Prep for Final Flashcards
Prep for Final
Accounting firm, during the heat of tax season, hired an
ordained minister to raise the tax staff’s emotional and
spiritual awareness level to help them better serve their
client’s needs. Does the expense constitute an ordinary and necessary business expense?
This problem addresses the general question of the meaning of “ordinary and necessary business expenses under § 162(a). Whether expenses are ordinary and necessary is a factual issue. To be deductible the expense must be both ordinary and necessary. They are necessary if they are appropriate and helpful, rather than absolutely essential. They are ordinary if “we know from experience” that these types of expenses are “common and accepted”
in this type of business. Welch v. Helvering. Therefore, what is ordinary and necessary varies by industry and changes over time. “The standard set up by the statute is not a rule of law, it is rather a way of life. Life in all its
fullness must supply the answer to the riddle.” Welch
The deductibility of a similar expenditure by a wood products broker was denied in Lionel Trebilcock, 64 T.C. 852 (1975), aff’d, 557 F.2d 1226 (6th Cir. 1977). However, there have been recent news stories of businesses
providing similar services to improve the work quality of its employees. Google workplace spirituality today and you get over 7 million hits and a very interesting discussion in Wikipedia detailing the development of the workplace spirituality movement since 1920. The answer to this question is uncertain.
Bill operates a printing business. On October 1, 20X1 he
incurred the following expenses:
· $50,000 to build an addition to the building housing the
business
· $2,000 to replace a section of roof on the building
· $1,000 to purchase 12 months worth of paper supplies
Which of these expenses are currently deductible as ordinary
and necessary business expenses and which are capital
expenditures?
Section 263 requires the capitalization of amounts paid to acquire, produce,
or improve tangible property. On the other hand, Sec. 162 allows the
deduction of all ordinary and necessary business expenses, including the
costs of certain supplies, repairs, and maintenance. This problem points out
the need to distinguish between capital expenditures and deductible supply,
repair and maintenance costs. The “repair regulations” provide important
guidance in this area. However, detailed examination of those regulations is
left for the Tax Timing class.
The cost of non-incidental materials and supplies are generally deducted in
the tax year first used or consumed. The regulations define “materials and
supplies” to mean tangible property used or consumed in the taxpayer’s
business operations that is not inventory and that is, among other things,
reasonably expected to be consumed in 12 months or less, beginning when
used in a taxpayer’s operations, has an acquisition or production cost of less
than $200, or it otherwise identified in published guidance. Under these
provisions, the paper would be deductible
The regulations also provide that the cost of certain routine maintenance
need not be capitalized. Under a routine maintenance safe harbor, an
amount paid is deductible if it is for recurring activities that a taxpayer
expects to perform to keep a unit of property in its ordinarily efficient
operating condition. The activities are routine only if, at the time the unit of
property is placed in service, the taxpayer reasonably expects to perform the
activities more than once during the class life of the unit of property. This
routine maintenance exception allows expensing for routine maintenance
activities on a building and its structural components (including building
“systems”). However, an activity is covered only if the taxpayer reasonably
expects to perform such maintenance more than once over a 10-year period.
This should allow for the expensing of the roof repairs.
The costs of the building addition must be capitalized.
Note that the regulations also provide important de minimis exceptions to
the capitalization requirements. One allows the deduction of amounts (up to
a specified ceiling) paid for the acquisition or production of a unit of tangible
property if the taxpayer had an applicable financial statement, had written
accounting procedures for expensing amounts paid for property that did not
exceed specified dollar amounts, and treated those amounts as expenses on
its applicable financial statement. The required written accounting
procedures in effect as of the beginning of the tax year may specify a per
item amount of less than $5,000. For taxpayers without an applicable
financial statement, they may elect the de minimis safe harbor and expense
up to $500 per invoice/item.
The regulations also provide a safe harbor for amounts paid for property
with an economic useful life of 12 months or less if the taxpayer’s accounting
procedures in place at the beginning of the tax year provide for the current
deduction of such amounts. The cost of each item of short- lived property
that is deductible under this de minimis rule may not exceed $5,000 ($500
for taxpayers without an applicable financial statement).
Christine is tired of practicing accounting and decides to open a
restaurant. In January, 20X1 she incurs the following
expenses: $15,000 in training employees, $11,900 in interior
decorating consulting, and $15,000 in advertising. In February,
20X1 Christine incurs the following additional expenses:
$5,000 employee compensation and $4,900 advertising. The
restaurant is ready for business on February 1, 20X1 but due to
road closures in the area does not receive its first customer
until March 1, 20X1. How much is Christine’s allowable 20X1
deduction for these expenditures?
Section 162 provides for a deduction for “ordinary and necessary expenses”
“in carrying on” a “trade or business.” Any expenses incurred by Christine
before her business began for purposes of § 162 will not meet this test.
Section 195 applies to expenses incurred before the trade or business has
begun (“start up expenses”). Start up expenditures are amounts paid for:
a) investigating the acquisition or creation of a trade or business; b) creating
a trade or business, and c) other expenses incurred before the first day of
for profit activities § 195(c)(1)(A) but only if the expense would have been
deductible if the trade or business was already in existence. § 195(c)(1)(B).
Thus, if the expenses are capitalizable under § 263, they will not fall within
§ 195.
In the problem the interior decorator fees a raise capitalization issue. Treas.
Reg. § 1.263(a)-2(d) requires capitalization of architect’s fees. We need
more facts here to see if the interior decorator fees were part of a major
remodel.
Another issue is the advertising expenses. In INDOPCO, Inc. v.
Commissioner the U.S. Supreme Court held that investment banking fees
and other fees paid by in connection with a friendly acquisition of had to be
capitalized because the acquisition provided long-term benefits to the
existing business from the acquisition synergies. The breadth of the
Supreme Court’s decision calls into question whether expenses previously
thought to be immediately deductible must now be capitalized. Since
advertising arguable creates an asset with a useful life of more than one
year, there was concern that INDOPCO would prevent the deduction of
advertising costs. However, in Rev. Rul. 92-80 the government stated that
advertising expenses will remain deductible despite INDOPCO until further
notice. But the Treasury reserves the right to require capitalization of
advertising expenses, on a prospective basis, if it changed its mind on the
proper treatment of advertising expenses.
For the rest of this problem we will assume that all the expenses qualify
under § 195.
Next we must determine when Christine’s trade or business commenced.
Section 195(c)(2) says to look to the regulations for rules relating to this
test. However, there are none. So we must look to case law. In Walsh v.
Commissioner, a restaurant was held to begin “carrying on” its business
when it opened its doors to customers. Applying Walsh, all of the January
and February expenses are start up expense. It should be noted that when a
business commences is a question of fact, and if the circumstances are
different, or the judge is different, a different conclusion is possible.
Next you must apply the § 195 rules. Section 195 allows you to elect to
deduct the start up expenses up to $5,000 § 195(b)(1)(A). Treas. Reg.
§ 1.195-1 has eliminated the need to make a proper election as it now
assumes a proper election to have been made whether or not any election
was actually made.
The maximum deduction is reduced dollar for dollar to the extent that the
start up expenses exceed $50,000 § 195(b)(1)(A)(ii). Christine incurred
total startup expenses of $51,800. The maximum deduction is reduced to
the extent the startup expenses exceed $50,000. Therefore the deduction is
limited to $3,200 ($5,000 – ($51,800 – 50,000)).
That leaves $48,600 which may not be immediately deducted but will be
amortized over 180 months starting with the month in which the active
trade or business began, or $270 a month. Since the business began on
March 1, 20X1, Christine is entitled to 10 months of amortization, or $2,700
in addition to the $3,200 deduction for a total 20X1 deduction of $5,900.
She will take annual deductions of $3,240 thereafter until the amount is fully
recovered.
Note that if Christine incurred these expenses but never opened her
business, she would not be entitled to any deduction under § 195. However,
when she abandons the business she will be entitled to deduct the expenses
under § 165(c)(2) for losses incurred in a transaction entered into for profit,
not connected with a trade or business. See Domenic, 34 T.C.M. 469 and
Rev. Rul. 77-254, 1977-2 C.B. 63. On the other hand, if she opened her
business and disposed of it prior to fully amortizing the start up costs, she
will deduct the remaining unamortized start up expenses under § 165(c)(1)
in the year of disposition. § 195(b)(2)
Christine’s business is a huge success. She pays her chef
$750,000 in salary plus a $250,000 year end bonus, and she
pays herself a salary of $3 million. Will the salaries and bonus
be deductible?
