CLASSIFICATION OF DEDUCTIBLE EXPENSES

I. Itemized deductions that have AGI limitations include medical expenses and personal casualty losses.
2. Section 212 Expenses: production or collection of income.
Deductible for AGI: rent and royalty income, professional fees
Itemized deductions (deductions from AGI): investment interest expense
All other investment-related expenses are miscellaneous itemized deductions that are not deductible.
3. Section 162: Trade or Business Expenses
it provides a deduction for all ordinary and necessary expenses in a trade or business.
4. A current deduction is not allowed for capital expenditures except amortization, depletion, or depreciation
5. The code specifically states a “reasonableness” requirement for salaries.

6. Personal Expenses
These expenses are usually deductions from AGI:
Contributions to qualified charitable organizations.
Medical expenses.
State taxes.
Personal casualty losses.
Mortgage interest and property tax on residence.

Salary income $60,000; Net rent income 6,000; Dividend income 3,500;
Payment of alimony (divorce finalized in March 2019) 12,000; Mortgage interest on residence 9900
Property tax on residence 1200 Contribution to traditional IRA 5,000;
Contribution to United Church 2,100
Loss on the sale of real estate (held for investment) 2,000; Medical expenses 3,250
State income tax 300 Federal income tax 7,000
a. Calculate Daniel’s AGI.
Gross income= 60,000+6000+3500=69500
Deduction for AGI=0+5000+2000=7000 (Alimony finalized in 2019)
Adjusted gross income=62500
b. Should Daniel itemize his deductions from AGI or take the standard deduction?
Itemized deduction: 9900+1200+2100+300+ (3250-62500*0.1, limit to 0) =13500
Standard deduction for 2019 is 12,200, which is less than itemized deduction. Daniel should itemize his
deduction from AGI. The federal income tax of 7000 is not deductible. Alimony payment is miscellaneous
itemized deduction, so it is not deductible from 2018 through 2015.

TIMING OF EXPENSE RECOGNITION

Cash Method Requirements
-The expenses are deductible only when they are actually paid
- charge expenses on credit cards
Accrual Method Requirements
a. all events test: (1) all events have occurred to create liability and (2) the amount of can be determined with
reasonable accuracy.
b. economic performance test
exception: allows certain recurring items to be deducted immediately if all following conditions are met:
1. The item is recurring in nature and is treated consistently
2. The accrued item is not material or accruing it in the current period results in better matching
3. All events have occurred that determine the existence of the liability, and the amount of the liability
can be determined with reasonable accuracy.
4. Economic performance occurs within a reasonable period (no later than 8½ months).
c. Reserves such as warranties and bad debts are not allowed for deduction because the economic
performance test cannot be satisfied.

DISALLOWANCE POSSIBILITIES
1. Public Policy Limitation
Payments in violation of public policy are not deductible.
-Bribes and kickbacks
-Fines and penalties
- Treble damage payments resulting from violation of the antitrust law.
2. Legal Expenses Incurred in Civil or Criminal Penalties
Personal legal expenses are not deductible.
3. Expenses Relating to an Illegal Business
The ordinary and necessary expenses of operating an illegal business are deductible.
Drug dealers are not allowed a deduction for ordinary and necessary business expenses, except for cost of
goods sold.
4. Political Contributions and Lobbying Activities
Political contributions and Lobbying expenses are not deductible
There are two exceptions to the disallowance of lobbying expenses:
 First, the disallowance provision does not apply to activities devoted solely to monitoring legislation.
Second, a de minimis exception is provided for annual in-house expenditures if such expenditures do not
exceed $2,000. If the in-house expenditures exceed $2,000, none of the in-house expenditures can be
deducted.
5. Excessive Executive Compensation
1. The compensation is subject to the reasonableness requirement.
2. The millionaires’ provision limits the amount the employer can deduct for the taxable compensation of a
covered executive to $1 million annually.

6. Investigation of a Business
If the taxpayer is in a business that is similar to that being investigated, all investigation expenses are
deductible
When the taxpayer is not in a business that is similar to the one being investigated, and the business is not
acquired, all investigation expenses generally are nondeductible.
If the taxpayer is not in a business that is similar to the one being investigated and actually acquires the
new business, the expenses must be capitalized as startup expenditures.
7. Hobby Losses
1. Activities that have both personal and profit-seeking motives are classified as hobbies
2. An activity is not a hobby if it shows a profit in at least three out of five consecutive years. If the activity
involves horses, a profit in at least two of the previous seven tax years
a) Whether the activity is conducted in a businesslike manner. b) The expertise of the taxpayers or their advisers. c) The time and effort expended.

d) The expectation that the assets of the activity will appreciate in value. e) The taxpayer’s previous success in conducting similar activities.

f) The history of income or losses from the activity. g) The relationship of profits earned to losses incurred. h) The financial status of the taxpayer

i) Elements of personal pleasure or recreation in the activity.

