Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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Student Name
Class/Section
Date
KEY NUMBER TAX RETURN SUMMARY
Chapter 3
Comprehensive Problem 1
Business Income or Loss (Line 12) ________________
Rental Real Estate (Line 17) ________________
Adjusted Gross Income (Line 37) ________________
Tax Liability (Line 60) ________________
Amount Owed (Line 76) ________________
Comprehensive Problem 2A
Adjusted Gross Income (Line 37) ________________
Exemptions (Line 42) ________________
Tax Liability (Line 60) ________________
Tax Overpaid (Line 73) ________________
Comprehensive Problem 2B
Pensions and Annuities (Line 16b) ________________
Adjusted Gross Income (Line 37) ________________
Itemized Deductions (Line 40) ________________
Tax Liability (Line 60) ________________
Tax Overpaid (Line 73) ________________
Questions and Problems 3-59
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Chapter 4
Business Income and
Expenses, Part II
LEARNING OBJECTIVES
.............................................. .........................
After completing this chapter, you should be able to:
LO 4.1 Classify self-employed and employee expense deductions
for adjusted gross income and from adjusted gross income.
LO 4.2 Identify the requirements for deducting travel and transpor-
tation expenses and be able to complete Form 2106.
LO 4.3 Ascertain when a home office deduction may be claimed
and how the deduction is computed.
LO 4.4 Determine the requirements for claiming other common
business expenses such as entertainment, education,
uniforms, and business gifts.
LO 4.5 Complete a basic Schedule C (Profit or Loss from Business).
LO 4.6 Understand the special rules applicable to moving expenses.
LO 4.7 Apply the factors used to determine whether an activity is
a hobby, and understand the tax treatment of hobby
losses.
Overview
The material in this chapter is a continuation of the business income and expense coverage
in Chapter 3. The common business expenses covered are travel, transportation, office in
the home, entertainment, education, dues, subscriptions, publications, special clothing,
uniforms, business gifts, moving expenses, and hobby losses. These expenses are frequently
reported on individual Schedule C, ‘‘Profit or Loss from Business (Sole Proprietorship),’’
which is also covered in thi s chapter. The expenses covered in this chapter may also be
associated with rental and royalty income (Schedule E, as covered in Chapter 3) and farm-
ing income (Schedule F).
The expenses described in this chapter may also be deducted by employees as employee
business expenses on Schedule A (see Chapter 5) when they are not reimbursed by the
employer. For example, professional dues can be deducted by a CPA who is self-employed
in practice (Schedule C) or by a CPA employee of a manufacturing corporation who is not
reimbursed for the dues by his or her employer (Schedule A).
4-1
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SECTION 4.1
CLASSIFICATION OF DEDUCTIONS—EMPLOYEES
Business expenses incurred by an employee in performing services for his or her employer
are generally considered miscellaneous itemized deductions, subject to the 2 percent of
adjusted gross income limitation. As such, the expenses are deductible only if the taxpayer
itemizes deductions and only if the taxpayer’s total miscell aneous deductions exceed 2 per-
cent of adjusted gross income.
In some cases, however, reimbursed employee business expenses may be treated as
deductions in arriving at adjusted gross income. If an employee receives a reimbursement
for employee business expenses under an accountable plan, the reimbursement is not
included in gross income and the expenses are not included as deductions on the tax-
payer’s return. As a result of this treatment, the expenses are effectively treated as deduc-
tions in arriving at adjusted gross income. An accountable plan is one which requires the
employee to substantiate expenses (for example, with r eceipts) and to r eturn amounts
reimbursed in excess of the substantiated expenses. Where such a plan exists, and an
employee fails to substantiate the entire amount of his or her expenses or fails to return
any excess reimbursement within a reasonable period of time, the excess amounts are not
considered to have been reimbursed under an accountable plan. As such, the reimburse-
ment is included in wages, and the expenses, even though reimbursed, are deductible only
as miscellaneous itemized deductions, subject to the 2 percent of adjusted gross income
limitation.