Section 162(a) allows a deduction for “reasonable” salary. You must meet
two tests: the payment must have compensatory “intent” and be reasonable
in “amount.” Treas. Reg. 1.162-7 Bonuses are treated as salary. Treas. Reg.
§ 1.162-9
Compensatory intent looks to whether the payment was really for services
rather than something else such as a disguised dividend. If Christine’s
business is run as a corporation, there is a motivation to pay out all the
profits as salary to her to avoid corporate double taxation.
As to reasonableness of the amount, the courts have developed a variety of
factors to examine. The principal factors are: a) the qualifications of the
employee; b) nature, extent and scope of employee’s work; c) size and
complexity of the business; d) the employee’s contribution to the success of
the business; e) how the employee’s salary compares to the salary scale of
employees generally; f) how the employee’s salary compares to the salary
scale of the industry; and g) prevailing economic conditions. Reasonableness
is thus a facts and circumstances determination and case law, as you might
expect, is highly inconsistent.
It is hard to apply these factors in a specific case. For example, Exacto
Spring Corporation dealt with a closely held company where the cofounder,
CEO and principal owner was paid $1,000,000 + a year. The court held that
the factor tests don’t provide any basis for a rational analysis. The court
noted that it could not function as a “super- HR” department. Instead it
applied a “rate of return” test. Since the rate of return earned by the
company exceeded expectations, higher than normal compensation was held
to be appropriate. The fact that the other shareholders did not complain was
an important factor in establishing “reasonableness.” Interestingly currently
there are more issues dealing with whether the salary paid to the owner was
unreasonably low, rather than unreasonably high as people attempt to avoid
paying social security taxes.
It should be noted that reasonableness of compensation is rarely an issue
when the employee is not also an owner of the business, or related to the
owner. If there is an arm’s length relationship between the business and the
employee, it is assumed that the employee has earned what the business
decides to pay.
Darryl lives in Connecticut and commutes by train to his office
in New York City each day. On one particular day, Darryl spent
$5 on a train ticket to New York, ate breakfast at the train
station for $10 and, after arriving at work, spent $20 in cab
fare to meet with a client. Which costs, if any, are deductible?
In additional to the capitalization rules, certain expenses are non-deductible
because they are personal in nature. Section 262 denies a deduction for
personal expenses. The issue often arises when looking at transportation
and commuting costs.
The costs of commuting to work are nondeductible personal expenses.
Treas. Reg. §§1.162-2(e), 1.212-1(f), 1.262-1(b)(5). Similarly, the cost of
breakfast is a non-deductible personal. § 262.
Only the $20 in cab fare to meet a client would be deductible under § 162
since it was incurred after Darryl had already arrived at work. The taxpayer’s
commute terminates after the taxpayer has arrived at the initial work
location, and any transportation costs incurred thereafter while on the job
(other than the commute home), are deductible costs incurred while in
“work” status.
Fred works and lives in San Francisco. One day, Fred flew from
San Francisco to Los Angeles on business. He ate lunch in Los
Angeles by himself and flew home that evening. Fred’s airfare
cost $200. The meal, with tip and tax included, cost $50. Which
costs, if any, are deductible?
Under section 162(a) all ordinary and necessary business expenses are
deductible. Section 162(a)(2) expands on this rule to provide that certain
expense (meals and lodging other than amount which are lavish or
extravagant under the circumstances) incurred while away from home in
pursuit of a trade or business are deductible where they would not have
been deductible if the taxpayer was not away from home.
The U.S. Supreme Court in Correl v. U.S. held that the requirement “away”
means that the taxpayer the travel must be sufficient far as to require a stop
for sleep or rest. The “from home” requirement refers to the location of his
principal place of business, not necessarily where he sleeps. Fred is not away
from home on business because he does not spend overnight in LA. The
airfare is deductible because it is work related travel expenses not involving
commuting. The meal eaten alone is not deductible because it is a personal
expenses and does not fall within § 162(a)(2) because he was not away
from home.
It is interesting to note that neither the Code nor the regulations define
“home.” The weight of authority is that, for purposes of this rule, “home” is
your work location. If Fred lived in New York but worked in San Francisco,
his “home” would be San Francisco and the money spent getting back and
forth between the two coasts would be non-deductible commuting expenses.
However, this view is not universally held. In Wallace v. Commissioner, 144
F.2d 407 (9th Cir. 1944) the Court held that home has its normal meaning -
where you live. This case is important because California courts lie in the 9th
Federal Circuit.
How would your answer to Problem 6 change if the business
meetings covered two days and Fred spent the night in Los
Angeles incurring $500 in hotel costs and $25 to have his suit
pressed, returning home late the next day?
Fred is now “away from home” since his business trip required an overnight
stay. His hotel costs are deductible (assuming $500 for one night in Los
Angeles is not lavish or extravagant under the circumstances). His meals are
now deductible, even if eaten alone, because he is traveling away from
home. The meals remain subject to the 50% limitation on deductibility under
§ 274(n)(1). The laundry can be considered an expense “incidental to travel”
under Treas. Reg. § 1.162-2(a) if necessitated by the travel.
The key benefit of meeting the away from home test is that all meals as well
as housing costs become deductible.
Steve is a tax partner who regularly takes key tax client
personnel to San Francisco Giant games in his firm’s luxury box
seats. Steve’s firm picks up the entire $500 bill consisting of: 2
tickets ($400) and hot dogs, garlic fries, snacks, and drinks
enjoyed at the game ($100). Steve always has bonafide
business discussions with his client during the ball game. How
much of the $500 can Steve’s firm deduct?
The 2017 Tax Cut and Jobs Act changed the rules on entertainment. §
274(a) specifically states that no deduction “shall be allowed for any item,
with respect to an activity which is of a type generally considered to
constitute entertainment.” § 1.274-2(b)(1) includes into the definition of
entertainment “nightclubs, cocktail lounges, theatres, country clubs, golf and
athletic clubs, sporting events”. The new law eliminated the exception if
there were bonafide business discussions. Thus, the fact that Steve had
business discussions with the client during the game is irrelevant and the
ticket price is not deductible at all.
In general, client meals are 50% allowed under Sec. 274(n) and 274(k).
However, § 1.274-2(b)(1) includes meals and beverages in the definition of
“entertainment” when incurred during the entertainment activity. Thus, the
food and beverages enjoyed at the game are also likely not deductible.
Tax Experts, Inc. (TE) incurred the following expenses for
meals for the year: $20,000 in client meals where TE
employees took out clients to discuss business, $5,000 in food
and beverage for annual employee-only Christmas party held at
TE’s office, $3,000 on food and beverage for the week-long
employee training on the new tax compliance software. How
much of the $28,000 would be deductible by TE?
Unlike meals eaten alone, meals eaten with a business client can be
deductible, whether at home or away from home. Any meal is a deductible
business expense if the meal is taken with a customer and significant
business occurs during or immediately before or after the meal.
§ 274(a)(1)(A); Treas. Reg. § 1.274-2(d)(3) The cost of the meal must not
be lavish of extravagant § 274(k)(1)(A). However, any deductible meal
expense is limited to 50% of the cost of the meal. § 274(n)(1)
§ 274(n)(2) allows specific exceptions to the 50% rule where taxpayers can
actually deduct 100% of meal costs. An annual Christmas party would fall
under recreational or social activities, primarily for benefit of employees [§
274(e)(4)]. Employee Training sessions would fall under business meetings
[§ 274(e)(5)]. However, since § 274(e)(5) is not listed under § 274(n)(2)
as one of the section that allows 100% expensing, it is subject to 50%.
Thus, the total amount deductible would be $16,500 [$20,000 * 50% +
$5,000 * 100% + $3,000 * 50%]
Joe is a partner at a local CPA firm. He is a member of the
Olympic Club located near his office. The Club has athletic and
eating facilities, the costs of both are included in his
membership dues. He spends 80% of his time at the club
meeting with clients for lunch and the remaining 20% for
personal purposes. He pays club dues of $500 per month. May
Joe deduct any of the dues?
