Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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and interviewing new tenants, doing bookkeeping, and purchasing/
installing new appliances, drapes, carpets, and toilets. He keeps a log
to prove how many hours he works on his property in case he is aud-
ited. Since both the above tests are met, Allan’s real estate rental
activity is not a passive activity. If Allan has an overall loss of $40,000
on the real estate rentals, he can deduct the entire loss on his tax
return as an active business, not a passive loss. N
Income from passive investments can be used by taxpayers to absorb passive losses that
would otherwise be disallowed. The passive loss limitations are very complex. Certain oil
and gas investments are not subject to the passive loss limitations, and special rules apply to
investments in qualified low-income housing.
According t o Amazing but True Elvis Facts by Bruce Nash and Allan Zullo (pub-
lished by Andrews McMeel, May 1995), Elvis hated dealing with accountants, so
he let the IRS handle his taxes. Never having a single tax shelter, one year he
reportedly handed over 90 percent of his income.
SECTION 3.3BAD DEBTS
When a taxpayer sells goods or services on credit and the accounts receivable subsequently
become worthless (uncollectible), a bad debt deduction is allowed to the extent that income
arising from the sales was previously included in income. Currently, taxpayers must use the
specific charge-off method and are allowed deductions for bad debts only after the debts
are determined to be partially or completely worthless.
A taxpayer who uses the specific charge-off method must be able to satisfy the IRS that
the debt is worthless and demonstrate the amount of the worthlessness. For a totally
worthless account, a deduction is allowed for the entire amount of t he taxpayer’s basis
in the account in the year the debt becomes worthless. The taxpayer’s basis in the debt
is the amount of income recognized from the recording of the debt, or the amount paid
for the debt if it was purchased.
EXAMPLE Todd owns a small retail store. During the current tax year, Todd has
$8,500 wort h of uncollectible accounts receivable. Assuming he
reported $7,8 00 in sales income from the accounts, that amount is his
basis in the accounts receivable. Therefore, Todd’s deduction for bad
debts is limited to $7,800 for the year. N
Self-Study Problem 3.2
Sherry Moore has a limited partnership investment in a commercial rental
project in which she has no personal involvement. During 2010, her share of
the partnership loss equals $15,000. Sherry also has a rental house that she
actively manages, and this activity generated a $21,000 loss for 2010. Sherry
had no passive loss carryover from prior years. If Sherry’s modified adjusted
gross income before passive losses is $102,000, calculate the deduction
amounts for Sherry’s 2010 tax return using Form 8582 on page 3-13.
Section 3.3
Bad Debts 3-9
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Business and Nonbusiness Bad Debts
Bad d ebts fall into one of two categories, business bad debts or nonbusiness bad debts.
Debts that arise from the taxpayer’s trade or business are classified as business bad
debts, while all other debts are considered nonbusiness bad debts. The distinction between
the two types of debts is important, since business bad debts are ordinary deductions and
nonbusiness bad debts are short-term capital losses. Only $3,000 of net capital losses may
be deducted against ordinary income in any one tax year. Unused short-term capital losses
are carried forward and may be deductible in future years, subject to the $3,000 annual lim-
itation. The treatment of capital gains and losses is discussed in Chapter 8.
EXAMPLE Robert loaned his friend, Calvin, $5,000 to start a business. In the
current year, Calvin went bankrupt and the debt became completely
worthless. Since the debt is a nonbusiness debt, Robert may claim
only a $3,000 short-term capital loss deduction this year (assuming no
other capital transactio ns). The $2,000 unused deduction may be car-
ried forward to the next year. This is not a business bad-debt deduc-
tion, because Robert is not in the business of loaning funds. N
Self-Study Problem 3.3
Indicate whether the debt in each of the following cases is a busine ss or non-
business debt.
Business Nonbusiness
1. Accounts receivable of a doctor from patients _____ _____
2. A father loans his son $2,000 to buy a car _____ _____
3. A corporate president loans another corporation
$100,000
_____ _____
4. Loans by a bank to its customers _____ _____
5. A taxpayer loans her sister $15,000 to start a business _____ _____
Your clients, Tom (age 48) and Teri (age 45) Trendy, have a son, Tim (age 27).
Tim lives in Hawaii where he studies the effects of various sunscreens on his
ability to surf. Last year, Tim was out of money and wanted to move back
home and live with Tom and Teri. To prevent this, Tom lent Tim $20,000 with
the understanding that he would stay in Hawaii and not come home. Tom
had Tim sign a formal note, including a stated interest rate and due date. Tom
has a substantial portfolio of stocks and bonds with a number of capital gains
and losses in the current year. He concluded that Tim is a deadbeat and the
$20,000 note is worthless. Consequently, Tom wants to report Tim’s bad debt
on his and Teri’s current tax return and net it against his other capital gains
and losses. Tom is adamant about this. Would you sign the Paid Preparer’s
declaration (see example above) on this return? Why or why not?