EXAMPLE During 2010, Kelly receives from her employer $4,500 as a reim-
bursement of travel expenses under an expense account reimburse-
ment plan. Under the reimburse ment plan, Kelly is required to
substantiate her expenditures and to return any excess reimburse-
ment to her employer, and in fa ct she satisfies both these require-
ments. None of the reimbursement is included in income and Kelly
does not include any of the expenses as deductions on her return.
This treatment of the reimbursed expenses results in the direct
deduction of the expenses against the reimbursement income, effec-
tively treating the expenses as deductions in arriving at adjusted
gross income. N
EXAMPLE Assume that Kelly is reimbursed under a plan which does not require
her to substantiate her expenses to her employer. The reimburse-
ment wi ll be included as wages and she will be able to d educt the
expe nses only if she itemizes deductions and only as miscellaneous
itemized deductions subject to the 2 percent of adjusted gross
income limitation. N
Employers can provide tax benefits to their employees for a small administrative
cost by replacing a nonaccountable plan for employee expense reimbursement
with an accountable plan. By usin g an accountable plan, the employee receives a
reimbursement of business expenses without having to include those amounts in
taxable income.
4-2 Chapter 4
Business Income and Expenses, Part II
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SECTION 4.2TRAVEL EXPENSES
Travel expenses are defined as ordinary and necessary expenses incurred in traveling away
from home in pursuit of the taxpayer’s trade or business. These expenses are deductible as
long as they can be substantiated and are not lavish or extravagant. Transportation
expenses incurred while not away from home, business gifts, and business entertainment
are not included as travel expenses, although these items are separately deductible, subject
to certain limitations. Expenses included as part of the travel deduction include the cost of
such items as meals, lodging, taxis, tips, and laundry. Most travel expenses are fully deduct-
ible, but Congress decided that a portion of the cost of meals is a personal expense. There-
fore, only 50 percent of the cost of meals is deductible. If an employer reimburses an
employee for the cost of business meals, then the 50 percent limitation applies to the
employer so that the employer can deduct only 50 percent of the expense.
To deduct travel expenses, a taxpayer must be in travel status. The taxpayer must be
away from home ‘‘overnight.’’ Overnight does not literally mean 24 hours; it is a pe riod
of time longer than an ordinary work day in which rest or relief from work is required.
Also, the taxpayer must be away from his or her ‘‘tax home’’ to be on travel status. A tax
home is the taxpayer’s principal place of business or employment, and not necessarily
the same location as his or her family residence. If the taxpayer has two or more places
of business, the taxpayer’s tax home is at the princip al place of business. Factors that deter-
mine the principal place of business include total time spent in each location, the degree of
business activity, and the relative amount of income from each location.
Expenses of a temporary assignment are deductible if it is not practical to return home
at the end of each day’s work. If the assignment is for a long period of time or indefinite
(gener ally more than 1 year ), the new location may be considered the taxpayer’s new tax
home and he or she may lose the travel deduction. If the travel deduction is lost, an
employee must include as income any reimbursements of travel expenses.
Self-Study Problem 4.1
For each of the following independent situations, indicate whether the deduc-
tion should be classified as a deduction for adjusted gross income (DFOR) or
a deduction from adjusted gross income (DFROM).
DFOR DFROM
1. Abel, an employee of Rose Corporation,
is reimbursed for $5,000 of auto expenses
every year. Rose Corporation does not
require any substantiation and includes
the $5,000 in Abel’s wages. Abel’s actual
business auto expense is $950.
______________ _____ _________
2. Lola, an employee of Elm Corporation,
pays $50 for a subscription to a profes-
sional journal. Lola’s employer does not
have an expense reimbursement plan.
______________ _____ _________
3. Frank, an employee of Azalea, Inc., pays
$675 for travel expenses. Frank substanti-
ates his expenses and timely submits a
request for reimbursement under his
employer’s accountable plan.
______________ _____ _________
Section 4.2
Travel Expenses 4-3
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Taxpayers who make a combined business and pleasure trip within the United States
may deduct all of the costs incurred in traveling to and from the business destination pro-
vided the trip is primarily for business. Once at the destination, only the business portion of
the travel costs for meals, lodging, local transportation, and incidental expenses may be
deducted; any costs which are not associated with the taxpayer’s business are not deduct-
ible. If a taxpayer makes a trip which is primarily for pleasure, the travel expenses to and
from the destination are not deductible even though the taxpayer engages in some business
activity while at the destination. Although the traveling expenses to and from the destina-
tion are not deductible, any expenses incurred while at the destination that are related to
the taxpayer’s business are deductible.
