Tax 3300 Final Review

Trade/business qualities

Expectation of making profit

Regularity and continuity of operations (doesn't have to be all year)

Active participation

Business expense deduction criteria

Expenses must be ordinary and necessary to be deductible

Ordinary meaning it is normal in the type of business conducted and is not capital in nature (doesn't need to be recurring)

Necessary meaning a prudent businessperson would incur the same expense and the expense is expected to be appropriate and helpful in business

Compensation for services must also be reasonable in amount
Reasonableness is in respect to salaries and other compensation

Cash method requirements

Expenses of cash basis taxpayers are deductible only when they are actually paid with cash or other property

Accrual method requirements

Period in which an accrual basis taxpayer can deduct an expense is determined by applying the "all events test" and "economic performance test"

Economic performance test is met when service, property, or use of property giving rise to the liability is actually performed for, provided to, or used by the taxpayer

Prepaid expenses (12-month rule)

Taxpayers can deduct prepaid expenses only if the amount will be used up before 12 months since benefit started

Ex: If you prepaid for $10,000 of expenses on March 2020 and use $9,000 in 2020 and $1,000 by March 2021, you can deduct the sum ($10,000) in the 2020

If benefit is not used up before 12 months, you can only deduct what is used in the year of

Public policy limitation

Payments considered to be in violation of public policy are not deductible

Expenses contrary to public policy that are not deductible

Bribes and kickbacks
Fines and penalties paid to a government for violation of law

Ordinary and necessary expenses of operating an illegal business are deductible

Exception applies to expenses incurred in illegal trafficking in drugs except COGS (COGS are deductible)

Investigation of a business (similar)

If taxpayer is in a business that is the same or similar as investigated business, all expenses are deductible in year paid or incurred

Similar is if business has similar suppliers, customers, advertisement

Investigation of a business (not similar)

If not acquired, all expenses nondeductible

If acquired, expenses are capitalized as startup expenditures
$5,000 deducted immediately less amount spent on investigation over $50,000
Excess is amortized over 15 years (180 months)

Hobby losses and rebuttable presumption

Itemized deductions

Only otherwise deductible expenses are deductible

hobby expenses are deductible only to the extent of hobby revenue

Rebuttable presumption: if taxpayer shows profit in 3 out 5 consecutive years (2 out of 7 for horses) prior to year in question, burden of proof is shifted to IRS to prove if activity is hobby or trade/business

Hobby loss and personal/rental use expense deduction order

Otherwise deductible expenses (ex: property taxes, home mortgage interest)

All other expenses except below

Amounts for depreciation, amortization, depletion

*Miscellaneous itemized deductions are not deductible

Primarily personal use vacation house

if residence is rented for fewer than 15 days in a year, it is a personal residence

Rent income excluded from gross income

Mortgage interest and real estate taxes are allowed as itemized deduction

No other expenses such as depreciation and maintenance are deductible

Primarily rental use vacation house

if residence is rented for 15 days or more in a year and isn't used for personal purposes for more than the greater of 14 days or 10% of total days rented, residence is treated as rental property

Expenses allocated between personal and rental days if there are any personal use days during the year

Real estate taxes allocated to personal days are deductible as itemized deduction

Mortgage interest and depreciation/utilities allocated to personal days can't be deducted

Deduction of expenses allocation to rental days is for AGI can exceed rent income and result in rental loss

Personal/rental use vacation house

if residence is rented for 15 days or more in a year and is used for personal purposes for more than the greater of 14 days or 10% of total days rented, it is treated as a personal/rental use residence

Expenses must be allocated between personal and rental days and are allowed only to extent of rental income (no losses allowed)

same ordering rule as hobby deductions

For personal, only real estate taxes are deductible (itemized)

Personal/rental use Court approach

Real estate taxes and mortgage interest allocated over 365 days

Other expenses (depreciation, utilities, maintenance, etc.) allocated over basis of total days used

Personal/rental use IRS approach

Real estate taxes and mortgage interest allocated over basis of total days used

Other expenses allocated over basis of total days used

Conversion from personal to rental

Residence can be treated as purely rental use instead of rental/personal if it is converted to rental for 12 consecutive months

If residence was sold at year end, 12 months rule doesn't have to be satisfied, only prove rental status from conversion to year end

By converting, losses are allowed through an extension of return or amended return

Transactions between related parties

Losses incurred from sale of capital assets to related parties are not deductible

Disallowed losses can be used as an offset against future gains when related party sells the asset to a third party

Price sold to 3rd party - Right of offset - Basis of related party

Right of offset can't be carried over or used over the offset gain

Related parties

Siblings, spouse, ancestors, lineal descendants

Corporations that are more than 50% owned by above

NO cousins, in-laws, aunts/uncles

Goodwill/intangible assets from selling an asset

Goodwill is treated as a capital gain

Other intangible assets such as non-compete covenants are ordinary income

Seller cares about classification but buyer doesn't care

Goodwill and non-compete covenants are amortized over 15 years (180 months) so buyer doesn't care about classification