Club dues are never deductible regardless of the amount of business use of
the club. § 274(a)(3). This was enacted to end the practice of professionals
attempting to deduct their golf course and similar dues as business
expenses, arguing that they conducted business while at the club.
On January 30, 20X1 Jim, a calendar year taxpayer, purchased
and immediately placed into service new depreciable
equipment for $700,000 for his business. The equipment has a
“class life” of 7 years but Jim hopes to use the machine for 10
years. At the end of the 10 years, Jim expects the salvage value
to be $10,000. Jim’s aggregate amount of taxable income from
his business is $550,000, before any deductions related to this
purchase. Compute each year of Jim’s deductions related to
this equipment. Assume §§ 168(k) and 179 do not to apply.
Under these assumptions, only the basic rules of § 168 will apply. Since this
is tangible personal property, depreciation is calculated using the double
declining balance method. § 168(b)(1)(A). Since the class life is seven
years, it is five-year property § 168(e)(1) which has a five-year applicable
recovery period. § 168(c). The applicable convention is the half-year
convention. § 168(d) The depreciable basis is $700,000 since the salvage
value is considered to be zero. § 168(b)(4).
20X1: He can claim first year regular depreciation of $140,000 ($700,000 ÷
5 years x 200% x 1⁄2 year convention = $140,000).
20X2 depreciation is $224,000 (560,000 ÷ 5 years x 200% = $224,000)
20X3 depreciation is $134,400 (336,000 ÷ 5 years x 200% = 134,400)
20X4 depreciation is $80,640 (201,600 ÷ 5 years x 200% = $80,640). (Note
that we do not switch to straight line here because straight line is exactly the
same as DDB and we only switch when straight line is greater. Straight line
would be computed by dividing the remaining basis ($201,600) by the
remaining useful life (2.5).)
20X5 we switch to straight line because the straight line depreciation
(120,960÷ 1.5 years = $80,640) is greater than the DDB depreciation 20X5
depreciation is therefore $80,640.
20X6 depreciation is $40,320
On November 1, 20X1, Sam, a calendar year taxpayer,
purchased a computer for business and personal purposes,
immediately placing it in service. The computer cost $4,800
and was his only business purchase in 20X1. The computer is
used 60% for business in each year. The computer has an
eight-year class life. Compute Sam’s allowable depreciation
deduction for 20X1 and 20X2. Assume § 168(k) and § 179 do
not apply.
First we calculate the full year depreciation amount. Since the purchases
were all in the last quarter of his tax year, and were his only purchases for
the year, it triggers the use of the mid-quarter. § 168(d)(3). Under the midquarter convention, goods purchased in January – March are deemed owed
for 10.5 months, in April – June deemed owned for 7.5 months, July –
September deemed owned for 4.5 months and October – December deemed
owned for 1.5 months (assuming a calendar year taxpayer). Therefore,
rather than getting 50% of the calculated full year depreciation, he gets only
12.5% (1.5 / 12).
20X1: He can claim first year regular depreciation of $144 ($4,800 ÷ 5 years
x 200% x (1⁄5/12) mid-qtr year conv = $240,* 60% business usage, equals
$144).
20X2: depreciation is $1,117.44 ([$4,800 – 144] ÷ 5 years x 200% =
$1,862.40, * 60% business usage, equals $1,117.44).
On January 30, 20X1, Tom bought a new building for $250,000
of which $200,000 is attributable to the building and the
balance to the land and immediately placed it in service. How
much depreciation is Tom allowed for 20X1 and 20X2?
Land is not an asset eligible for depreciation. We need to allocate the
purchase price between the value of the land and the value of the building,
and only depreciate the building value. Here was told that the building value
is $200,000.
Real estate is depreciated using the straight line method, no salvage value
and a mid-month convention. The analysis of this problem depends on
whether the building is residential rental property or other property.
Students need to identify that this is an issue in determining the correct
depreciable life.
If residential rental property under § 168(e)(2)(A), it has an applicable
recovery period of 27.5 years § 168(c). Under the mid-month convention,
any property purchased in a month is deemed purchased in the middle of
the month, regardless of the actual date of purchase. Since the building was
purchased in January, it is deemed placed in service January 15 and Tom
will be entitled to 11 1⁄2 months of depreciation in the first year.
For residential rental property his 20X1 depreciation = $200,000 ÷ 27.5
years x 11.5/12 month = $6,970. In 20X2 (and for the following 25 years)
his annual depreciation = 200,000 / 27.5 = $7,273. His final year
depreciation would be $3,932.
On the other hand, if this was not residential rental property the applicable
recovery period is 39 years § 168(c). His 20X1 depreciation = $200,000 ÷
39 years x 11.5/12 month = $4,915 In 20X2 (and for the following 37
years) his annual depreciation = 200,000 / 39 = $5,128 His final year
depreciation would be $221.
Jerry owns a dairy farm and decides to do small “patch-up” work to some damage done to the floors and walls due to water seepage. Jerry incurs $200 in repairing the damages. He can deduct this cost and is not required to capitalize it.
One can expect this type of occurrence in the normal life of such a building and this type of work does not enhance the useful life of the building nor increase the building’s value. It is a deductible repair.
The correct answer is ‘True’.
Alice and Jack spent $3,000 on investigating a location in the Philadelphia area in which they plan to build a new restaurant. They also spent $1,000 providing meals and entertainment to impress the area’s top chefs. At the time they incurred the costs, they had yet to open their restaurant to customers. They can treat the entire $4,000 as start up expenses which they can begin amortizing in the month they start their business.
Taxpayers are not allowed capitalize expenditures as start up cost that would not otherwise be deductible if incurred when they were engaged in an active trade or business. Since the meals and entertainment expenses would only be 50% deductible per §274(n), only $3,500 would be capitalized as a part of start up costs.
The correct answer is ‘False’.
CPA firm brings in a yoga instructor during the tax busy season to help relieve stress of the employees. Which is true about the CPA firm’s ability to take a deduction for the yoga instructor’s services?
Select one:
a. CPA firm can deduct as long as they can show the expense is appropriate and helpful to its business.
b. CPA firm can deduct as long as it can show the expense is common and accepted in their business.
c. CPA can only deduct if they can show BOTH from part a and b. Correct
In order to deduct the yoga instructor’s services, CPA Firm has to show that the expense is “ordinary and necessary”, which means that it must be appropriate and helpful AND a common and accepted expense.
The correct answer is: CPA can only deduct if they can show BOTH from part a and b.
Doug is a self-employed CPA. He belongs to a country club. He uses the club 100% for business purposes as he entertains important clients of his firm. He usually takes clients to his club immediately following bonafide business discussions. Under these facts, Doug can deduct his club membership dues.
The rule is clear. Sec. 274(a)(3) states that there is no deduction for amount paid or incurred for membership in any club, even if for business purpose.
The correct answer is ‘False’.
Millionaire Enterprises pays Jim Smith, its CEO and majority shareholder, a $3 million in salary and bonuses in 20X0. CEOs, in similar businesses with a similar educational backgrounds, were paid about $1.5 million in salary and bonuses in 20X0. Millionaire enterprises enjoyed a very profitable year in 20X0 and can trace its success directly to the actions of Jim Smith. Note Millionaire Enterprises is NOT a publicly held company. How much of Jim Smith’s 20X0 salary is likely deductible as reasonable compensation?
Select one:
a. $0
b. $1 million
c. $1.5 million
d. $3 million Correct
Per Exacto Springs Case, to determine reasonable compensation, we can look to rate of return. Since Millionaire Enterprises had a very profitable year that can be traced directly to Jim Smith’s actions, the $3 million will likely be deemed reasonable, even though it is more than other CEOs in similar businesses.
The correct answer is: $3 million
Paul gets on a round trip flight from San Francisco to Seattle for a business trip, coming back the same day. Cost $200 He has lunch by himself that day ($30) and takes the client out for dinner to discuss business ($80). He flies back that night. How much is his total deduction related to this trip?
Select one:
a. $200
b. $240 Correct
c. $260
d. $280
The flight is deductible under Sec. 162(a)(2). The Correl case required “sleep and rest” rule related to meals to be “away from home”. So, Paul’s lunch meal that he ate by himself is not deductible (just as if he would have been in SF), but the client meal is 50% allowed. So, the total deduction is 240, which is the flight of $200, plus 50% of the $80 client meal.