3-10 Chapter 3
Business Income and Expenses, Part I
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
SECTION 3.4
INVENTORIES
The cost of inventory a taxpayer owns has a significant impact on the taxable income of the
taxpayer. The deduction for the cost of goods sold of a retail business is a direct function of
the amount of the beginning and ending in ventories. Cost of goods sold, which is the larg-
est single deduction for many businesses, is calculated as follows:
Beginning inventory $ 75,000
Add: purchases
250,000
Costs of goods available for sale $ 325,000
Less: ending inventory
(100,000)
Cost of goods sold
$ 225,000
Valuation of inventories used in calculating the cost of goods sold is necessary to reflect
clearly the income of the taxpayer.
To calculate cost of goods sold, the taxpayer must value the beginning and ending
inventories of the business. He or sh e must determine the cost of the items on hand.
This process is not as easy as it seems, since the taxpayer will often have paid different pri-
ces during the year for the same item. There are two common methods of inventory val-
uation used by taxpayers: first in, first out (FIFO) and last in, first out (LIFO). The FIFO
method is based on the assumption that the first merchandise acquired is the first to be
sold. Accordingly, the inventory on hand consists of the most recently acquired goods.
Alternatively, when the taxpayer uses the LIFO method, it is assumed that the most
recently acquired goods are sold first and the inventory on hand consists of the earliest pur-
chases. FIFO and LIFO are simply calculation assumptions; the goods that are actually on
hand do not have to correspond to the assumptions of the method selected. In addition to
the LIFO and FIFO methods which are commonly used by taxpayers in valuing beginning
and ending inventories, taxpayers may specifically identify the goods that are sold and the
goods that are in ending inventory. However, the process of specifi cally identifying items
sold and on hand is not a practical alternative for most taxpayers.
EXAMPLE Page made the following purchases of a particular inventory item
during 2010:
March 1 50 units at $120 per unit $ 6,000
August 1 40 units at $130 per unit 5,200
December 1 25 units at $140 per unit
3,500
Total
$14,700
If the ending inventory is sixty units, it is valued under the FIFO
method as illustrated below:
25 units at $140 each $ 3,500
35 units at $130 each
4,550
Ending inventory
$ 8,050
Assuming that Page had no beginning inventory of the item, the
same ending inventory (sixty units) would be valued using the LIFO
method as follows:
50 units at $120 each $ 6,000
10 units at $130 each
1,300
Ending inventory
$ 7,300
Section 3.4
Inventories 3-11
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The cost of goods sold for both the FIFO and LIFO methods are pre-
sented below:
FIFO LIFO
Beginning inventory $ 0 $ 0
Add: purchases
14,700 14,700
Cost of goods available for sale $14,700 $14,700
Less: ending inventory
(8,050) (7,300)
Cost of goods sold
$ 6,650 $ 7,400
Notice that taxable income will be $750 more when t he FIFO
method is used instead of the LIFO method. During periods of infla-
tion, taxpayers pay less tax if they use the LIFO inventory valuation
method. N
A taxpayer m ay adopt the LIFO method by using it in a tax return and attaching Form
970 to make the election. Once the election is made, the method may be changed only with
the consent of the IRS . Also, if the LIFO election is made for reporting taxable income,
taxpayers must use the same method for preparing their financial statements. In other
words, a taxpayer may no t use LIFO for his or her tax return and use FIFO for financial
statements presented to a bank. This rule is strictly enforced by the IRS.
Self-Study Problem 3.4
Kelly owns a small retail store. During the year, Kelly purchases $175,000
worth of inventory. Her beginning inventory is $62,500 and her ending inven-
tory is $57,200. Also, she withdrew $4,500 in inventory for her personal use
during the year. Use Part III of Schedule C below to calculate Kelly’s cost of
goods sold for the year.
3-12 Chapter 3
Business Income and Expenses, Part I
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Section 3.4
Inventories 3-13
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3-14 Chapter 3
Business Income and Expenses, Part I
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
SECTION 3.5
NET OPERATING LOSSES
Unde r th e Un ited States tax law, a taxpayer i s require d to file an annual tax ret urn. The
pattern of a taxpayer’s i ncome, howev er, can lead to inequities among taxpayers with the
same total amount of taxable income over a number of years. The inequities arise because
of the progressive rates involved in the tax calculation. The higher the taxpayer’s income,
the higher the tax rate paid (see Chapter 12 for a discu ssion of tax rates). To alleviate this
problem, Congress enacted the Net Operating Loss (NOL) provision. The following
example shows inequities that could result if the net operating loss provision were not
in the tax law.
