Chapter 10 - Business Expenses

The way in which a taxpayer derives their income

determines whether business expenses are allowed on their tax return

Expenses incurred in operating a business or investment activity are

deductible if they are ordinary, necessary, and reasonable

Personal expenses are deductible only if

a tax law specifically provides for the deduction

Investigation expenses

are expenses to investigate the creation or purchase of a business

Examples of investigation expenses

• analyzing markets

• labor supply

• availability of resources

Deductibility of investigation expenses, if related to expansion of existing business

can deduct regardless of whether decision is to proceed or not

Deductibility of investigation expenses, if related to opening a new business not currently engaged in

expenses only deductible if decision is to proceed (considered start-up costs)

Start-up costs

expenses that would be deductible as ordinary and necessary business expenses if a business had already begun

Examples of start-up costs

• advertising

• training employees

• rent paid

The maximum amount of start-up expenses that are deductible

in the year the business begins is $5,000

If the total start-up expenses exceed $50,000

then the $5,000 deduction is phased-out for each dollar of start-up costs in excess of $50,000

Once start-up expenses reach $55,000

the $5,000 amount has been reduced to $0

Start-up expenses that are not deductible in the year incurred

can be amortized (straight-line) over 180 months starting with the month that business operations begin

Travel expenses for trips with business purposes

may be deducted

To determine the types of expenses that are deductible

you must determine whether the taxpayer is in: a transportation mode or a travel mode

Transportation mode

• non-overnight travel

• expenses can only be deducted for the cost of transportation from a point of origin to destination and then back to origin

  • can be a variety of means such as automobile, rental car, taxi, bus …

Travel mode

Additional living expenses can be deducted if taxpayer is required to be away from home overnight

• lodging, 100% of meals if served at or by a restaurant, and laundry expenses

Transportation costs deductible

when primary purpose is business related

Commuting between residence and place of business

is not deductible

Travel from one job/work area to another

is deductible

Travel from home to a temporary work location

is deductible if short-term (outside taxpayer area and one year or loss)

Determination of how to deduct operating costs

• actual costs of operating vehicle based on business use mileage percentage or

• prescribed milage rate of 65.5 cents per mile (includes all operating costs except parking and tolls)

Travel mode requires

being away overnight and away from tax home

Tax home is

the primary work location where regular business work conducted, not necessarily place of personal residence

If engagement is accepted away from personal residence

length of time needs to be considered

One year or less

new location is temporary and tax home has not shifted

More than one year or indefinite

tax home shifts to new location

• travel expenses cannot be deducted

• transportation to the new location is commuting (not deductible)

Taxpayer may mix

business and personal travel within same stay

Business travel mixed with personal; following rules apply

• the cost of travel to the location

• if a taxpayer does not meet the 50% test

• business days rule

• other travel expenses

The cost of travel to the location is deductible

only if more than 50% of the total days are business days

If a taxpayer does not meet the 50% test

then none of the transportation costs are deductible

The tax law treats travel days to conduct business

as business days

If Friday and Monday are both business days

then the traveler can count the weekend as business days

Other travel expenses such as lodging and meals

these are only deductible only for business days, any day that has some business activity is classified as business day

Circumstances when taxpayers can deduct lodging even when not away from home

• the employer requires the employee to stay overnight

• the lodging does not exceed five days and does not occur more than once per quarter

• the employee is required to participate in the event that necessitates the overnight stay

• the lodging is not lavish or extravagant

  even if requirements not met, deductible with valid business reason

Travel cannot

be a form of business education

ex: professor touring a country to learn more about it for courses

Companion travel costs are

deductible only if they are employee of the taxpayer or their presence serves legitimate business purpose

Cannot deduct the

costs for attending investment seminars unless individual is in business managing investments

Review the tax rules applicable to both entertainment and education expenses

• entertainment expenses not allowed

• specific rules applicable to education expenses

Deductions are not allowed

for entertainment expenses

Entertainment expenses include

• recreation and amusement activities

• entertainment facilities

• club dues for above activities or social purposes

Expenses that are deductible (not considered entertainment)

• dues for public clubs (eg. rotary clubs), professional organizations, chambers of commerce, and trade associations

• gift provided to others for business purposes (up to $25 per donee) (does not include incidental cost)

• 50% of business meals (receipt must distinguish cost of meals from cost of entertainment)

• employer-paid recreation/social event (eg. holiday party)

Education expenses are not deductible if incurred to

• meet the minimum standard of a current job or

• qualify for a new trade or business

Otherwise deductible if the education

• maintains or improves existing skills required in a current job or

• meets the requirements of an employer or imposed by law to retain employment status

Taxpayer can deduct education expenses if

conditions met, including costs of required books and travel to attend classes

• transportation expenses such as public transit, airfare or automobile expenses

Businesses will likely

require financing at some point

The deduction for business interest expenses considers

the limitations on these associated costs

The deduction for interest expense

may be limited

Congress limited deduction for net business interest expense to

business interest income + (30% X business adjusted taxable income)

