Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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Section 4.3
Transportation 4-9
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3,060*
* See Chapter 7 for depreciation limits for automobiles. The limits do not affect this probl em.
4-10 Chapter 4
Business Income and Expenses, Part II
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SECTION 4.4
OFFICE IN THE HOME
Some taxpayers operate trades or businesses in their homes and q ualify for home office
deductions. The tax law imposes strict limits on the availability of the deduction. In
fact, the deduction for an office in the home is allowed by exception. The general rule
for a home office deduction states that a taxpayer will not be allowed a deduction for
the use of a dwelling unit used by the taxpayer as a residence. The law provides four excep-
tions to the general rule under which a deduction may be allowed.
Under the first exception, a deduction is allowed if the home office is used on a regular
basis and exclusively as the taxpayer’s principal place of business. An employee may qualify
under this exception, provided the business use of his or her home office is for ‘‘the con-
venience of the employer’’ when the employer does not provide a regular office. A home
office qualifies as a principal place of business if it is used in the conduct of administrative
or management activities of a trade or business that are not substantially performed at a
different fixed location.
A second exception states that a deduction is allowed if the home office is used exclusively
and on a regular basis by patients, clients, or customers in meetings or dealings with the tax-
payer in the normal course of a trade or business. That exception allows doctors and sales-
people to deduct home office expenses even though they maintain another office away from
their residence, and even though the office is not the taxpayer’s principal place of business.
Under the third exception, the deduction of home office expenses is allowed if the home
office is a separate structure not attached to the dwelling unit and is used exclusively and on
a regular basis in the taxpayer’s trade or business.
The fourth and final exception to the rule allows a deduction of a portion of the cost of a
dwelling unit if it is used on a regular basis for the storage of business inventory or product
samples held for use in the taxpayer’s trade or business of selling products. Under this
fourth exception, the taxpayer’s home must be the taxpayer’s sole place of business.
The Gross Income Limitation
The home office deduction may not redu ce the net income from the business below zero,
except for mortgage interest and property taxes allocable to the office, which are generally
tax deductible anyway. The other costs of operating a home, which are included in the
home office allocation, include rent, home insurance, repairs, cleaning, gardening, home-
owners’ association dues, and depreciation on the cost of the home. Depreciation expense
is considered only after all other expenses have been allowed. Any unused deductions may
be car ried over to offset income in future years.
EXAMPLE Jane, an accounting professor, maintains an office in her apartment
where she conducts a small tax practice. Jane properly allocates
$1,500 in rent to the home office, and during the year she collects
$1,400 in fees from various clients. Assuming Jane has no other
expenses associated with her practice, only $1,400 of the rent may
be claimed as a home office deduction, since she may not show a loss
from the practice due to the gross income limitation. The unused
portion is carried over to the next taxable year. N
EXAMPLE Assume the same facts as those in the previous example, except Jane
owns her home. She has taxes of $100, interest of $600, maintenance
Section 4.4
Office in the Home 4-11
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expenses of $200, and depreciation of $1,000 attributable to the home
office. Her deduction for home office expenses is calculated as follows:
Gross income from tax practice $ 1,400
Less: mortgage interest and real estate taxes
(700)
Balance $ 700
Less: maintenance expense
(200)
Balance $ 500
Depreciation (maximum allowed)
(500)
Net income from tax practice
$0
Please note that the only way the home office can generate an
overall business loss for Jane is if her home office mortgage interest
and taxes exceed her gross business income. N
If a home office is used for both business and p ersonal purposes, no deduction is
allowed. For example, Professor Jane in the previous example would not be allowed a
deduction for any expenses associated with the office in her home if the office was also
used for personal activities, such as watching television.
The Home Office Allocation
The calculation of home office expenses involves the allocation of the total expenses of a
taxpayer’s dwelling between business and personal use. This allocation is usually made
on the basis of the number of square feet of business space as a percentage of the total num-
ber of square feet in the residence, or on the basis of the number of rooms devoted to busi-
ness use as a percentage of the total number of rooms in the dwelling.