The correct answer is: $240
Sue is a sales representative for a corporation which sells computer systems. Sue and her customer were in a business meeting. In order to help improve her business relations with the customer she invites him to lunch with her immediately following the meeting and pays $100 for the meal. Later that evening, Sue takes another client to a SF Giants baseball game where they discussed business during the game. The two tickets cost $200. How much of the $300 paid by Sue is deductible?
Select one:
a. None
b. $50 Correct
c. $150
d. $250
e. $300
$50 is deductible. Since they were discussing business immediately before (or during or after) the meal, it is a deductible business meal. However, under § 274(a) only 50% of the cost is deductible. None of the entertainment (baseball game) is deductible, per § 274(a).
The correct answer is: $50
Fun Company had two events this year in which they provided food and beverages: their summer picnic (spending $6,000) and their Christmas party (spending $4,000). Only employees were allowed to attend the Christmas party, but spouses and children of employees were also invited to the summer picnic. How much of the $10,000 expenditure for this food and beverage is deductible by Fun Company?
Select one:
a. $0
b. $4,000
c. $5,000
d. $7,000
e. $10,000 Incorrect
Section 274(e)(4), referenced from Section 274(n)(2)(A), states that expenses for recreational and social activities are 100% allowed if primarily for the benefit of employees. In this problem, the Christmas party qualifies, but the picnic will include more non-employees so it would be limited to 50%. So, all $4,000, plus $3,000 (50% of $6,000), or a total of $7,000 would be deductible.
The correct answer is: $7,000
On July 4, 20X1, Tom bought a new residential rental real estate for $350,000 of which $275,000 is attributable to the building and the balance to the land and immediately placed it in service. How much depreciation is Tom allowed for 20X1?
Select one:
a. $3,232
b. $4,583 Correct
c. $5,417
d. $5,833
e. $10,000
Your answer is correct.
Land is not an asset eligible for depreciation. We need to allocate the purchase price between the value of the land and the value of the building, and only depreciate the building value. Here was told that the building value is $275,000.
Residential rental property under § 168(e)(2)(A) has an applicable recovery period of 27.5 years § 168(c). Under the mid-month convention, any property purchased in a month is deemed purchased in the middle of the month, regardless of the actual date of purchase. Since the building was purchased in July, it is deemed placed in service July 15 and Tom will be entitled to 5 1⁄2 months of depreciation in the first year.
His 20X1 depreciation = $275,000 ÷ 27.5 years x 5.5/12 month = $4,583.
The correct answer is: $4,583
On October 5, 20X1, Mom&Pop Corp, a calendar year taxpayer, purchased and immediately placed into service new depreciable equipment for $300,000 for his business. The equipment has a “class life” of 8 years and was the only asset purchased during the year. Compute Jim’s deductions related to this equipment in 20X1. Assume §§ 168(k) and 179 do not apply.
Select one:
a. $7,500
b. $9,375
c. $15,000 Correct
d. $45,000
e. $60,000
Your answer is correct.
Since the purchase was all in the last quarter of his tax year, and was his only purchase for the year, it triggers the use of the mid-quarter. § 168(d)(3). Under the mid-quarter convention, goods purchased in January – March are deemed owed for 10.5 months, in April – June deemed owned for 7.5 months, July – September deemed owned for 4.5 months and October – December deemed owned for 1.5 months (assuming a calendar year taxpayer). Therefore, rather than getting 50% of the calculated full year depreciation, he gets only 12.5% (1.5 / 12).
20X1: He can claim first year regular depreciation of $15,000 ($300,000 ÷ 5 years x 200% x (1⁄5/12) mid-qtr year conv = $15,000.
The correct answer is: $15,000
Skip owns 30% of the outstanding X Corporation stock. His shares are worth $1,000,000. He incurred $1,700 of expenses to attend the company’s annual shareholder meeting in which some important business decisions were to be made. The expenses consisted of $1,000 airfare, $500 hotel costs and $200 for meals. Which, if any, of these costs may he deduct?
Under § 212, individuals are allowed to deduct ordinary and necessary expenses paid or incurred during the taxable year for: (i) the production or collection of income, (ii) the management, conservation, or maintenance of property held for the production of income, or (iii) in connection with the determination, collection, or refund of any tax. In Higgins v. Commissioner, the US Supreme Court ruled that managing your own investments does not constitute a trade or business and therefore related expenses are not deductible under § 162. They are deductible, if at all, under § 212.
Harris v. Commissioner, dealt with an individual who traveled out to his property to clear the land and stack firewood. The court found that the costs of some of the trips were appropriate given the value of his investment in the land, but that the primary purpose of one of the trips was personal and was not to maintain the investment property. Thus whether there is another, personal motive is an important factor.
The Tax Court has generally looks at four factors to determine the deductibility of expenses for attending shareholder meetings under § 212: (1) were the costs incurred as part of a rationally planned, systematic investigation of business operations; (2) were the costs reasonable in relation to the magnitude of the investment and the value of the information reasonably expected to be derived from the trip; (3) do the circumstances negate a disguised personal motive for the travel; and (4) whether there is some showing of practical application, e.g., through investment decisions based on information gained from the trip. You can see these factors being weighed by the Court in Harris.
How those factors apply to our problem is a facts and circumstances analysis. In our problem, given the size of his investment, the dollars spent seem reasonable. It does not appear there was a hidden personal motive for taking the trip unrelated to his investment in the company. If so, the deduction for the meal expense of $200 will be limited by § 274(n) to 50% or $100.
It should be noted that in Rev. Rul. 56-511 the service ruled that attending a shareholder’s meeting is not deductible under § 212. However in LTR 8042071 and 8220084 deductions for attending shareholder meetings were allowed.
Tom likes to invest his personal money in a variety of types of investments. This year he spent $1,000 in travel costs and registration fees attending seminars discussing different types of investments. May he deduct the expenses under § 212?
This type of expense is specifically prohibited as a deduction by §274(h)(7). However, if Tom were in the trade or business of an investment advisor, the expense would be deductible under § 162 and § 274(h)(7) would have no application.
Sue paid her attorney $5,000 for his successful work in increasing the alimony payments she is entitled to receive from Tom. She also paid him $2,000 for his work in increasing child support payments due her. Her ex-husband Tom paid $6,000 to his lawyer. Are either Sue or Tom allowed to deduct any of these expenses?
Under § 262, no deduction is allowed for personal expenses. Attorney’s fees related to divorce are not deductible. Treas. Reg. § 1.262-1(b)(7). However, because alimony is taxable income to Sue, expenses incurred in the attempt (successful or not) to produce more alimony are deductible under §212(1). In Wild v. Commissioner the court extended this rule and held that attorney fees properly allocable to initially obtaining alimony were also deductible. Thus, Sue can deduct $5,000 in attorney’s fees relating to increasing her alimony.
No deduction is allowed to Sue with respect to the $2,000 of attorney fees to increase child support. Since child support is not income, the expenses do not relate to the production of income.
Tom is not entitled to deduct any of his attorney fee expenses since he is not producing income. Further, Treas. Reg. § 1.212-1(m) provides that an expense (not otherwise deductible) paid or incurred by an individual in determining or contesting a liability asserted against him does not become deductible by reason of the fact that property held by him for the production of income may be required to be used or sold for the purpose of satisfying such liability.
John is an executive of Bank W. The Bank reimbursed him $20,000 for the following legal and accounting fees he incurred:
Accountant fees for preparation of tax return $2,000
Accountant fees for tax advice 5,000
Legal fees for preparation of will 3,000
Legal fees for tax advice 10,000
What are the tax consequences to John?
John must report $20,000 of income unless an exclusion in § 132 applies. The only possible exclusion is working condition fringe which requires that, had John paid the expenses himself, they would have been deductible by him under § 162 or §167. The accountants fees for the tax return and for tax advice as well as the legal fees for tax advice would be deductible by John, but under § 212, not §162 or § 167 and thus the reimbursement does not qualify for exclusion. Generally fees for will preparation are not deductible unless they are related to tax planning. Rev. Rul. 72-545. Thus John will have $20,000 of income and may claim a miscellaneous itemized deduction of $17,000.
Jack and Jill, a married couple, run a sole proprietorship that is reported on Schedule C of their Form 1040. They paid $10,000 to have their tax return prepared, of which 75% of the cost relates to determining the income and expenses attributable to the business. What is the treatment of the $10,000 expense?