Adjusted taxable income does not include

depreciation, amortization, or depletion

Disallowed business interest can

be carried forward indefinitely

Rationale for interest expense limitation

intent is to discourage businesses from taking on too much debt

High-level of debt

increases risk for long-term survival for business

Limitation applies to taxpayers with

average annual gross receipts over last three years that exceeds $29 million

Two exceptions to the threshold

• real property trade or businesses can elect out of the limitation if they use the alternative depreciation system (ADS) to depreciate real property

• farming businesses can elect out of the limitation if they use ADS to depreciate property with a recovery period of 10 years or more

Reality for many businesses is that

not all debts will be collected

A bad debt is an

amount owed to a business that a debtor is unlikely to pay

Direct write-off method

identifies specific debts as partially or entirely uncollectible and a deduction is made

Which method is required for tax purposes

direct write-off method

Allowance for bad debt method

• estimated as a percentage of accounts receivable at year-end

• based on historical patterns and experience

• used for financial reporting, but no permitted for tax purposes

Whether bad debts are deductible depend on

whether the business uses the cash or accrual method

Cash method

income is not recognized until cash is received, therefore cannot deduct a bad debt

Accrual method

income recognized when earned - even if not yet paid

If a debtor never pays the amount owed

the business can deduct a bad debt to offset the income already recognized

A business bad debt is

any debt created in the ordinary course of business operations

Business bad debt may result from

• lending money by those in the trade or business of providing loans

  or

• credit extended to customers who purchase goods or services from a business

A non-business bad debt

is any bona fide loan a taxpayer does not make in a business capacity but that has a genuine profit motive

Bona fide requires

evidence of expectation of repayment:

• loan document

• interest

• collateral requirement

If a loan is not bona fide

treated as a gift to the recipient under tax law

Net operating loss (NOL)

occurs when certain deductible expenditures exceed taxable revenue for a year

Taxpayers can carry

NOLs forward to offset future income

There are currently

three sets of rules for net operating losses, depending on the year the taxpayer incurred the loss (pre-2018, 2018-2020, post-2020)

NOL rules ensure

that over time taxes are paid on the income earned over the life of the business

In the year the NOL is used

the NOL is a deduction for AGI

If the NOL is used in a prior year

the taxpayer deducts the NOL against income in that year and can receive a refund of previously paid taxes by filing an amended return

Year of loss: pre-2018 NOLs

carry back: 2 years

carry forward: 20 years

offset: 100% of taxable income

Year of loss: 2018-2020 NOLs

carry back: 5 years

carry forward: indefinitely

offset: 100% of 2020 taxable income, 80% of post-2020 taxable income

Year of loss: post 2020 NOLs

carry back: no

carry forward: indefinitely

offset: 80% of post-2020 taxable income

Only business losses and casualty losses

can create an NOL

Because the taxable loss for an individual includes personal deductions and investment expenses and losses

these must be added bacl to taxable loss to determine the NOL

Losses from rental activity are treated

as business losses for purposes of computing the NOL

NOL computation steps

• compute individual taxable income or loss

• identify and classify business income and deductions from non-business income and deductions

• ask if the taxpayer itemizes deductions?

• if taxpayer used standard deduction, add back

• if taxpayer used itemized deduction, add back

• add back net capital losses (not to exceed $3,000)

• if an NOL from another tax year

Compute individual taxable income or loss

• if a loss, proceed to steps 2-6

• if report taxable income, pay tax due on income and skip remaining steps

Identify and classify business income and deductions from non-business income and deductions

• business income includes wages, income that flow from S corporation or partnership, or sole proprietorship

• non-business income includes all other sources of income

Ask if the taxpayer itemizes deduction?

If not, proceed to step 4 otherwise proceed to step 5

If taxpayer used standard deduction, add back the following

standard deduction - nonbusiness income

If taxpayer used itemized deduction, add back the following

(itemized deductions - personal casualty losses) - non-business income

Add back net capital losses (not to exceed $3,000), determined as follows

non-business capital losses - non-business capital gain

If an NOL from another tax year increased this year’s taxable loss

this must be added back to the taxable loss to compute the NOL just for the current tax year

Congress has limited

the amount of business losses an individual can deduct each tax year

The limitation on excess business losses applies

to non-corporate taxpayers for losses from sole proprietorships, partnerships, S corporations, and limited liability companies

Wages and capital gains cannot

be used to reduce the amount of the excess business loss

Deductibility is limited according to the following rules

• the disallowance applies to business losses that exceed $578,000/$289,000 (married filing jointly/other) for 2023

• the disallowed amount is added to the taxpayer’s NOL carry forward

• this limitation applies after application of the passive loss rules (ch 11)