Chapter 5: Business Expenses 1
Solutions to Chapter 5 Problem Assignments
Check Your Understanding
1. Trade or Business
What are the characteristics of a qualified trade or business?
Solution: To be a qualified trade or business, an activity must have a profit motive (to make money) and the taxpayer must spend a sufficient amount of time in the business so that it is not considered simply an investment activity or a hobby. The motivation for the activity cannot be primarily personal pleasure; it must be profit.
2. Investment Expenses
What is an investment activity and how are its expenses deducted?
Solution: An investment activity is one in which the owner intends to make a profit but does not spend sufficient time to elevate it to a trade or business. Typically, the income from an investment activity comes from owning income-producing assets or from long-term appreciation in assets.
Investment expenses are deductible but the deduction may be limited. Individuals are only permitted to deduct their investment expenses as miscellaneous itemized deductions subject to the 2 percent of AGI limitation.
3. Timing of Expense Deduction
Marvin, an attorney, is a cash-basis, calendar-year taxpayer. Marvin's two daughters each own 50 percent of the stock of Marvil Corporation, a calendar-year, accrual-basiscorporation. During year 1, Marvin completes some legal work for Marvil Corporation on December 18 and earns a $20,000 fee. In which year should Marvil Corporation deduct the legal expense if
a. payment is made to Marvin on December 30, year 1?
b. payment is made to Marvin on January 6, year 2?
Solution: a. Because Marvin’s daughters own Marvil Corporation, it is a related entity. Marvil can only deduct the legal expense in the year Marvin recognizes the income. These events both happen in year 1; thus, Marvil can deduct the expense in year 1.
b. Marvil cannot deduct the payment for the legal expense until year 2, the year Marvin recognizes the income.
4. Substantiation
What records can the IRS require from a taxpayer to substantiate a tax deduction?
Solution: Substantiation may be provided in the form of receipts, canceled checks, and paid bills. If the expense is for travel, entertainment, gifts or automobile expenses, the substantiation could include diaries, trip sheets, travel logs, paid bills, receipts, account books, and expense reports. These should document the amount of the expense, the time and place of the expense, the business purpose for the expense, the date and description of a gift and the business relationship to the person receiving a gift.
5. Timing of Expense Deduction
Aloha Airlines is required by law to have its aircraft engines tested and recertified after 5,000 flight hours. Molokai Maintenance performs the engine tests and recertification for $2,200 per aircraft. For financial accounting purposes, Aloha establishes a reserve account and accrues a maintenance expense of 44 cents per flight hour. When the maintenance is done, the amount paid for the maintenance is deducted from the reserve account. For tax purposes, when can the maintenance expense be deducted?
Solution: Businesses are not permitted to use reserves for expenses for tax purposes. Aloha can only deduct the repair expenses in the year the repairs are performed, if it is an accrual-basis taxpayer, or when they are paid, if it is a cash-basis taxpayer.
6. Business Investigation Expenses
Diane owns and manages a successful clothing store in Dallas. Just prior to the graduation of her brother, Cameron, they investigated the possibility of opening another store in Atlanta for Cameron to manage. Diane and Cameron each paid $1,600 in travel costs while looking for sites for the store. Each paid $300 in legal fees for a lawyer to compile a list of zoning regulations and other relevant city ordinances. They decide that it is not feasible to open a new store at the present time. Can Diane and Cameron deduct their business investigation expenses? Explain.
Solution: Diane can deduct the $1,900 ($1,600 + $300) in the current year as business investigation expenses. Diane can deduct this amount because she is already in the clothing business and expenses for potential expansion are ordinary business expenses whether or not a new store is opened. Her brother, however, is not permitted any deduction for the $1,900 that he expended. Cameron could only deduct the $1,900 (along with start-up expenses not exceeding $5,000 in total) if the new store was opened.
7. Organization Costs vs. Business Expenses
In its first year of operations, Bell Corporation paid its attorney $4,000 and its accountant $2,000 for services related to the organization of the corporation. In its second year of operations, Bell paid the attorney $700 to handle contract negotiations with a new customer. Which expenses are immediately deductible and which ones must Bell Corporation amortize?
Solution: $5,000 of the $6,000 organizational costs are deducted in the first tax year and the remaining $1,000 are capitalized and amortized over 180 months starting with the month the corporation begins business. The $700 legal fee is fully deductible in the second year as a business expense.
12. Hobby vs. Business
What factors differentiate a hobby from an active business?
Solution: Factors that differentiate a hobby from a business include:
The manner in which the taxpayer carries on the activity;
The expertise of the taxpayer andof the taxpayer’s consultants;
The time and effort spent by the taxpayer in the activity;
The taxpayer’s history of profits or losses for this activity;
The success of the taxpayer in similar activities;
The overall financial status of the taxpayer; and
The elements of pleasure or recreation that are part of the activity.
13. Tax vs. Financial Accounting
Differentiate permanent differences and temporary differences. Provide examples of each.