The entire $10,000 of tax return preparation fees would be deductible under §212(3) as a miscellaneous itemized deduction. However, we can treat the 75% allocable to the business as an above the line § 162 expense per Rev. Rul. 92-29. The remaining 25% will be deductible under § 212(3) as a miscellaneous itemized deduction.
Sue has always owned dogs. She began raising and training dogs for dog shows. In 20X1, her first year of raising and training dogs, she incurred a loss of $10,000. In 20X2, she had a smaller loss of only $1,000. Sue deducted these losses on her income tax return. On January 1 of 20X3, Sue received a notice that the IRS intends to disallow these losses under § 183. Sue believes she is engaging in these activities for profit and that the activities will show a profit starting in 20X3 and beyond. What are Sue’s options?
The starting point for the analysis is § 183 which applies if an activity is not engaged in for profit. The definition of “not engaged in for profit” is anything other than one for which deductions are allowable under §§ 162 or 212. §183(c). It is a facts and circumstances test with the relevant factors set forth in Treas. Reg. § 1.183-2(b). The key factors are: 1) Keeping complete and accurate books, having a separate bank account, abandoning unprofitable methods, 2) The time and effort expended by the taxpayer in carrying out the activity; 3) The success of the taxpayer in carrying out other similar or dissimilar activities and 4) The financial status of the taxpayer.
There is a presumption her activity is engaged in for profit if it makes money in three out of five consecutive years. § 183(d) While Sue’s business has yet to turn a profit, she is only two years into her operations. It is still possible for her to show a profit in three of the first five years of her business if she makes money in the current year and the following two years.
Sue has the ability to file an election under § 183(e). The impact of filing this election will be to bar the IRS from assessing a deficiency until the end of the 5th year of the business. This gives her the time to see if she is profitable for each of the next three years and therefore can benefit from the presumption that she had a profit motive for the activities from the start. To make the election Sue must file Form 5213 within 60 days after receipt of the I.R.S. notice. § 183(e)(3); Treas. Reg. §12.9(d)]
Alternatively, Sue could choose not to wait and to attempt to prove to the IRS that she entered into the business for profit. She would need to address the factors in the regulations and would bear the burden of proof.
John and Julia love cooking. They are both teachers and decided that because they have the summers off and enjoy it so much, they would start a small catering business. They are both very organized people and have kept detailed records of their expenses, appointments, and income. They have been doing this for three years and have a small but steadily building clientele. The business is not yet a profitable one but they hope, with a little bit of luck, it will turn around. Are their expenses subject to the §183 limitations?
Since John and Julia have lost money in each of the first three years, there is no way for them to have income in three of their first five years. Therefore they cannot file an election under § 183(e).
They will bear the burden of proof of showing that they entered into the catering business with the dominant intent of realizing a profit. They will need to rely on the factors set forth in the regulations. In their favor are the facts that they kept detailed records of expenses, appointments and income and had a growing clientele. Bad facts include the fact that they have other full time jobs and have yet to make a profit. The fact that they enjoy cooking is neither good nor bad. There is no rule that says you cannot enjoy your work.
Ron has the following income and expenses from an activity he conducts from which is not engaged in for profit. His income and expenses properly allocated to this activity were as follows:
Income $2,000
Property Taxes 800
Utilities & Maintenance 500
Depreciation 1,000
Ron’s adjusted gross income for the year is $68,000 without considering the above items. How much of these expenses may Ron deduct?
Since the facts tell us that Ron does not engage in this activity for profit, we are subject to § 183. Ron will report the $2,000 of income. Under § 183 he will be allowed his full deduction for property taxes and his deduction related of the remaining expenses will be limited to the excess of his income from the activity over the property tax deduction. All excess deductions will be lost permanently.
In determining which expenses are deductible, that are divided into three groups or “tiers.” Tier 1 are deductions which are allowable under other provisions of the code even if he had no earned any income from the hobby. § 183(b)(1). This includes his property taxes, qualified residence interest, and casualty losses. These expenses are deductible in full even if Ron had no income. However, the income from the hobby is first reduced by these Tier 1 expenses, before we can determine whether any of the remaining expenses are deductible.
The remaining expenses are further categorized into Tier 2 and Tier 3 expenses. Tier 2 deductions are all deductions which are not in Tier 1 or Tier 3. They are deductions other than those that affect basis. § 183(b)(2), Treas. Reg. §1.183-1(b)(1)(i). Tier 3 deductions are those that affect basis (e.g. depreciation). § 183(b)(2), Treas. Reg. § 1.183-1(b)(1)(i).
Here the property taxes of $800 are Tier 1 deductions, the utilities and maintenance are Tier 2 deductions and the depreciation is a Tier 3 deduction. After reducing the $2,000 of income for the Tier 1 property taxes, we are left with $1,200 of allowable deductions at Tier 2. Since our Tier 2 deductions are $500, they will be allowed in full and we are left with $700 of allowable Tier 3 deductions. We can take $700 of the $1,000 of depreciation and the remaining $300 of other expenses will never be deductible. There is no carryover of the disallowed expense.
Ron will report the $2,000 as gross income. He will take the property taxes as a regular itemized deduction. The $1,200 of other expenses allowed will be treated as miscellaneous itemized deduction under § 67 subject to the 2% AGI floor. Temp. Treas. Reg. § 1.67-1T(a)(1)(iv), Purdey v. U.S. 92-2 USTC ¶50,894 (Fed. Cl. 1997).
Ron’s AGI is $70,000 ($68,000 + 2,000) and 2% of AGI = $1,400. Assuming he has no other miscellaneous itemized deductions, none of the $1,200 Tier 2 and Tier 3 deductions may be taken. He will still have to report the $2,000 of income but will actually get only the $800 of property taxes as an allowable deduction.
Sue and Dan own a mountain home that they used in the current year for 45 days. They rented out the home for 15 days. Their rental income and the annual expenses for the home were as follows:
Rental Income $2,000
Qualified Residence Interest 2,000
Property Taxes 1,000
Utilities & Maintenance 3,000
Depreciation 6,000
Determine the tax consequences to Sue and Dan.
Section 280A deals with the allowance of deductions related to personal residences which are rented out part of the year as well as home office expenses. Section 280A(a) provides the general rule that no deductions relating to a dwelling unit used as a residence are allowed, except as provided elsewhere in § 280A. Much like § 183, we divide our expenses into three tiers and apply similar ordering rules. A key difference from § 183, however, is that disallowance expenses carry over to future years and can be taken if there is sufficient income.
First we must determine the meaning of “residence.” Under § 280A(d), a taxpayer uses a dwelling as a residence if the number of days of personal use exceeds the greater of: a) 14 days or b) 10% of the rental days. Since their 45 days of personal use exceeds the greater of these amounts, the house is considered to be used as a residence by Sue and Dan and deductions are subject to limitation.
To compute their allowable rental property deductions, we first divide the expenses into three tiers, allocate the deduction in each of those tiers between business use and personal use, and finally apply the income limitation to the Tier 2 and Tier 3 business use expenses. Prop. Treas. Reg. §1.280A-2(i)(5).
Tier 1 expenses are those deductible without regard to business use identified in §280A(b): Taxes, qualified residence interest, and casualty losses. Prop. Treas. Reg. §1.280A-2(i)(5)(i). Tier 2 are all other expenses which would be deducted in a profit-motivated activity such as utilities and maintenance expenses but which don’t reduce basis. Prop. Treas. Reg. §1.280A-2(i)(5)(i). Tier 3 expenses are those expenses which would be deducted in a profit-motivated activity which reduce the basis of assets such as depreciation. Prop. Treas. Reg. § 1.280A- 2(i)(5)(i).
Next we must allocate the expenses between personal use and business use. While Tier 1 expenses remain fully deductible, only the allocated Tier 1 business use expenses will reduce available income as we determine Tier 2 and Tier 3 allowable expenses. On the other hand, any Tier 2 or Tier 3 expenses allocated to personal use will never be deductible, and those allocated to business use are deductible only to the extent of remaining income.
Tier 1 expenses are allocated between rental use and personal use based on the number of rental days to number of days in the year. Bolton v. Commissioner. Here the rental use was 15 days and there are 365 days (366 in leap year). Therefore only $82 of mortgage interest and $41 of taxes are allocable to the rental use. The balance of the taxes and mortgage interest remains fully deductible, but are ignored in applying the income limitation to the Tier 2 and Tier 3 expenses.
