Essentials of taxation 2016 cengage chapter 05

Chapter Business Deductions Essentials of Taxation © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Big Picture (slide of 4) • Michael Forney operates his small engine service and repair business as a C corp with a December 31 yearend, uses the accrual method of accounting, and has $435,500 of gross income • Forney owns 80% of the corp’s stock, while his wife, Kathleen, and his mother, Terry, each own 10% of the stock • Michael is a full-time employee at his business – His mother helps out with the books for about two hours a week – At this time, Kathleen does not work at the business The Big Picture (slide of 4) • Michael Forney reports the following expense information from his small engine service and repair business Salaries and wages (including Michael’s salary of $55,000 and Terry’s salary of $3,000) Building rent Depreciation of machinery, equipment, and office furnishings* Insurance (coverage for all assets) Consulting Fees Utilities Taxes and licenses Advertising Interest expense Charitable contributions Dues –Small Engine Repair Institute Political contributions • $150,000 24,000 13,000 6,000 6,000 12,000 6,000 3,000 3,000 3,000 10,000 2,000 *$130,000 of new machinery and equipment were purchased this year The financial reporting system depreciation is based on straight-line depreciation over 10 years The MACRS cost recovery period for tax purposes is years Prior year assets have been fully depreciated The Big Picture (slide of 4) • Michael would like to know the amount of his deductible expenses for tax purposes and would like your advice on another matter • Because his business has been very profitable over the years, it has built up large cash reserves, and its cash flow continues to be strong – His business has never paid any dividends to the shareholders • For next year, he is considering paying himself a salary of $140,000 and his mother a salary of $30,000 – This would give them more cash to spend for planned vacations and home improvements The Big Picture (slide of 4) • Finally, during the current year, Michael purchased another personal residence for $300,000 and converted his original residence to rental property – The original residence cost $250,000 five years ago and has a current market value of $180,000 • He also purchased a condo for $170,000 near his business, which he will rent out to tenants • Read the chapter and formulate your response Trade or Business Deductions (slide of 2) • Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including: – Reasonable salaries paid for services – Expenses for the use of business property – One-half of self-employment taxes paid • Such expenses are deducted for AGI Trade or Business Deductions (slide of 2) • In order for expenses to be deductible, they must be: – Ordinary: normal, usual, or customary for others in similar business, and not capital in nature – Necessary: prudent businessperson would incur same expense – Reasonable: question of fact – Incurred in conduct of business Trade or Business Deductions (slide of 2) • In order for expenses to be deductible, they must be: – Ordinary: normal, usual, or customary for others in similar business, and not capital in nature – Necessary: prudent businessperson would incur same expense – Reasonable: question of fact – Incurred in conduct of business Trade or Business Deductions (slide of 2) • In order for expenses to be deductible, they must be: – Ordinary: normal, usual, or customary for others in similar business, and not capital in nature – Necessary: prudent businessperson would incur same expense – Reasonable: question of fact – Incurred in conduct of business The Big Picture - Example Ordinary and Necessary Requirement • Return to the facts of The Big Picture on p 5-1 • The business, a closely held C corp, is owned by Michael Forney, his wife, Kathleen, and his mother, Terry • The company has been highly profitable – It has never paid dividends • Michael is the key employee of the business – His mother plays a very minor role • Assume their current salaries of $55,000 and $3,000 are comparable to what they could earn at similar companies for the work they 10 Farm Property (slide of 2) 92 Alternative Depreciation System (ADS) (slide of 2) • ADS is an alternative depreciation system that is used in calculating depreciation for: – Alternative minimum tax (AMT) – Assets used predominantly outside the U.S – Property owned by the taxpayer and leased to tax exempt entities – Earnings and profits 93 Alternative Depreciation System (ADS) (slide of 2) • Generally, use straight-line recovery without regard to salvage value – For AMT, 150% declining balance is allowed for personalty – Half-year, mid-quarter, and mid-month conventions still apply 94 Amortization (slide of 2) • Can claim amortization deduction on § 197 intangibles – Use straight-line recovery over 15 years (180 months) beginning in month intangible is acquired • Section 197 intangibles include acquired goodwill, going-concern value, trademarks, trade names, etc 95 Amortization (slide of 2) • Startup expenditures are also partially amortizable