EXAMPLE Lois operates a hair-styling salon in her home. The salon occupies 400
square feet of her residence, which has a total of 1,600 square feet. Her
expenses for her residence are presented below and allocated as shown.
Expenses Total Amount
Business
Percentage*
Business
Portion
Rent $10,000 25% $2,500
Utilities 4,000 25% 1,000
Cleaning 2,000 25% 500
* 400 sq. ft./1,600 sq. ft. N
Self-employed taxpayers filing Schedule C and claiming a deduction for home office
expenses are required to file Form 8829, Expenses for Business Use of Your Home. Tax
return problems 2A and 2B at the end of this chapter provide an opportunity to use this form.
Self-Study Problem 4.4
Terry is a self-employed lawyer who maintains an office in her home. The office
is used exclusively for client work, and clients regularly visit her home office.
The mortgage interest and real estate taxes allocated to the business use of the
home amount to $2,100, and maintenance, utilities, and cleaning service alloca-
ble to the business use of the home total $1,400. If gross billings of Terry’s prac-
tice are $2,800 for this year and Terry has no other expenses allocable to the
business, calculate the net income or loss she may report from the practice.
$____________
4-12 Chapter 4
Business Income and Expenses, Part II
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SECTION 4.5
ENTERTAINMENT
Self-employed taxpayers and employees are allowed deductions for 50 percent of the cost
of entertainment incurred in connection with their trade or business. To obtain a deduc-
tion, certain conditions must be satisfied. The entertainment ex penses must be
(1) directly related to or (2) associated with the active conduct of the taxpayer’s trade
or business. Expenses directly related to the taxpayer’s trade or business are costs related
to an actual business meeting, such as the expense of a sales luncheon where a salesperson
is making a sale to a client. It is not necessary tha t the sale actually be made, but the par-
ties must discuss business and the taxpayer must have a reasonable expectation of making
the sale.
Expenses associated with the conduct of the taxpayer’s trade or business are generally
those expenses which serve a specific business purpose, such as obtaining new business.
The entertainment must take place immediately before or after a bona fide business dis-
cussion. For example, a sales presentation may be made in the morning before l unch. The
client may be taken to lunch after the meeting, and business need not be the primary
topic of the lunch since the parties involved just attended the sa les meeting. Entertain-
ment includes activities such as attending sports events, playing golf or tennis, and
attending plays.
The deduction of the costs of entertainment facilities, such as yachts, hunting or fish-
ing camps, recreational vehicles, and airplanes is strictly limited. A taxpayer may not
deduct the cost of depreciation, maintenance, and annual f ees for such facilities. How-
ever, other business expenses are not affected by this limitation. For example, the cost
of qualified entertainment on a yacht is de ductible, even though the cost of the yacht
is no t.
Generally, club dues are not deductible. Nondeductible club dues include dues paid
to country clubs, business luncheon clubs, and airline and hotel clubs. Dues paid to profes-
sional organizations, such as bar or medical organizations, or civic or public organizations,
such as Chambers of Commerce, Kiwanis, and Rotary, however, continue to be allowed as
deductions.
Self-Study Problem 4.5
Eugene is an outside salesman who specializes in selling life insurance to weal-
thy customers. During 2010, Eugene joins and uses the Country Club as a place
to entertain customers and sell insurance to new and existing clients. During
the year, Eugene paid the following amounts at the club:
Annual dues $2,000
Business meals, directly related (84 days) 1,700
Personal meals (36 days) 400
Greens fees (personal use)
600
Total
$4,700
Calculate the amount of the $4,700 spent by Eugene that he is allowed as a
deduction (before the 2 percent of adjusted gross income limitation) for
entertainment.
$ ____________
Section 4.5
Entertainment 4-13
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SECTION 4.6
EDUCATIONAL EXPENSES
Please note: Educational incentives such as qualified tuition programs, educational
savings accounts, and the new deduction for higher education expenses are discussed
in Section 5.8. The deduction for education loan interest is discussed in Section 5.3.
Education tax credits are discussed in Section 6.4. Because numerous education
incentives have been added in the last several years, the tax law in this area has
become very complex. There may be more than one tax option for treating a partic-
ular education expense. This section deals primarily with the deduction of continu-
ing education expenses incurred by taxpayers already employed or self-employed.