Since the taxpayers had $2,000 of rental income and $123 of Tier 1 expenses were allocated to business use, the income limitation of §280A(c)(5) will allow a maximum deduction of $1,877 of the remaining expenses. We must allocate the expenses between Tier 2 (everything except depreciation) and Tier 3 (depreciation) expenses and further allocated those expenses between rental use and personal use.
Tier 2 and Tier 3 the expenses are allocated between rental use and personal use based on a different formula - the number of rental days to total days of use (not days in the year as was used to allocate Tier 1 expenses). §280A(e)(1). Rental use was 15 days; total use was 60 days (15 days rental + 45 days personal use). Therefore 1⁄4 of each Tier 2 and Tier 3 expense will be allocated to the rental activity and the remaining 3⁄4 are nondeductible personal use. As a result, $750 utilities and maintenance (Tier 2 Expense) and $1,500 depreciation (Tier 3 Expense) are allocated to the rental use.
Applying the § 280A(c)(5) limitation
Gross Receipts from Business 2,000
(Business Expenses not connected with the use of the home) (0)
Gross Income (Prop. Treas. Reg. § 1.280A-3(d)(2)) 2,000
Allocated Tier 1 expenses (123)
Limit on Tier 2 Expenses 1,877
Allocated Tier 2 Expenses subject to limit (750)
Limit on Tier 3 Expenses 1,127
Tier 3 Expense subject to limit 1,500
In conclusion, all of the interest and property taxes will be deductible. Of the utilities and maintenance cost, the $750 of allocated to the rental activity will be deductible. Only $1,127 of the $1,500 depreciation expense allocated to the rental activity will be currently deductible. However, the $373 of depreciation disallowed may be carried over to subsequent year as a Tier 3 expense per the flush language in § 280A(c)(5).
How would your answer to Problem 9 change if Sue and Dan rented out the residence for only 14 days?
Section 280A(e) limits the allowable deductions to the rental income. However, a special rule applies if the property is rented for less than 15 days, which it was here. Under §280A(g) Sue and Dan are denied all deductions other than deduction not tied to income (Tier 1 deductions), but can exclude the income. Thus, while they need not report the rent received, they are not entitled to claim any deduction for the $3,000 of utilities expenses or the $3,000 of depreciation. On the other hand, they still get their deduction for the $2,000 qualified residence interest under § 163(h)(3) (assuming the requirement of that statute are met) and the $1,000 in property taxes (under § 164) because these deductions are allowable whether or not the dwelling is rented. § 280A(b).
Chris is a professional saxaphone player, hiring himself out to do gigs at various pubs and entertainment halls. He has set up a special room in his house which is soundproofed in which he practices, has a telephone and answering machine used for business calls, and where he keeps his books and records. He does not use the room for anything other than his music business. His records show the following items of income and expense for the current year:
Business Income and Expense, unrelated to the home
Performance Fee Income 20,250
Business Expenses 12,000
Allocated expenses related to business use of the home
Real estate taxes 3,000
Qualified residence interest 1,000
Utilities 3,000
Depreciation 2,000
In each of the past five years, Chris’s business has been profitable. What are the tax consequences to Chris?
The prior problems dealt with the issue of the deductibility of the expense of a dwelling being used in a rental business. This question raises the deductibility of the expense of the “home office” - a portion of a dwelling used in a trade or business. Section 280A(c)(1) says deductions are allowed with respect to a portion of a dwelling unit exclusively used on a regular basis as 1) the principal place of business of any trade or business of the taxpayer, 2) a place where patients, clients or customers are met, or 3) a separate structure, used in a trade or business.
Under Prop. Treas. Reg. §1.280A-2(b)(2) there is a three part test to determine what is the “principal place of business.” You look to: 1) the portion of total income attributable to each location; 2) the amount of time spent at each location; and 3) the facilities available at each location.
Chris’ home wouldn’t appear to by his principal place of business since he earns his living in nightclubs and not at home. However, the flush language of § 280A(c)(1) states that a home office will meet the principal use test if the home is used for the administrative or management activities of Chris’ trade or business and Chris has no other fixed location where he conducts substantial administrative or management activities. Chris will meet this test and be allowed a deduction for the home expenses properly allocable to his office.
Since Chris is using only a portion of the house, there must be an allocation of his home expenses between business use and personal use, and among the same three tiers discussed in the previous problem. The allocations can be made on any reasonable basis. Usually it is based on the square footage of the work area divided by the total square footage of the home. In our problem, however, we are provided with the expenses already allocated.
The deductibility of these allocated expenses is subject to the income limitation as follows:
Gross Receipts from Business 20,250
(Business Expenses not connected with the use of the home) (12,000)
Gross Income (Prop. Treas. Reg. § 1.280A-3(d)(2)) 8,250
Allocated Tier 1 expenses (4,000)
Limit on Tier 2 Expenses 4,250
Allocated Tier 2 Expenses (3,000)
Limit on Tier 3 Expenses 1,250
Tier 3 Expense subject to limit 1,250
Therefore, the 4,000 interest and taxes, the $3,000 utilities expense and $1,250 of the depreciation will be currently deductible. The remaining $750 Tier 3 depreciation expense is not currently deductible because of the income limitation but will be carried into future years.
Note that under Rev. Proc. 2013-13 the is a safe harbor allowance for home office deductions. Under this safe harbor, Chris would take his Tier 1 expenses plus $5 times the square footage of his office up to 300 square feet ($1,500) which is significantly below the actual deduction Chris is allowed. There are some benefits to the safe harbor, however. First, it reduces the paperwork required since no allocation of Tier 2 or Tier 3 expenses is required. Second, none of the safe harbor deduction is treated as depreciation so that Chris will not need to reduce the basis in his home.
How would your answer to Problem 11 change if the business expenses were $30,000?
If the business expenses were $30,000 there would be no gross income from the business under § 280A. It would show $9,750 negative gross income. Therefore only the $4,000 of Tier 1 expenses would be allowable. The remaining $3,000 of utilities and $2,000 of depreciation would carry over, retaining their character as Tier 2 or Tier 3 expenses. Overall Chris would show a $13,750 loss from the business - the $20,250 of gross receipts less the $30,000 of business expenses and $4,000 of Tier 1 expenses. The non home related expenses are not limited by § 280A(a).
How would your answer to Problem 12 change if Chris’s activities had never been profitable and were subject to § 183?
A home office deduction is available only if a portion of a dwelling unit is used for the taxpayer in the course of his trade or business. If Chris was conducting his hobby from his home, there would be no home office deduction available.
What about § 280A(f)(3) which provides that § 183 does not apply to dwelling units? That would not help us here since we don’t qualify for the home office deduction under § 280A(c)(1).
Here is where § 280A(f)(3) might apply. Assume that taxpayer rents out his house for a few weeks during the year and otherwise uses it as his residence and that his rental activities do not meet the profit motive requirement of § 162. Thus his expenses are potentially subject to denial under § 183. In this circumstance §280A(f)(3) will allow a § 280A deduction of the home expenses allocable to the rental activity and § 183 does not apply to prevent the deductions. Guido Ruggiero TC Memo 1997-423 (1997). However, if the taxpayer’s personal use of the home was insufficient for the home to be treated as his residence, § 280A would not apply. In that circumstance §183 would apply to deny the deductions in excess of income (other than Tier 1 deductions). Senate Report No. 94-938 (PL 94-455) p.153
How would your answer to Problem 11 change if, instead of running his own business, Chris were an employee of the San Francisco Symphony, which provides practice rooms for its musicians?
Under § 280A(c)(1) flush language, if an employee wants to claim a deduction for a home office, there is an additional test that must be met. The home studio will qualify as a principal place of business only if it is maintained “for the convenience of the employer.” Since the Symphony provides practice rooms, it would be difficult to argue that Chris’ home office is maintained for the convenience of the Symphony. Chris would not be entitled to any deduction for his home office.
Robert, who has always loved dogs, trains dogs in his free time. Which is the least relevant factor in determining whether the dog training is an activity engaged in for profit?