Solution: A permanent difference between tax and financial accounting is one that results from a treatment that does not reverse over time (the difference remains imbedded in their respective net incomes permanently). A temporary or timing difference is one that does reverse in a later period. (Over two or more periods, the income or deductions for financial accounting will equal the income or deductions for tax accounting.) Examples of timing differences include differences in depreciation schedules, bad debt deductions vs. allowances for bad debt, and prepaid expenses. Examples of permanent differences include tax-exempt interest income on municipal bonds, life insurance proceeds, and nondeductible fines.
17. UNICAPRules
Which of the following costs must be included in inventory by a manufacturer under the UNICAP rules?
a. Factory insurance
b. Advertising
c. Payroll taxes for factory employees
d. Research and experimentation costs
e. Repairs to factory equipment
Solution: a. Factory insurance - Included
b. Advertising – Not included
c. Payroll taxes for factory employees - Included
d. Research and experimentation costs – Not included
e. Repairs to factory equipment – Included
Crunch the Numbers
20. Prepaid Rent
On October 1, Bender Company (a calendar-year, cash-basis taxpayer) signs a lease with Realco Corporation to rent office space for 36 months. Bender obtains favorable monthly payments of $600 by agreeing to prepay the rent for the entire 36-month period.
a. If Bender Company pays the entire $21,600 on October 1, how much can it deduct in the current year?
b. Assume the same facts above except that the lease requires Bender Company to make three annual payments of $7,200 each on October 1 of each year for the next 12 months rent. On October 1 of the current year, Bender Company pays $7,200 for the first 12-month rental period. How much can Bender Company deduct in the current year?
Solution: a. Bender can only deduct $1,800 (3 x $600) rent for the three months remaining in the current year, because the rent payment is for a period extending beyond the end of the succeeding year.
b. Bender can deduct the $7,200 in each year that it is paid. The contract calls for the advance payments and each payment does not extend beyond the end of the year following the year it is paid.
21. Prepaid Expenses
On December 15, Simon Corporation (a cash-basis, calendar-year corporation) paid $5,000 for five months of supplies and $9,000 for an insurance policy covering its office building for the next three calendar years. How much can Simon deduct this year for these expenses?
Solution: Simon can only deduct the $5,000 paid for supplies. The insurance payment must be capitalized and written off one-third in each of the years it covers as if Simon was an accrual-basis taxpayer.
23. Interest Deduction
When Kelley couldn’t make several monthly payments on a business loan, her brother Mike made three of the monthly payments of $700 each, a total of $2,100 ($1,950 for interest expense and $150 for principal) for Kelley’s loan. Kelley makes the other nine monthly payments herself ($5,850 for interest expense and $450 for principal).
a. What is Mike’s deduction for interest expense?
b. What is Kelley’s deduction for interest expense?
c. What could they have done to preserve the tax deductions? Explain.
Solution: a. Mike cannot deduct anything because it is not his loan.
b. Kelley can only deduct the $5,850 interest expense for the nine monthly payments that she made.
c. Mike should have given (or loaned) the money to Kelley and let Kelley make the loan payments. That way, Kelley could take a deduction for the $7,800 interest paid that year.
24. Business Meals and Club Dues
Elisa spends $1,000 on business lunches to entertain her customers at the local country club. The club charges an annual membership fee of $800. Elisa uses the facility 80 percent of the time for business. Her employer does not reimburse her for any of these expenses. What is her deductible expense?
Solution: Elisa can deduct $500 (50% x $1,000) of the business lunches only. She has no deduction for any portion of the club dues.
25. Entertainment Expenses
Jim, a self-employed individual, takes an important customer to the hockey playoffs. Although the face value of a ticket is only $70, he pays a scalper $400 for each ticket. Assuming all other requirements are met, how much can Jim deduct for the two tickets?
Solution: $70. Entertainment tickets are not only subject to the 50% limit, but the 50% limit applies to the face value of the tickets. Thus, Jim is allowed a deduction for only one-half of the face value of the tickets or $70 (50% x $140).
26. Travel Expenses
Martha lives with her husband in Los Angeles but works in San Diego. During the week she stays in a hotel in San Diego and eats in nearby restaurants. On weekends, she flies home to Los Angeles. During the year, Martha spent $5,000 for the hotel, and $2,000 for meals while in San Diego. Her airfare for travel between San Diego and Los Angeles was $2,500. What is Martha’s deduction for travel expenses?
Solution: Martha cannot deduct any travel expenses. Her tax home is in San Diego. Her travel to Los Angeles is purely personal and her expenses are nondeductible.
27. Travel Expenses
Mark flew from Baltimore to Phoenix on business. He spent four days on business and visited friends for two days before returning home. He stayed at a hotel for the four business days but he stayed at his friend’s home the last two days. He paid the following expenses:
Airfare / $420Hotel / 500
Meals for 4 business days / 200
Meals for 2 days visiting friends / 80
Gift for customer in Phoenix / 80
Gift for friends / 30
Rental car for 6 days at $20 per day / 120
How much qualifies as deductible travel expenses?
