SOLUTION: SMC Tax Accounting Deductions and Losses & Adjusted Gross Income Outline

Pearson’s Federal Taxation 2020:
Individuals
Thirty-Third Edition
Chapter 6
Deductions and Losses
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Deductions – Generally
• All income is taxable unless specifically excluded.
• No deductions are allowed unless specifically
allowed.
• IRC lays out requirements for deductibility.
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1-3
“For” vs. “From” AGI
“For” AGI – e.g.,
business deductions,
IRAs, SE health
insurance, half SE tax.
AGI = “THE LINE”
“From” AGI – e.g.,
greater of: itemized
deductions or standard
deduction.
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“For” AGI – § 62 Deductions
• Trade or business expenses (Schedule C)
• Loss on sale of trade or business property (Form 4797)
• Expenses for rental or royalty property (Schedule E)
• $300 cash contributions (CARES Act)
• Penalties for early withdrawals of savings (Schedule 1)
• Retirement plans (Schedule 1)
• Medical Savings Accounts (Schedule 1)
• Student loan interest expense up to $2,500 (Schedule 1)
• Unreimbursed K-12 teacher expenses up to $250 (Schedule 1)
• Half of self-employment taxes (Schedule 1)
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Qualified Business Income Deduction –
Sec. 199A
• Qualified Business Income deduction (Form 8995; Form
1040 Line 10)
• Deduction is not a “for AGI” deduction because it is not
listed in § 62
• Deduction is not an itemized deduction (§ 63(d))
• Deductible even if taxpayer takes standard deduction
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Business Activity – Profit Motive
• Expenditures must be because of profit-motivated
activity.
• Expenses must be “ordinary and necessary” to be
deductible.
• Expenses must be “reasonable.”
• Trade or business is defined as “holding one’s self out
to others as engaged in the selling of goods or
services.”
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Expenses not Deductible
• Hobby/personal expenses are not trade or
business expenses.
• § 212 – Individuals could deduct expenses for
investment activity. Can no longer deduct through
2025.
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Legal and Accounting Fees
• If incurred in the ordinary course of a trade or
business, then deduct For AGI; personal not
deductible.
• Includes tax preparation fees for Schedules C, E
(Part I), and F.
• Legal fees for purchasing property must be
capitalized to property’s cost basis.
• Settlements/legal fees associated with defending
against sexual abuse or harassment suits subject to
NDA are not deductible.
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Deductions “From” AGI – Schedule A
• Certain expenditures must exceed a threshold
before the excess can be deducted.
– Medical expenses (7.5% of AGI).
– Casualty losses (10% of AGI) (Form 4684).
• Certain deductions may have other limitations:
– Charitable contributions (% of AGI).
• Other deductions: taxes, interest, certain miscellaneous
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Capitalization vs. Expense Deductions
• Certain expenses which normally would be deductible
may be required to be capitalized per § 263.
• Must capitalize costs if:
1. It provides a permanent improvement or “betterment”
that increases the value of any property; OR
2. “Restore” the property to its normal usage.
• Compare to repairs – keep asset in good condition.
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Expenses Related to Exempt Income
• Cannot deduct any expenses allocated or related to taxexempt income
• Example: interest on debt incurred to purchase tax-exempt
securities
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Expenditures Contrary to Public Policy
• No deduction if payment is:
– Illegal (Sec. 162(c)(1)); or
– Penalty or fine from illegal act (Sec. 162(f)).
• Examples:
– Illegal payments to government employees;
– Kickbacks, rebates, and bribes under Medicare and Medicaid;
– Payments of fines and penalties;
– Illegal under a federal law; illegal under a state law if state
generally enforces law
– Illegal under Foreign Corrupt Practices Act (payment to foreign
government)
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Expenses Relating to Any Illegal
Activity
• While bribes, kickbacks, and fines/penalties for illegal
acts are not deductible, ordinary and necessary
expenses in running the business are deductible.
• Taxpayer must report income from illegal activity.
• However, if activity is drug dealing (including legal
state marijuana sales) or trafficking, then NO
expenses are deductible under Sec. 280E.
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Lobbying and Political Contributions
• Expenses for participating or intervening in a political
campaign are not deductible.
• Generally, expenses associated with lobbying or direct
contact with legislators in order to influence legislation are not
deductible per § 162(e).
– Exception (before 12/22/2017): influencing local
legislators (city or county) on matters of direct interest to
the taxpayer’s business.
– Exception: expenses incurred directly by taxpayer for
lobbying do not exceed $2,000.
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Business Investigation and PreOpening Expenses
• § 195 – Allows a current deduction for start-up
expenses in year business starts.
– Business investigation
– Pre-opening/start-up costs