Select one:
a. Whether Robert had net income or a net loss in the first year of activity
b. Amount of hours Robert spent each week in the activity
c. The level of his expertise and experience in training dogs
d. Robert’s financial status Incorrect
e. Robert’s use of detailed books that record all transactions in the activity
All of these are important factors to determining whether a taxpayer is engaged in an activity for profit:
Amount of hours Robert spent each week in the activity
The level of his expertise and experience in training dogs
Robert’s financial status
Robert’s use of detailed books that record all transactions in the activity
Whether Robert had net income or a net loss in the first year of the activity is likely the least important factor, as many business may start off losing money in the first year. The trend after year 1 would likely be more important.
The correct answer is: Whether Robert had net income or a net loss in the first year of activity
David has been audited by the IRS. The IRS asserts that David’s dog training is not an activity engaged in for profit. David had a net loss of $22,000 and $16,000 in the first two years. David believes that the first two years of losses related to start up costs to get the business “rolling”. He expects to break even in year 3 and be very profitable in year 4 and 5. He also anticipates by year 4 that he will quit his job and work full time in the dog training business. Under these facts, David should file a §183(e) election.
Select one:
True
False Incorrect
A §183(e) election postpones any assessment of tax where the IRS is alleging that the activity is not for profit. David should make the election because he believes that his factors are stronger after year 5, including devoting more time to the activity and having a better history of income in the activity. As an added bonus, he might even earn the presumption of being for profit if he can turn a profit in year 3, 4, and 5.
The correct answer is ‘True’.
Which of the following statements is TRUE?
Select one:
a. Section 183 will never limit deductions with respect to an activity if the taxpayer shows a profit in the activity in at least 3 of the preceding 5 taxable years
b. Section 183 will always limit deductions with respect to an activity if the taxpayer shows a loss in the activity in at least 3 of the preceding 5 taxable years
c. If §183 applies to an activity for a taxable year, the taxpayer must include the hobby income, but all hobby expenses have been suspended. Correct
d. Losses disallowed under § 183 are carried forward to succeeding taxable years
Earning income in 3 out of 5 years (or not earning income in 3 out of 5 years) merely raises a presumption. That presumption can be overcome with facts to the contrary. Section 183 requires taxpayers determined to be engged in activity not for profit to include the hobby income, but all hobby expenses have been suspended. The excess losses, as well as any disallowed deductions, cannot be carried over.
The correct answer is: If §183 applies to an activity for a taxable year, the taxpayer must include the hobby income, but all hobby expenses have been suspended.
T pays a CPA $10,000 to prepare his income tax return. His CPA estimates that 60% of the $10,000 fees relate to preparing T’s sole proprietorship business (Sch C), a portion of his tax return. How should T handle the $10,000 tax preparation fee on his return?
Select one:
a. Deduct $6,000 as a business expense “above the line” and $4,000 is a nondeductible misc. itemized expenditure. Correct
b. Deduct $4,000 as a business expense “above the line” and $6,000 is a nondeductible misc. itemized expenditure.
c. Deduct all $10,000 as a business expense “above the line”
d. The $10,000 is a nondeductible misc. itemized expenditure.
Feedback Under 212(3), the tax preparation fee is a misc. itemized deduction, currently suspended by 2017 Tax Cuts and Jobs Act. However, Rev Rul 92-29 allows the portion that relates to preparing Sch C to be deducted "above the line" on Sch C to offset business income. Thus, 60% of the $10,000 ($6,000) is deducted on Sch C and $4,000 is a nondeductible misc. itemized deduction (because it is suspended).
The correct answer is: Deduct $6,000 as a business expense “above the line” and $4,000 is a nondeductible misc. itemized expenditure.
Becky sells home-made jewelry out of her home. A room in her home qualifies as a home office. The room’s square footage makes up 10% of the overall square footage of the house. Considering expenses unrelated to the home, the jewelry business has net income of $2,000. She has property taxes and mortgage interest on her entire home of $10,000. How much mortgage interest and property taxes can she deduct anywhere on her return in the current year?
Select one:
a. $0
b. $1,000
c. $2,000
d. $10,000 Correct
Of the $10,000 of property taxes and mortgage interest, $9,000 is deemed personal and deductible on Sch A and $1,000 is business and deductible on Sch C to reduce business income. So, the full $10,000 is deducted somewhere on the return.
The correct answer is: $10,000
Becky sells home-made jewelry out of her home. A room in her home qualifies as a home office. The room’s square footage makes up 10% of the overall square footage of the house. Considering expenses unrelated to the home, the jewelry business has net income of $2,000. She has property taxes and mortgage interest on her entire home of $10,000. Also, she has utilities on her entire home of $8,000. How much utilites can she deduct anywhere on her return in the current year?
Select one:
a. $0
b. $800 Correct
c. $2,000
d. $8,000
e. None of the above
Of the $10,000 of property taxes and mortgage interest, $9,000 is deemed personal and deductible on Sch A and $1,000 is business and deductible on Sch C to reduce business income. This reduces the net business income to $1,000. Of the $8,000 utilities, 10% ($800) is related to business. The other $7,000 is personal and nondeductible. Since $800 is less than the $1,000 net business income, all $800 is deductible on Sch C, reducing net business income.
The correct answers are: $800, None of the above
Becky sells home-made jewelry out of her home. A room in her home qualifies as a home office. The room’s square footage makes up 10% of the overall square footage of the house. Considering expenses unrelated to the home, the jewelry business has net income of $2,000. She has property taxes and mortgage interest on her entire home of $10,000. Also, she has utilities on her entire home of $8,000. Also, she has depreciation on her entire home of $6,000. How much depreciation can she deduct anywhere on her return in the current year?
Select one:
a. $0
b. $200 Correct
c. $600
d. $2,000
e. $6,000
Of the $10,000 of property taxes and mortgage interest, $9,000 is deemed personal and deductible on Sch A and $1,000 is business and deductible on Sch C to reduce business income. This reduces the net business income to $1,000. Of the $8,000 utilities, 10% ($800) is related to business. The other $7,000 is personal and nondeductible. Since $800 is less than the $1,000 net business income, all $800 is deductible on Sch C, reducing net business income to $200. Of the $6,000 of depreciation, only $600 is related to business and thus deductible. However, home related expenses are limited to net business income, which is $200. Thus, only $200 is deductible in the current year and $400 would be carried forward.
The correct answer is: $200
Sue and Dan own a mountain home which they personally used for in the current year for 146 days and rented out for 146 days. It was left unoccupied for 73 days. What percent of property taxes are deducted “above the line” directly against rental income?Twenty percent (73 / 365) of the depreciation expense for the year must be allocated to the rental income.
Select one:
a. 20%
b. 40% Correct
c. 50%
d. 60%
The allocation formula stated (146 days rented / 365 days in the year), or 40% in this problem, applies to the apportionment of taxes as well as mortgage interest.
The correct answer is: 40%
Sue and Dan own a mountain home which they personally used for in the current year for 73 days and rented out for 73 days. Twenty percent (73 / 365) of the depreciation expense for the year must be allocated to the rental income.
Select one:
True Incorrect
False
The allocation formula stated (73 days rented / 365 days in the year) applies to the apportionment of mortgage interest and taxes only. All other expenses would be allocated based on a formula of days rented (73) to total days used (144) or 50%
The correct answer is ‘False’.
Sue and Dan own a home in Indianapolis, Indiana, the site of the 2016 National Football League Super Bowl. Their home is close to the stadium. A travel agent offered them $20,000 a week if they would rent their house for the 16 days leading up to the game. They come to you for advise. You tell them that if they only rent their home for two weeks (2 days less than the 16 days they stated) they would not have to report any of the income and could still deduct their expenses for cleaning the house before and after the rental. Your advice is not completely accurate.
Select one:
True Correct
False
While you were correct that if the rental was limited to 14 days, they will not be taxed on the income. However, they are not allowed any deductions, other than those items which are deductible regardless of income (mortgage interest and property taxes). So you were incorrect when you told them they could deduct the house cleaning costs.
The correct answer is ‘True’.
Tom, single and runs his own tax preparer business. He has Net Schedule C income of $150,000. His only other income is interest income unrelated to his business of $12,500. Assume he takes the $12,000 standard deduction on his current tax return. He runs the business by himself out of his home so he does not pay any W-2 wages nor has he purchased any tangible property.
Ignoring the self-employment tax deduction, how much Section 199A deduction is available to Tom on his current year return?
