Chapter 1 Business Income, Deductions, and

Transcript:Chapter 1 Business Income, Deductions, and:
Chapter 1 Business Income, Deductions, and Accounting Methods Learning Objectives Describe the general requirements for deducting business expenses and identify common business deductions. Apply the limitations on business deductions to distinguish between deductible and nondeductible business expenses. Identify and explain special business deductions specifically permitted under the tax laws. Explain the concept of an accounting period and describe accounting periods available to businesses. Identify and describe accounting methods available to businesses and apply cash and accrual methods to determine business income and expense deductions. Business Income and Deductions Schedule C – Trade or business income Includes revenue from services and sales activities Gross profit from sales − cost of goods is a return of capital Business income does not include excluded and deferred income Deductions must be directly connected to business activity Ordinary and necessary means conducive to profit generation Reasonable in amount means not extravagant Reasonableness Example Rick owns a business that employs his brother, Ben. Ben is paid $45,000 per year by Rick’s business. In comparison, other employees with Ben’s responsibilities are only paid $30,000 per year. What is Rick’s business deduction for employing Ben? Reasonableness Solution A reasonable amount for compensating Ben is $30,000 rather than $45,000. Hence, Rick can only deduct $30,000. The extra $15,000 ($45,000 paid minus $30,000 deduction) is a gift from Rick to Ben. Statutory Limits on Business Expense Deductions Expenses against public policy No deduction for fines, bribes, lobby expenditures, or political contributions Expenses relating to tax-exempt income Interest on loan where proceeds invested in municipal bonds Key man insurance premiums – no deduction if business is beneficiary of life insurance Capital expenditures Personal expenses Capital Expenditures Does the expenditure provide future benefit (beyond this year)? If so, capitalize rather than deduct. 12-month rule for prepaid expenses: Deduct if benefit < 12 months and Benefits do not extend beyond end of next tax year Does not apply to interest 12-Month Rule Example Ben, a cash basis taxpayer, makes the following payments on June 30 of this year: $10,000 for the next 10 months of utilities. $12,000 for insurance over the next 24 months. $9,600 for the next 8 months of interest on a business loan. What amounts are deductible this year? 12-Month Rule Solution Ben can deduct all $10,000 for the utilities because: the benefit is not more than 12 months and the benefit ends prior to the end of next year.