CHAPTER

14 BUSINESS EXPENSES

1. IRC SECTION 162: TRADE OR BUSINESS EXPENSES

(a) In general
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the
taxable year in carrying on any trade or business, including
(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging other than amounts which
are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or
business; and
(3) rentals or other payments required to be made as a condition to the continued use or possession,
for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking
title or in which he has no equity.
For purposes of the preceding sentence, the place of residence of a Member of Congress (including any
Delegate and Resident Commissioner) within the State, congressional district, or possession which he
represents in Congress shall be considered his home, but amounts expended by such Members within each
taxable year for living expenses shall not be deductible for income tax purposes in excess of $3,000. For
purposes of paragraph (2), the taxpayer shall not be treated as being temporarily away from home during
any period of employment if such period exceeds 1 year. The preceding sentence shall not apply to any
Federal employee during any period for which such employee is certified by the Attorney General (or the
designee thereof) as traveling on behalf of the United States in temporary duty status to investigate or
prosecute, or provide support services for the investigation or prosecution of, a Federal crime.

FIVE PARTS TEST FOR 162(a), an item must: <In order to be deductible>

a)
i.

Be paid or incurred during the taxable year,

ii.

Be for carrying on any trade or business,

1.

The expenses of investigating and looking for a new business and trips preparatory to entering a
business are not deductible as an ordinary and necessary business expense incurred in carrying on a
trade or business

2.

The word pursuit in the statutory phrase in pursuit of a trade or business is not used in the sense
of searching for or following after, but in the sense of in connection with or in the course of a
trade or business

3.

The pursuit phrase takes color from the more general carrying on expression

4.

<need to have a business before carrying on a business>

5.

<when the taxpayer has proceeded beyond an initial investigation stage and has entered a
transactional stage> when the taxpayer reaches the transactional stage, amounts paid to complete the
transaction generally must be capitalized

iii.

Be an expense,

iv.

Be a necessary expense,
1.

Necessary: imposes only the minimal requirement that the expense be appropriate and helpful for
the development of the taxpayers business

v.

Be an ordinary expenses.
1.

Ordinary:
a)

the expense must relate to a transaction of common or frequent occurrence in the type of
business involved

b)

the situation is unique in the life of the individual affected but not in the life of the group, the
community, of which he is a part.

c)

Ordinary does not mean that the payments must be habitual or normal in the sense that the
same taxpayer will have to make them often.***the expense is an ordinary one because we know
from experience that payments for such a purpose, whether the amount is large or small, are the

common and accepted means of defense against attack.

162(a) v.s. 263(a)Deductible v.s. Capitalization

b)
i.

162(a): allows a taxpayer to deduct ordinary and necessary business expenses paid or incurred during
the taxable year
1.

incurred for the purpose of changing the corporate structure for the benefit of future operations are
not ordinary and necessary business expenses

2.

well-established rule that expenses incurred in reorganizing or restructuring corporate entity are not
deductible under 162(a)

3.

Allowing deductions for advertising expenses, incidental building repairs, and employer-incurred
training costs of an ongoing business

ii.

263(a): no deduction shall be allowed for any amount paid out for new buildings or for permanent
improvements or betterments made to increase the value of any property
1.

A taxpayers expenditure that servers to create or enhancea separate and distinct asset should be
capitalized under 263

c)

Repairs v.s. Improvements

i.

Repairs: deductible now

1.

To repair is to restore to a sound state or to mend, while a replacement connotes a substitution

2.

Repair merely keeps the property in an operating condition over its probable useful life for the use for
which it was acquired

3.

The expenditure did not add to the value or prolong the expected life of the property over what they
were before the event occurred which made the repairs necessary

4.

The repairs merely served to keep the property in an operating condition over its probable useful life
for the purpose for which it was used

5.

Safe harbor for routine maintenance performed on a unit of property

a)

Def.: recurring activities that a taxpayer expects to perform as a result of the use of the property
to keep it in its ordinarily efficient operating condition

b)

Examples: inspection, cleaning, testing, and certain replacement of parts

c)

To be routine the activity generally must be done more than once over the propertys life and
factors such as industry practice

ii.

Improvements: capitalization
1.

Under the capitalization regulation, a taxpayer generally must capitalize amounts paid to improve a
unit of property
a)

A unit of property is considered improved if amounts are paid after the property is placed in
service that
i.

Result in the betterment of the property

1.

Ameliorates a material condition or defect in property that either existed at acquisition

or arose during production of the property, whether or not the taxpayer was aware of
the condition or defect

2.

Results in a material addition to the property

3.

Results in a material increase in capacity, productivity, efficiency, strength, or qualify of

the property

ii.