Per § 199A(b)(2), Tom can take a deduction for 20% of Qualified Business Income (QBI). § 199A(c)(1) defines QBI as coming from a “qualified trade or business”. § 199A(d) identifies a qualified trade or business as any trade or business other than a “specified trade or business”. Unfortunately for Tom, per § 199A(d)(2), his tax preparer business is a specified service trade or business” since it is in the field of accounting.
However, per § 199A(d)(3) taxable income exception (below the threshold amount), Tom can treat his Specified Service Income of $150,000 as QBI.
Tom’s taxable income is calculated as follows: Sch C Income $150,000 Interest Income $ 12,500 Standard deduction ($ 12,000) Taxable Income $150,500
NOTE: For simplicity, we are ignoring the self-employment deduction.
Since Tom’s taxable income is less than $157,500, he can take the full 20% of $150,000, i.e. $30,000, as a § 199A deduction.
Taxable Income Limit: He still must apply the taxable income rule at § 199A(a)(1)(B): the deduction cannot exceed 20% of taxable income less any net long term capital gain. 20% of the taxable income ($150,500) would be 30,100. Since the limit is higher, he is eligible for a deduction of $30,000.
How would your answer to Problem 1 change if Tom received $100,000 of interest income rather than $12,500?
Tom’s tax preparer business is still a specified service trade or business since it is in the field of accounting. Since his taxable income exceeds $217,500, he is not eligible for the § 199A(d)(3) taxable income exception and thus will get zero § 199A deduction.
Tom grows tired of tax preparation. Instead, he starts a new business, opening up a restaurant as a sole proprietorship. He has Net Schedule C income of $150,000. His only other income is interest income unrelated to his business of $12,500. Assume he takes the $12,000 standard deduction on his current tax return. He purchases a building and a lot of tangible personal property for the restaurant. He also hires one employee. He pays W-2 wages of $40,000 and has tangible property of $600,000.
Ignoring the self-employment tax deduction, how much Section 199A deduction is available to Tom on his current year return?
Per § 199A(b)(2), Tom can take a deduction for 20% of Qualified Business Income (QBI). § 199A(c)(1) defines QBI as coming from a “qualified trade or business”. § 199A(d) identifies a qualified trade or business as any trade or business other than a “specified trade or business”. Tom’s restaurant business is not one of the specified trade or business. Thus, the $150,000 of net Schedule C income is QBI.
Tom’s taxable income is calculated as follows: Sch C Income $150,000 Interest Income $ 12,500 Standard deduction ($ 12,000) Taxable Income $150,500
Tom § 199A expense would normally be subject to the wage and property limitations of § 199A(b)(2)(B). However, since his taxable income is less than $157,500, Tom qualifies for the exception under § 199A(b)(3)(B).
Therefore, he can take the full 20% of $150,000, i.e. $30,000, as a § 199A deduction.
Taxable Income Limit: He still must apply the taxable income rule at § 199A(a)(1)(B): the deduction cannot exceed 20% of taxable income less any net long term capital gain. 20% of the taxable income ($150,500) would be 30,100. Since the limit is higher, he is eligible for a deduction of $30,000.
How would your answer to Problem 3 change if Tom received $100,000 of interest income rather than $12,500?
Sch C Income $150,000
Interest Income $100,000
Standard deduction ($ 12,000)
Taxable Income $238,000
Now we have QBI with taxable income above the range or more than the threshold + 50K ($207,500). The computation at 199A(b)(3)(B) applies.
The lesser of:
• 20% of QBI $30,000 ($150,000 * 20%)
-OR-
The greater of
• 50% of W-2 wages $20,000 ($150,000 * $20,000)
Or
25 % of W-2 wages $10,000 (40,000 * 25%) + $15,000 [(2.5% of unadjusted basis ($600,000)]= $15,000 TOTAL $25,000
Tom’s § 199A deduction would be limited to $25,000.
Taxable Income Limit: He still must apply the taxable income rule at § 199A(a)(1)(B): the deduction cannot exceed 20% of taxable income less any net long term capital gain. 20% of the taxable income ($238,000) would be $47,600. Since the limit is higher, he is eligible for a deduction of $25,000.
How would your answer to Problem 3 change if Tom received $39,500 of interest income rather than $12,500?
Tom needs to figure out his excess amount, per of § 199A(b)(3)(B)(iii):
QBI deduction without the W-2 & Basis limit
LESS: QBI deduction if limit applied in full
20% * $150,000 LESS [25% * $40,000 + 2.5% * $600,000]
$30,000 LESS $25,000 = $5,000
Phase-in of the Limit:
$5,000 * 40% = $2,000
40% comes from (177,500 – 157,500) / 50,000
Full Deduction less Limit:
(20% * $150,000) Less $2,000 = $28,000
Tom has qualified business income (QBI) and his taxable income is “in the range”:
Sch C Income $150,000
Interest Income $ 39,500
Standard deduction ($ 12,000)
Taxable Income $177,500 * ignoring self employment tax deduction for this problem.
Tom needs to figure out his excess amount, per of § 199A(b)(3)(B)(iii):
QBI deduction per (2)(A) over the amount determined under 2(B).
Recall from Problem #4
The lesser of:
• 20% of QBI $30,000 ($150,000 * 20%)
-OR-
The greater of
• 50% of W-2 wages $20,000 ($150,000 * $20,000)
Or
25 % of W-2 wages $10,000 (40,000 * 25%) + $15,000 [(2.5% of unadjusted basis ($600,000)]= $15,000 TOTAL $25,000Tom’s § 199A deduction would be limited to $25,000.
Thus, the limit (“excess amount”) is $5,000
Phase-in of the Limit: 199A(b)(3)(B)(ii)
$5,000 * 40% [(177,500-1557,500)/50,000]= $2,000
Full Deduction less Limit:
(20% * $150,000) Less $2,000 = $28,000
Taxable Income Limit: He still must apply the taxable income rule at § 199A(a)(1)(B): the deduction cannot exceed 20% of taxable income less any net long term capital gain. 20% of the taxable income ($177,500) would be $35,500. Since the limit is higher, he is eligible for a deduction of $28,000.
How would your answer to Problem 1 change where Tom was a tax preparer assuming Tom received $39,500 of interest income rather than $12,500?
Tom’s taxable income is calculated as follows: Sch C Income $150,000 Interest Income $ 39,500 Standard deduction ($ 12,000) Taxable Income $177,500
Recall that Tom’s business is a specified service business per 199A(d)(2). 199A(d)(3) provides that if a specified service business generates income greater than the threshold (199A(e )(2), 157,500 (for Tom as single) but not in excess of the top or the range (+50k or +100K mfj), “then that income will not fail to be as qualified business income but only the” applicable percentage.
199A(d)(3)(B) provides the computation to arrive at applicable percentage: 100%- percentage equal to the ratio of excess of taxable income in excess of threshold bears to the range ($50K, $100K mfj).
Tom’s applicable percentage is: 60% [1- [(177,500-157,500)/50,000)]]
* SSI $150,000 * Applicable percentage 90,000 (150,000 * applicable % 60%) * Line 2 now becomes the “new QBI” and 199A(b) applies * 199A(b)(2) initial deduction $18,000 (90,000 * 20%) * 199A(b)(3)(B)(ii) provides for an additional limit when the taxable income is in “the range”: the reduction is “the amount which bears the same ratio to “the excess amount” as the excess of taxable income over the threshold bears to the range. * 199A(b)(3)(B)(iii) the excess is the amount determined under 2(A) [SSI * 20%] over the 2(B) computation- wages computation. * We don’t have any wages in this fact pattern so the computation is as follows: excess of $18,000 (20% * 90,000) and no wages * (ii) computation [(177,500-157,500]/50,000]= 40% * 18,000 *40% = $7,200 (this is the reduction) * 18,000- 7,200 = 10,800 this is your 199A deduction.
The key to this is that 199A(d) takes the initial 20% of SSI income and reduces it by the percentage computation at 199A(d)(3)(B) converting it to “applicable percentage” which then essentially becomes the “new” QBI and the limitation at 199A(b)(3)(B) applies.
Taxable Income Limit: He still must apply the taxable income rule at § 199A(a)(1)(B): the deduction cannot exceed 20% of taxable income less any net long term capital gain. 20% of the taxable income ($177,500) would be $35,500. Since the limit is higher, he is eligible for a deduction of $10,800.
