CHAPTER 5 — PART ONE INTRODUCTION TO BUSINESS EXPENSES I. WHAT IS

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Chapter 5 - 1

                        CHAPTER 5 -- PART ONE
                  INTRODUCTION TO BUSINESS EXPENSES

I. WHAT IS DEDUCTIBLE

 A. Legislative Grace

     1. Only deductions specifically allowed by the tax law. Congress's
        attempt to implement the ability-to-pay concept.

     2. All requirements for the deduction must be satisfied.

 B. Business Purpose -- In order to be deductible, there must be a business
    purpose for an expenditure that is unrelated to its tax effect.

     In most cases, a business purpose can be established by showing that an
     expense is related to a profit-motivated transaction.


II. Reporting of Deductions by Individuals 

  A. Deductions "for" adjusted gross income (AGI) vs. deductions "from" AGI
     -- Deductions for AGI receive more favorable treatment.

      1. Deductions FOR AGI are always deductible

      2. Deductions FROM AGI are subject to various limitations
                                                                                 Chapter 5 - 2

 B. Exhibit 5-1

                                     EXHIBIT 5-1
                  INDIVIDUAL INCOME TAX COMPUTATION FRAMEWORK

         All Sources of Income (Broadly Defined)

Minus:   Exclusions From Income

Equals: Gross Income

Minus:   Deductions FOR Adjusted Gross Income

         Trade or Business Expenses
         Rental and Royalty Expenses
         Trade or Business Losses
         Capital Loss Deduction ($3,000 maximum)
         Other Specifically Allowable Deductions

Equals: ADJUSTED GROSS INCOME

Minus:   Deductions FROM Adjusted Gross Income

         The Greater of:

             1)   Standard Deduction

          OR

             2)   Allowable Itemized Deductions
                  Deductible personal expenditures
                      Medical expenses
                      Home mortgage interest / investment interest
                      Property taxes / state income taxes
                      Charitable contributions
                      Personal casualty losses

                  Other miscellaneous itemized deductions
                     Investment expenses for the production of income
                     Expenses related to tax return preparation and compliance
                     Unreimbursed employee business expenses

Minus:   Personal and Dependency Exemptions


Equals: Taxable Income
                                                                           Chapter 5 - 3

III. Conduit Reporting

 A. Conduit entities must report their "ordinary taxable income" separately
    from any items of income or expense that receives special treatment at
    the owner (partner, shareholder) level. This includes any deduction that is
    subject to a limitation or is not deductible on the owner's returns.
    Examples include miscellaneous expenses (subject to 2% of AGI limit),
    charitable contributions, investment interest, investment expenses, and
    nondeductible expenses.

IV. Initial Categorization of Expenditures - Figure 5-1



                                  Expenditure




            Profit-motivated                              Personal
           business expense                               expense



    Trade or              Expense           Specifically             Nondeductible
    Business               For the            Allowed                  Personal
    Expense              Production           Itemized                 expense
                         Of income           deduction
                                                                       Chapter 5 - 4

A. Motivation for Expenditure

   1. Profit Motivated v. Personal Expenditures
      a. Primarily Profit Motivated

   2. Profit Motivated Expenditures are further classified as being:

       a. Trade or Business Expenses

       b. Production of Income Expenses (Investment Related Expenses)

       Note: Both types of expenses are related to activities that are profit-
       motivated. A trade or business activity will be identified by the extent
       of the taxpayer's involvement and whether the intent is to earn a living
       from the activity.

   3. Personal Expenditures
      a. General Disallowance
      b. Specifically Allowed Itemized Deductions

B. Importance of correct categorization

   1. Trade or Business Expenses - All ordinary and necessary business
      expenses that are reasonable in amount are deductible.

   2. Production of Income Expenses - All ordinary and necessary
      investment expenses that are reasonable in amount are allowable as
      deductions. However, the amount of the actual deduction may be
      limited due to the nature of the investment activity (eg. passive loss
      limitations in Chapter 7) or through limitations put on deductions of
      individual investment expenses (miscellaneous itemized deduction
      limitation in Chapter 8).

   3. Personal Expenditures - In general are disallowed; however, certain
      personal expenditures (medical, taxes, home mortgage interest) are
      allowed as a deduction. Some of these are also subject to limitations
      (medical, casualty and theft losses, miscellaneous itemized). Further,
      only individuals who have significant personal deductions can actually
      take advantage of the allowable deductions (i.e. individuals who use
      the standard deduction do not benefit from specific expenditures).
                                                                       Chapter 5 - 5

V. TRADE OR BUSINESS v. PRODUCTION OF INCOME ACTIVITY

 A. Trade of Business is a commonly used term in tax law - not well defined

 B. Provision of Goods & Services Test

 C. 1987 Supreme Court Decision - 3 Tests (Is gambling a TorB?)

    1. Profit Motive - primary purpose for engaging in the activity must be to
       earn income or a profit

    2. Continuity & Regularity of Activity  must be continuity and regularity
       in the taxpayer's involvement in the activity

    3. Must be a Livelihood/ Not a Hobby - activities that are sporadic,
       constitute a hobby or an amusement diversion are not TorB.

 D. Active Investor v. Active Trader

    1. Investor who trades on own account for long-term appreciation and
       current dividends, interest, etc. is not engaged in a TorB. Therefore,
       the investor's activities are related to production of income, and
       investment expenses are deductible only as miscellaneous itemized
       deductions.

    2. Trader who trades for short-term profits and not long-term
       appreciation and current dividends, interest, etc. may be engaged in a
       TorB if the trader's activities are frequent and substantial. Therefore,
       the expenses will be deductible FOR AGI.

    3. Dealers in Securities who trade for other taxpayer's accounts and rely
       on the commissions from such trading for their livelihood are engaged
       in a TorB.
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