Restore the property

1.

Returns the property to its ordinarily efficient operating condition after it deteriorated
to a state of disrepair where it was no longer functional for its intended use

2.

Is a replacement of a part or a combination of parts that comprise a major component

or structural part of the property

iii.

Adapt the property to a new or different use

1.

If the adaptation is not consistent with the taxpayers intended ordinary use of the
property at the time it was originally placed in service by the taxpayer

2.

The regulations generally require capitalization of: <for intangible asset>

a)

An amount paid to acquire, create, or enhance an intangible asset

b)

An amount paid to facilitate an acquisition or creation of an intangible

c)

An amount paid to facilitate a restructuring or reorganization of a business entity or a transaction

involving the acquisition of capital, including a stock issuance, borrowing, or recapitalization

iii.

Summary:
1.

Decisive distinctions between current expenses and capital expenditures are those of degree and
not of kind

2.

The general idea is that the cost of property acquired for business use is a charge against income that
it helps to earn, ratably over the expected useful life of the propertycapitalization

3.

Expenditures made to enable the taxpayer to use the property for that expected period and for the
planned purpose generally should be deductible expensesdeductible now

d) Start-up expenditures
i.

Congress enacted Section 195 in order to clarify the treatment of start-up expenditures, expenses
incurred in establishing a trade or business that are not part of the transactional stage

ii.

How to calculate:
1.

Deduct up to $5,000 in the year in which the business begins, reduced by the amount of start-up
expenditures that exceed $50,000

2.

The remaining are amortized over a period of not less than 180 months from the month in which the
business begins

iii.

Start-up expenditures are defined in Sec. 195(c)(1)(A) as amounts incurred with respect to:
1.

Investigating the creation or acquisition of an active trade or business

2.

Creating an active trade or business; or

3.

Activities engaged in for profit *** before the day on which the active trade or business begins, in
anticipation of such activity becoming an active trade or business

iv.

The statute specifically provides that amounts deductible under Sec. 163 (interest), 164 (taxes), and 174
(research expenses) do not constitute start-up expenditures <deductible now>

v.

Sec. 195(b)(2) provides that where a business is completely disposed of prior to the completion of the
amortization period, any start-up expenditures not previously deducted may be deducted to the extent
provided in Sec. 165

2. SPECIFIC BUSINESS DEDUCTION

a) REASONABLE SALARIES
i.

ii.

iii.

Seven part tests

1.

The type and extent of the services rendered

2.

The scarcity of qualified employees

3.

The qualifications and prior earning capacity of the employee

4.

The contributions of the employee to the business venture

5.

The net earnings of the employer

6.

The prevailing compensation paid to employees with comparable jobs

7.

The peculiar characteristics of the employers business

Indirect market test

1.

% of profits

2.

Facts

Two part tests <only for employees>

1.

Up to $1 million

2.

Reasonablefacts
a)

iv.

Arms-length deal

$1 Million Ceiling

1.

Congress has imposed a $1 million ceiling on the amount of compensation (either cash or other
remuneration) that a publicly held corporation may deduct in any year

2.

Certain types of compensation are not taken into account in computing the $1 million ceiling including
compensation paid on commission basis; compensation paid solely on account of attainment of
performance goals; and amounts that are excluded from the recipients gross income

v.

Golden Parachutes
1.

When ownership of a corp. changes hands through a takeover, merger, or otherwise, a key executive
may bail out either voluntarily or involuntarily

2.

When generous, these severance packages are known as golden parachutes

3.

280G lets the air out of golden parachutes by prohibiting a 162 deduction to the payor corporation
for excess parachute payments and by tagging the recipient of such payments with a 20% excise tax in
addition to income and social security taxes

b) Travel Away From home

i.

In upholding the Commissioners disallowance of these deductions, the Court said that three conditions
must thus be satisfied before a traveling expense deduction may be made
1.

The expense must be a reasonable and necessary traveling expense, as that term is generally
understood. This includes such items as transportation fares and food and lodging expenses incurred
while traveling

2.

The expense must be incurred while away from home

3.

The expense must be incurred in pursuit of business

a)

This means that there must be a direct connection between the expenditure and the carrying on
of the trade or business of the taxpayer or of his employer

b)

Such an expenditure must be necessary or appropriate to the development and pursuit if the
business or trade

ii.

Living expenses paid by a single taxpayer who has no home and is continuously employed on the road may
not be deducted in computing net income

iii.

iv.

Travel expenses are deductible only if

1.

reasonable and necessary

2.

Incurred while away from home

3.

