SOLUTIONS MANUAL - Chapter 1 Business Income, Deductions, and Acco...

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.1 Chapter 1 Business Income, Deductions, and Accounting Methods

SOLUTIONS MANUAL

Discussion Questions 1.[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.

2.[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.

3.[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.

4.[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.McGraw-Hill's Taxation of Business Entities 2024, 15e Brian Spilker, Ayers, Robinson, Outslay, Worsham, Barrick, Weaver (Solutions Manual All Chapters) Supplement files download link at the end of this file. 1 / 4

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

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 2

• [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?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 employee 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 2 / 4

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

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 3 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 $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 50 percent of the cost of meals as a business expense, the meals must be ordinary and necessary to Troy’s business, 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).

• [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 (65.5 cents per mile for 2023) 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 they may deduct only meals (50%), 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%), lodging, transportation, and incidental expenditures for the business portion of the trip. For international travel taking more than 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. 3 / 4

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

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 4 Finally, remember that travel days are considered business activity days for both domestic and international travel.

• [LO 2] Clyde lives and operates a sole proprietorship in Dallas, Texas. This year Clyde

found it necessary to travel to Fort Worth (about 25 miles away) for legitimate business reasons. Is Clyde’s trip likely to qualify as “away from home”? Why would this designation matter?Besides the cost of transportation, the deduction for travel expenses includes meals (50%), lodging, and incidental expenses. However, travel expenses are only deductible if the taxpayer is away from home overnight while traveling. For this purpose, a taxpayer is “away from home overnight” if the trip is of sufficient duration to require sleep or rest.It’s likely that Clyde’s trip will not satisfy this condition and that he will not be able to deduct costs for meals and lodging.

• [LO 2] Describe the record-keeping requirements for deducting business expenses,

including mixed-motive expenditures.Taxpayers must keep specific, written, contemporaneous records of time, amount of the expenditure, and business purpose of the travel. No deductions are allowed absent sufficient records to document business purpose. Records of the expenditure amount, however, may not be necessary if the taxpayer claims per diem amounts.

• [LO 2] Describe the computation of the limit placed on the business interest deduction. Is

the disallowed business interest ever deductible?The deduction of business interest expense is limited to the sum of business interest income plus 30 percent of the business's adjusted taxable income. Business interest is defined as any interest paid on debt allocable to a trade or business activity, and adjusted taxable income is taxable income allocable to the business activity computed before deductions for interest expense and net operating loss carryovers. Disallowed business interest can be carried forward indefinitely.

• [LO 2] Describe the gross receipts test and identify how this test relates to the business

interest deduction.The gross receipts test is an annual test designed to identify small businesses that Congress intended to exempt from some of the more complex and onerous provisions of the law, such as the business interest deduction. As the name implies, size is measured by whether average gross receipts exceeds a threshold amount, and businesses whose gross receipts do not exceed the threshold in any tax year are not subject to this limitation in that year. This amount was originally set at $25 million, but since it is indexed for inflation, the amount in 2023 is set at $29 million. The average gross receipts is determined using the previous three years of receipts (after subtracting sales returns and allowances). When the business has not been in existence for three prior tax years, the test is conducted using the years that it was in existence. Also, in the case of a taxable year of less than 12 months (a short year), the amount of gross receipts must be annualized by multiplying the gross

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