Chapter 6
Deductions and Losses
Learning Objectives
? Distinguish between deductions for and
from AGI
? Discuss the criteria for deducting
business and investment
? List the substantiation requirements for
deducting travel and entertainment
expenses
? Explain the timing of deductions under
both the cash and accrual methods
Learning Objectives
? Explain the Tax consequences of wash sales
? Tax consequences of transaction between
related parties
? Discuss the criteria for determining whether
an activity is a hobby or trade or business
? Determine the tax consequences of vacation
homes,
For Versus From AGI Classification
? For AGI
– Reduces AGI which affects the
allowable deduction for itemized
deductions
– Most common deductions for AGI
? Trade or business expenses
? IRAs
? Alimony
? Losses on investment
? Interest paid by certain
individuals on qualified
educational loans
? 1/2 of self-employment tax and
60 % of health insurance costs
paid by self-employed
individuals
For Versus From AGI Classification
? From AGI
– Itemized deduction
only will have tax
benefit if the total
deductions exceed
the applicable
standard deduction
Criteria For Deducting Business
And Investment Expenses
? Related to a profit-
motivated activity
? Ordinary expenses
? Necessary expenses
? Reasonable expenses
? Properly documented
? An expense of the
taxpayers(not someone
else’s expense)
General Restrictions on the
Deductibility of Expenses
? Capitalization versus
expense deduction
? Expenses related to
exempt income
? Expenditures that are
contrary to public
policy
? Other expenditures
that are specifically
disallowed
Proper Substantiation
Requirement
? The taxpayer has the
burden of proof
? The Cohan rule
? More restrictive
substantiation
requirements for
travel,entertainment,
business gifts
When An Expense Is
Deductible
? Cash method
– Deduct expenses when
paid
– Prepaid expenses which
extend beyond the end
of tax year must be
amortized
– Points paid in principal
residence
? Clearly disclosed
? Secured by residence
When An Expense Is
Deductible
? Accrual method
– Allowed to deduct expenses in the
period in which the expenses
accrue under the all-events test and
economic performance test
– All-events test is met
? When amount of liability is
established
? Amount of liability is determined
with reasonable accuracy
– Economic performance test is met
? When economic performance is
deemed to occur (see Table I6-1)
Special Disallowance Rules
? Wash sales occurs
when,substantially
identical” stock or
securities are
acquired by the
taxpayer within a 61
day period of time
that extends from 30
days before the date
of sale to 30 days
after the date of sale
Special Disallowance Rules
? Related parties
transaction
? Losses on sales
of property and
expenses that
remain unpaid at
the end of the
tax year,
Special Disallowance Rules
? Hobby losses
– The IRS uses several factors
to determine whether an
activity is profit-motivated
? Does the taxpayer conduct
the activity in a businesslike
manner
? The time and effort expended
? Whether the assets are
expected to appreciate,
? Hobby Income must be reported
on Form 1040 and Expenses are
deducted on Schedule A,
Special Disallowance Rules
? Property used for
personal and
rental use
(Vacation Home)
– See allocation
formula on page 6-
32 in textbook
? Home office
? Entertainment
facility
Tax Planning
Considerations
? Control timing of hobby
losses
? Unreasonable
Compensation – If the
IRS feels that a salary
payment to an officer is
excessive,it will often
recharacterize the
excess portion as a
dividend
? Timing of deductions
Compliance And Procedural
Considerations
? Schedule C for individual trade or
business
? Schedule E for rents and royalties
? Other investment expenses are
reported on Schedule A
Compliance And Procedural
Considerations
? Proper substantiation
– IRS scrutiny
– Statutory requirements
? Travel and entertainment are of
particular interest to the IRS
Compliance And Procedural
Considerations
? Hobby Losses
– Form 8829 to claim home office
deduction on Schedule C
– Form 2106 to claim home office
deduction by employees
– Taxpayer may be willing to extend
statute of limitation’s period to prove
profit motive by filing Form 5231