EXAMPLE A and B are both single taxpayers with one exemption. Their taxable
income over a 3-year period is as shown in the following table. Notice
their total taxable income for the 3-year period is the same ($150,000
each). However, the pattern of income is very different. As a result,
without relief, B’s tax liability is $20,165 ($46,247 $26,082) more
than A’s tax liability.
Year A’s Income
A’s Tax
Liability B’s Income
B’s Tax
Liability
1 $ 50,000 $ 8,694 $120,000 $27,320
2 50,000 8,694 (60,000) 0
3
50,000 8,694 90,000 18,927
Total
$150,000 $26,082 $150,000 $46,247
N
To provide taxpayer B relief from this inequitable tax situation, a deduction for NOLs is
allowed by the tax law. Under this provision, a net operating loss from one tax year can be
used as a deduction in another tax year. The net operating loss provision is primarily
designed to provide relief for trade or business losses. Generally, only losses from the oper-
ation of a trade or business, casualty and theft losses, or confiscation losses can generate a
net operating loss. Thus, individual taxpayers with only wages, itemized deductions (except
casualty losses), and personal exemptions could not generate a net operating loss.
Carrybacks and Carryovers
Under the general rule, a net operating loss is carried back 2 years and forward 20 years.
The NOL is first carried back to the second prior year and then to the prior year (or until
the NOL is used in full). If there is still unused NOL, the loss is carried forward to future
tax years in chronological order. Taxpayers may make an irrevocable election to forgo the
2-year carryback and only use the 20-year ca rryover. When a taxpayer has two different
NOL deductions available in a tax year, then the earliest year’s loss is used first.
Where there is a net op erating loss carryback, the taxpayer must file an amended tax
return on Form 1040X or a quick claim for refund Form 1045. In future tax years, the
net operating loss deduction is shown as a current deduction on the tax return for that
year. Calculation of NOLs for individual taxpayers is very complex and beyond the scope
of this text.
EXAMPLE Desiree has a net operating loss of $20,000 in 2010. She uses this NOL
deduction in the following order: 2008, 2009, 2011 through 2030.
Note she could elect not to carryback to the 2008 and 2009 tax years
but rather just deduct the loss in 2011 and future years. N
Section 3.5
Net Operating Losses 3-15
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
In order to provide relief to businesses during the recent economic downturn,
the tax law was temporarily changed to allow 2008 and 2009 NOLs to be carried
back 3 , 4, or 5 years at the election of the taxpayer. The expanded carryback
period may be extended to 2010. Please see the Whittenburg Web site for
information on laws pending as we go to press.
For example, Peter has an eligible $20,000 net operating loss in 2009. He
may elect to carry the loss back to any year between 2004 and 2007. Peter
should elect to carry the loss back to the year which gives him the b iggest
tax benefit. Peter may also carry the loss forward and forgo the carryback
period.
A taxpayer with a net operating loss who was in a low tax bracket for the carry-
back period, but expects to be in a high tax bracket the following year, may wish
to elect out of the carryback period. The taxpayer will get a bigger tax benefit
from deducting the NOL in the high-income year.
SECTION 3.6 INDIVIDUAL RETIREMENT ACCOUNTS
There are two principal types of IRAs in the U.S. tax law. One is the traditional IRA and the
other is the Roth IRA. Annual contributions to a traditional IRA are deductible, and retire-
ment distributions are taxable. Annual contributions to a Roth IRA ar e not deductible, and
retirement distributions are nontaxable. Earnings in both types of IRAs are not taxable in
the current year.
Self-Study Problem 3.5
Indicate whether the following statements are tr ue or false by circling the
appropriate letter.
TF1. NOL deductions are first carried back 3 years and then forward
15 years.
TF2. The itemized deduction for home mortgage interest can generate
an NOL for an individual taxpayer.
TF3. The purpose of the NOL provision in the tax law is to alleviate
some of the inequities caused by the progressive tax rate
structure.
TF4. The election not to carry back an NOL deduction is irrevocable.
TF5. When taxpayers have an NOL deduction, they can use it any year
they choose, as long as the tax year is within the prescribed
deduction period.
3-16 Chapter 3
Business Income and Expenses, Part I
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
EXAMPLE Gene has $30,000 in his IRA in 2010. The earnings for the year on this
IRA are $1,600. These earnings are not taxed to Gene in the current
year. N
IRA Annual Contributions
There are annual contribution limits for both traditional and Roth IRAs. In 2010, the max-
imum annual contribution that may be made to either type of IRA is equal to the lesser of
(1) 100 percent of the taxpayer’s compensation or self-employment income (earned
income) or (2) $5,000 (or $10,000 if an additional $5,000 is contributed to a spouse’s
IRA, and the spo use has no earned income). The maximum contribution to a spouse’s
IRA may not exceed $5,000. In 2010, there is an additional ‘‘catch-up’’ $1,000 annual con-
tribution allowed for taxpayers and spouses age 50 and over, increasing the maximum
contribution to $6,000.
