Business Income, Deductions, and Accounting Methods
1.[LO 1] What is an “ordinary and necessary” business expenditure?
“Ordinary” and “necessary” imply that an expense must be customary and helpful, respectively. Because these terms are subjective, the tests are ambiguous. However, ordinary is interpreted by the courts as including expenses which may be unusual for a specific taxpayer (but not for that type of business) and necessary is not interpreted as only essential expenses. These limits can be contrasted with the reasonable limit on amounts and the bona fide requirement for profit motivation. 2.[LO 1] Is cost of goods sold deductible as a business expense for a business selling inventory? Explain.
No. Under the return of capital principal, cost of goods sold represents a reduction in gross income rather than a business expense. For example, if a taxpayer sells inventory for $100,000 and reports a cost of goods sold of $40,000, the business’s gross income is $60,000 ($100,000 – 40,000) not $100,000. 3.[LO 1] Tom is an attorney who often represents individuals injured while working (worker liability claims). This year Dewey spent $50 on a book entitled Plumbing For Dummies and paid $500 to take a course on plumbing residences and rental housing. Can you imagine circumstances in which these expenditures would be deductible as “ordinary and necessary” for an attorney. Explain.
“Ordinary” and “necessary” imply that an expense must be customary and helpful, respectively. Because these terms are subjective, the tests are ambiguous. However, ordinary is interpreted by the courts as including expenses which may be unusual for a specific taxpayer (but not for that type of business) and necessary is not interpreted as only essential expenses. Tom may represent a plumber and incurred this expenditure so he can better understand and explain how his client was injured on the job. In this case, the expenses would be both ordinary and necessary to Tom’s practice as an attorney, and therefore deductible. 4.[LO 1] Jake is a professional dog trainer who purchases and trains dogs for use by law enforcement agencies. Last year Jake purchased 500 bags of dog food from a large pet food company at an average cost of $30 per bag. This year, however, Jake purchased 500 bags of dog food from a local pet food company at an average cost of $45 per bag. Under what circumstances would the IRS likely challenge the cost Jake’s dog food as unreasonable?
Reasonableness is an issue of fact and circumstance, and extravagance is difficult to determine definitely. However, a common test for reasonableness is whether the expenditure is comparable to an arm's length amount – a price charged by objective (unrelated) individuals who do not receive any incidental personal benefits. Reasonableness is most likely to be an issue when a payment is made to a related individual or the taxpayer enjoys some personal benefit incidental to the expenditure. Hence, the IRS is most likely to challenge the cost of the dog food if the Jake or his family controlled the local pet food company. 5.[LO 2] What kinds of deductions are prohibited as a matter of public policy? Why might Congress deem it important to disallow deductions for expenditures against public policy?
The IRC lists bribes, kickbacks, and “other” illegal payments as nondeductible. Congress didn’t want the tax benefits associated with deductions to benefit or subsidize wrongdoing. Of course, this rationale doesn’t really explain the prohibition against deducting political contributions which is probably better explained by the potential perception that political efforts are being subsidized by taxpayers. 6.[LO 2] Provide an example of an expense associated with the production of tax-exempt income, and explain what might happen if Congress repealed the prohibition against deducting expenses incurred to produce...