Taxchapter 8.docx

Taxchapter 8.docx

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Taxchapter8

Chapter8

BusinessIncome,Deductions,andAccountingMethods

SOLUTIONSMANUAL

DiscussionQuestions:

1.[LO1]Whatisan“ordinaryandnecessary”businessexpenditure?

“Ordinary”and“necessary”implythatanexpensemustbecustomaryandhelpful,respectively.Becausethesetermsaresubjective,thetestsareambiguous.However,ordinaryisinterpretedbythecourtsasincludingexpenseswhichmaybeunusualforaspecifictaxpayer（butnotforthattypeofbusiness）andnecessaryisnotinterpretedasonlyessentialexpenses.Theselimitscanbecontrastedwiththereasonablelimitonamountsandthebonafiderequirementforprofitmotivation.

2.[LO1]Iscostofgoodssolddeductibleasabusinessexpenseforabusinesssellinginventory?

Explain.

No.Underthereturnofcapitalprincipal,costofgoodssoldrepresentsareductioningrossincomeratherthanabusinessexpense.Forexample,ifataxpayersellsinventoryfor$100,000andreportsacostofgoodssoldof$40,000,thebusiness’sgrossincomeis$60,000（$100,000–40,000）not$100,000.

3.[LO1]Tomisanattorneywhooftenrepresentsindividualsinjuredwhileworking（workerliabilityclaims）.ThisyearDeweyspent$50onabookentitledPlumbingForDummiesandpaid$500totakeacourseonplumbingresidencesandrentalhousing.Canyouimaginecircumstancesinwhichtheseexpenditureswouldbedeductibleas“ordinaryandnecessary”foranattorney.Explain.

“Ordinary”and“necessary”implythatanexpensemustbecustomaryandhelpful,respectively.Becausethesetermsaresubjective,thetestsareambiguous.However,ordinaryisinterpretedbythecourtsasincludingexpenseswhichmaybeunusualforaspecifictaxpayer（butnotforthattypeofbusiness）andnecessaryisnotinterpretedasonlyessentialexpenses.Tommayrepresentaplumberandincurredtheseexpendituresohecanbetterunderstandandexplainhowhisclientwasinjuredonthejob.Inthiscase,theexpenseswouldbebothordinaryandnecessarytoTom’spracticeasanattorney,andthereforedeductible.

4.[LO1]Jakeisaprofessionaldogtrainerwhopurchasesandtrainsdogsforusebylawenforcementagencies.LastyearJakepurchased500bagsofdogfoodfromalargepetfoodcompanyatanaveragecostof$30perbag.Thisyear,however,Jakepurchased500bagsofdogfoodfromalocalpetfoodcompanyatanaveragecostof$45perbag.UnderwhatcircumstanceswouldtheIRSlikelychallengethecostJake’sdogfoodasunreasonable?

Reasonablenessisanissueoffactandcircumstance,andextravaganceisdifficulttodeterminedefinitely.However,acommontestforreasonablenessiswhethertheexpenditureiscomparabletoanarm'slengthamount–apricechargedbyobjective（unrelated）individualswhodonotreceiveanyincidentalpersonalbenefits.Reasonablenessismostlikelytobeanissuewhenapaymentismadetoarelatedindividualorthetaxpayerenjoyssomepersonalbenefitincidentaltotheexpenditure.Hence,theIRSismostlikelytochallengethecostofthedogfoodiftheJakeorhisfamilycontrolledthelocalpetfoodcompany.

5.[LO2]Whatkindsofdeductionsareprohibitedasamatterofpublicpolicy?

WhymightCongressdeemitimportanttodisallowdeductionsforexpendituresagainstpublicpolicy?

TheIRClistsbribes,kickbacks,and“other”illegalpaymentsasnondeductible.Congressdidn’twantthetaxbenefitsassociatedwithdeductionstobenefitorsubsidizewrongdoing.Ofcourse,thisrationaledoesn’treallyexplaintheprohibitionagainstdeductingpoliticalcontributionswhichisprobablybetterexplainedbythepotentialperceptionthatpoliticaleffortsarebeingsubsidizedbytaxpayers.

6.[LO2]Provideanexampleofanexpenseassociatedwiththeproductionoftax-exemptincome,andexplainwhatmighthappenifCongressrepealedtheprohibitionagainstdeductingexpensesincurredtoproducetax-exemptincome.

Twocommonexamplesareinterestexpenseassociatedwithdebtusedtopurchasemunicipalbondsandlifeinsurancepremiumspaidonkeymaninsurance.Ifthisprohibitionwererepealed,thentaxpayerswouldhaveanincentivetoborrowtoinvestinmunicipalbondsorborrowtoinvestinemployeelifeinsurance.Thisformerpracticewouldleadtohigherdemandformunicipalbonds（lessyield）andlessrevenueforthegovernment.Thelatterpracticewouldleadtohigherdemandforinsurance（higherpremiums?

）andlessrevenueforthegovernment.Bothpracticescouldleadtoaperceptionofinequitybetweenthosetaxpayersabletoutilizethetaxarbitragetoreducetaxesandthosewhocouldnotusethepractice.

