Instructor’s Manual

Ch 5: Introduction to Business Expenses

Concepts in Federal
Taxation 2015 22nd Edition
Murphy
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Introduction to Business Expenses

Students tend to lose sight of the meaning of "Legislative Grace," that any deduction is
the result of a specific Act of Congress that must be strictly applied and interpreted.
Instead, they want to use GAAP. Try to continually reinforce the concept that nothing is
deductible unless a provision in tax law allows the deduction.

Free-Writing Assignment: Problem 26 offers a good set of facts that leads to a

commonly questioned issue. That is, items that are easily determined to be deductible
often lose their impact on taxable income due to their location of deductibility in the
individual income tax formula. This problem is an extension of the deductible "for" versus
"from" AGI issues.

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Teaching Tip #1: Comprehensive Problem 92 is a good summary of many of the topics
concerning deductibility. This problem is a good final in-class exercise before moving to
Chapter 6: Business Expenses.

Teaching Tip #2: Integrative Tax Return Problem 91 is the third part of the six part
comprehensive tax return problem.

Teaching Tip #2: Rely on Table 5-1 to help students understand the rules for properly
classifying a vacation home. Students tend to miss the importance of correct
classification and try to move directly to computations.

Free-Writing Assignments: Have students determine the common characteristics and

similar tax law rules for hobbies, vacation homes, and home offices. Then have them
determine the differences and explain why the tax law differences exist. Have the
students base their explanations on the underlying tax concepts. Finally, assign students
the task of communicating their explanations via memo to a classmate who is having
difficulty with the rules for hobbies, vacation homes, and home offices.

Writing Assignments: Problems 31, 36, 40, 46, 48, and 57, and Tax Planning Case
97 are the suggested writing assignment problems for this chapter.

Discussion Case 95 offers another interesting approach to determining whether a

dominant business motive exists. At the conclusion of this chapter, students should be
ready to take on situations that require analysis of dominant business motive
characteristics.

Lecture Outline
I. Legislative Grace
A. Deductions allowed are subtracted from gross income implementing the
Ability-to-pay concept (Problem 26)
B. Deductions are permitted only if all requirements satisfied
1. Not merely because a taxpayer thinks it is fair
2. Rules must be strictly interpreted and applied (Examples 1 and 2)
C. Business Purpose Concept (Examples 3 and 4)
1. Primary or dominant motive (Discussion Case 95)

II. Reporting Deductions (Problems 27 and 28)

A. Use Exhibit 5-1 to highlight the two major types of deductions (for/from) in
the individual tax model

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1. Hint: Put Exhibit 5-1 on screen (or on the board) to demonstrate the
locations of these two classes of deductions.
2. Deductions "for" AGI (above the line deductions) generally have a
business purpose
3. Deductions "from" AGI (Itemized deductions) generally have a personal
flavor (Example 5)
B. Conduit entity reporting (Problem 29 and 30)
1. Separately reported items (Example 6)
a. Miscellaneous itemized deductions (Example 7)
b. 2% x AGI floor for deductions
c. Charitable contributions
d. Investment interest
e. Investment expense
f. §179 expense (special election to expense certain capital
expenditures)
g. Nondeductible expenses
2. Ordinary deductions used to calculate taxable income or loss

III. Classification of Deductions (Figure 5-1)

A. Profit-motivated expenditures (Example 8)
B. Trade or Business Expenses (Problems 31 to 33)
1. High taxpayer involvement -- regular and continuous activity
2. Intent to earn a living -- not a hobby
3. Profit motive
4. Facts and circumstances of each case for classification
C. Active investor vs. active trader status
1. Trader is generally in a trade or business for livelihood
a. Main source of income is from selling for more than cost
b. No commissioned trading for clients/customers
c. Securities held short-term
d. Plays the swings in the market
e. Expenses deductible for AGI
2. Active investor's activities are for the production of income
a. Long-term appreciation goal
b. Expenses deductible as miscellaneous itemized deductions
3. Securities dealer earns income from fees or commissions
a. Trade or business expenses

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b. Acts as agent for buyers and/or sellers