EXAMPLE Quincy, ag e 31, works for B ig Corpo ration and has a salary of
$40,000 for 2010. Quincy is eligible to contribute the maximum
$5,000 to his traditional or Roth IRA for 2010. If Quincy has a spouse
who does not work, he could also contribute $5,000 for her. If Quincy
is 55 years old instead of 31 years old, h e could contribute $6,000 to
his traditional or Roth IRA, and $5,000 or $ 6,000 for his spouse
depending on whether she is old enough to qualify for the $1,000
‘‘cat ch-up ’’ contributi on. N
The IRA limitation calculations discussed below are quite complex and change
every year. Most taxpayers and tax preparers use tax software to assist them in
calculating allowable IRA deductions. It is a standard belief in the tax commu-
nity that computer software has paved the way for the enormous complexity
we see in today’s tax law. Although it is important to understand the rules for
calculating IRA contributions, please also take solace in the fact that these calcu-
lations, as well as many others shown in this text, are not often done by hand
in practice.
The annual deduction maximums above are reduced for traditional IRAs if the taxpayer
is an active participant in another qualified retirement plan. The annual contribution
allowed for a Roth IRA is reduced for all tax payers over certain income level s, but is not
affected by whether the taxp ayer or spouse is an active participant in another retirement
plan. In each case, the maximum annual contribution is phased out proportionately
between certain adjusted gross income (AGI) ranges, as shown below.
2010 AGI Phase-out Ranges for Roth IRA Contributions
Filing Status AGI Phase-out Range
Single or HOH $105,000–$120,000
Married, Joint $167,000–$177,000
Note: Active plan participation status is not relevant to
the Roth IRA phase-out calculation.
Section 3.6
Individual Retirement Accounts 3-17
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
If a taxpayer contributes to both a traditional IRA and a Roth IRA, the combined con-
tributions cannot exceed the normal annual limit ($5,000 or $6,000 if age 50 or older in
2010).
A nondeductible traditional IRA contribution may be made by taxpayers with income
over the phase-out ranges shown above. Although the taxpayer cannot deduct the contri-
bution, all income earned in the IRA account is sheltered from tax until the earnings are
withdrawn, similar to the treatment of annuities discussed in Chapter 2. Many high-income
taxpayers make nondeductible traditional IRA contributions each year because of the
deferral of tax on the earnings of the IRA.
EXAMPLE Ed, age 31, is single and is covered by a retirement plan. If his modi-
fied adjusted gross income is $61,000, Ed’s maximum deductible tradi-
tional IRA contribution is $2,500. With income of $61,000, his $5,000
contribution is proportionately phased out by dividing the amount
remaining in his phase-out range, $66,000$61,000, or $5,000, by the
$10,000 phase-out range (the difference between the bottom and top
of the $56,000 and $66,000 phase-out range) and multiplying this by
the $5,000 maximum IRA deduction as follows:
ð$66,000 $61,000Þ
$10,000
$5,000 ¼ $2,500 allowed IRA deduction
Ed may choose to contribute the $5,000 maximum to a tradi-
tional IRA, but the remaining $2,500 will not be deductible. Alter-
natively, he may contribute the remaining $2,500 to a Roth IRA
since his income is below the phase-out range for Roth IRA contri-
butions. He could also choose to ignore the allowed traditional IRA
contribution and contribute the full $5,000 to a Roth IRA. In any
event, he cannot contribute more than $5,000 in total to IRAs, and
his maximum allowed tax deduction for a traditional IRA contribu-
tion will be $2,500. N
2010 AGI Phase-out Ranges for Traditional IRA Contributions
Type of Taxpayer Phase-out Range
Single or HOH, not a plan participant No phase-out
Single or HOH, active plan participant $56,000–$66,000
Married, Joint, both active participants $89,000–$109,000
Married, Joint, neithe r active plan participants No phase-out
Married, Joint, one an active participant (See Note 1 below)
Active participant spouse $89,000–$109,000 ( Joint AGI)
Non-active participant spouse $167,000–$177,000 ( Joint AGI)
Note 1: When one spouse is an active participant in a retirement plan and the other
is not, two separate income limitations apply. The active participant spouse may make
a full deductible IRA contribution unless the $89,000–$109,000 phase-out range
applies to the couple’s joint income. The spouse who is not an active participant may
make a full deductible IRA contribution unless the higher $167,000–$177,000 phase-
out range applies to the couple’s joint income.
3-18 Chapter 3
Business Income and Expenses, Part I
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.