Special rules and limitations apply to combined business and pleasure travel outside the
United States. Even though a trip is primarily for business, if the trip has any element of
pleasure, the cost of traveling to and from the destination must be allocated between the
business and personal portions of the tr ip. The travel expenses for transportation to and
from the destination must be allocated based on the number of business days compared to
the total number of days outside the United States. The rules for travel costs to and from
the destination where the trip is primarily for pleasure are the same as the rules for travel
within the United States; none of the travel costs are deductible. Once at the destination,
the taxpayer’s expenses directly related to the taxpayer’s business are deductible. For a com-
plete explanation of travel outside the United States, see IRS Publication 463.
No deduction for travel expenses is allowed unless the taxpayer keeps proper e xpense
records. Taxpayers must substantiate the following:
1. The amount of each separate expenditure, such as airfare and lodging. Expenses such
as meals and taxi fares may be accumulated and reported in reasonable categories. As
an alternative to reporting actual expenses, a per diem method may be used in certain
circumstances.
2. The dates of departure and return for each trip and the number of business days on
the trip.
3. The destination or locality of the travel described by the name of the city or town.
4. The business reason for the travel or the business benefit expected to be gained from
the travel.
Per Diem Substantiation
Instead of requiring actual expense records, employers who reimburse employees for travel
expenses using an accountable plan can choose a per diem method of substantiation. The
primary advantage of using a per diem method to substantiate expenses is that it eliminates
much of the record keeping usually associated with travel expenses. The IRS has approved
three per diem methods to substantiate travel expenses. The first two methods are for
travel expenses, including lodging, meals, and incidentals, for employees. The third
method is only for meals and incidentals and is the only per diem method allowed to
self-employed taxpayers.
1. The Regular Federal Rate Method. Under this method the employee is allowed a per
diem amount for travel equal to the current federal per diem rate. In 2010, the current
federal per diem standard base rate is $116 per day ($70 for lodging and $46 for meals
and incidentals). However, the federal rate can be higher than the standard rate for
high-cost areas. For example, the rate for travel in San Francisco in September 2010
is $263 per day ($192 for lodging and $71 for meals and incidentals). A complete list
of the regular per diem rates in effect for each area of the United States is in IRS
Publication 1542 published only on the Internet, changed and updated regularly, at
www.irs.gov. A paper copy of the publication is no longer published by the IRS.
4-4 Chapter 4
Business Income and Expenses, Part II
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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.
2. The High-Low Method. The high-low method provides a simplified way of computing
the federal per diem rate for travel within the United States. This method avoids the
need to keep a current list of the per diem rates for all localities in the U.S. Under
this m ethod a small number of locations are designated as high-cost localities and all
other locations are deemed to be low-cost areas. In 2010, the high-cost allowance is
$258 per day and the low-cost amount is $163 per day. If an employer uses this
method to reimburse an employee any time during a calendar year, this method must
be used for all travel for that employee in the same calendar year.
3. The Meals and Incidental Expenses (M&IE) Method. Under this method the employee
uses a current per diem amount for M&IE only. Actual cost records are required for
lodging expenses. The M&IE rate may be taken from the per diem rate tables or the
high-low method may be used. For 2010, the M&IE allowance is $65 per day for
high-cost localities and $52 per day for low-cost localities. The M&IE method is the
only per diem method that can be used by self-employed taxpayers to substantiate
travel expenses.
Per diem rates are revised more often than annually, with different effective dates
throughout the year. For purposes of illustration and problems, the rates above are
assumed to be chosen for the full year. Different rates than those shown above may apply.