D. Expenses for the Production of Income
1. Called nonbusiness expenses or Investment expenses
2. IRC §212 (Example 9)
E. Rental Activity (Problem 34)
1. Treated like trade or business expenses (Examples 10 and 11)
2. Sale of the rental property at a loss
a. Capital loss limitation rules apply to production-of-income
activities
b. No limitations for trade or business losses
(Examples 12 and 13)
F. Personal Expenditures are generally not deductible
G. Mixed-use assets cause a problem (Examples 14 and 15)
1. Assets used both to earn income and for personal purposes
2. Allocate between business and personal (Problem 35)
H. Mixed-use expenditures are also troublesome (Example 16)
1. Expenses incurred for both profit and personal reasons
2. Allocate and deduct by rules for each use

IV. Tests for Deductibility (Problems 37 and 38): Three positive tests; five negative
tests
A. Must be
1. Ordinary (Examples 17 and 18)
a. Normal
b. Common
c. Accepted under regular business circumstances
d. Doesn't have to be regularly recurring
2. Necessary (Examples 20 and 21)
a. Appropriate and helpful
b. A reasonable and prudent business would incur
c. Taxpayer's judgment generally not challenged by courts
3. Reasonable (Examples 22 and 23)
a. Usually an issue with related parties and salary amounts
b. Generally a question of fact
B. And must Not be,
1. Personal (Example 24)
a. Motivation for incurring expenses primarily business

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b. Significant business motivation is not enough

2. Capital Expenditures (Examples 25 to 27; Problem 39)
a. Expenditure results in an asset, so no immediate deduction
b. Useful life extends substantially beyond end of the year
c. Repairs and maintenance are current expenses that keep
business assets in normal operating condition
1. Fix a broken gas line
2. Repainting
3. Patch a roof
d. Capitalize betterments, improvements, and replacements
1. Because they extend the life or add to value
2. Cost deducted over useful life, through
▪ Depreciation, or
▪ Amortization
e. Start-up costs are capitalized for new businesses
(Examples 28 to 30; Problems 40 and 41)
1. May elect to expense $5,000 in year begin operations
▪ Costs in excess of $5,000 are amortized over 180
months
▪ $5,000 current year expenses is phased out
dollar-for-dollar if start-up costs exceed $50,000.
2. No deduction if expenses do not lead to starting a new
business
3. Take current deduction for investigating costs in same
line of business
3. Frustration of Public Policy (Problem 42)
a. Fines for breaking city, state, or federal laws are not deductible
1. Only relates to laws, not private company policies
2. Examples 31 and 32; Problem 43
b. Expenses of illegal businesses are deductible (Example 33)
1. But not expenses for illegal sales of drugs
2. Cost of Goods Sold is always deductible under the
Capital Recovery Concept
c. Lobbying and political costs not deductible
1. Examples 34 and 35; Problems 44 and 45
2. Except
▪ Costs to influence local legislators, and

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▪ Costs to monitor any legislation, and

4. Related to tax-exempt income (Problems 46 and 47)
a. Eliminates double benefit (Example 36)
5. Another person's expense (Problems 49 and 50)
a. Lacks business purpose
b. Can't recover another taxpayer's capital (Example 37)
c. Exception -- Medical expenses on behalf of a dependent
V. Limited Mixed-Use Expenses
A. Hobby expenses (Problems 51 and 52)
1. Profit is not the primary motive, therefore a lack of business purpose
2. Nine subjective factors (consider all facts and circumstances)
a. Business-like manner
b. Expertise or advice of experts
c. Time and effort spent on activity
d. Expectation that assets will appreciate in value
e. Success in similar activities
f. History of income or losses in the activity
g. Amount of occasional profits
h. Taxpayer's financial status
i. Elements of personal pleasure or recreation
3. Amount of deduction cannot exceed gross income from the hobby --
hobby losses are the excess amounts that are not deductible
a. Specific order for computing the amount (Example 38)
1. Category 1: Otherwise allowable deductibles (e.g., home
mortgage interest and property taxes)
2. Category 2: Hobby expenses that would be ordinarily
deductible if the endeavor is a business (e.g., supplies,
utilities, repairs, maintenance, auto expense)
3. Category 3: Depreciation on assets used to carry on the
hobby
b. Expenses in excess of income (Hobby Loss) are not deductible,
anytime
c. Deduct allowed expenses as Miscellaneous Itemized Deduction
(2% x AGI) -- Taxpayer's use of the standard deduction
eliminates any benefits of the deduction
Hint: Use an example where the actual amount deductible is close
to zero due to the 2% floor (except for the "otherwise allowables").