Goodwill will have a lower tax rate than non-compete covenants so seller cares about classification

State/local tax deduction

Tax deduction is limited to $10,000 for joint and $5,000 for separate

You choose to deduct state/local income tax or state/local sales and use tax

Personal casualty losses are deductible if and type of deduction

How to calculate deduction

only deductible if incurred in area designated as a " federal disaster area" by the president (itemized deduction)

If in federal disaster area, loss is X - $100 per casualty event - 10% AGI

If you have more casualty losses than gains

First offset against gains with personal casualty losses that aren't from disaster area

Then deduct personal casualty losses from disaster area if needed

If there are more casualty losses that aren't from disaster area than gains

Offset against gains

Personal casualty losses that aren't from disaster area are not deductible

Personal casualty losses from disaster area are deductible

If you have more personal casualty gain than loss

all losses are deductible for AGI as capital losses

Personal casualty gains are capital gains

Interest on home equity mortgages

not deductible

Only acquisition indebtedness (money borrowed from banks to acquire real property for primary residence is deductible as long as loan is no more than $750,000)

Cancelled debt (bad debt) deduction can be made if

Reasonable collection efforts have been made and

Money given is established to be a loan, rather than a gift (ex: contract, interest paid, collateral, past loans)

Personal losses are deductible only if

they are completely worthless

If only portion of loan is uncollectible, it is deductible only at time of final settlement (final settlement is time when taxpayer has done all they could to collect but it becomes clear that they can't collect)

Cancelled debt deduction is considered

short term capital loss and for AGI (limited to $3,000 per year)

Casualty loss test

Identifiable

Sudden, unexpected, and unusual in nature

Damaging to your property

When can you take a theft loss deduction and what happens if you can recover a casualty loss

You can take a deduction for theft loss in year it was discovered

You can't claim a casualty loss deduction if there is a reasonable prospect of recovery or if your insurance policy can cover all of the loss (uncovered loss can be deducted)

If you receive more cash from insurance policy than the basis of the asset insured

you must pay taxes as if sold

Ex: The basis of the car your own is $10,000 but the insurance policy gives you $20,000, you pay taxes on the $10,000 gain

Casualty loss for business use property amount and type of deduction

If property is completely destroyed, amount of loss is adjusted basis

If property is partially damaged, amount of loss is lesser of adjusted basis or change in FMV immediately before and after accident

Deductible for AGI

Independent contractor vs employee

Relationship is determined by looking at substance of relationship

Ex: payment per project or hourly, location of work, amount of control in work, etc.

Commute expense

by itself is not deductible

An additional expense incurred for business in transportation is deductible

Commute from one job to another job is deductible
If you go home in between going between jobs, that expense is also deductible

Travel expense going to a conference related to your trade/business is deductible
If your spouse goes too and also is involved in that trade/business, it is deductible

Mix of personal and business expense for domestic

If there are more days spent for business than personal, you can deduct the entire cost of the transportation

If more personal days, no transportation cost is deductible

Mix of personal and business expense for international

allocate travel cost based on personal and business days

Days spent flying are business days

Intervening days are business days (days stuck in airport)

Days between business days (weekend, holidays) are business days

Exceptions to allocating costs in international travel (becomes all or nothing)

If entire trip is 7 days or less or

Less than 25% of the trip is personal or

Taxpayer has no substantial control over the arrangement of the trip

What are considered travel expenses and which ones are deductible (personal/business)

Travel expenses include transportation expenses, meals, lodging, incidental expenses

Personal days aren't deductible and business days are deductible

Travel expenses deductibility test

away from home for the day that is substantially longer than your normal working day (overnight)

Must be temporary travel, intent to return

Section 212 expenses

Allows deductions for ordinary and necessary expenses paid or incurred for

Production or collection of income

Management, conservation, or maintenance of property held for the production of income

Expenses paid in connection with the determination, collection, or refund of tax

*Expenses related to the generation of rent and royalty income are for AGI

Section 121

you can exclude up to $250,000 of realized gain from sale of principal residence (excess gain is treated as long-term capital gain)

Section 121 requirements

Must be primary residence (at least 6 months)

Must be owned and used as a primary residence for 2 years out of 5 consecutive years immediately preceding date of sale

Does not mean 5 years have to pass first and the 2 years do not have to be consecutive

If residence was used for business for 3/5 years and personal for 2/5 years, only 2/5 of the exclusion is deductible

Section 121 can only be used by a taxpayer once every 2 years

Exception to 2 year rule for section 121

If you cannot satisfy 2 year rule because of unforeseen circumstances, you allocate based on months as primary residence out of 24 months (ex: If it was your primary residence for one year, only $125,000 is excluded)

Change in health (can include relatives or family)
Change in employment
Other unforeseen circumstances