Wednesday, January 16, 2013

Uniform Capitalization UNICAP § 263A

 What are the Uniform Capitalization UNICAP § 263A Rules?

The UNICAP rules deny taxpayers immediate deduction for costs of producing property that taxpayer will use in its business or sell as inventory.  Costs that must be capitalized (or added to the cost of inventory) include depreciation on equipment used in producing the property, employee’s wages allocable to production of the property, and an appropriate share of the rent and utilities expenses of the facility where property is produced. § 263A is for tangibles. This better matches expenses other related income and avoid un-wanted deferral of taxes by IRS.

If § 263A applies to property, they the must apply direct and indirect costs allocated to the property. A taxpayer cannot capitalize a cost if it would not be otherwise deductible. Same limitations in other deduction rules apply, for example the entertainment 50% limitation.

Direct v. Indirect Costs under UNICAP rules and Section 263A

Direct Costs = Materials and labor directly attributable to some specific property produced are CAPITALIZED.

Indirect Costs = ALWAYS HAVE TO CAPITALIZE. Includes rent, utilities, insurance, an indirect labor costs, compensation that can’t be attributed, quality control and inspection, certain taxes on production facilities, costs of soliciting contracts to make property, hazardous waste costs, and storage costs.

Costs that are never capitalized – Selling and distribution expenses, overall management costs, research and development, deductible losses (§ 165), income taxes, product liability insurance, and strike costs. Even if they are arguable attributable to creating or buying some piece of tangible property.

Mixed- Service Costs – They are indirect business admin costs. Much in the same way that the regulations dictate that they must allocate indirect costs. They say that mixed service costs, some of them to pieces of property and deduct others. Statutory Formula.

How much do these costs directly benefit the making or buying of tangible property and how much do they not? Then split up. Split between deductibility.  Personnel, Payroll departments, Security Departments.

Qualified Creative Exceptions. § 263A(h) – includes a personal efforts requirement, but does not mean that the taxpayer has to physically create the art in question. THINK ARTISTS.  If they are doing something, it probably qualifiedunder 263A(h)- Not performing detailed design work, then does not qualify because he not exerting effort.

Section 162 Reasonable Compensation

What does the IRS consider reasonable compensation?

§ 162(a)(1) allows for “a reasonable allowance for salaries or other compensation for personal services actually rendered.”

This section often comes into play because the double taxation of corporations. If the officers and executives of a corporation are substantially identical with its major shareholders, a temptation may arise to distribute some of the earnings of the corporation under the label of additional compensation for services, rather than under the dividend label to save on taxes.

The reduction in dividend tax lessens that tax advantage of compensation over dividends, but in many situations a significant tax advantage for compensation remains. There are several exception for performance related compensation. However, what is reasonable compensation for the IRS is subject to lots of debate between the taxpayer and IRS on audit.

To find what is reasonable compensation, look at the market return. If investors are obtaining a high rate of return, executives should be compensated. Courts approach it many different ways. No indication how any of the factors should be weighed. Courts are not human resource departments. The test is unpredictable and leads to arbitrary conclusion.

No Super Personnel Department for Closely Held Corporation. The primary purpose of § 162(a)(1), which is to prevent dividends (or in some cases gifts), which are not deductible from corporate income, from being disguised as salary, which is. The IRS limits the amount of salary that a corporation can deduct from its income primarily in order to prevent the corporation from eluding the corporate income tax by paying dividends but calling them salary because salary is deductible and dividends are not.

Unreasonable compensation cases with can get very sticky. This is a lot like valuation, and courts rely heavily on expert testimony. How do you figure out if the compensation is reasonable? The IRS can really go after companies for unreasonable compensation and appeals might be necessary.

Tuesday, January 15, 2013

Rev. Rul. 92-80 Advertising Costs

How does INDOPCO ruling affect the treatment of advertising costs as business expenses, which were generally deductible under § 162?


INDOPCO does not affect the treatment of advertising costs under § 162. These costs are generally deductible under that section even though advertising may have some future effect on business activities, as in the case of institutional or goodwill advertising. Maintain good image with public.

Taxpayers can immediately deduct promotional material that is given out to potential customers. Same thing for package design. However, trademarks are capital costs. Remember to capitalize the cost of the trademark. Deduct the package design but capitalize the facilitation of hiring the lawyer for the trademark.  EVEN PAYING FOR MARKETING STRATEGY IS DEDUCTION.