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Example 38 can be modified to accent the issue where hobby

expenses are deductible and where the gross income is reported.
B. Vacation home expenses (Problems 53 to 56)
1. Stress need to classify usage. Table 5-1 is crucial for understanding
a. Personal residence classification: Report no rental income or
rental deductions
b. Vacation home classification: Report rental income and rental
expenses up to that amount
1. Specific order for deducting expenses (same category
system as "hobby")
2. No loss allowed
3. Allocate expenses between personal and rental based on
the percentage of personal use to total use
c. Rental property classification: Income and expenses reported
and losses are allowed (Examples 39 and 40)
C. Home office expenses (Problems 57 to 59)
1. Strict tests must be satisfied
2. Deductible if a portion of a home is
a. EXCLUSIVELY used on a REGULAR basis,
b. as a PRINCIPAL place of BUSINESS, or
c. as a place for MEETING with clients or customers in the
NORMAL course of the trade or business.
3. #2b above effectively eliminates most employees from deducting
a. An employee's business is that of being an employee,
b. Principal location of that business is at the employer's office.
c. After 12/31/98, taxpayers with no other location available for
administrative or management activities do not need to meet the
PRINCIPAL place of BUSINESS rule.
4. An employee may qualify for deductions of home office expenses, if
a. The office is for the CONVENIENCE of the employer, and
b. It is required as a condition of employment. (Example 41)
1. Employer controls decision
2. Commonly, there would not be adequate office space at
the regular place of business for the employee to do
his/her required work
5. If EMPLOYEE home office expenses do qualify,

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a. Allowable deductions taken FROM adjusted gross income

(Example 42)
b. 2% x AGI floor limitation for
1. Other employee business expenses directly related to the
home office activity (MISCELLANEOUS ITEMIZED
DEDUCTIONS), including
▪ Allocable portion of the home's insurance, utilities
& depreciation, and miscellaneous business
supplies
6. Self-employed persons and employees with second businesses
a. May deduct up to the amount of gross income minus other
business expenses (Example 43)
1. The home office must be the "focal point" of the business
activities (REGULAR USE), and
2. No personal activities can occur in the home office space
(EXCLUSIVE USE)
b. All amounts that qualify are deductible "for" AGI, since they
relate directly to the business.
c. Deductions of expenses are prioritized
1. Ordinary and necessary business expenses not relating
to the home.
2. Otherwise allowable deductions, e.g. mortgage interest &
taxes of the home.
3. An allocable portion of home expenses, e.g. utilities,
insurance, and depreciation.
d. No loss can be recognized because of the c3 expenses above.
e. Excess home office expenses can be carried over to
subsequent years because they have business purpose.
f. Telephone expenses relating to the home office are not
deductible unless a separate line is employed. All business-
related long distance calls are deductible.

VI. Timing of Deductions - Effect of Accounting Method (Example 44)

A. Cash method (Problems 60 and 61)
1. Deduct when check mailed (Example 45)
a. Non-Sufficient Funds check: No deduction until check made
good

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2. Fair market value of property or services paid (Example 46)

a. Services given also generate revenue
b. Gain/loss may be realized
3. Credit card charges deemed paid on transaction date (Example 47)
a. Notes on open account to credit
1. Expense when paid off
2. Except banks
4. Prepaid expenses (Examples 48 to 51)
a. Deductible under one-year rule exception
1. As long as required by creditor, and
2. Expensing does not distort net income
b. Prepaid interest not deductible under one-year rule
1. Must use accrual method (Example 52)
2. Principal residence mortgage points may be deductible
(Chapter 8)
B. Accrual method -- Two Tests for Deduction (Problems 62 to 67)
1. All-events test (Example 53)
a. Liability truly exists
b. Amount determined with reasonable accuracy
2. Economic Performance Test (Table 5-2; Examples 54 to 56)
a. Services or property provided to taxpayer, or
b. Taxpayer uses the property
3. Exception to Economic Performance, if all of the following are met
(recurring item exception) (Examples 57 to 60)
a. All-events test is met
b. Economic performance occurs within shorter of,
1. 8.5 months after close of tax year, or
2. Reasonable time after close of year
c. Taxpayer must consistently treat item the same
d. Expense either is,
1. Not material, or
2. Accrual of expense results in better matching than
accruing when economic performance occurs
C. Related party accrued expenses (Problems 68 and 69)
1. Timing of deduction limited for accrued expenses payable to a related
cash basis taxpayer (Example 61)
a. Related parties

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1. Taxpayer's family members, and