Deductible if already in the business
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Business Investigation and PreOpening Expenses
• Can elect to deduct
• Current deduction = lesser of:
– Actual amounts spent; or
– $5,000 with dollar-for-dollar phase-out for amounts
over $50,000.
• Rest must be capitalized and amortized over 180 months
starting in month new business begins.
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Substantiation
• Taxpayer must keep proof of deduction (receipts, cancelled
checks, etc.).
• Cohan rule: courts may allow deduction not properly
substantiated if clear expenditure was made (e.g.,
taxpayer’s records destroyed).
• Sec. 274 – for travel, gifts, and certain property (e.g.,
computers), must follow specific requirements including
providing following information: expense amount, time and
place of travel, date and description of gift, business
purpose, business relationship to taxpayer. Cohan rule
does not apply.
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When Expenses Are Deductible –
Cash Method
• General Rule: deduct expenditures when paid
• Credit card charge: when charged
• Mail late in year: deductible but have proof of mailing
• Receive late in year and payee doesn’t cash:
deductible
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Prepaid Expenses – Cash Basis
• Generally, prepaid expenses are not deductible when
paid.
• Exception: prepaid rent can be deducted when paid if:
1. Period covered by prepayment ≤ 1 year;
2. Prepayment is required by the lease.
(Zaninovich case)
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Prepaid Interest – Cash Basis
• Generally – Taxpayer can only deduct over period of time
to which interest expense relates.
• Exception – points if:
1.
2.
3.
4.
1. Paid in connection with purchase (not refinancing) of
principal residence, which secures loan
2. Are a percentage of loan
3. Points are an established business practice in the
region
4. Specified as “points” in loan agreement
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Accrual Method
• Taxpayer can deduct amounts paid if both :
1. All-Events Test; AND
2. Economic Performance (“EP”) Test
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All-Events Test – Two Requirements
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Exception to Economic Performance
Test – Must Meet ALL Criteria
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Hobby Losses – Sec. 183
• Question of whether taxpayer engaged in activity is for
profit or personal: based on factors (next slide).
• Presumptive Rule: The taxpayer is presumed to have a
profit motive if he/she can show a profit for 3 out of 5
consecutive years. The IRS then will have the burden of
proof to disprove the taxpayer’s position.
– May have to extend statute of limitations (Form 5213).
• If activity considered a hobby, then taxpayer could deduct
expense up to amount of gross income as miscellaneous
itemized deduction but TCJA suspended through 2025.
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Hobby Loss – Factors –Taxpayer must
prove
• Whether taxpayer conducts in businesslike manner
• Expertise of taxpayer or taxpayer’s advisors
• Time and effort expended by taxpayer
• Whether assets used expected to appreciate
• Success in carrying on other similar activities
• History of profits or losses
• Amount of occasional profits
• Taxpayer’s financial status
• Elements of personal pleasure or recreation
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Vacation Homes – Sec. 280A
• Deductions limited if property is taxpayer’s
“residence.”
• Property is residence if taxpayer’s personal use
exceeds the greater of:
1. 14 days or
2. 10% of the number of days property is rented at
FMV.
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Vacation Homes – Categories
Three categories:
1. Primarily Personal – rented for 15 days
and personal use exceeded larger of: a) 14 days or b)
10% rented days.
3. Primarily Rental – rented for > 15 days and personal
use did not exceed larger of: a) 14 days or b) 10%
rented days.
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Vacation Homes – Tax Impact
1. Primarily personal – Taxpayer may exclude from gross
income the rental income received, but may not deduct
expenses related to the home, other than the itemized
deductions otherwise allowed for property tax and
mortgage interest expense.
2. Mixed personal and rental – Taxpayer must report all rental
income and reduce by allocated rental expenses. A rental
loss is not allowed. Losses are carried forward, and are
deductible against the subsequent year’s rental income.
3. Primarily rental – Taxpayer must report all rental income
and may deduct all allocated rental expenses (even if
resulting in a loss) against that income. Interest and
property taxes are deductible without any allocation.
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Vacation Homes – Allocation of Expenses
• Expenses must be allocated between taxpayer’s
personal and rental use.
• Personal Use:
– Taxpayer or family uses property for personal use,
unless charged FMV rent.
– Property is being used under reciprocal-use
arrangement.
– Any day FMV rent is not charged.
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Vacation Homes – Order of Deductions
• Tier 1: Otherwise deductible even if no trade or
business
• Tier 2: Trade or business expenses other than
depreciation
• Tier 3: Depreciation
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Vacation Homes
ERROR: no allocation of
Tier 1; all are deductible
on Schedule E
(c) Is incorrect
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Vacation Homes – Allocation of
Expenses
Total Expenses for Year x Number of Rental Days 
Total Number of Days Used
• Some courts favor approach for interest and taxes
of allocating based on ratio of number of rental
days  total number of days in year NOTE THAT
IF CATEGORY 3, ALL INTEREST AND TAXES
ARE DEDUCTIBLE.
• Only depreciation actually deducted reduces basis
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Copyright
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Pearson’s Federal Taxation 2020:
Individuals
Thirty-Third Edition
Chapter 7
Business Expenses and
Deferred Compensation
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Types of Employee (“EE”) Expenses
• REIMBURSED
• UNREIMBURSED
– Expenses incurred by
EE.
– Expenses incurred by
EE.
– Reimbursed by
Employer (“ER”).
– Not reimbursed by ER.
– EE can deduct “For”
AGI if amounts were
taken into income.
– Not deductible starting
in 2018.
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Employer–Employee Relationship
• Definition of ER/EE: ER has right to control and direct
EE regarding end results and means of performing
services.
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Qualified Business Income (QBI)
Deduction (Ch. 8)
• Reduces taxable income, not AGI; not an itemized
deduction
• Lesser of:
– 20% of qualified business income
– 20% of taxable income, less net capital gain
• Not to exceed greater of:
− 50% of W-2 wages
− 25% of W-2 wages, plus 2.5% of unadjusted
basis of qualified property
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Deductibility of Travel Expenses
• Self-employed
– Deductible “For” AGI.
• Employee
– Not deductible if unreimbursed starting in 2018.
• Personal
– Not deductible.
• The following slides pertain primarily to the
deductibility of business expenses for self-employed
individuals.
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Requirements for Travel Deduction
• Expenses must be business related.
• Worker must be away from tax home overnight on a
temporary basis.
• If not away from home, can deduct only transportation
costs if business related.
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“Away From Home” Requirement –
Issues (1 of 2)
• Where is taxpayer’s home? Principal place of
business.
• “Temporary” v s. “Indefinite” v s. “Permanent”
ersu
ersu
• Away one year or less: either temporary or
indefinite depending on facts and circumstances
• More than one year: indefinite
• “Overnight”: reasonable to need to obtain sleep or rest
on trip in order to meet demands of job.
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“Away From Home” Requirement –
Issues (2 of 2)
• Temporary
– Travel expenses are deductible.
• Indefinite
– Tax home shifts to assigned work place.
– Travel expenses are not deductible.
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Business vs. Pleasure
• If primarily personal, deduct only expenses
directly related to business.
• If primarily business, all travel expenses
deductible, plus other expenses allocated to
personal.
• To determine primary purpose, compare time
spent on personal and business activities.
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Automobile Expenses – deduct actual
expenses or mileage rate
• Standard Mileage
• Actual