Only in the unusual circumstance where advertising is directed towards obtaining future benefits significantly beyond those traditionally associated with ordinary product advertising or institutional goodwill advertising, must costs of that advertising me capitalized. What are benefits beyond advertising?

Advertising costs that create a separate and distinct asset must be capitalized. If there is ad campaign, but the only reason is to get admitted to a business organization. There is no other purpose but to create a separate and distinct asset. Make someone argument that you got something else.

Monday, January 14, 2013

IRS Trade or Business

What is the IRS definition of a Trade or Business?

Look at differences between a profit seeking activity and a trade or business. Harder to show than something was necessary and ordinary. TRADE=BUSINESS

TEST: To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, hobby, or amusement diversion does not qualify.

BROAD DEFINITION: Business is a very comprehensive term and embraces everything about which a person can be employed. In deciding whether an activity is a trade or business, courts need to examine the facts on a CASE-BY-CASE BASIS, looking into whether the taxpayer devoted his full-time efforts towards the activity on a regular, continuous, and substantial basis

Allowance of a deduction constitutes something of a congressional blessing, an indication that Congress regards the expenditure in question as worthy and appropriate for the taxpayer to do. A finding of “necessity” cannot be made, however, if allowance of the deduction would frustrate sharply defined national or state policies proscribing particular types of conduct, evidence by some governmental declaration thereof.

The test of non-deductibility always is the severity and immediacy of the frustration resulting from allowance of the deduction. The flexibility of such a standard is necessary if we are to accommodate both the congressional intent to tax only net income, and the presumption against congressional intent to encourage violation of declared public policy.

POLICY: § 162 business expense deduction should not encourage taxpayers to violate the law.

Personal Residence Deduction Requirements 163


Qualified Residence Income- Section 163- Itemized Deduction - Taxpayers are allowed to deduct most interest on mortgages that are secured by their personal residence. Very important politically because many people do it.

Personal Residence Deduction Requirements: § 163(h)(3)

FIRST, the number of personal residence is limited to two. § 163(h)(4)(A)(ii). Second home only qualifies if it used 15 days a year. Married couples may deduct one each.

SECOND, the home in question must secure the mortgage loan whose interest obligation the taxpayer seeks to deduct.

THIRD, the mortgage loan must be either “acquisition indebtedness” or “home equity indebtedness." Acquisition Debt is essentially a purchase-money mortgage, used either to buy or build the residence. 1,000,000 or 500,000. Home Equity Debt is any debt secured by a residence that is not acquisition indebtedness. $100,000 Cap. Equity=  FMV-Outstanding Mortgage

A taxpayer who has sufficient equity in the residence may borrow against that equity, use the proceeds for any purpose whatever, and still deduct the interest on the debt.

There is criticism about the vertical equity problem. The rich get more subsidy than the poor in this manner. Lots of people take this exemption. Maybe the Federal Government is losing too much REVENUE on the program.  Economic distortion problem. From the political perspective, lots of people bought their homes calculating their purchases with the interest deduction. All these rules apply to mobile homes.

Finally, the loan amounts generating deductible interest (but not directly the interest itself) are limited by dollar-level maximums: Interest with respect up to $1 millions of acquisition indebtedness can be deducted, as can interest with respect for up to $100,000 of home equity debt. These numbers have not been adjusted recently.

Saturday, January 12, 2013

Casualty Loss Deduction Section 165

Casualty Losses – Only Personal Loss Deduction Allowed

§ 165(a) – Losses incurred in a trade or business, or in activities engaged in for profits, are generally deductible. POLICY: The usual justification is that income tax should reach only the net income from business and profit-seeking activities, not gross receipts from those activities. 

§ 262(a) provides a general casualty loss rule that no deduction shall be allowed “for personal living, or family expenses” The tax rules disallowing for deductions for gradual loss in wealth in effect presume conclusively that the amount by which the value of an asset is diminished over time is itself the best measure of the consumption value enjoyed by the taxpayer over the same period.

§ 165(c)(3) will allow you to claim a casualty loss deduction.

Casualty Loss Requirements:

A deductible casualty loss has had to be a SUDDEN and somewhat dramatic event. § 165(c)(3) – FIRE, STORM, SHIPWRECK. OTHER CASUALTY, OR THEFT, SOMETHING SUDDEN

§ 165(h)(1) - Even if the property damage is a result of an acceptable sort of casualty, a casualty loss deduction is allowed only if and to the extent that the taxpayer’s loss exceeded $100.

