all of the DPAD benefit for that year o As taxable income is reduced by NOL carry back, there is a corresponding reduction in the DPAD If qualified production activities income (QPAI) cant be used in a particular year due to the taxable income limitation, it is lost forever o Another important limitation is that the amount of the DPAD cant exceed 50% of certain W-2 wages paid by the taxpayer during the tax year An employers W-2 wages include the sum of the aggregate amount of wages & elective deferrals required to be included on the W-2 wage statements for certain employees during the employers taxable year Elective deferrals include amounts deferred under Section 457 plans & Roth contributions An employer previously included wages paid to all workers during a tax year & not just the wages of employees engaged in qualified production activities However, an employer is now permitted to include only those W-2 wages paid to employees engaged in qualified production activities Calculation of QPAI o Qualified production activities income (QPAI) is the excess of domestic production gross receipts (DPGR) over the sum of: The cost of goods sold allocated to such receipts Other deductions, expenses or losses directly allocated to such receipts The ratable portion of deductions, expenses & losses not directly allocable to such receipts or another class of income o QPAI is determined on an item by item basis; because all items must be netted in the calculation, the final QPAI amount can be either positive or negative o 5 specific categories of DPGR qualify for the DPAD: The lease, license, sale, exchange or other disposition of qualified production property (QPP) that was manufactured, produced, grown or extracted (MPGE) in the U.S. Qualified films largely created in the U.S. The production of electricity, natural gas or potable water Construction (not self construction) performed in the U.S. Engineering & architectural services for domestic construction o The sale of food & beverages prepared by a taxpayer at a retail establishment & the transmission or distribution of electricity, natural gas or potable water are specifically excluded from the definition of DPGR

Eligible Taxpayers The deduction is available to a variety of taxpayers including individuals, partnerships, S corporations, C corporations, cooperatives, estates & trusts For a pass-through entity (i.e. partnerships, S corporations), the deduction flows to the individual owners In the case of a sole proprietor, a deduction for AGI results & is claimed in Form 1040 o Form 8903 must be attached to support the deduction

Net Operating Losses


A net operating loss in a particular tax year would produce no tax benefit if the Code did not provide for the carry back & carry forward of such losses to profitable years To provide partial relief from inequitable tax treatment, a deduction is allowed for NOLs o Provision permits NOLs for any one year to be offset against taxable income of other years o Only losses from the operation of a trade or business (or profession), casualty & theft losses, or losses from the confiscation of a business by a foreign government can create an NOL A salaried individual with itemized deductions & personal exemptions in excess of gross income is not permitted to deduct the excess amounts as an NOL A personal casualty loss is treated as a business loss & can therefore create or increase an NOL for an individual Carry Back & Carry Over Periods General Rules: o An NOL generally must be applied initially to the 2 taxable years preceding the year of the loss (unless an election is made not to carry the loss back at all) It is carried first to the 2nd year prior & then to the immediately preceding tax year (or until used up) If the loss is not fully used in the carry back period, it must be carried forward to the 1st year after the loss year, and then forward through a period of 20 years o A 3 years carry back period is available for any portion of an individuals NOL resulting from a casualty or theft loss This rule also applies to NOLs that are attributable to presidentially declared disasters that are incurred by a small business Small business is one whose average annual gross receipts for a 3 year period are $5 million or less o A 5 year carry back period & a 20 year carry over period are allowed for a farming loss Taxpayer may elect to wave the special 5 year carry back period; in such a case, the general 2 year carry back period applies A farming loss is the amount of the NOL for the taxable year if only income & deductions attributable to the farming business are taken into account The amount of the farming loss cannot exceed the amount of the taxpayers NOL for the taxable year A farming loss for any taxable year is treated as a separate NOL for such year & applied after the remaining portion of the NOL for the year is taken into account o If the loss is being carried to a preceding year, an amended return is filed on Form 1040x, or a quick refund claim is filed on Form 1045 In either case, a refund of taxes previously paid is requested