Depreciation
Gas & Oil
Repairs & Maintenance
Insurance
License Fees






58¢ per mile (2019)
57.5¢ per mile (2020)
Parking
Tolls
Interest Expense
Personal Property
Taxes
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Automobile Expenses
• If change from mileage method to actual costs, basis of
automobile must be reduced by 27 cents per mile (2020),
26 cents per mile (2019), 25 cents per mile (2017, 2018);
and use straight line depreciation method (ADS)
• Can change from actual costs to mileage method, only if
depreciated under ADS.
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Entertainment and Club Dues
• Entertainment expenses are no longer deductible
starting in 2018.
• No deduction allowed for costs to build or maintain
entertainment or recreation facilities (e.g., skyboxes,
ski lodges).
• No deduction allowed for club dues (airline clubs, golf
clubs, social clubs).
• Can deduct dues for professional, civic, and public
service organizations (e.g., chambers of commerce,
trade associations).
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Meals
• Generally deductible, limited to 50% of cost.
• Must meet the following criteria:





Must be “ordinary” and “necessary.”
Cannot be lavish or extravagant.
Taxpayer must be present when meal is provided.
Food is being provided to client or potential client.
Food must be billed separately if provided with
entertainment.
• Meals purchased while traveling “away from home”
are also deductible.
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Business Gifts
• Deductible up to $25 per donee.
• Amounts > $25 are disallowed.
• Not subject to 50% reduction.
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Employee Business Expenses
• ACCOUNTABLE
1. Substantiation – EE
must make adequate
accounting to ER.
2. Employee must
return excess
reimbursement.
• NONACCOUNTABLE
1. Reimbursement is
included in EE’s gross
income. EE cannot
deduct these
amounts.
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Accountable Plans
• Reimbursements are included in gross income and
expenses are deductible “For” AGI.
• Can use per diem allowances for meals and lodging
expenses in lieu of actual expenses.
– Taxpayer need only substantiate the time, place,
and business purpose of the trip. No other receipts
of actual costs are needed.
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Requirements for Moving Expenses
• After 2017, moving expenses are not deductible to
either self-employed individuals and employees.
• Exception: taxpayers who are actively serving in the
Armed Services may deduct moving expenses.
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Requirements for Deductibility of
Educational Expenses
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Home Office – Sec. 280A
• To deduct home office expenses, office must be used
regularly and exclusively as:
▪ Principal place of business for taxpayer’s trade or
business, OR
▪ Meets or deals with clients in the normal course of
business
• Form 8829
• Principal place of business:
• Where primary services performed
• Used for administrative/management services and no
other location where taxpayer conducts these services
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Types of Home Office Expenses
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Calculating the Home Office Deduction
• Total Home Office expenses = 100% of direct
expenses + pro rata share of indirect expenses.
• Safe Harbor – Instead of deducting direct + indirect
expenses, the taxpayer can deduct $5/square foot
(max of 300 sq. ft.) for home office expenses.
• Cannot exceed net income from business activity.
– Carryforward disallowed expenses
– Ordering …
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