SOLUTIONS MANUAL - 14e Brian Spilker (All Chapters Download link a...

Solutions Manual for McGraw-Hill's Taxation of Business Entities 2023 Edition, 14e Brian Spilker (All Chapters Download link at the end of this file) 1 / 4

Solutions Manual—Taxation of Business Entities, by Spilker et al.

Chapter 1 Business Income, Deductions, and Accounting Methods

SOLUTIONS MANUAL

Discussion Questions

• [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 unusual 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.

• [LO 1] Explain how cost of goods is treated when a business sells inventory.

Under the return of capital principle, 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.

• [LO 1] Whether a business expense is “reasonable in amount” is often a difficult question.

Explain why determining reasonableness is difficult and describe a circumstance where reasonableness is likely to be questioned by the IRS.Reasonableness is an issue of fact and circumstance, and extravagance is difficult to determine because of the subjectivity and multitude of factors involved in determining price. 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.

• [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 of Jake’s dog food as unreasonable?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. Hence, the IRS is most likely to challenge the cost of the dog food if Jake’s relatives control or own the local pet food company and was benefiting from the increased price.

• [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 that are against public policy? 2 / 4

Solutions Manual—Taxation of Business Entities, by Spilker et al.

The Code 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.

• [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 tax-exempt income.Two common examples are interest expense associated with debt used to purchase municipal bonds and life insurance premiums paid on key man insurance. If this prohibition were repealed, then taxpayers would have an incentive to borrow to invest in municipal bonds or borrow to invest in employee life insurance. This former practice would lead to higher demand for municipal bonds (less yield) and less revenue for the government. The latter practice would lead to higher demand for insurance (higher premiums?) and less revenue for the government. Both practices could lead to a perception of inequity between those taxpayers able to utilize the tax arbitrage to reduce taxes and those who could not use the practice.

• [LO 2] {Research} Peggy is a rodeo clown, and this year she expended $1,000 on special

“funny” clothes and outfits. Peggy would like to deduct the cost of these clothes as work- related because she refuses to wear the clothes unless she is working. Under what circumstances can Peggy deduct the cost of her clown clothes?Taxpayers may deduct the cost of uniforms or special clothing they use in their business when the clothing is not appropriate to wear as ordinary clothing outside the place of business. In Peggy’s case, the clown clothes are analogous to special uniforms or protective garments and could be deductible. See D. Techner, TC Memo 1997-498. Erhard Seminar Training, TC Memo 1986-526 provides an example of clothes that were not deductible because they were appropriate for normal wear. However, the cost of clothing would not likely be deductible if the clothes were unacceptable solely because of the taxpayer’s sense of fashion.

• [LO 2] Jimmy is a sole proprietor of a small dry-cleaning business. This month Jimmy

paid for his groceries by writing checks from the checking account dedicated to the dry- cleaning business. Why do you suppose Jimmy is using his business checking account rather than his personal checking account to pay for personal expenditures?Jimmy might be trying to reduce his bank charges by using one account for both personal and business expenditures, but he could also be trying to disguise personal expenditures as business expenses. By commingling business and personal expenditures, Jimmy will need to separate personal and business expenditures before claiming any business deductions.

• [LO 2] Troy operates an editorial service that often entertains prospective authors to

encourage them to use Troy's service. This year Troy paid $3,000 for the cost of meals and 3 / 4

Solutions Manual—Taxation of Business Entities, by Spilker et al.

$6,200 for the cost of entertaining authors. Describe the conditions under which Troy can deduct a portion of the cost of the meals as a business expense.To deduct 100 percent of the cost of meals as a business expense, the meals must be ordinary and necessary to Troy’s business, provided by a restaurant, and the amount must be reasonable under the circumstances. In addition, Troy or an employee must be present when the meal is furnished, and the meal must be furnished to an actual or potential business associate. Finally, the cost of the meals must be separately stated (by invoice) from the cost of the entertainment (the cost of the entertainment is not deductible). If the meals and beverages are not provided by a restaurant, then only 50 percent is deductible (assuming all of the other requirements are met).

• [LO 2] Susmita purchased a car this year and uses it for both business and personal

purposes. Susmita drove the car 11,000 miles on business trips and 9,000 miles for personal transportation. Describe how Susmita will determine the amount of deductible expenses associated with the auto.Because only the expense relating to business use is deductible, the taxpayer must allocate the expenses between the business and personal use portions. A common method of allocation is relative use. In this instance, Susmita would calculate the business portion based upon the ratio of business miles to total miles (11/20 or 55 percent). She would then deduct the costs of operating the vehicle for business purposes plus depreciation on the business portion (55 percent) of the vehicle’s tax basis. Alternatively, in lieu of deducting these costs, Susmita may elect to deduct a standard amount for each business mile she drives. The standard mileage rate (58.5 cents per mile for the first six months of 2022 and 62.6 cents for the final six months) represents the per-mile cost of operating an automobile (including depreciation or lease payments). Once Susmita has made this election, she must continue to use it throughout the life of the auto.

• [LO 1, LO 2] What expenses are deductible when a taxpayer combines both business and

personal activities on a trip? How do the rules for international travel differ from the rules for domestic travel?If the taxpayer has both business and personal motives for a trip, but the primary or dominant motive is business, the taxpayer may deduct the transportation costs to get to the place of business, but she may deduct only meals (50% or 100% if provided by a restaurant), lodging, transportation on site, and incidental expenditures for the business portion of the travel. If the taxpayer’s primary purpose for the trip is personal, the taxpayer may not deduct transportation costs to travel to and from the location, but the taxpayer may deduct meals (50% or 100% if provided by a restaurant), lodging, transportation, and incidental expenditures for the business portion of the trip. For international travel in excess of one week, the taxpayer must allocate the cost of the transportation between personal (nondeductible) and business (deductible) activities.Taxpayers generally determine the nondeductible portion of the transportation costs by multiplying the travel costs by a ratio of personal activity days to total days travelling.

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