under § 195 – Treatment is available only by election • Allows the taxpayer to deduct the lesser of: – The amount of startup expenditures, or – $5,000, reduced by the amount startup expenditures exceed $50,000 – Any amounts not deducted may be amortized ratably over 180-months beginning in month trade or business begins 96 Depletion (slide of 4) • Two methods of natural resource depletion – Cost: determined by using the adjusted basis of the resource and allocating over the recoverable units – Percentage: determined using percentage provided in Code and multiplying by gross income from resource sales 97 Depletion (slide of 4) • Cost depletion – Depletion is computed on a per unit basis – Per unit amount is determined by dividing the basis of the resource by the estimated recoverable units of resource • Number of units sold in year × per unit depletion = depletion for year – Total depletion can not exceed total cost of the property 98 Depletion (slide of 4) • Percentage depletion – Depletion is computed by using the statutory percentage rate for the type of resource – Rate is applied to the gross income from the property 99 Depletion (slide of 4) • Percentage depletion – Percentage depletion cannot exceed 50% of the taxable income (before depletion) from the property – Percentage depletion reduces basis in property – However, total percentage depletion may exceed the total cost of the property • Example: Property with zero basis but still generating income 100 Intangible Drilling Costs (IDC) • Intangible drilling costs include – Costs for making the property ready for drilling – Costs of drilling the hole • Treatment of IDC – Expense in the year incurred, or – Capitalize and write off through depletion • It is generally advantageous to write off IDC immediately 101 Refocus On The Big Picture (slide of 4) • In general, the expenses incurred in Michael Forney’s small engine service and repair business are deductible as long as they are ordinary and necessary expenses • In addition, the salaries and wages paid must be reasonable – His plan to increase salaries radically next year for himself and his mother probably should not be pursued, because most or all of the increase could be considered unreasonable • Charitable contributions generally are limited to 10% of taxable income before the charitable contribution deduction • Political contributions are not deductible 102 Refocus On The Big Picture (slide of 4) • Michael can elect to expense the costs of the machinery and equipment under § 179 For 2015, the § 179 deduction is limited to $500,000 and cannot exceed the taxable income derived from the business (before the § 179 deduction) In this case, the entire $130,000 is deductible Gross income Less: Salaries and wages Building rent § 179 deduction Insurance Consulting fees Utilities Taxes and licenses Advertising Dues- Small Engine Repair Institute Interest expense TI before the charitable contribution deduction Less: Charitable contributions (limited to 10% of taxable income) Taxable income $435,500 (150,000) (24,000) (130,000) (6,000) (6,000) (12,000) (6,000) (3,000) (3,000) (3,000) $ 92,500 (3,000) $ 89,500 103 Refocus On The Big Picture (slide of 4) • • • • • • As to Michael’s rental properties, he will be required to report all associated rent income and expenses, including depreciation on the house he converted from personal use to rental use and on the rental condo he purchased What If? Instead assume that Mr Forney placed in service $142,000 of new machinery and equipment that qualifies for the § 179 deduction In addition, Michael thinks that he can justify increasing his salary to $115,500, which will increase total salaries and wages to $210,500 Michael can elect to expense $142,000 of the cost of the machinery under § 179 As a result of the increased salary and MACRS deductions, the charitable contribution deduction now is limited to $2,000 – The remainder ($1,000) is carried over to the next tax year 104 Refocus On The Big Picture (slide of 4) Gross income $ 435,500 Less: Salaries and wages (210,500) Building rent (24,000) § 179 deduction (142,000) Insurance (6,000) Consulting Fees (6,000) Utilities (12,000) Taxes and licenses (6,000) Advertising (3,000) Dues (3,000) Interest expense (3,000) TI before the charitable contribution deduction $ 20,000 Less: Charitable contributions (limited to 10% of taxable income) (2,000) Taxable income $ 18,000 105 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr Donald R Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 106 ... three other most highly compensated officers 26 Investigation Of A Business (slide of 3) • Investigation expenses - incurred to determine the feasibility of entering a new business or expanding... expenses in excess of $50,000 29 The Big Picture - Example 15 Investigation Of A Business • Return to the facts of The Big Picture on p 5-1 • Michael Forney investigates the purchase of Southside Small... Picture (slide of 4) • Michael would like to know the amount of his deductible expenses for tax purposes and would like your advice on another matter • Because his business has been very profitable