Incurred in pursuit of business

The IRS has consistently taken the position that a taxpayers home for purposes of 162(a) is the area or
vicinity of his principal place of employment

v.

Effectuation of the travel expense provision must be guided by the policy underlying the provision that
costs necessary to producing income may be deducted from taxable income.

vi.

Where business necessity requires that a taxpayer maintain two places of abode, and thereby incur
additional and duplicate living expenses, such duplicate expenses are a cost of producing income and
should ordinarily be deductible
1.

vii.

Duplicated living expenses necessitated by business are deductible

Commuting expenses:
1.

A taxpayers cost of commuting between the taxpayers residence and the taxpayers place of business
or employment generally are nondeductible personal expenses

2.

The costs of going between one business location and another business location generally are
deductible

3.

Daily transportation expenses incurred in going between an office in a taxpayers residence and other
work locations were deductible where the home office was the taxpayers principal place of business
within the meaning of 280A(c)(1)(A) for the trade or business conducted by the taxpayer at those
other work locations

viii.

Temporary work place

1.

Daily transportation expenses are deductible business expenses when paid or incurred in going

between the taxpayers residence and a temporary work site outside that metropolitan area
2.

A taxpayer must have at least one regular place of business located away from the taxpayers
residence in order to deduct daily transportation expenses incurred in going between the taxpayers
residence and a temporary work location in the same trade or business regardless of the distance

3.

Def.: any location at which the taxpayer performs services on an irregular or short-term basis
a)

ix.

1 year

Daily transportation expenses

1.

A taxpayer may deduct daily transportation expenses incurred in going between the taxpayers
residence and temporary work location outside the metropolitan area where the taxpayer lives and
normally works. However, unless paragraph (2) or (3) below applies, daily transportation expenses
incurred in going between the taxpayers residence and a temporary work location within that
metropolitan area are nondeductible commuting expenses

2.

If a taxpayer has one or more regular work locations away from the taxpayers residence, the taxpayer
may deduct daily transportation expenses incurred in going between the taxpayers residence and a
temporary work location in the same trade or business, regardless of the distance

3.

If a taxpayers residence is the taxpayers principal place of business within the meaning of
280A(c)(1)(A), the taxpayer may deduct daily transportation expenses incurred in going between the
residence and another work location in the same trade or business, regardless of whether the other
work location is regular or temporary and regardless of the distance

c)

NECESSARY RENTAL AND SIMILAR PAYMENTS

i.

If rent is paid to produce title eventually then the rental agreement may be treated as a sale.

d) EXPENSES FOR EDUCATION

i.

Ordinary and necessary expenses paid or incurred in carrying on a trade or business during a tax year are
deductible.

ii.

Maintenance current degree is deductible

iii.

Improve/advance education level is not deduction, but may subject to life time credit

3. MISCELLANEOUS BUSINESS DEDUCTIONS

a) Business meals and entertainment
i.

ii.

274 imposes two principal limitation on the deductibility:

1.

50% limitation extends to all deductible meals

2.

Directly related to or associated with the taxpayers trade or business

Most business meals generate deductible expenses only if they are not lavish or extravagant and only if
the deducting taxpayer or an employee of the taxpayer is present at the meal

iii.

Entertainment facilities
1.

No deduction was allowed for such expenses unless the use of the facility was directly related to the
taxpayers trade or business and was primarily for business purposes

2.

Expenses of facilities to the extent used in business for non-entertainment purposes remain deductible

3.

Although expenditures for entertainment facilities are not deductible, entertainment activities related
to the use of such facilities remain 50% deductible if the rules for deduction of entertainment activity
expenditures are satisfied

b) Uniforms
i.

Deductions for uniforms are allowed only if

1.

The uniforms are specifically required as a condition of employment

2.

Are not of a type adaptable to general or continued usage to the extent that they take the place of
ordinary clothing

c)

Advertising
i.

Generally advertising expenses of a business are deductible in the year in which they are incurred or paid
even though the benefits may extend over several years

ii.

The cost of advertising in magazines, television, and sports programs is currently deductible

iii.

Contributions directly or indirectly to political candidates and political parties are not allowed as deductions

d)

Dues
i.

e)

In general dues paid to organizations directly related to ones business are deductible under 162
Business losses

i.

The business loss can be deducted against other types of income such as income from investments, other
businesses, or salaries

4. DEPRECIATION
a)

Introduction
i.

What kind of asset?

1.

ii.

Personal/business
1.

iii.

b)

Intangible/tangible
Business is deductible

Which year? Which rule?

1.

Purpose: to get expense now, invest more to

2.

Current law which table --- how many years

a)

Straight line

b)

Accelerated

Prerequisites for deduction

i.

c)

167(a) and 168(a) restrict the depreciation deduction to either

1.