Solution: $1,100 deductible travel expenses. The airfare of $420, $500 for the hotel, $100 (50% x $200) for meals for the 4 business days, and $80 ($20 x 4) for the cost of 4 days for the rental car = $1,100 deductible travel expenses. He may also deduct $25 of the cost of the gift for the customer in Phoenix, but that is not a travel expense.
28. Temporary Assignments
Tim accepts a temporary assignment that is 500 miles away from his office. The assignment is expected to last 7 months. Tim spends $7,000 for lodging and transportation and $3,000 for meals during these 7 months. At the end of the 7 months, Tim is notified that the assignment is extended for another 10 months. Tim incurs $13,000 in travel expenses ($4,000 of which is for meals) during months 8 through 17. What qualifies as deductible travel expenses?
Solution: $8,500. The $7,000 for lodging and transportation and $1,500 ($3,000 x 50%) for meals during the first seven months are deductible as travel expenses. At that point, the assignment is no longer temporary because the 10-month extension will extend it beyond the one-year limit; the expenses from that point on no longer qualify as travel expenses.
30. Transportation Expense
John is a teacher at a local high school. During 2010, he travels three days per week to a school in the next county to work with gifted children in an after-school program that does not end until 6:30 P.M. He normally eats dinner before driving home. If he drives 75 miles each way on 90 days to the gifted program, his meal expense is $900, and he maintains adequate records, how much may John deduct for these trips?
Solution: $6,750 (90 days x 150 miles x 50¢); John is allowed to deduct his mileage only. He has no deduction for meals as he is not “traveling away from home.”
31. Foreign Travel
Luis, a self-employed individual, flies from New York to Rome. He spends seven days in Rome on business and stays over in Rome for an additional three days to vacation. Transportation costs incurred were $1,400; his hotel cost $200 per day for a total of $2,000; and his meals cost $100 per day for a total of $1,000. What expenses can Luis deduct?
Solution: $2,730. Luis can deduct $980 (7/10 x $1,400) transportation costs, $1,400 (7 x $200) for his hotel, and $350 (7 x $100 x 50%) for his meals, for a total of $2,730.
32. Uncollectible Accounts
Maria earns $50,000 from consulting contracts during the year. She collects only $48,000 from her clients and expects the $2,000 will remain uncollectible.
a. If Maria’s business is on the accrual basis, what is her gross income for the year and how much can she deduct for bad debt expense?
b. If Maria’s business is on the cash basis, what is her gross income for the year and how much can she deduct for bad debt expense?
Solution: a. Maria must recognize $50,000 of income during the current year. She will deduct the $2,000 as a bad debt in the year she determines it is uncollectible.
b. Maria will recognize only $48,000 of income in the current year. She has no deduction for the $2,000 that she cannot collect because it was never recognized as income.
33. Insurance
In the current year, Melbourne Corporation pays the $2,000 annual premium for a life insurance policy on its president, for which Melbourne Corporation is the beneficiary. Melbourne also pays $20,000 in annual premiums for group term life insurance for its employees as an employee benefit; the employees designate the beneficiaries. Additionally, Melbourne pays $16,000 in annual premiums for business fire, casualty, and theft insurance. How much can Melbourne deduct as business expenses?
Solution:Melbourne can deduct $36,000 ($16,000 + $20,000) in insurance expense. The $2,000 premium for the president’s life insurance policy is not deductible because the insurance proceeds would be tax exempt.
38. Book/Tax Differences
Maxwell Corporation has income per books before tax of $400,000. Included in the income per books is $8,000 interest income from tax-exempt municipal bonds. In computing income per books, Maxwell deducted $22,000 for meals and entertainment expenses, $3,300 for premiums on officers' life insurance policies (the corporation is the beneficiary for these policies), and $200 for fines.
a. What is Maxwell Corporation's taxable income?
b. What should Maxwell Corporation report as its income tax expense on its financial statements, assuming it uses a 34 percent tax rate?
Solution: a. $406,500. ($400,000 - $8,000 tax-exempt interest income + $11,000 (50% x $22,000) meals and entertainment expense + $3,300 life insurance premium + $200 fines).
b. $138,210 ($406,500 x 34%).Tax expense on the financial statement and taxes payable will be the same because all of the adjustments are for permanent differences between tax and financial accounting income.
39. Book/Tax Differences
Sorbon Corporation pays federal income tax at a 34 percent rate. In year 1, Sorbon deducts $80,000 as bad debt expense in computing its book income but deducts only $70,000 for bad debt expense on its tax return.
a. What is the difference between Sorbon's book tax expense and its federal tax liability?
b. How does Sorbon account for this difference on its financial statements?
c. In year 2, Sorbon reports $50,000 for bad debt expense on its books and $60,000 bad debt expense in computing taxable income. How does Sorbon account for this difference on its financial statements?
Solution: a. $3,400 [($80,000 - $70,000) x 34%]