3. Amount computed:
If an activity is a hobby, the expenses are deductible only to the extent of the gross income from the hobby.
These expenses must be deducted in the following order:
1. property taxes and home mortgage interest.
2. maintenance, utilities, and supplies
3. depreciation, amortization, and depletion.
4. Hobby expenses except taxes & home mortgage interest are classified as miscellaneous itemized
deductions that are not deductible. The net effect is to tax on all income from a hobby.

Alex, who is single, conducts an activity in 2019 that is appropriately classified as a hobby. The activity
produces the following revenues and expenses:
Revenue $18,000 Property taxes 3,000 Materials and supplies 4,500
Utilities 2,000 Advertising 5,000 Insurance 750 Depreciation 4,000
Without regard to this activity, Alex’s AGI is $42,000. Determine the amount of income Alex must report and
the amount of the expenses he is permitted to deduct.
 Alex must report the $18,000 as revenues. Property taxes of $3000 can be deducted; these deductions
would be allowed even if there was no revenue from the hobby. The remaining expenses are miscellaneous
itemized deductions which are not deductible.
8. No deduction for personal expenses
9. Rental of Vacation Homes
A. Primarily Personal Use
rented for fewer than 15 days in a year
The rent income is excluded from gross income, and mortgage interest and property taxes are allowed
as itemized deductions. Depreciation, utilities, and maintenance are NOT deductible.
B. Primarily Rental Use
rented for 15 days or more in a year and is not used for personal purposes for more than the greater of (1)
14 days or (2) 10 percent of the total days rented
The real estate taxes allocated to the personal days are deductible as an itemized deduction. However,
the mortgage interest allocated to the personal days cannot be deducted
C. Personal/Rental Use
rented for 15 days or more in a year and is used for personal purposes for more than the greater of (1) 14
day
-real estate taxes and mortgage interest must be deducted first.
-If a positive net income results, maintenance, utilities, and insurance are deductible
-Finally, if any positive balance remains, depreciation is allowed.
-Any disallowed expenses are carried forward
- The Courts have held that real estate taxes and mortgage interest, are allocated on the basis of 365 days
The IRS allocates real estate taxes and mortgage interest on the basis of total days of use. Other expenses
are allocated on the basis of total days used.

During the year, Anna rented her vacation home for 30 days, used it personally for 20 days, and left it vacant for
315 days. She had the following income and expenses:
Rent income $ 7,000 Real estate taxes 2,500 Interest on mortgage 9,000 Utilities 2,400
Repairs 1,000 Roof replacement (a capital expenditure) 12,000 Depreciation 7,500
a. Compute Anna’s net rent income or loss and the amounts she can itemize on her tax return, using the court’s
approach to allocating property taxes and interest.
Gross Income 7000 Deduct: Tax and interest (30/365*11500) (945) Reminder=6055
Utilities and repair (30/50*(2400+1000)) (2040) Remainer=4015
Depreciation (30/50*7500, limit to remainder) (4015)
Net rental income=0
She can itemize 10,555 of property taxes and mortgage interest (11,500-945). Thus, under the court approach,
Anna has no net rental income and has an itemized deduction of 10,555.
b. How would your answer in part (a) differ using the IRS’s method of allocating property taxes and interest?
Gross income 7000 Deduct tax and interest (30/50*11,500) (6900) Remainder=100
Utilities and repairs (30/50*(2400+1000), limit to 100) (100) Net rental income=0
Anna can deduct the remaining taxes and interest of 4600 as itemized deductions. Under the IRS rule, she has no
rental income and has an itemized deduction of 4600
How would your answer differ if Anna had rented the house for 87 days and had used it personally for 13 days?
Because Anna used it fewer than 15 days, it is classified rental property.
Rental (87%):
Net income=7000-(9000+2500)*87%-(2400+1000)*87%-7500*87%=-12488
Personal (13%)
Net income=0-(9000+2500)*13%-(2400+1000)*13 %-7500*13%=0
Anna can deduct 2500*13% of property tax as itemized deductions and take a rental loss deduction for AGI of
12488. The mortgage interest of 9000*13% is not deductible as an itemized deduction because it is not qualified
residence interest.
10. Transactions between Related Parties (only apply to loss transaction)
Losses are disallowed from sales or exchanges of property between related parties.
Section 267 disallows then deduction for accrued expense by related parties.
Related parties include the following:
Brothers and sisters, spouse, parents and grandparents, children and grandchildren
A corporation that is owned more than 50 percent by the taxpayer.
Two corporations that are members of a controlled group.
A series of other complex relationships between trusts, corporations, partnerships
Constructive ownership: stock owned related entities is deemed to be owned by the taxpayer
A right of offset is created equal to the disallowed loss. When the property is subsequently sold to a
nonrelated party, any gain recognized is reduced by the right of offset. Any right of offset is permanently lost if
it is not used by the related-party buyer on a subsequent sale or exchange