Property used in a trade or business

2.

Property held for the production of income

The useful life concept

i.

d)

Its only property that has an identifiable useful life to the taxpayer which can qualify for the deduction
Depreciation methods

i.

Straight line method P372

ii.

Declining balance method P372

e)

The accelerated cost recovery system

i.

Use 167, if 168 doesnt apply

ii.

ACRS is mandatory, not elective, although some elections may be made within the system
1.

ACRS applies to most tangible depreciable property

2.

ACRS is not the exclusive depreciation deduction section; its mandatory when it applies, but if its
inapplicable, 167 is used

iii.

Recovery Periods
1.

Under current ACRS each item of property is assigned to one of several classifications which is
generally dependent upon the propertys class life under the A.D.R. system

2.

Under each classification items of property are assigned to an applicable recovery period which
becomes the period of time over which that property is depreciated

iv.

Disregard of salvage value

v.

Depreciation methods
1.

vi.

Depends upon the classification of property

Conventions
1.

Anti-churning rules
a)

ACRS is intended to encourage new capital investment, and Congress does not want taxpayers
merely to churn their old investments to take advantage of the more rapid current ACRS writeoffs

b)

The anti-churning rules apply if, and only if, the current ACRS rules allow the taxpayer a more
rapid writeoff in the first year the property is placed in service than deprecation allowed for that
year by the rules under which the property was being depreciated by the related person

f)

The Related concept of depletion

i.

A taxpayer could establish a value for certain natural resources at the time of their discovery ,or within
thirty days thereafter, and when write off that value as the taxpayer exploited the resources

ii.

Although there was thus a limit beyond which depletion deductions could not be taken, the variation from
the depreciation deduction, where allowances can never exceed cost or other basis, is apparent

iii.
g)

In order to be considered depreciable property, it must have a determinable useful life

Property subject to the allowance for depreciation means property that is subject to exhaustion, wear and tear,
or obsolescence

i.
h)

the test is whether property will suffer exhaustion, wear and tear, or obsolescence in its use by a business
Special depreciation rules on personal property

i.

197 applies the rules for the write-off of many types of intangible property

ii.

Current ACRS under 168

1.

Applies to most tangible personal property

2.

half-year convention
a)

An administrative rule of convenience which, for depreciation purposes, treats property as if it

were placed in service at the midpoint of the year no matter when during the year it is actually
placed in service

3.

mid-quarter convention
a)

If more than 40% of the cost of all ACRS personal property acquire during a year is placed in
service in the fourth quarter of the year, the mid-quarter rule is invoked

i)

168(k) additional depreciation

i.

j)

New depreciable personal property acquired

179 bonus depreciation

i.

179 allows a taxpayer to elect to write off a part of the cost of some depreciable personal property as an
ordinary expense deduction in the year in which the property is placed in service

ii.

To all qualifying property a taxpayer places in service during the year

iii.

179 is applicable only to property qualifying under ACRS or to off-the-shelf computer software, which is
1245 property and which is acquired by purchase for use in the active conduct of the taxpayers trade
or business

k)

280F limitations on listed property

i.

280F also limits ACRS deductions allowed on certain other listed property that has a business use of 50%
or less

ii.

iii.

Includes:
1.

passenger automobiles and other property used as a means of transportation

2.

property of a type generally used for entertainment, recreation, or amusement purposes

3.

computers not used exclusively at a regular business establishment

4.

cellular phones or similar telecommunications equipment

In general, any use of listed property in connection with the performance of services by an employee is not
considered business use, unless the use is for the convenience of the employer and is required as a
condition of employment

iv.

Listed property with a business use of 50% or less, can be depreciated using only the alternative
depreciation system of 168(g)

v.

If the more-than-50-percent test is met for the year that a listed property is placed in service, but is not met
in a subsequent yearrecaptured as ordinary income

l)

Amortization of goodwill and certain other intangibles

i.

Amortization permits a ratable write-off of the basis of an intangible asset over the useful life of the asset

ii.

197 intangible
1.

Under the provision, the AB of any 197 intangible which is acquired by a taxpayer in connection
with the conduct of a trade or business or an activity engaged in for the production of income may be

amortized over 15 year period beginning with the month in which the asset is acquired
2.

Generally inapplicable to an asset that is self-created by the taxpayer unless it is created in connection
with a transaction that involves the acquisition of a trade or a substantial portion thereof

3.

Special rule:
a)

The loss is not recognized and the basis of such asset is allocated to the AB of the remaining 197
assets acquired in the transaction

4.

Nondeductible start-up expenditures are amortized over 15 year period