EXAMPLE During 2010, Susan travels from Los Angeles to Hawaii for a 3-day busi-
ness trip and pays $450 for the airfare. While in Hawaii, Susan spends
3 days on business and an additional 2 days on vacation. The lodging
and meal costs are $300 and $120, respectively, for the business portion
of the trip. The total cost of meals and lodging for the personal por-
tion of the trip is $260. Susan may deduct $450 for the airfare, $300
for the business lodging, and $60 (50 percent of $120) for the business
meals. None of the $260 of personal expenses is deductible. N
Self-Study Problem 4.2
Byron is a certified public accountant who is self-employed. He is required to
make a 5-day business trip to Salt Lake City for an au dit. Since he is going to
be in Utah, Byron decides to stay for the weekend and go skiing. His expenses
for the trip are as follows:
Airfare to Salt Lake City and return $ 190
Hotel while on the audit (5 nights at $65 per night) 325
Total cost of meals while on the audit 136
Laundry in Salt Lake City 22
Taxi fares in Salt Lake City 72
Transportation from Salt Lake City to and from
Park City ski resort 100
Lodging at Park City ski resort 190
Lift tickets 27
Ski rental 24
Meals at Park City
82
Total
$1,168
If Byron has proper records to substantiate the above expenses, how much
may he deduct as travel expenses for the 7-day trip?
$ ____________
Section 4.2
Travel Expenses 4-5
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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 4.3
TRANSPORTATION
Certain transportation expenses for business purposes are deductible by taxpayers. Deduct-
ible expenses include travel by airplane, rail, and bus, and the cost of operating and main-
taining an automobile. Meals and lodging are not included in the transportation expense
deduction; those expenses may be deducted as travel expenses. Transportation expenses
may be deducted even if the taxpayer is not away from his or her tax home.
Deductible transportation costs do not include the normal costs of commuting to and
from the taxpayer’s place of regular employment. Commuting includes the expenses of
buses, subways, taxis, and operating a private car between home and the taxpayer’s princi-
pal place of work, and is generally a nondeductible personal expense. The cost of transpor-
tation between the taxpayer’s home and a work location is generally not deductible, except
in the three sets of circumstances described below:
1. A taxpayer is allowed to deduct daily transportation expenses incurred in going
between the taxpayer’s residence and work locations outside the metropolitan area
where the taxpayer lives and normally works.
2. If the taxpay er has a regular place of business, daily expenses for transportation
between the taxpayer’s home and temporary work locations are deductible.
3. A taxpayer may deduct daily expenses for transportation between the taxpayer’s home
and other regular or temporary work locations if the taxpayer’s residence is the tax-
payer’s principal place of business, based on the home office rules, which are dis-
cussed later in this chapter.
In all cases, the additional costs of hauling tools and instruments are deductible. For
example, the cost of renting a trailer to haul tools to a job site is deductible.
If the taxpayer works at two or more jobs during the same day, he or she may deduct the
cost of going from one job to the other or from one business location to another. The
deductible expense is based on the cost of travel by the shortest, most normally traveled
route, even if the taxpayer uses another route. If the taxpayer has a second job which is
on a weekend, or another nonwork day, th e commuting expenses to the second job are
not deductible.
EXAMPLE Walter is a CPA working full-time Monday through Friday. On
Tuesday night he teaches a class at a local university. Walter leaves
the office at 5:30 p.m. on his class day and, after dinner at a local
cafe, teaches his class from 7:00 p.m. to 10:00 p.m. The distance from
Walter’s home to his office is 12 miles, the distance from his office to
the university is 15 miles, and the distance from the university to his
home is 18 miles. If Walter teaches the class thirty-two times a year,
his mi leage deduction is based on 480 miles (32 15 miles). While he
is traveling from home to the office (12 miles) and from the university
to home (18 miles), he is commuting and the mileage is not deductible.
If Walter taught the class in the afternoon and returned to his regular
job before going home, he could claim a deduction based on the
round-trip mileage from his office to and from the university, 30
miles (2 15 miles). Alternatively, if he taught the course on a day
(Saturday) when he did not work at his full-time job, Walter would
not be entitled to any mileage deduction. N
4-6 Chapter 4
Business Income and Expenses, Part II
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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.