Taxpayers may deduct educational expenses if specific conditions are met. The tax law is
silent with respect to educational expense deductions, therefore we must look to the IRS reg-
ulations for the allowable deductions. There are two tests related to the deduction of educa-
tional expenses, at least one of which must be met to deduct the expenses. The tests are:
1. the educational expenses must be paid to meet the requirements of the taxpayer’s employer
or the requirements of law or regulation for keeping the taxpayer’s salary, status, or job, or
2. the educational expenses must be paid to maintain or improve existing skills required in
performing the duties of the taxpayer’s present work.
Educational expenses meeting one of the above tests, which have a bona fide business
purpose, may be deducted even if the education leads to a college degree.
Educational expenses are not deductible, even if one of the above tests is met, if (1) the
education is required to meet the minimum requirements for the taxpayer’s current job, or
(2) the education is part of a program that will lead to a new trade or business even if the
taxpayer does not intend to enter that new trade or business.
Education Required by Employer or Law
Taxpayers who are required to meet educational standards beyond minimum requirements
may deduct the expenses of the education. However, the expenses must be paid for educa-
tion to maintain the taxpayer’s current job, not to meet the minimum requirements for that
job. If the education qualifies the taxpayer for a new trade or business, the expenses are not
deductible.
EXAMPLE Jenny is a high school teacher working under a temporary teaching
certificate. The state in which she teaches requires a master’s degree
to receive a permanent certificate, and Jenny only has a bachelor’s
degree. Her expenses to obtain a master’s degree are not deductible
even though the degree is required by her school district, since she
has not yet met the minimum educational requirements to be a per-
manent teacher.
However, Jenny may qualify for the deduction for higher education
expenses discussed in Section 5.8 or the lifetime learning credit dis-
cussed in Section 6.4. N
Maintaining or Improving Existing Skills
Expenses that are paid by a taxpayer for education to maintain or improve existing skills are
deductible. Expenses deductible under this category include the costs of continuing educa-
tion courses and academic work at a college or university. However, the education must
not lead to qualification in a new trade or business.
4-14 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.
EXAMPLE John is a certified public accountant (CPA) in practice with a CPA firm.
He decides a law degree would be helpful to him in his present job
since he does a lot of income tax planning for clients. He enrolls in a
night program at a local law school. John’s educational expenses are
not deductible since the program leads to a new trade or business,
the practice of law. Whether John plans to practice law is not
relevant.
However, John may qualify for the deduction for higher education
expenses discussed in Section 5.8, or the lifetime learning credit dis-
cussed in Section 6.4. N
EXAMPLE Kenzie recently completed her degree in accounting and went to
work for a local CPA firm. She spends $1,000 for a CPA exam review
course to help her pass the exam. The $1,000 is not deductible since
passing the CPA exam leads to a new trade or business, that of being
a licensed CPA as opposed to an accountant.
Depending on whether Kenzie takes this course at a qualified insti-
tution of higher education, and other circumstances, she may qualify
for the lifetime learning credit discussed in Section 6.4. N
Expenses of Travel for Educational Purposes
Travel expenses incurred while away from home for trips that are primarily to obtain qual-
ifying education are also deductible. For example, a ta xpayer may deduct travel expenses
for attending a continuing education course in a distant city. Whether a trip is primarily
personal or primarily educational depends on the relative amount of time devoted to
each activity. If the trip qualifies as primarily for educational purposes, the cost of trans-
portation to and from the destination is fully deductible. The lodging and meal expenses
directly connected with the educational activity are also deductible. As is the case with
travel expenses, the cost of meals is only 50 percent deductible. Expenses for ‘‘travel as a
form of education’’ are not deductible.
