Chapter 6 Individual Deductions

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Chapter 6
Individual Deductions

SOLUTIONS MANUAL

Discussion Questions:

1.[LO 1] It has been suggested that tax policy favors deductions for AGI compared to itemized deductions. Describe two ways in which deductions for AGI are treated more favorably than itemized deductions.

Itemized deductions must exceed the standard deduction before taxpayers receive any tax benefit from the deductions (this is equivalent to an overall floor limit). In contrast, business deductions that are deductible for AGI (above the line) reduce taxable income without being subject to an overall floor limit. Itemized deductions are subject to phase out (for high income taxpayers except for 2010), whereas there is no phase out or reduction for deductions for AGI. Finally, itemized deductions are subject to many mechanical limitations including ceilings, floors, and phase-outs whereas business deductions are generally not subject to these limits (there are limits on certain specific deductions, but this will be described in greater detail in chapter 8). 2.[LO 1] How is a business activity distinguished from an investment activity? Why is this distinction important for the purpose of calculating federal income taxes?

Both business and investment activities are motivated primarily by profit intent, but they can be distinguished by the level of profit-seeking activity. A business activity is commonly described as a sustained, continuous, high level of profit-seeking activity, whereas investment activities don’t require a high level of involvement. The distinction can be important for the location of deductions, because business deductions are claimed above the line (for AGI on Schedule C) while investment deductions are generally itemized or from AGI deductions (with the exception of rent and royalty expenses which are deductible for AGI on Schedule E). 3.[LO 1] Describe how a business element is reflected in the requirements to deduct moving expenses and how Congress limited this deduction to substantial moves.

A move could be related to business if the individual is partially or even primarily motivated by the desire to change jobs or start a new business. The business test for a moving expense deduction requires the taxpayer to be employed full time 39 of the first 52 weeks (or self-employed for 78 of the first 104 weeks) after the move. A substantial move is determined by the distance test (comparing the distance from

the taxpayer’s old residence to the new job versus the distance from the old residence to the old job). 4.[LO 1] Explain why Congress allows self-employed taxpayers to deduct the cost of health insurance above the line (for AGI) when employees can only itemize this cost as a medical expense. Would a self-employed taxpayer ever prefer to claim health insurance premiums as an itemized deductions rather than a deduction for AGI? Explain. This deduction provides a measure of equity between employees and the self-employed. The cost of health insurance is essentially a personal expense. However, employees typically aren’t required to pay insurance premiums because their employers pay the premiums for them as a form of compensation. The employer is allowed to deduct the premium as a compensation expense and the employee is allowed to exclude from taxable income the value of the premiums paid on his behalf. Thus, from the employee’s perspective, this arrangement has the same effect as if (1) the employer pays the employee cash compensation in the amount of the premium and (2) the employee pays the premium and deducts the expense for AGI (completely offsetting the compensation income). In contrast to employees, self-employed taxpayers pay their own health insurance costs, because they don’t have an employer to pay these costs for them. Absent a rule to the contrary, self-employed taxpayers would deduct their medical expenses as itemized deductions subject to strict limitations, because the...
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