§ 165(h)(2) which provides that the total amount of a taxpayer’s casualty losses for the year is deductible only to the extent is exceeds 10% of the taxpayer’s AGI in the same year. Sometimes specific exceptions to waive rules.

§ 165(h)(2)(B)- If the casualty gains exceed casualty losses, the gains are treated as capital gains and the losses are treated as capital losses.

Steps for Calculating the Deductions – Lesser of Adjusted Basis or Loss! 


  1. For each piece of property damaged, begin with FMV of the property before casualty.
  2. Subtract the value of the property after the casualty.
  3. Compare the result with the adjusted basis of the property, taking the lesser of the two numbers as the tentative casualty loss.
  4. Subtract the amount of any recoveries from tortfeasors or insurance coverage.
  5. Once that process is complete for each piece of property damaged in the casualty, the tentative casualty losses are added; and 
  6. Casualty gains if any, and statutory $100 deductible are subtracted for each casualty,
  7. If the taxpayer suffered more than one casualty, the steps above must be repeated for each piece of property in each additional casualty suffered. 
  8. Once the gains and loses from each casualty are computed, the taxpayer adds them together, then subtracts 10 percent of AGI. 1. That is the amount allowed for the deduction. 2. Check to see if this is bigger than the standard deduction.




Thursday, January 10, 2013

State and Local Tax Deduction

State and Local Tax Deductions 

History and Rationale of State and Local Tax Deduction - Best justified as a concession to Federalism. The Federal Government recognizes by this deduction that state and local governments have their own revenue needs. They can get money how they please. Consents to assess federal taxes only against the income that remains after state and local governments have exacted their assessments. POLICY: Equality issues if states provide different services and assess different kinds of taxes.

What Kind of State and Local Taxes are Deductible

Generally, § 164 provides that:
State and local income taxes, OR Sales tax , PICK ONE Real property taxes, and Personal property taxes are deductible, as are a few less general types of tax

For example: Interest imposed on real property, for the general public welfare. Then it is property tax and is deductible. Distinguish from fees that increase that value of the property assessed. Allows foreign taxes, this is controversial. Not a lot of wealth taxes, other countries do. What kinds of wealth taxes are deductible?

§ 164(b)(1) taxes must be on the value of something, not the weight or use for example. Presumably the idea is to allow deduction only of taxes imposed for a general-revenue raising purposes, rather than to recoup for externalities such as increased road costs due to the use of heavy vehicles

§ 164(c)(1) disallows deductions for assessments that tend to increase the value of the property assessed. For example, fees for new sidewalks or other improvements around a house that would increase its value for resale.f. What do we mean by tax: taxes and fees. There is a big distinction. Taxes are charges for primarily raising state revenue

NO FEES FOR USE or STATE PRIVILEGE! For example access to parks or a state university. These are not the type of state and local taxes that are deductible on a federal return. 

Tuesday, January 8, 2013

Ordinary and Necessary Business expenses

§ 162 says that deductions shall be allowable for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.An ordinary expense is one that is normally to be expected in view of the circumstances facing the business, and a “necessary” expense is one that is appropriate and helpful to the business.

Necessary means “appropriate and helpful” in the development of the taxpayer’s business. A requirement that a business show the absolute necessity of its expenses, in other words, would put the IRS in the position of reviewing every business decision to ensure that no money was spent unnecessarily.

Ordinary Expense-  The question of whether expenditure is “ordinary” has been more controversial in the development of the business deduction.  "Ordinary” means something that is “normal, usual, or customary” in the trade or business in which the taxpayer is engaged. Commonplace and used up in the course of a year. NOT CAPITAL EXPENSE.

The Principal function of the term “ordinary” is to clarify the distinction, often difficult, between those expenses that are currently deductible and those that are in the nature of capital expenditures, which, if deducible at all, must be amortized over the useful life of the asset.

There could be a public policy exception for some types of ordinary and necessary business expenses under § 162.

More Business Tax Information:

What are IRS Ordinary and Necessary Business Expenses

Popular Accounting Problems

The information on this site is for informational purposes only and should not be used as a substitute for the professional advice of an accountant, tax advisor, attorney, or other professional.