Sequence of Use of NOLs- rule is to always use the earliest years loss until it is completely absorbed if the taxpayer has NOLs in 2 or more years o The later years losses can then be used until they are also absorbed or lost Thus, one years return could show NOL carryovers from 2 or more years Each loss is computed & applied separately Election to Forgo Carry Backo In such a case, the loss is available as a carry over for 20 years Election may be made if a taxpayer is in a low marginal tax bracket in the carry back years, but expects to be in a high marginal tax bracket in future years Computation of the Net Operating Loss NOL provisions apply solely to business-related losses Certain adjustments must be made so the loss more closely resembles the taxpayers economic loss To arrive at the NOL for an individual, taxable income must be adjusted by adding back the following items: o 1. No deduction is allowed for personal & dependency exemptions; these amounts dont reflect economic or business outlays o 2. The NOL carry over or carry back from another year is not allowed in the computation of the current years NOL o 3. Capital losses & non-business deductions are limited in determining the current years NOL; these limits are as follows: The excess of non-business capital losses over non-business capital gains must be added back The excess of non-business deductions over the sum of non-business income & net non-business capital gains must be added back Net non-business capital gains are the excess of non-business capital gains over non-business capital losses Non business income is income that is not attributable or derived from a taxpayers trade or business o It includes items such as dividends, investment interest, alimony received & SS income Non-business deductions are those deductions that are not attributable or derived from a taxpayers trade or business o Examples are IRA deductions, alimony paid deductions, most itemized deductions (except for personal casualty & theft losses & losses incurred in a transaction entered into for profit) and employee business expense deductions A taxpayer who does not itemize deductions computes the excess of non-business deductions over non-business income by substituting the standard deduction for total itemized deductions The excess of business capital losses over the sum of business capital gains & the excess of non-business income & net non-business capital gains over nonbusiness deductions must be added back The add-back for net non-business capital losses & excess business capital losses doesnt include net capital losses not included in the current year computation of taxable income because of the capital loss limitation provisions

Re-computation of Tax Liability for Year to Which NOL is Carried When an NOL is carried back to a non-loss year, the taxable income & income tax for the carry back year must be re-computed by including the NOL as a deduction for AGI o Several deductions are based on the amount of AGI o When an NOL is carried back, all such deductions except the charitable contributions deduction must be re-computed on the basis of the new AGI after the NOL has been applied Deduction for charitable contributions is determined without regard to any NOL carry back, but with regard to any other modification affecting AGI o Any tax credits limited by or based upon the tax must be re-computed, based on the recomputed tax Calculation of the Remaining NOL After computing the amount of the refund claim for the initial carry back year, it is then necessary to determine the extent to which any NOL remains to carry over to future years The amount of this carry over loss is the excess of the NOL over the taxable income of the year to which the loss is being applied o However, the taxable income of the year to which the loss is being applied must be determined with the following modifications: No deduction is allowed for excess capital losses over capital gains No deduction is allowed for the NOL that is being carried back However, deductions are allowed for NOLs occurring before the loss year Any deductions claimed that are based on or limited by AGI must be determined after making the preceding adjustments However, charitable contributions dont take into account any NOL carry back No deduction is allowed for personal & dependency exemptions Tax Planning

Tax Consequences of the Groetzinger Case Documentation of Related Taxpayer Loans, Casualty Losses & Theft Losses
Since non- bona fide loans between related taxpayers may be treated as gifts, adequate documentation is needed to substantiate a bad-debt deduction if the loan subsequently becomes worthless o Documentation should include proper executive of the note (legal form) & the establishment of a bona fide purpose for the loan o It is also desirable to stipulate a reasonable rate of interest & a fixed maturity date Since theft loss is not permitted for misplaced items, a loss should be documented by a police report & evidence of the value of the property o Similar documentation of the value of property should be provided to support a casualty loss deduction because the amount of the loss is measured, in part, by the decline in fair market value of the property o Casualty loss deductions must be reported on Form 4684

Worthless Securities
To be deductible, a security must be completely worthless Taxpayer must prove that the security was not worthless in a prior year & was worthless in the year claimed The only safe practice is to claim a loss for the earliest year when it may possibly be allowed & to renew the claim in subsequent years if there is any reasonable chance it will be applicable to the income for those years o Statute of limitations for worthless securities is 7 years

Small Business Stock


Because Section 1244 limits the amount of loss classified as ordinary loss on a yearly basis, a taxpayer might maximize the benefits by selling the stock in more than one taxable year o The result could be that the losses in any 1 taxable year would not exceed the Section 1244 limits on ordinary loss

Casualty Losses
A special election is available for taxpayers who sustain casualty losses in an area designated by the President as a disaster area o This election affects only the timing, not the calculation of the deduction o The deduction can be taken in the year before the year in which the loss occurred The benefit is a faster refund It will also be advantageous to carry the loss back if the taxpayers tax rate in the carry back year is higher than the tax rate in the year of the loss

Net Operating Losses


For an individual, the benefits from a loss carry back could be scaled down or lost due to the economic adjustments that must be made to taxable income for the year to which the loss is carried A taxpayer should attempt to minimize the number of taxable years to which an NOL is carried o The more years to which the NOL is applied, the more benefits are lost from adjustments for items such as personal & dependency exemptions The election not to carry back the loss might also be advantageous if there is a disparity in marginal tax rates applicable to different tax years

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