Deductions and Losses
Learning Objectives
? Distinguish between deductions for and
from AGI
? Discuss the criteria for deducting
business and investment
? List the substantiation requirements for
deducting travel and entertainment
expenses
? Explain the timing of deductions under
both the cash and accrual methods
Learning Objectives
? Explain the Tax consequences of wash sales
? Tax consequences of transaction between
related parties
? Discuss the criteria for determining whether
an activity is a hobby or trade or business
? Determine the tax consequences of vacation
homes,
For Versus From AGI Classification
? For AGI
– Reduces AGI which affects the
allowable deduction for itemized
deductions
– Most common deductions for AGI
? Trade or business expenses
? IRAs
? Alimony
? Losses on investment
? Interest paid by certain
individuals on qualified
educational loans
? 1/2 of self-employment tax and
60 % of health insurance costs
paid by self-employed
individuals
For Versus From AGI Classification
? From AGI
– Itemized deduction
only will have tax
benefit if the total
deductions exceed
the applicable
standard deduction
Criteria For Deducting Business
And Investment Expenses
? Related to a profit-
motivated activity
? Ordinary expenses
? Necessary expenses
? Reasonable expenses
? Properly documented
? An expense of the
taxpayers(not someone
else’s expense)
General Restrictions on the
Deductibility of Expenses
? Capitalization versus
expense deduction
? Expenses related to
exempt income
? Expenditures that are
contrary to public
policy
? Other expenditures
that are specifically
disallowed
Proper Substantiation
Requirement
? The taxpayer has the
burden of proof
? The Cohan rule
? More restrictive
substantiation
requirements for
travel,entertainment,
business gifts
When An Expense Is
Deductible
? Cash method
– Deduct expenses when
paid
– Prepaid expenses which
extend beyond the end
of tax year must be
amortized
– Points paid in principal
residence
? Clearly disclosed
? Secured by residence
When An Expense Is
Deductible
? Accrual method
– Allowed to deduct expenses in the
period in which the expenses
accrue under the all-events test and
economic performance test
– All-events test is met
? When amount of liability is
established
? Amount of liability is determined
with reasonable accuracy
– Economic performance test is met
? When economic performance is
deemed to occur (see Table I6-1)
Special Disallowance Rules
? Wash sales occurs
when,substantially
identical” stock or
securities are
acquired by the
taxpayer within a 61
day period of time
that extends from 30
days before the date
of sale to 30 days
after the date of sale
Special Disallowance Rules
? Related parties
transaction
? Losses on sales
of property and
expenses that
remain unpaid at
the end of the
tax year,
Special Disallowance Rules
? Hobby losses
– The IRS uses several factors
to determine whether an
activity is profit-motivated
? Does the taxpayer conduct
the activity in a businesslike
manner
? The time and effort expended
? Whether the assets are
expected to appreciate,
? Hobby Income must be reported
on Form 1040 and Expenses are
deducted on Schedule A,
Special Disallowance Rules
? Property used for
personal and
rental use
(Vacation Home)
– See allocation
formula on page 6-
32 in textbook
? Home office
? Entertainment
facility
Tax Planning
Considerations
? Control timing of hobby
losses
? Unreasonable
Compensation – If the
IRS feels that a salary
payment to an officer is
excessive,it will often
recharacterize the
excess portion as a
dividend
? Timing of deductions
Compliance And Procedural
Considerations
? Schedule C for individual trade or
business
? Schedule E for rents and royalties
? Other investment expenses are
reported on Schedule A
Compliance And Procedural
Considerations
? Proper substantiation
– IRS scrutiny
– Statutory requirements
? Travel and entertainment are of
particular interest to the IRS
Compliance And Procedural
Considerations
? Hobby Losses
– Form 8829 to claim home office
deduction on Schedule C
– Form 2106 to claim home office
deduction by employees
– Taxpayer may be willing to extend
statute of limitation’s period to prove
profit motive by filing Form 5231