Taxpayers may deduct the actual expenses of transportation, or they may be entitled to
use a standard mileage rate to calculate their deduction for transportation costs. The stan-
dard mileage rate for 2010 is 50 cents per mile. Most costs associated with the operation of
an automobile, such as gasoline, oil, insurance, repairs and maintenance, as well as depre-
ciation, are built into the st andard m ileage rate. The deduction for parking and toll fees
related to business transportation (not commuting) and the deduction for interes t on car
loans and state and local personal property tax es on the automobile are determined sepa-
rately. Self-employed taxpayers deduct the business portion of the state and local personal
property taxes and interest on automobile loans on Schedule C or F. Employees may
deduct state and local personal property taxes on Schedule A to the extent otherwise allow-
able. An employee is not allowed to treat interest on an automobile loan as other than con-
sumer interest, even though the automobile is used in the business of performing services
as an employee. Since no deduction is allowed for consumer interest, employees may not
deduct the interest (see Chapter 5). To use the standard mileage method, the taxpayer
must:
1. own or lease the automobile,
2. not use the automobile, for hire,
3. not operate a fleet of automobiles, using five or more at the same time,
4. not have claimed depreciation on the automobile using any method other than
straight-line depreciation, and
5. not have claimed Section 179 (Expense Election) depreciation on the automobile
(see Chapter 7, for a complete discussion of depreciation, and Section 179).
If the taxpayer is entitled to use either the actual cost or the standard mileage method,
he or she may select the method that results in the largest tax deduction for the first year. If
the taxpayer does not use the standard mileage method in the first year, the method is not
available for any subsequent year. A change to the actual cost method can be made any
year. If after using the standard mileage method, the taxpayer uses actual costs to determine
the automobile expense deduction, depreciation on the automobile must be calculated
using straight-line dep reciation.
Taxpayers who use actual cost to calculate their transportation deductions must keep
adequate cost records. The deductible portion of the total automobile expenses is based
on the ratio of the number of business miles driven during the year to the total miles
driven during the tax year multiplied by the total automobile expenses for the year.
The business-use percentage is applied to the total automobile expenses for the year,
including depreciation, but excluding any expenses which are directly attributable to
business use of the automobile, such as business parking fees and tolls. The deduction
for interest and personal property taxes is also separately computed, and for employees
the amounts are deductible only to the extent otherwise allowable as itemized deductions.
Employees are not allowed a deduction for the interest, including the business portion,
due to the disallowance of deductions for consumer interest. (See Chapter 5.) Taxpayers
other than self-employed taxpayers calculate their deductible transportation expenses on
Form 2106.
Section 4.3
Transportation 4-7
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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 T. J. is a salesman who drove his automobile 22,500 total miles during
the 2010 tax year. The business use of the automobile was 80 percent
of the total miles driven. T he actual cost of gasoline, oil, repairs,
depreciation, and insurance for the year was $10,000. The automo-
bile expense deduction is calculated as follows:
1. Standard mileage method:
Business mileage ¼ 18,000 miles (22,500 miles 80%)
18,000 miles 50 cents/mile
$9,000
2. Actual cost method:
80% $10,000 (total actual cost)
$8,000
Since the deduction is larger using the standard mileage method,
T. J. should deduct that amount. N
Filing fake tax returns is popular in prisons. The Treasury Inspector General
estimated that prison inmates receive millions in bogus refunds each year. On
October 15, 2008, the president signed the Inmate Fraud Prevention Act,
meant to curb prison tax return abuses. However, in 2009, 1,295 prisoners,
including 241 serving life sentences, claimed and received over $9 million in
first-time homebuyer credits before they were caught.
Self-Study Problem 4.3
Marc Lusebrink, an employee of Oak Corporation, bought a used automobile
and drove it 17,944 miles on business d uring 2010 and a total (including
business miles) of 23,925 miles. His total expenses for his automobile for the
year are:
Gasoline $4,475
Oil changes 150
Insurance 570
Tires 225
Repairs
620
Total
$6,040
The automobile cost $14,000 on January 1 when Marc started to work, and
depreciation expense for the year, assuming 100 percent business use, would
be $2,800. His business parking and toll fees for business amount to $316. Use
Form 2106 on pages 4-9 and 4-10 to calculate Marc’s transportation expense
deduction (before the 2 percent of adjusted gross income limitation) for the
year.
4-8 Chapter 4
Business Income and Expenses, Part II
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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.