7.[LO2]{Research}Jerryisaself-employedrockstarandthisyearheexpended$1,000onspecial“flashy”clothesandoutfits.Jerrywouldliketodeductthecostoftheseclothesaswork-relatedbecausetheclothesarenotacceptabletoJerry’ssenseoffashion.UnderwhatcircumstancescanJerrydeductthecostoftheseworkclothes?

Taxpayersmaydeductthecostofuniformsorspecialclothingtheyuseintheirbusinesswhentheclothingisnotappropriatetowearasordinaryclothingoutsidetheplaceofbusiness.InJerry’scase,theflashyrockoutfitscouldbeanalogoustospecialuniformsorprotectivegarmentsandcouldbedeductible.SeeD.Texchner,TCMemo1997-498.ErhardSeminarTraining,TCMemo1986-526providesanexampleofclothesthatwerenotdeductiblebecausetheywereappropriatefor

normalwear.However,thecostofclothingwouldnotlikelybedeductibleiftheclotheswereunacceptablesolelybecauseofthetaxpayer’ssenseoffashion.

8.[LO2]Jimmyisasoleproprietorofasmalldrycleaningbusiness.ThismonthJimmypaidforhisgroceriesbywritingchecksfromthecheckingaccountdedicatedtothedrycleaningbusiness.WhydoyousupposeJimmyisusinghisbusinesscheckingaccountratherthanhispersonalcheckingaccounttopayforpersonalexpenditures?

Jimmymightbetryingtoreducehisbankchargesbyusingoneaccountforbothpersonalandbusinessexpenditures,buthecouldalsobetryingtodisguisepersonalexpendituresasbusinessexpenses.Bycomminglingbusinessandpersonalexpenditures,Jimmywillneedtoseparatepersonalandbusinessexpendituresbeforeclaiminganybusinessdeductions.

9.[LO2]Timemploysthreesalesrepresentativeswhooftentakeclientstodinnerandprovideentertainmentinordertoincreasesales.ThisyearTimreimbursedtherepresentatives$2,500forthecostofmealsand$8,250forthecostofentertainingclients.DescribetheconditionsunderwhichTimcanclaimdeductionsformealsandentertainment.

Todeductanyportionofthecostofamealasabusinessexpense,theamountmustbereasonableunderthecircumstances,thetaxpayer（oranemployee）mustbepresentwhenthemealisfurnished,andthemealmustbedirectlyassociatedwiththeactiveconductofthetaxpayer’sbusiness.Similartobusinessmeals,entertainmentassociatedwithbusinessactivitiescontainsasignificantelementofenjoyment.Hence,only50%ofallowablebusinessentertainmentmaybedeductedasabusinessexpense.Further,entertainmentdeductionsareallowableonlyif“businessassociates”areentertained,theamountspaidarereasonableinamount,andtheentertainmentiseither“directlyrelated”or“associatedwith”theactiveconductofbusiness

10.[LO2]Jennyuseshercarforbothbusinessandpersonalpurposes.Shepurchasedtheautothisyearanddrove11,000milesonbusinesstripsand9,000milesforpersonaltransportation.DescribehowJennywilldeterminetheamountofdeductibleexpensesassociatedwiththeauto.

Becauseonlytheexpenserelatingtobusinessuseisdeductible,thetaxpayermustallocatetheexpensesbetweenthebusinessandpersonaluseportions.Acommonmethodofallocationisrelativeuse.InthisinstanceJennywouldcalculatethebusinessportionbasedupontheratioofbusinessmilestototalmiles（11/20or55percent）.Shewouldthendeductthecostsofoperatingthevehicleforbusinesspurposesplusdepreciationonthebusinessportion（55percent）ofthevehicle’staxbasis.Alternatively,inlieuofdeductingthesecosts,Jennymaysimplydeductastandardamountforeachbusinessmileshedrives.Thestandardmileagerate

representstheper-milecostofoperatinganautomobile（includingdepreciationorleasepayments）.

11.[LO1,LO2]Whatexpensesaredeductiblewhenataxpayercombinesbothbusinessandpersonalactivitiesonatrip?

Howdotherulesforinternationaltraveldifferfromtherulesfordomestictravel?

Ifthetaxpayerhasbothbusinessandpersonalmotivesforatrip,buttheprimaryordominantmotiveisbusiness,thetaxpayermaydeductthetransportationcoststogettotheplaceofbusiness,butshemaydeductonlymeals（50%）,lodging,transportationonsite,andincidentalexpendituresforthebusinessportionofthetravel.Ifthetaxpayer’sprimarypurposeforthetripispersonal,thetaxpayermaynotdeducttransportationcoststotraveltoandfromthelocationbutthetaxpayermaydeductmeals（50%）,lodging,transportation,andincidentalexpendituresforthebusinessportionofthetrip.Forinternationaltravelinexcessofoneweek,thetaxpayermustallocatethecostofthetransportationbetweenpersonal（nondeductible）andbusiness（deductible）activities.Taxpayersgenerallydeterminethenondeductibleportionofthetransportationcostsbymultiplyingthetravelcostsbyaratioofpersonalactivitydaystototaldaystraveling.

12.[LO2]ClydelivesandoperatesasoleproprietorshipinDallas,Texas.ThisyearClydefounditnecessarytotraveltoFortWorth（about25milesaway）forlegitimatebusinessreasons.IsClyde’striplikelytoqualifyas“awayfromhome,”andwhywouldthisdesignation