EXAMPLE Jay is a doctor who attended a continuing education seminar in New
York in 2010. His expenses related to attendance at the program are
as follows:
Lodging in New York $ 350
Transportation 700
Meals 150
Fee for the course
250
Total
$1,450
Jay’s educational expense deduction for the seminar would be
$1,375 including lodging of $350, transportation of $700, meals of $75
(50 percent of the cost of the meals), and the course fee of $250. N
EXAMPLE Natalie is an instructor of Japanese at Big State University. She spends
the summer traveling in Japan to improve her understanding of the
Japanese language and culture. Although Natalie arranges her trip to
improve her ability to teach the Japanese language, no educati on
deduction is allowed for the travel expenses. N
Section 4.6
Educational Expenses 4-15
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Eligible educators may deduct up to $250 for classroom materials such as books,
supplies, computer equipment, and supplementary materials as a deduction in
arriving at AGI. An eligible educator is a kindergarten through grade-twelve
teacher, counselor, or principal who works at least 900 hours during the school
year. Please note: As we go to press, this deduction has not yet been extended
to tax year 2010.
SECTION 4.7
DUES, SUBSCRIPTIONS, AND PUBLICATIONS
Doctors, lawyers, accountants, engineers, teachers, and other professionals engaged in
practice or employed may deduct certain dues and the cost of certain subscriptions and
publications. Included in this category of deductions are items such as membership to
the local bar for a lawyer, dues to the American Instit ute of Certified Public Accountants
for an accountant, and the cost of subscriptions to any journal that is directly related to the
taxpayer’s profession.
EXAMPLE Hal is a federal law enforcement officer who pays $200 per year for a
subscription to the official agency work manu al. The agency provides
a manual in the office for its employees, but Hal spends a lot of time
on the road away from the office. Hal may deduct the cost of the
subscription. N
Not all publications can be deducted in the year they are purchased. The cost of books
(libraries) that have long useful lives may not be immediately deducted; these costs must be
Self-Study Problem 4.6
Nadine has a bachelor’s degree in education and has held a teaching position
at a high school in Yuma, Arizona, for 10 years. In 2010, the school board votes
to require a master’s degree as the minimum requirement to hold a teaching
position in the district. Under a grandfather clause, Nadine can keep her job as
long as she shows progress towards a master’s degree. Nadine enrolls in three
graduate classes at Arizona State University during the summer term and must
be away from home to attend the classes. Her expenses are as follows:
Lodging in Tempe, Arizona $1,200
Transportation 350
Meals 200
Books 175
Tuition 550
Weekend trip to the Grand Canyon
175
Total
$2,650
Calculate Nadine’s educational expense deduction (before the 2 percent lim-
itation) for the current year. Assume Nadine’s household income is too high
for her to qualify for the new deduction for higher education expenses dis-
cussed in Section 5.8 or the lifetime learning credit discussed in Section 6.4.
$____________
4-16 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.
allocated over the useful lives of the publications. The costs of short-lived publications,
suc h as a 1-year tax service, may be deducted in the year they are purchased, since they
have no long-term value.
EXAMPLE Bill is a new graduate of law school. On July 1 he opens a law office
and purchases a set of law books for $8,400. Bill must depreciate the
library, rather than claim a deduction for the full cost in the year of
purchase. N
SECTION 4.8
SPECIAL CLOTHING AND UNIFORMS
Employees and self-employed individuals are allowed a deduction for the costs of special
work clothing or uniforms. The deduction is not allowed for the general cost and upkee p
of normal work clothes; the clothing must be specialized. To be deductible, the clothing or
uniforms must (1 ) be required as a condit ion of employment, and (2) not be suitable for
everyday use. Both conditions must be met for the deduction to be allowed. It is not
enough that the employee is required to wear special clothing if the clothing can be
worn while the employee is not on the job. If the clot hing or uniforms qualify, the costs
of purchase, alterati ons, laundry, and their maintenance are deductible.
The uniforms worn by police officers, firefighters, nurses, and letter carriers qualify for
the deduction. The costs of uniforms of transportation workers, such as bus drivers, train
conductors, and airline pilots, are deductible if the uniforms are used for work only. The
uniforms must not be worn when the employee is not working. Uniforms that can be con-
verted to clothes suitable for general wear never qualify for the deduction.