Robin Corporation is owned as follows:

Isabelle 26% Peter, Isabelle’s husband 19% Sonya, Isabelle’s mother 15%
Reggie, Isabelle’s father 25% Quinn, an unrelated party 15%
Robin is on the accrual basis, and Isabelle and Peter are on the cash basis. Isabelle and Peter each loaned Robin
Corporation $40,000 out of their separate funds. On December 31, 2019, Robin accrued interest at 7% on both
loans. The interest was paid on February 4, 2020. What is the tax treatment of this interest expense/income to
Isabelle, Peter, and Robin?
Robin can take a deduction for interest of 2800 in 2019 on the loan from Peter
defer the deduction of 2800 on the loan from Isabelle until 2020
Both Isabelle and Peter have interest income in 2020 when it is received.
Because this is not greater than 50% ownership, Peter is not a related party with respect to Robin.
Isabelle, however, owns 85% ownership (26+19+25+15). Section 267 disallows then deduction for accrued
expense by related parties.

Brittany Callihan sold stock (basis of $184,000) to her son, Ridge, for $160,000, the fair market value.
a. What are the tax consequences to Brittany?
Brittany’s 24000 loss is not deductible due to section 267 (it is a related-party transaction): The loss is realized
but not recognized.
b. What are the tax consequences to Ridge if he later sells the stock for $190,000? For $152,000? For $174,000?
1. if the stock was sold for 190000, Ridge’s recognized gain is 6000 (190,000-160,000-24,000)
2. if the stock is sold for 152,000, Ridge recognized loss is 8000 (152,000-160,000). The 24,000 loss that was
realized By Brittany is not deductible by either Brittany or Ridge and is lost permanently.
3. if the stock is sold for 174,000, there is no recognized gain to Ridge (174,000-160,000-14,000). The
remaining 10,000 (24,000-14,000) of unrecognized loss is lost permanently
Essay questions:
1) AL owns 60% of parent corp. P corp owns all of subsidiary Corp S. AL sells some property at a loss to S.
Can he deduct the loss? No
2) Under 267 (c) (1):
Stock owned by a corporation, partnership, estate, or trust, directly or indirectly, is deemed owned
proportionately by the entity’s shareholders, partners, or beneficiaries.
3) Under 267 (c) (2):
Stock owned by an individual’s family, directly or indirectly, is deemed owned by the individual. An individual’s
family includes only his or her brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal
descendants
4) AL owns 30%, his wife Sue owns 10%, and Sue’s brother Grey owns 20%, and not related third party own
40% of Fun Corp.
-if AL sell something at a loss to Fun Corp, could he deduct loss?
Yes. 40%<50%
-Could Sue deduct a loss if she sells something to the Corp
No. 60%>50%
5) Stock constructively owned by a person by reason of item 1 is deemed owned by that person for the purpose
of applying items 1, 2, or 3, but stock constructively owned by an individual by reason of items 2 or 3 is not
deemed owned by the individual to make another person the constructive owner of the same stock.
6) Sad corporation has 200 shares outstanding. Son owns 100 shares. Sick corporation owns 50 shares. The
remaining 50 shares owned by unrelated parties. Father owns 60% share of sick corporation. Son sell something
at a loss to Sad corporation, can he deduct loss?
Father owns 0.6*50 shares of sad corporation (267 c1)
Once you impute the 30 shares if Sad to father using 267 c1, 267 c5 says that the Father is deemed to actually
own theses shares for purpose for allowing another rule to be used. Therefore, you can now use the family rule
to get another 30 shares to the Son. Therefore, Son has 130 shares of Sad Corporation, greater than 50%. No
deduction is allowed.