Income Tax Chapter 7: Business Deductions and Losses

Bad debt:

If a taxpayer sells goods or provides services on credit and, later, the account receivable becomes worthless, a ______ deduction is allowed only if the income related to the account receivable was previously included in income. No deduction is allowed.

Specific Charge-off Method:

Must be used for tax purposes when accounting for bad debts. A taxpayer using thise method may claim a deduction in the year when a specific business debt becomes either partially or wholly worthless. A nonbusiness debt must be wholly worthless to claim a deduction. The taxpayer must be able to document the fact that the debt is either partially or completely worthless. legal proceedings against the debtor are not required as long as the taxpayer can demonstrate that collection is unlikely.

Reserve Method:

Certain financial institutions are allowed to use this method for computing deductions for bad debt.

Nonbusiness Bad Debt:

Unrelated to the lender’s trade or business either when it was created or when it became worthless. Loans to relatives or friends are the most common type of nonbusiness bad debt. Can’t deduct bad debt until you are told you will never deduct again.

Business Bad Debt:

Treated as an ordinary deduction in the year incurred. In contrast, a nonbusiness bad debt is always treated as a short-term capital loss. You can deduct as soon as you know the loan is impaired.

An individual may deduct the following losses under code 165:

• Losses incurred in a trade or business.

• Loss incurred in a transaction entered into for profit.

• Losses caused by fire, storm, shipwreck, or other casualty or by theft.

Casualty Loss:

A loss that arises from an identifiable event that is sudden, unexpected, or unusual. Generally, losses resulting from fire, storm, or shipwreck are these losses. Weather that causes damage must be unusual and severe for the particular region. Damage must be to the taxpayer’s property to qualify as this. President has to say it is a federal disaster zone.

Theft Losses:

Includes, but is not necessarily limited to, larceny, embezzlement, and robbery. Theft does’nt include misplaced items. They are deducted in the year of discovery, which may not be the same year of the theft. If the insurance claim exists, and there is a reasonable expectation of recovering the adjusted basis of the asset from the insurance company, no deduction is permitted. if, in the year of settlement, the recovery is less than the asset’s adjusted basis, a partial deduction may be available. If the recovery is greater than the asset’s adjusted basis, gain may be recognized.

Disaster Area Losses:

Are casualties sustained in an area designated as a disaster area by the President of the United States. In these cases, a taxpayer may elect to treat the loss as having occurred in the taxable year immediately preceding the taxable year in which the disaster actually occurred.

A different measurement rule applies for particular destruction of business or rental property and for partial or complete destruction of personal use property. In these situations, the loss is lesser of the following:

• The adjusted basis of the property.

• The difference between the fair market value of the property before the event and the fair market value immediately after the event.

Generally, an appraisal before and after the casualty is needed to measure the amount of the loss. However, the cost of repairs can be used if the following criteria are met:

• The repairs are necessary to restore the property to its condition immediately before the casualty.

• The amount spent for repairs is not excessive.

• The repairs do not extend beyond the damage suffered.

• The values of the property after the repairs does not, as a result of the repairs, exceed the value of the property immediately before the casualty.

Qualified Disaster Loss:

An area in which the president has declared a major disaster from January 1, 2020 to September 2, 2025, for incidents that began between December 28, 2019, and ended no later than August 3, 2025.

Research and Experimental (R&D) Expenditures:

These are incurred in connection with the taxpayer’s trade or business which are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. The term generally includes all such costs incident to the development or improvement of a product, including the costs of obtaining a patent.

Expenditures paid or incurred for the following are not considered research and experimentation expenditures:

• Expenditures for the acquisition or improvement of land.

• Expenditure for the acquisition or improvement of depreciable or depletable property to be used in connection with research or experimentation

• Exploration expenditures paid or incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral, including oil and gas.

Excess Business Loss:

The aggregate deductions for the year attributable to the taxpayer’s business.

Less: The sum of aggregate gross income or gains of the taxpayer’s

Less: A threshold amount (in 2026, $512,000 for married taxpayers filing a joint return; $256,000 for all other taxpayers)

Net Operating Loss:

To provide partial relief from this inequitable tax treatment, a NOL is allowed. NOLs for any year can be offset against taxable income of other years.

Carrying Forward NOL:

Taxpayers must wait at least one year to receive a tax benefit from the loss.

NOL Deduction Limit:

Limited to 80 percent of taxable income, determined without regard to the NOL deduction itself. If the carryover is less than the computed limitation, the entire carryover is allowed as a deduction.

To arrive at the NOL for an individual, taxable income must be adjusted as follows:

1. The NOL carryover from another year is not allowed in the computation of the current year’s NOL.

2. The qualified business income deduction is not allowed.

3. Capital losses and nonbusiness deductions are limited in determining the current year’s NOL.

The limits determining the current year’s NOL:

• The excess of nonbusiness capital losses over nonbusiness capital gains must be added back.

• The excess of nonbusiness deductions over the sum of nonbusiness income and net nonbusiness capital gains must be added back.

• The excess of business capital losses over the sum of business capital gains and the excess of nonbusiness income and net nonbusiness capital gains over nonbusiness deductions must be added back.

• The add-back for net nonbusiness capital losses and excess business capital losses does not include net capital losses not included in the current-year computation of taxable income because of the capital loss limitation provisions.

Income has three different measures:

Gross income, adjusted gross income, and taxable income.

Deductions for AGI:

Include to get AGI from gross income: business expenses, rental expenses, capital losses, and all items on schedule 1 page 2.

Deductions from AGI:

Include after you have AGI and to get taxable income: standard or itemized deduction (whichever is higher), qualified business income deduction, all items on schedule 1A (new deductions).

Business and income producing deductibles are deductible as long as they are:

Reasonable, ordinary, and necessary.

Personal Expenses:

Are not deductible unless the tax code explicitly says they are. Can find the list on schedule 1 page 2 (for AGI), schedule 1A, and schedule A (from AGI).

For individual income tax:

Use the cash basis.

When notified stock is worthless special rules:

1. Allowed to assume stock is sold for nothing.

2. On the last day of the year in which it becomes worthless.

Losses on Section 1244 Stock:

For small business corporations. Means capitalization is less than or equal to $1,000,000. Only applies to the initial buyer of the stock. The rule is:

• Single → First $50,000 of section 1244 stock loss is treated as ordinary (deduct all this year). Any amount above $50,000 remains capital.

• Married Filing Jointly → First $100,000 is ordinary.

Measuring the loss of a business casualty:

• If completely destroyed, the loss is the basis of the asset.

• If partially destroyed, loss is the lower of basis or loss in value.

Measuring Personal Casualty Loss:

Loss is always the lower of basis or loss in value.

R&D Expenses can either be:

1. Expense them when paid.

2. Defer and amortize over 60 months starting with the month the new item is first used.

Foreign R&D:

Defer and amortize over 180 months starting in the month first used.