Taxpayers who are in the armed forces reserves may deduct the unreimbursed cost of
their uniforms if military regulations restrict their wear to duty time as a reservist. Generally,
members of the armed forces may not deduct the cost of their uniforms, as the member is
usually required to wear his or her uniform during off-duty hours or the uniforms are suit-
able for off-duty wear. However, if local regulations prohibit wearing fatigues off-duty, the
cost of uniforms is deductible to the extent the cost exceeds any uniform allowances.
The costs of protective clothing, such as safety shoes, hard hats, and rubber boots,
requ ired on the job are also deductible. However, the cost of regular work clothing and
standard shoes may not be deducted even if required by the employer or union rules,
since the clothing is suitable for general wear. For example, a lawyer may not deduct the
cost of suits that an employer requires him or her to wear.
Self-Study Problem 4.7
Indicate which of the following dues, subscriptions, and publications are deduct-
ible (D) and which are not deductible (ND) by circling the correct answer.
1. Dues to the Am erican Medical Association paid by a physician. D ND
2. A subscription to a tax journal paid for by an accounting
professor.
DND
3. Dues to a health spa paid by a lawyer. D ND
4. Subscription to an education journal paid for by a high school
teacher.
DND
5. Subscription to Motor Trend magazine paid for by a regis-
tered nurse.
DND
Section 4.8
Special Clothing and Uniforms 4-17
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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.
For performances, entertainer Dinah Shore wore floor-length formal show
gowns that she deducted as ‘‘uniforms. ’’ The IRS disallowed the deduction,
but Shore prevailed when she was able to show that her gowns were not adapt-
able to general usage since most were too tight to permit sitting.
SECTION 4.9
BUSINESS GIFTS
Within limits, taxpayers are allowed a deduction for business gifts. Salespersons and other
taxpayers may deduct up to $25 per year per donee. For purposes of this limitation, a hus-
band and wife count as one donee. Thus, the maximum that a taxpayer could deduct for
gifts to a clien t or potential client and his or her spouse is a total of $25 per year, unless
the spouse is also a client, in which case the spouse may receive a separate $25 gift. Inci-
dental expenses such as gift wrapping and shipping may be excluded from the limitation
and are fully ded ucti ble. There is no limitation f or small business gifts costing up to $4
each that have the taxpayer’s name or company name imprinted on them, such as penc ils
and calendars, and no limitation on promotional materials, such as signs and display racks.
Also, the cost of gifts of tangible personal property made to employees for length of service
on the job and safety achievement may be deducted up to a limit of $400 per employee per
year. If the gift is made in conjunction with a ‘‘qualified plan,’’ the limit is raised to $1,600.
Gifts made to a taxpayer’s supervisor (or individuals at a higher employment level) are not
deductible. Those gifts are considered nondeductible personal expenses.
EXAMPLE Marc is a salesperson who gives gifts to his clients. During the year,
Marc gives Mr. Alford a gift costing $20 and Mrs. Alford (not a client)
a gift costing $15. He also gives Ms. Bland a gift that cost $24 plus $2
for wrapping. Marc may deduct a total of $25 for the two gifts to
Mr. and Mrs. Alford, and $26 for the gift to Ms. Bland. The $2 gift-
wrapping charge is not included as part of the $25 limitation on the
gift to Ms. Bland. N
Substantiation Requirement
To deduct entertainment expenses (discussed in Section 4.5) and business gifts, taxpayers
must be able to substantiate the deduction. The four items that must be subs tantiated to
deduct entertainment expenses and gifts are the:
Self-Study Problem 4.8
Steve and Beverly are married and have adjusted gross income of $32,000. Bev-
erly is a registered nurse, and in 2010 she spent $225 on uniforms and $150 on
white support hose. The laundry on the uniforms for the year was $75. Steve is
an installe r for the light company, and he wears regular work clothes that are
required by his employer. The work clothes cost Steve $400 during the year.
Also, Steve must wear safety shoes on the job that cost $120 this year, and he
purchased pole-climbing equipment, spikes, and a safety belt that cost $275.
If Steve and Beverly file a joint return this year, what is their deduction on
Schedule A for special clothing and uniforms, before considering the limitation
on miscellaneous deductions?
$ ____________
4-18 Chapter 4
Business Income and Expenses, Part II
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.