2. Businesses that taxpayer directly or indirectly owns >
50%
2. Required to use cash method -- matching principles invoked
(Example 62)
3. If both parties are accrual taxpayers, no problem exists
D. Financial and Taxable income differences (Problems 70 and 71)
1. Matching and conservatism are not tax concepts
2. All-events and economic performance tests disallow estimates
(Example 63)
a. Bad debts (discussed in Chapter 6) -- specific write-off required
for tax vs. allowance method (GAAP)
b. Vacation pay -- tax accrual if performance within 2.5 months
c. Warranties -- deducted only when performance occurs

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3. Temporary differences
a. Depreciation and §179
b. Amortization of Intangible Assets
c. Limits on losses
4. Permanent differences
a. 50% of business meals and entertainment
b. Business gifts limited to $25 per donee
c. Denial of excessive compensation
d. Deduction of federal income tax
e. Exemption deduction
f. Standard deduction amounts

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Annotated Bibliography
DEDUCTIBILITY OF BUSINESS AIRCRAFT by Karen C. Miller and Tonya K. Flesher, Journal of
Accountancy Online, (July 2003), http://www.aicpa.org/pubs/jofa/jul2003/miller.htm
A successful defense of this travel deduction requires evidence the expense is ordinary,
necessary, reasonable and not lavish. Adequate planning and appropriate documentation
can help companies maximize their use of corporate aircraft and support tax deductions.

CASH OR ACCRUAL? by Robert Jennings, Journal of Accountancy (May 2001),

www.aicpa.org/pubs/jofa/may2001/jennings.htm
Describes Rev. Proc. 2000-22 and its effect on small business’ choice of accounting
method.

THE NEW AND IMPROVED HOME OFFICE DEDUCTION by Gary M. Fleischman and Thomas H.
Payne, Journal of Accountancy 30 (March 1999), aicpa.org/pubs/jofa/mar1999/fleisch.htm
New rules make it possible for more taxpayers to deduct home office expenses. The
Taxpayer Relief Act of 1997 expanded the definition of what constitutes a principal place
of business, describing additional criteria that will let taxpayers deduct home office
expenses if the office is the only place they perform substantial business activities.

SHIFTING THE BURDEN OF PROOF by Ray A. Knight and Lee G. Knight, Journal of Accountancy
89 (September 1999), aicpa.org/pubs/jofa/sept1999/knight.htm
Taxpayers failing to keep adequate records will bear the burden of proof if an IRS audit
goes to court and also will suffer the consequences of inadequate recordkeeping under
existing law.

HOME OFFICE MARCHES ON (IN SPITE OF SOLIMAN) by Pamela K. Revak, 75 TAXES -- The Tax
Magazine 549 - 60 (Oct. 1997).
A look at the home office deduction, before and after the Taxpayer Relief Act of 1997.

THE HOBBY LOSS ASSAULT ON DISTRIBUTORS OF DIRECT SELLERS - HARDLY JUSTIFIED AND
PARTICULARLY UNWARRANTED by Bruce J. Squillante, 75 TAXES -- The Tax Magazine 631 -
635 (Oct. 1997).
The applicability of the hobby loss rules to the direct selling industry is discussed.

ARE DOWNSIZING COSTS RELATED TO ACQUISITIONS DEDUCTIBLE AFTER INDOPCO? by Susan

L. Megaard and David R. Brennan, 85 Journal of Taxation 163-71 (Sept. 1996).
Explores deductibility of downsizing costs (severance payments, outplacement services,
retraining) made as part of a taxable acquisition of a business. Deductibility depends on
which party paid the costs (target or acquirer) and when liability for the costs arose.

DEDUCTING DEFICIENCY INTEREST AS A BUSINESS EXPENSE: RECENT DEVELOPMENTS SINCE

TRA 86 by Linda M. Johnson and Giles B. Sutton, 74 TAXES -- The Tax Magazine 318-25 (May
1996).
Advice on assuring deductibility of interest on an unincorporated business income tax
deficiency under the Tax Court rationale in Redlark, that errors resulting in deficiency

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Ch 5: Introduction to Business Expenses

adjustments must arise out of the normal conduct of a taxpayer's business.

DIFFICULTIES WITH HOUSEHOLD EMPLOYMENT TAXES by Dannie A. Tobias. Journal of State

Taxation, Summer 1994, vol 13, pp 60-65.
Summary of factors used to determine whether household employees are independent
contractors or employees. Includes a review of federal and state paperwork required of
employers of household workers.

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